Table of
Contents





UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q


(Mark
one)


þ
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the Quarterly Period Ended June 30, 2008





OR





o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the Transition Period From ___ to ___





Commission
File Number 0-51344













DESERT
      CAPITAL REIT, INC.(Exact
      Name of Registrant as specified in its charter)Maryland
            20-0495883(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)1291
      Galleria Drive, Suite 200, Henderson, NV 89014(Address
      of principal executive office)(Zip
      Code)Registrant's
      telephone number, including area code:  (800)
      419-2855




Indicate
by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.


Yes þ  No o





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


Large
      Accelerated Filer o
            Accelerated
      Filer oNon-Accelerated
      Filer þ (Do
      not check if a smaller reporting company)
            Smaller
      Reporting Company o




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act.)


Yes o No þ





The
number of shares of the registrant's common stock, par value $0.01 per share,
outstanding as of August 13, 2008 was 16,807,867.




Table of Contents





DESERT
CAPITAL REIT, INC.


FORM
10-Q


For
the Quarter Ended June 30, 2008




INDEX


PagePart
      I. Financial Information
            
            1Item
      1. Financial Statements
            
            1a) Consolidated Balance Sheets as
      of June 30, 2008(unaudited)and December 31,
      2007
            
            1b) Consolidated Statements of
      Operations(unaudited)for the three and six months
      ended June 30, 2008 and 2007
            
            2c) Consolidated Statements
      of Cash Flows(unaudited)for the six months ended
      June 30, 2008 and 2007
            
            3d) Consolidated Statements of
      Changes in Stockholders' Equity(unaudited)for the six months ended June
      30, 2008
            
            4e) Notes
      to Consolidated Financial Statements
(unaudited)
            
            5Item 2. Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
            
            16Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk
            
            24Item 4T. Controls and
      Procedures
            
            25Part II. Other
      Information
            
            25Item 1. Legal
      Proceedings
            
            25Item 1A. Risk
      Factors
            
            25Item 2. Unregistered Sales of
      Equity Securities and Use of Proceeds
            
            25Item 3. Defaults Upon Senior
      Securities
            
            26Item 4. Submission of Matters to
      a Vote of Security Holders
            
            26Item 5. Other
      Information
            
            26Item 6.
      Exhibits
            
            26Signatures
            
            27Certification of CEO Pursuant to Section
      302Certification of CFO Pursuant to Section
      302Certification of CEO and CFO Pursuant to Section
      906






Table of Contents




Part I.  Financial InformationItem 1. Consolidated Financial
    StatementsDESERT CAPITAL REIT, INC.Consolidated
      Balance SheetsJune
      30,
              
              
              December
      31,2008
              
              
              2007(unaudited)ASSETSMortgage
      investments - net of allowance for loan losses of $14,442,933 at June 30,
      2008and
      $25,444,130 at December 31, 2007
              
              $
              92,122,462
              
              
              $
              118,017,926Loans
      held for sale
              
              
              3,569,000
              
              
              
              2,139,200Real
      estate owned
              
              
              29,157,770
              
              
              
              15,652,282Equity
      investments in real estate
              
              
              2,462,895
              
              
              
              -Notes
      receivable from related party
              
              
              15,112,500
              
              
              
              15,500,000Building
      and equipment - net
              
              
              7,058,585
              
              
              
              7,235,939Land
              
              
              1,820,000
              
              
              
              1,820,000Cash
      and cash equivalents
              
              
              340,706
              
              
              
              162,753Restricted
      cash
              
              
              142,546
              
              
              
              -Interest
      receivable
              
              
              999,309
              
              
              
              1,464,261Deferred
      financing costs
              
              
              957,915
              
              
              
              975,043Other
      investments
              
              
              1,928,000
              
              
              
              1,928,000Other
      assets
              
              
              809,833
              
              
              
              818,715Total
      assets
              
              $
              156,481,521
              
              
              $
              165,714,119LIABILITIES
      AND STOCKHOLDERS' EQUITYCredit
      facility
              
              $
              3,569,000
              
              
              $
              2,139,200Mortgage
      payable
              
              
              8,012,475
              
              
              
              8,132,769Junior
      subordinated notes payable
              
              
              30,928,000
              
              
              
              30,928,000Dividends
      payable
              
              
              428,862
              
              
              
              1,675,814Deferred
      income taxes
              
              
              684,138
              
              
              
              738,423Accounts
      payable and accrued expenses
              
              
              1,514,403
              
              
              
              1,052,637Total
      liabilities
              
              
              45,136,878
              
              
              
              44,666,843Preferred
      stock, $0.01 par value: 15,000,000 shares authorized, none
      outstanding
              
              
              -
              
              
              
              -Common
      stock, $0.01 par value: 100,000,000 shares authorized; 16,807,867 and
      16,724,549shares
      issued and outstanding on June 30, 2008, and December 31, 2007,
      respectively
              
              
              168,079
              
              
              
              167,246Additional
      paid-in capital
              
              
              165,538,010
              
              
              
              164,370,179Accumulated
      deficit
              
              
              (54,361,446
              )
              
              
              (43,490,149
              )Total
      stockholders' equity
              
              
              111,344,643
              
              
              
              121,047,276Total
      liabilities and stockholders' equity
              
              $
              156,481,521
              
              
              $
              165,714,119The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
 
  1
 Table of Contents
  DESERT CAPITAL REIT, INC.Consolidated
      Statements of Operations(unaudited)Three
      Months Ended June 30,
              
              
              Six
      Months Ended June 30,2008
              
              
              2007
              
              
              2008
              
              
              2007INTEREST
      INCOME:Mortgage
      investments
              
              $
              1,785,772
              
              
              $
              5,507,878
              
              
              $
              4,001,859
              
              
              $
              11,078,756Other
      interest
              
              
              491,902
              
              
              
              168,762
              
              
              
              1,040,050
              
              
              
              308,167Total
      interest income
              
              
              2,277,674
              
              
              
              5,676,640
              
              
              
              5,041,909
              
              
              
              11,386,923Interest
      expense
              
              
              841,601
              
              
              
              1,017,921
              
              
              
              1,695,304
              
              
              
              2,010,903Net
      interest income
              
              
              1,436,073
              
              
              
              4,658,719
              
              
              
              3,346,605
              
              
              
              9,376,020Provision
      for loan losses
              
              
              5,356,108
              
              
              
              108,949
              
              
              
              5,667,096
              
              
              
              213,351Net
      interest income after provision for loan loss
              
              
              (3,920,035
              )
              
              
              4,549,770
              
              
              
              (2,320,491
              )
              
              
              9,162,669NON-INTEREST
      INCOME:Loan
      brokerage fees
              
              
              -
              
              
              
              2,898,856
              
              
              
              -
              
              
              
              4,473,569Service
      and other loan fees
              
              
              -
              
              
              
              339,193
              
              
              
              -
              
              
              
              786,029Other
              
              
              246,622
              
              
              
              245,836
              
              
              
              622,468
              
              
              
              452,243Total
      non-interest income
              
              
              246,622
              
              
              
              3,483,885
              
              
              
              622,468
              
              
              
              5,711,841NON-INTEREST
      EXPENSE:Impairment
      of real estate owned
              
              
              2,805,749
              
              
              
              -
              
              
              
              2,806,806
              
              
              
              -Compensation
              
              
              -
              
              
              
              513,142
              
              
              
              -
              
              
              
              1,016,767Management
      fees
              
              
              423,613
              
              
              
              1,501,621
              
              
              
              845,873
              
              
              
              2,780,163Professional
      fees
              
              
              501,663
              
              
              
              597,208
              
              
              
              789,736
              
              
              
              877,345Insurance
              
              
              172,013
              
              
              
              99,950
              
              
              
              285,021
              
              
              
              207,289Depreciation
              
              
              122,586
              
              
              
              195,641
              
              
              
              242,310
              
              
              
              391,282Advertising
              
              
              -
              
              
              
              193,232
              
              
              
              148
              
              
              
              340,860Other
              
              
              290,101
              
              
              
              455,664
              
              
              
              558,434
              
              
              
              767,079Total
      non-interest expense
              
              
              4,315,725
              
              
              
              3,556,458
              
              
              
              5,528,328
              
              
              
              6,380,785Net
      income before taxes
              
              
              (7,989,138
              )
              
              
              4,477,197
              
              
              
              (7,226,351
              )
              
              
              8,493,725Income
      tax expense (benefit)
              
              
              (87,460
              )
              
              
              127,011
              
              
              
              (130,565
              )
              
              
              197,188Net
      income
              
              $
              (7,901,678
              )
              
              $
              4,350,186
              
              
              $
              (7,095,786
              )
              
              $
              8,296,537Earnings
      per share - basic
              
              $
              (0.47
              )
              
              $
              0.27
              
              
              $
              (0.42
              )
              
              $
              0.53Earnings
      per share - diluted
              
              $
              (0.47
              )
              
              $
              0.27
              
              
              $
              (0.42
              )
              
              $
              0.53Weighted
      average outstanding shares - basic
              
              
              16,807,867
              
              
              
              16,127,702
              
              
              
              16,795,296
              
              
              
              15,722,839Weighted
      average outstanding shares - diluted
              
              
              16,807,867
              
              
              
              16,154,387
              
              
              
              16,795,296
              
              
              
              15,752,839The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
 
  2
 Table of Contents
  DESERT CAPITAL REIT, INC.Consolidated
      Statements of Cash Flows(unaudited)Six
      Months Ended June 30,2008
              
              
              2007OPERATING
      ACTIVITIESNet
      income
              
              $
              (7,095,786
              )
              
              $
              8,296,537Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
              
              
              259,438
              
              
              
              408,411Stock
      based compensation
              
              
              -
              
              
              
              116,667Provision
      for loan losses
              
              
              5,667,096
              
              
              
              213,351Impairment
      of real estate owned
              
              
              2,806,806
              
              
              
              -Deferred
      tax benefit
              
              
              (54,285
              )
              
              
              -Mortgage
      loans originated for sale
              
              
              (6,332,000
              )
              
              
              (27,303,050
              )Mortgage
      loan sales
              
              
              4,902,200
              
              
              
              28,820,400Net
      change in:Interest
      receivable
              
              
              464,952
              
              
              
              40,202Other
      assets
              
              
              8,882
              
              
              
              (2,158
              )Deferred
      origination fees
              
              
              -
              
              
              
              130,576Accounts
      payable
              
              
              139,401
              
              
              
              (989,902
              )Net
      cash provided by operating activities
              
              
              766,704
              
              
              
              9,731,034INVESTING
      ACTIVITIESInvestment
      in real estate mortgages
              
              
              (8,200,894
              )
              
              
              (54,881,265
              )Proceeds
      from repayment/sale of real estate mortgages
              
              
              9,936,239
              
              
              
              37,644,451Proceeds
      from repayment of note receivable from related party
              
              
              387,500
              
              
              
              -Other
      investments
              
              
              -
              
              
              
              (1,000,000
              )Acquisition
      of building and equipment
              
              
              (64,956
              )
              
              
              (90,624
              )Net
      cash provided by (used in) investing activities
              
              
              2,057,889
              
              
              
              (18,327,438
              )FINANCING
      ACTIVITIESNet
      borrowings on credit facility
              
              
              1,429,800
              
              
              
              (1,517,350
              )Restricted
      cash
              
              
              (142,546
              )
              
              
              -Principal
      repayments of mortgage loans
              
              
              (120,294
              )
              
              
              (35,187
              )Issuance
      of common stock
              
              
              382,508
              
              
              
              20,339,129Dividends
      on common stock
              
              
              (4,155,566
              )
              
              
              (6,812,949
              )Offering
      costs paid
              
              
              (40,542
              )
              
              
              (2,058,883
              )Shares
      redeemed and retired
              
              
              -
              
              
              
              (1,152,704
              )Net
      cash provided by (used in) financing activities
              
              
              (2,646,640
              )
              
              
              8,762,056Net
      increase in cash and cash equivalents
              
              
              177,953
              
              
              
              165,652Cash
      and cash equivalents at beginning of period
              
              
              162,753
              
              
              
              2,434,948Cash
      and cash equivalents at end of period
              
              $
              340,706
              
              
              $
              2,600,600Supplemental
      disclosures of cash flow information:Cash
      paid for interest
              
              $
              1,790,808
              
              
              $
              1,960,111Cash
      paid for taxes
              
              
              -
              
              
              
              250,000Supplemental
      schedule of non-cash investing and financing:Common
      stock issued for dividend reinvestment program
              
              $
              866,897
              
              
              $
              2,494,734Common
      stock dividends declared but not paid
              
              
              428,862
              
              
              
              1,640,455Offering
      costs incurred but not paid
              
              
              53,005
              
              
              
              73,936Foreclosed
      real estate acquired in exchange for loans
              
              
              18,775,189
              
              
              
              16,576,275Real
      estate assets owned contributed to equity investments in real
      estate
              
              
              2,462,895
              
              
              
              -The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
 
  3
 Table of Contents


DESERT CAPITAL REIT, INC.Consolidated
      Statements of Changes in Stockholders' Equity(unaudited)Common
      Stock
                Number of
      Shares
              
              
              
              Common
      Stock
                Par
    Value
              
              
              
              Additional
      Paid-in
                Capital
              
              
              
              Accumulated
      Deficit
              
              
              
              TotalBalance
      at December 31, 2007
              16,724,549
              
              
              $
              167,246
              
              
              $
              164,370,179
              
              
              $
              (43,490,149)
              
              
              $
              121,047,276Issuance
      of common stock
              83,318
              
              
              
              833
              
              
              
              1,248,572
              
              
              
              -
              
              
              
              1,249,405Dividends
      on common stock
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (3,775,511)
              
              
              
              (3,775,511)Offering
      costs
              -
              
              
              
              -
              
              
              
              (80,741)
              
              
              
              -
              
              
              
              (80,741)Net
      income
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (7,095,786)
              
              
              
              (7,095,786)Balance
      at June 30, 2008
              16,807,867
              
              
              $
              168,079
              
              
              $
              165,538,010
              
              
              $
              (54,361,446)
              
              
              $
              111,344,643The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
  4
 Table of Contents





DesertCapital REIT, INC.


Condensed
Notes to Unaudited Consolidated Financial Statements


June
30, 2008





Note
1 – Organization





References
herein to “we,” “us,” “our” or “Company” refer to Desert Capital REIT, Inc. and
its subsidiaries unless the context specifically requires
otherwise.




We are a
Maryland corporation formed in December 2003 as a real estate investment trust
("REIT") that specializes in financing of short-term mortgage loans. We
generally invest in 12- to 18- month, first and second lien mortgage loans,
consisting of acquisition and development loans and construction loans to
developers and builders of residential and commercial property. We derive our
revenues primarily from interest payments received from mortgage investments
funded with our equity capital and borrowed funds. We generate net income for
distribution to our stockholders from the spread between interest income on our
mortgage investments, also referred to as loans, and the costs of financing the
acquisition of these investments. We also from time to time fund loans for
resale to private investors as short term investments that we generally hold for
less than 90 days.  While there are typically fees generated and
recognized upon funding, there are no gains or losses realized upon the
sale of these loans.  We generate a spread between the interest income
on the loans held for sale and the interest expense on any borrowings used
to finance the loans.  As we continue to foreclose on mortgage loans,
we have adjusted our portfolio strategy to include land ownership.





All of
our loan origination and loan servicing activities were conducted through
Consolidated Mortgage, LLC, (“Consolidated Mortgage”) which was our wholly-owned
subsidiary through November 2007 at which time it was sold to Sandstone Equity
Investors, LLC (“Sandstone” or “Advisor”), a related
party.  Consolidated Mortgage will continue to originate and service
loans for us.  We have a right of first refusal for the purchase of
all new loans originated by Consolidated
Mortgage.





We are
externally managed by Sandstone, which replaced Burton Management Company
(“Burton”) as our Advisor in November 2007 concurrently with the sale of
Consolidated Mortgage.  Sandstone’s management team consists of the
former management of Burton, which is also our management team.  See
Note 6 – Commitments and Related Parties.





We
qualified as a REIT under the Internal Revenue Code commencing with our taxable
year ended December 31, 2004 and expect to continue to qualify for the current
fiscal year. To maintain our tax status as a REIT, we plan to continue to
distribute at least 90% of our taxable income to stockholders.





Basis
of Presentation


The
accompanying unaudited consolidated interim financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements. The
accompanying unaudited consolidated interim financial statements should be read
in conjunction with the financial statements filed on Form 10-K/A and the
related management's discussion and analysis of financial condition and results
of operations filed on Form 10-K for the fiscal year ended December 31,
2007.  In our opinion, all adjustments (consisting only of normal
recurring accruals) considered necessary for a fair presentation have been
included.  The results of operations for the three and six months
ended June 30, 2008 are not necessarily indicative of results that may be
expected for the entire year ending December 31, 2008.





Note
2 - Summary of Significant Accounting Policies





Principles
of Consolidation


The
accompanying consolidated financial statements include our accounts and the
accounts of our wholly-owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.




Our
interest in Desert Capital TRS Statutory Trust I (the "Statutory Trust”), a
trust formed for the purpose of issuing trust preferred
securities,  is accounted for using the equity method and the assets
and liabilities are not consolidated into our financial statements due to our
determination that Desert Capital TRS Statutory Trust I is a variable interest
entity in which we are not the primary beneficiary under Financial Accounting
Standards Board (FASB) Interpretation No. 46R “Consolidation of Variable
Interest Entities – An Interpretation of ARB No. 51”(FIN
46R).   In addition we use the equity method to account for our
equity investments in real estate development ventures for which we have 50% or
less ownership and the ability to exercise significant influence over operating
and financial policies, but do not control. Consolidated net income includes our
proportionate share of the net income or net loss of these entities, which are
typically limited liability companies formed for the purpose of developing the
properties upon which we have foreclosed.


5
 Table of Contents


We use
the cost method to account for our investments in companies that we do not
control and for which we do not have the ability to exercise significant
influence over operating and financial policies. In accordance with the cost
method, these investments are recorded at cost or fair value, as
appropriate.





Reclassifications


Certain
reclassifications have been made in the investing activities section of the
consolidated statement of cash flow for the six months ended June 30, 2007
within the captions “Investment in real estate mortgages” and “Proceeds from
repayment/sale of real estate mortgages” to reflect gross receipts and payments
of mortgage investments.  Board of Directors’ compensation has been
reclassified from “Compensation” to “Other” in the non-interest expense section
of the statement of operations for the three and six months ended June 30,
2007.   These reclassifications were made to reflect such items
consistent with our 2008 presentation and had no impact on our cash flow from
investing activities, net income, or balance sheet as previously
reported.





Revenue
Recognition


Interest
income on our mortgage investments is recognized over the life of the investment
and recorded on the accrual basis. Income recognition is suspended for mortgage
investments at the earlier of the date on which payments become 90 days past due
or when, in the opinion of management, a full recovery of income and principal
becomes doubtful. Income recognition is resumed when the loan becomes
contractually current and performance is demonstrated to be
resumed.





Fees
generated upon the funding of loans held for sale are recognized when the loan
is funded.  There are no gains or losses realized upon the sale of
loans held for sale.





Prior to
our sale of Consolidated Mortgage in November 2007, we recognized revenues
related to the loan origination and loan servicing activities of Consolidated
Mortgage. Loan origination fees and certain direct origination costs associated
with mortgage investments that were funded by us, were deferred and recognized
as an adjustment to yield over the lives of the related loans using the
straight-line method. Loan brokerage fees generated by Consolidated Mortgage
were nonrefundable fees for brokering loans to third party investors. Loan
brokerage fees were recognized once the loans associated with the fees were
funded and recorded by the third party investors. Consolidated Mortgage also
charged fees, which were recorded as non-interest income, to service loans
brokered to third party investors, as well as other miscellaneous fees during
the loan term. These service and other loan fees were recognized throughout the
life of the loan as they were earned.





Real
Estate Owned


Real
estate owned consists of property acquired through foreclosures on mortgage
loans.  Our interests in real estate owned may be held directly by us,
or through limited liability companies.  In the case where we are one
of several investors in a larger loan, such loans are foreclosed upon using a
limited liability company to facilitate foreclosing our lender interest along
with private investors who hold the remaining loan balance and have similar
economic interests. We recorded real estate held directly or through limited
liability companies at the lower of the recorded amount of our related mortgage
loan being foreclosed (net of any impairment reserve), or our economic interest
in the property's estimated fair value, less estimated costs to sell, with fair
value based on appraisals and local market conditions.





On a
periodic basis, management assesses whether there are any indicators that the
fair value of our investments in real estate owned may be other than temporarily
impaired. An investment is considered impaired if the fair value of the
investment, as estimated by management, is less than the carrying value of the
investment. To the extent impairment has occurred, the loss shall be measured as
the excess of the carrying amount of the investment over the fair value of the
investment.




Equity
Investments in Real Estate


We have
contributed real estate assets acquired through foreclosure to operating joint
ventures with investors/developers who provide additional financing and
development expertise.




We
evaluate our investments in partially owned entities in accordance with
FIN 46R. We account for our investments in unconsolidated real estate
ventures under the equity method of accounting as we are not the primary
beneficiary for a “variable interest entity,” or a “VIE,” and we exercise
significant influence, but do not control these entities under the provisions of
the entities’ governing agreements pursuant to EITF 04-05. These investments are
recorded initially at cost or impaired value, as investments in real estate
entities, and subsequently adjusted for equity in earnings and cash
contributions and distributions in accordance with AICPA (American Institute of
Certified Public Accountants) Statement of Position No. 78-9, Accounting for
Investments in Real Estate Ventures.





On a
periodic basis, management assesses whether there are any indicators that the
fair value of our investments in equity investments in real estate may be other
than temporarily impaired. An investment is considered impaired if the fair
value of the investment, as estimated by management, is less than the carrying
value of the investment. To the extent impairment has occurred, the loss shall
be measured as the excess of the carrying amount of the investment over the fair
value of the investment.





6
 Table of Contents


Recent
Accounting Developments


In
December 2007, Financial Accounting Standards Board (“FASB”) issued SFAS No.
160, “Noncontrolling Interests in Consolidated Financial Statements – an
amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires that
ownership interests in subsidiaries held by parties other than the parent, and
the amount of consolidated net income, be clearly identified, labeled, and
presented in the consolidated financial statements within equity, but separate
from the parent’s equity. It also requires that once a subsidiary is
deconsolidated, any retained noncontrolling equity investment in the former
subsidiary be initially measured at fair value. Sufficient disclosures are
required to clearly identify and distinguish between the interests of the parent
and the interests of the noncontrolling owners.  In addition to the
amendments to ARB 51, this Statement amends SFAS No. 128 “Earnings per Share”;
so that earnings-per-share data will continue to be calculated the same way
those data were calculated before SFAS No. 160 was issued. SFAS No. 160 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008.  Earlier adoption is
prohibited.  SFAS No. 160 shall be applied prospectively as of the
beginning of the fiscal year in which SFAS No. 160 is initially applied, except
for the presentation and disclosure requirements.  The presentation
and disclosure requirements shall be applied retrospectively for all periods
presented.  SFAS No. 160 will be effective for us beginning January 1,
2009.  We have evaluated SFAS No. 160 and have determined that we have
not entered any business arrangements or corporate joint ventures that would
require the application of SFAS No. 160 for noncontrolling
interests.





In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS No.
141R”).  This Statement replaces SFAS No. 141.  SFAS No.
141R establishes principles and requirements for how the acquirer of a business
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree.  SFAS No. 141R also provides guidance for recognizing and
measuring the goodwill acquired in the business combination and determines what
information to disclose to enable users of the financial statements to evaluate
the nature and financial effects of the business combination.  This
Statement applies prospectively to business combinations for which the
acquisition date is on or after the beginning of the first annual reporting
period beginning on or after December 15, 2008.  We do not expect the
adoption of SFAS 141R to have a material impact on our Consolidated Financial
Statements.




In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and
Financial Liabilities.” SFAS 159 permits entities to choose to measure financial
assets and liabilities (except for those that are specifically scoped out of the
Statement) at fair value.  The election to measure a financial asset
or liability at fair value can be made on an instrument-by-instrument basis and
is irrevocable.  The difference between carrying value and fair value
at the election date is recorded as a transition adjustment to opening retained
earnings.  Subsequent changes in fair value are recognized in
earnings.  The Company may decide whether to elect the fair value
option for each eligible item on various defined election dates.  We
did not elect to report any financial assets or liabilities at fair value under
SFAS No. 159 on January 1, 2008.




In
September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair
value, establishes a framework for measuring fair value and expands disclosures
about fair value measurements.  SFAS 157 applies under other accounting
pronouncements that require or permit fair value measurements. Accordingly, SFAS
157 does not require any new fair value measurements. SFAS 157 is effective for
fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years.  This statement has modified the methodology for the
measurement of “Fair Value of Financial Instruments.” This change has had a
significant impact on the estimated fair value of our financial instruments as
of June 30, 2008.  See Note 14 - Fair Value of Financial
Instruments.





Note
3 - Mortgage Investments





Mortgage
investments represent first and second lien positions on acquisition and
development, construction and commercial property loans. As of June 30, 2008,
all of our loans had fixed interest rates and provided for payment of interest
only with a “balloon” payment of principal payable in full at the end of the
term.  Set forth below is the total outstanding principal amount of
our mortgage investments by category.





June
      30, 2008
            
            
            December
      31, 2007Acquisition
      and development loans
            
            $
            79,386,649
            
            
            $
            107,598,051Construction
      loans
            
            
            12,769,846
            
            
            
            17,665,105Commercial
      property
            
            
            14,408,900
            
            
            
            18,198,900Balance
      per loan portfolio
            
            
            106,565,395
            
            
            
            143,462,056Allowance
      for loan losses
            
            
            (14,442,933)
            
            
            
            (25,444,130)Mortgage
      investments - net
            
            $
            92,122,462
            
            
            $
            118,017,926





As of
June 30, 2008 and December 31, 2007, 15% and 22%, respectively, of the principal
balance of the outstanding mortgage notes were secured by second liens. As of
June 30, 2008 and December 31, 2007, the portfolio had a weighted average
contractual interest rate of 12.8% and 13.4%, respectively.





7
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Our
mortgage portfolio is primarily concentrated in the Southwestern United States.
As of June 30, 2008 and December 31, 2007, 83% and 87%, respectively, of the
principal balance of our portfolio was invested throughout Nevada, California,
and Arizona. Our borrowers’ ability to repay our notes is dependent upon the
real estate and general economic conditions in this area.





We have a
significant concentration of credit risk with our largest
borrowers.  At June 30, 2008, the aggregate original principal balance
of loans to our four largest borrowers was $50.2 million representing
approximately 47.1% of the original principal balance of our mortgage
investments and 54.5% of the carrying balance of our mortgage
investments.





As of
June 30, 2008, we had 49 loans in our portfolio from nine separate borrowers
that were on nonaccrual status.  The aggregate balance of these loans
was $97.0 million of which our portion was $58.0 million, with the remaining
balance being held by private investors.  We provided an allowance for
loan loss related to these nonperforming loans of $10.8 million, leaving a net
carrying balance of $47.3 million at June 30, 2008. Our balance on these loans
ranged from $2,800 to $9.5 million. Of the 49 loans, 45 were first lien loans
totaling $50.9 million and four were second lien loans totaling $7.1
million.  These loans are the subject of pending foreclosure
proceedings.





Nonperforming
and impaired loans


Details
on nonperforming and impaired loans and related allowances are as
follows:





June
      30, 2008Balance
            
            Allowance
      for
              loan
      losses
            
            Balance,
      net
              of
      allowanceNonperforming
      loans – no related allowance
            
            $
            18,864,905
            
            $
            -
            
            $
            18,864,905Nonperforming
      loans – related allowance
            
            
            39,152,990
            
            
            (10,760,641)
            
            
            28,392,349Subtotal
      nonperforming loans
            
            
            58,017,895
            
            
            (10,760,641)
            
            
            47,257,254Performing
      loans – no related allowance
            
            
            35,733,800
            
            
            
            
            
            35,733,800Performing
      loans – related allowance
            
            
            12,813,700
            
            
            (3,682,292)
            
            
            9,131,408Subtotal
      performing loans
            
            
            48,547,500
            
            
            (3,682,292)
            
            
            44,865,208Total
            
            $
            106,565,395
            
            $
            (14,442,933)
            
            $
            92,122,462





December
      31, 2007Balance
            
            Allowance
      for
              loan
      losses
            
            Balance,
      net
              of
      allowanceNonperforming
      loans – no related allowance
            
            $
            18,001,625
            
            $
            -
            
            $
            18,001,625Nonperforming
      loans – related allowance
            
            
            20,734,032
            
            
            (7,010,629)
            
            
            13,723,403Subtotal
      nonperforming loans
            
            
            38,735,657
            
            
            (7,010,629)
            
            
            31,725,028Performing
      loans – no related allowance
            
            
            62,378,668
            
            
            
            
            
            62,378,668Performing
      loans – related allowance
            
            
            42,347,731
            
            
            (18,433,501)
            
            
            23,914,230Subtotal
      performing loans
            
            
            104,726,399
            
            
            (18,433,501)
            
            
            86,292,898Total
            
            $
            143,462,056
            
            $
            (25,444,130)
            
            $
            118,017,926





During
the six month period ended June 30, 2008 we sold a mortgage loan for $2.7
million which had a carrying value of $2.7 million, net of an impairment of
$300,000 recorded in the fourth quarter of 2007.




Subsequent
to June 30, 2008, and prior to the issuance of this report, nonperforming loans
with a carrying value of $4.9 million were foreclosed and the collateral was
acquired. The original principal amount of these loans prior to allowance for
loan losses was $8.6 million.





Note
4 – Real Estate Owned





Real
estate owned consists of property acquired through foreclosures on mortgage
loans.  Our interests in real estate owned may be held directly by us,
or through limited liability companies.  In the case where we
are one of several investors in a larger loan, such loans are foreclosed
upon using a limited liability company to facilitate foreclosing our lender
interest along with private investors who hold the remaining loan balance and
have similar economic interests.   At June 30, 2008, we held real
estate through 13 limited liability companies, and our ownership percentage
ranged from 12.4% to 100%. We recorded real estate held directly or through
limited liability companies at the lower of the recorded amount of our related
mortgage loan being foreclosed (net of any impairment reserve), or our economic
interest in the property's estimated fair value, less estimated costs to sell,
with fair value based on appraisals and local market conditions.





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During
the six months ended June 30, 2008, we foreclosed on properties with an
aggregate original loan balance of $34.9 million, net of related allowance for
loan loss of $16.4, and additional capitalized costs of $273,000.  We
did not dispose of any real estate owned through sale during the six month
period ending June 30, 2008. During March 2008 we contributed 44 lots valued at
$2.5 million to a joint venture in which we have a 50% noncontrolling ownership
interest.  (See Note 5 - Equity Investments in Real
Estate.)





At June
30, 2008 and December 31, 2007, we had a net carrying balance in real estate
owned of $29.2 million and $15.7 million, respectively.  The following
summary provides an analysis of the changes in real estate owned during the six
months ended June 30, 2008:





Real
      Estate OwnedBalance
      December 31, 2007
            
            $
            15,652,282Foreclosures
            
            
            18,775,189Impairments
            
            
            (2,806,806
            )Real
      estate contributed as equity in joint ventures
            
            
            (2,462,895
            )Balance
      June 30, 2008
            
            $
            29,157,770





Following
is a summary of real estate owned as of June 30, 2008 and December 31,
2007:





Description
            
            Location
            
            June 30, 2008
            
            December 31, 2007Undeveloped
      land
            
            AZ,
      CA, NV
            
            $
            21,139,141
            
            $
            6,960,794Single
      family residential lots
            
            AZ,
      NV
            
            
            2,801,142
            
            
            5,595,927Office
      building
            
            NV,
      TX
            
            
            4,303,707
            
            
            2,190,204Other
            
            NV
            
            
            913,780
            
            
            905,357$
            29,157,770
            
            $
            15,652,282





Note
5 – Equity Investments in Real Estate





In March
2008, we formed a joint venture with a homebuilder for the construction of 44
single family homes in Las Vegas, Nevada. We contributed 44 lots to the joint
venture, which we had previously acquired through foreclosure and classified as
real estate owned. This venture is accounted for under the equity method of
accounting because we have a 50% noncontrolling ownership
interest.  Our venture partner manages the operations of the joint
venture. All major decisions require the approval of both joint venturers, and
voting rights and the sharing of profits and losses are in proportion to the
ownership percentages of each joint venture partner. We recorded our initial
investment at $2.5 million, the carrying value of the lots, and we will record
our net equity in income and cash contributions and distributions.  There
were no reportable operations for the three and six months ending June 30,
2008.  We have no responsibility to provide additional funding to the
venture. Additional funding for the construction of homes and sales of such will
be provided by our venture partner.  Our share of losses, if any,
would be limited to the value of lots contributed.




Note
6 - Commitments and Related Parties





Sandstone
is our Advisor and oversees our day-to-day operations including asset,
liability and capital management. In lieu of paying salaries to officers, we
compensate our Advisor pursuant to an advisory agreement that entitles it to
first-tier management compensation, second-tier management compensation, and
reimbursement of expenses. Our current advisor, Sandstone, replaced Burton in
November 2007 in conjunction with the sale of Consolidated Mortgage. The
officers and majority owners of our Advisor are also our executive officers. The
annual first-tier management compensation is 1% of the first $200 million of
gross average invested assets plus 0.8% of the gross average invested assets in
excess of $200 million, to be paid quarterly. The first-tier management
compensation payable under our current advisory agreement with Sandstone is
calculated in the same manner as the base management fee payable under our prior
advisory agreement with Burton.  The base management fees for the
three and six months ended June 30, 2008 were $424,000 and $846,000,
respectively, compared to $402,000 and $781,000, respectively for the same
periods in 2007.  At June 30, 2008, $424,000 of compensation due to
our Advisor was included in accounts payable and accrued expense in the
consolidated balance sheet. The second-tier management compensation is a tiered
percentage of the amount of our net income (taxable income) excluding provision
for loan loss and capital losses, before deducting second-tier compensation less
a threshold return, which is the net income that would produce an annualized
return on our average invested assets equal to the 10-year U.S. Treasury
rate plus 1.0%. The tiered percentage is the weighted average of 20% of the
first $200 million of average invested assets and 10% of the excess over $200
million of average invested assets. The second-tier management compensation is
calculated quarterly and any positive quarterly amount is paid by us, along with
the first-tier management compensation, within 15 days of receipt of the
computations. Second-tier management compensation payable under our current
advisory agreement with Sandstone is calculated in the same manner as the
incentive compensation payable under our prior advisory agreement with
Burton.  Second-tier management compensation for the three and six
months ended June 30, 2008 was zero, compared to $298,000 and $686,000,
respectively for the same periods in 2007.





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Consolidated
Mortgage previously had a management agreement in place with ARJ Management
(“ARJ”), a company of which our president and chief executive officer, Todd
Parriott, is president, director and controlling shareholder, pursuant to
which ARJ was paid a management fee equal to 33% of Consolidated Mortgage's
pre-tax net income. The fee was calculated and paid monthly. The management
agreement with ARJ was mutually terminated by the parties thereto as of November
21, 2007 in connection with the sale of Consolidated Mortgage.  The
management fee for the three and six months ended June 30, 2007 was $802,000 and
$1.3 million, respectively.





The
dealer-manager of our offering of common stock, CMC Financial Services, Inc.
(“CMCFS”), directs and oversees the sale of our equity securities. CMCFS
receives a marketing support fee and sales commissions based on the number of
shares of common stock it sells. CMCFS contracts with third party broker-dealers
to have a larger sales distribution of equity securities and compensates them
out of the sales commissions and marketing support fees it receives from us.
Because Sandstone owns CMCFS, it is our affiliate. CMCFS earned gross sales
commissions and marketing support fees for the three and six months ended June
30, 2008 of zero and $36,000, respectively, compared to $1.0 million and $1.9
million, respectively for the same periods in 2007. There was no amount
payable on June 30, 2008 for the gross sales commissions and marketing support
fees.  CMCFS paid a substantial portion of these fees to third party
broker dealers.  Sandstone acquired ownership of CMCFS on November 21,
2007.  Our Board of Directors suspended the sale of Desert Capital
REIT shares as of February 22, 2008.  This decision was made in
anticipation of the expiration of the offering, which would not allow sales of
shares to occur after March 22, 2008 pursuant to the
Prospectus.





CMCFS
also has an agreement with Consolidated Mortgage to provide investors for loans
brokered and serviced by Consolidated Mortgage for a fee equal to 25 basis
points of every dollar raised. The fee was calculated and paid
monthly.  We sold Consolidated Mortgage in November 2007 and are no
longer a party to this agreement.  The fee pursuant to this agreement
for the three and six months ended June 30, 2007 was $171,000 and
$256,000.




In
September 2005, a third-party borrower asked us to enter into a land banking
transaction, meaning that we would purchase a tract of land, and simultaneously
enter into an option contract with the borrower, pursuant to which the borrower
would purchase smaller parcels of the initial tract from us over time at a
specified price, until it had purchased the entire initial tract.  Due
to the rules with which we must comply to maintain our REIT status, actual title
to that land had to be owned by a separate entity and could not be held by the
Company.  As an accommodation to us and the third-party borrower, our
chairman and chief executive officer, Todd Parriott and co-chief operating
officer, Jonathan Arens formed a company, CM Land, LLC, for the specific purpose
of holding title to that land.  We funded $11.9 million of loans to CM
Land, LLC secured by the property.  We earned interest on loans made
to CM Land of $320,000 and 826,000 for the three and six months ended June 30,
2007.  In May 2007, the borrower did not exercise its option under the
contract to purchase the remaining portion of the land.  As a result,
we took title to the property directly. During the second quarter of 2008, based
upon declines in value of the underlying collateral, we recorded an impairment
of $254,000, bringing the total impairment to $5.2 million, resulting in a
carrying balance of $6.7 million, which is included in real estate
owned.




CM
Equity, LLC (“CM Equity”) was formed in June 2007 for the purpose of investing
in, developing, co-developing, operating, owning and financing commercial and
residential real estate projects. Some of the executive officers of CM
Equity are the same as our executive officers, and our Advisor is also the
manager of CM Equity.  In November 2007, we sold a nonperforming loan
with an outstanding balance of $1.95 million to CM Equity.   We
provided 100% financing on the sale.  The loan bears a fixed interest
rate of 8.25% and matures in November 2009.  No gain or loss was
recognized on the sale. We earned interest of $40,000 and $80,000 respectively
for the three and six months ended June 30, 2008, all of which has been paid
subsequent to the balance sheet date.





In
November 2007, our subsidiary, Desert Capital TRS, Inc. (“TRS”) sold all of
the issued and outstanding units of Consolidated Mortgage to Sandstone, for the
following consideration:





·
            293,001
      shares of our common stock with a value of $4.4 million based on the
      last offering of its common stock at a per share price of $15 per
      share.  We subsequently retired the 293,001 shares of
      stock.


·
            $105,000
      in cash.


·
            A
      $15.5 million promissory note payable by Consolidated Mortgage to the
      order of TRS.  The note bears interest at 9.0% per
      annum.  Principal and interest payments are due quarterly
      beginning on March 31, 2008.  The note matures in December
      2017.  The note is secured by all of the outstanding membership
      units of Consolidated Mortgage.  We earned interest of $344,000
      and $697,000 for the three and six months ended June 30,
      2008.  All payments have been made according to the terms of the
      promissory note.





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In
addition to the consideration received, we will receive a contingent
installment payment from Consolidated Mortgage on loans we fund in the future.
The $8.25 million contingent payment (the “Installment Payment”) is
payable  as follows: Sandstone will pay or cause Consolidated Mortgage
to pay to TRS, on the last day of each calendar quarter, an amount equal to: (i)
1% of the principal amount of all mortgage loans originated or brokered by
Consolidated Mortgage or any of its affiliates and funded by us during such
calendar quarter for the first $200 million of mortgage loans funded during each
calendar year; and (ii) 0.5% of the principal amount of all mortgage loans
originated or brokered by Consolidated Mortgage and funded by us during such
calendar quarter in excess of $200 million during each calendar year, commencing
on December 31, 2007 and continuing on the last day of each calendar quarter
thereafter, until TRS has received $8.25 million.  TRS’ right to
receive the Installment Payment is secured by all of the outstanding membership
units of Consolidated Mortgage.   For the three and six month
period ending June 30, 2008, we recognized income of $3,000 and $134,000
respectively, related to the contingent installment payment, of which $63,000
remained unpaid at June 30, 2008.





We also
entered into a loan origination agreement with Consolidated Mortgage and
Sandstone, which terminates one month after the last day of the month in which
the Installment Payment is paid in full.   During the term of the
Loan Origination Agreement we will have the right to fund all mortgage loans
identified by Consolidated Mortgage or any affiliate of Sandstone or
Consolidated Mortgage that becomes engaged in the business of originating or
brokering commercial loans. During the six months ended June 30, 2008, we funded
$13.8 million of loans originated by Consolidated
Mortgage.




Consolidated
Mortgage was not in compliance with certain financial covenants contained
in the $15.5 million promissory note payable to TRS at December 31,
2007, March 31, 2008 and June 30, 2008.  Our board of directors has
formed a special committee of independent directors to review the financial
covenants and approve a strategy to resolve the defaulted status of the
loan.  Subsequent to June 30, 2008, the special committee has granted
Consolidated Mortgage a limited waiver until October 10, 2008 either to enter
into an amendment to the loan agreement to modify such financial covenants upon
terms and conditions and in form and substance satisfactory to TRS or
demonstrate that Consolidated Mortgage is in compliance with the loan agreement
and will be in compliance with the loan agreement at December 31,
2008.  Consolidated Mortgage has timely made all principal and
interest payments due under the promissory note, and we do not believe the
promissory note is impaired.


We lease
office space to Sandstone, CMCFS, Consolidated Mortgage, and Residential Capital
Mortgage (an entity owned by certain of our officers) under noncancelable
operating leases which expire in July 2010.  For the three and six
months ended June 30, 2008 we recognized $138,000 and $275,000 of related party
rental income compared to $80,000 and $161,000, respectively for the same period
in 2007.




Note
7 – Other Investments





As of
June 30, 2008 and December 31, 2007 we had $1.9 million in other
investments.  Those investments consisted of the
following;




·
              In
      March 2007, we invested $1.0 million, representing equity and profits
      interest of 1.5%, in the development of a resort community near Lincoln
      City, Oregon.  This investment is being accounted for under the cost
      method.
 ·
              In
      June 2006, we invested $928,000 for 100% of the common shares of an
      affiliate entity which was formed to facilitate the issuance of $30.9
      million of junior subordinate notes.
                This entity pays dividends on both the common
      shares and preferred securities on a quarterly basis at a variable rate
      based on LIBOR.


Note
8 - Stock Based Compensation





Our Board
of Directors has adopted the 2004 Stock Incentive Plan of Desert Capital REIT,
Inc. (the “Plan”). Our directors, officers or any affiliate, and individual
consultants or advisors are eligible for stock based compensation under the
Plan. We have authorized 1,000,000 shares of common stock under the Plan. As
of June 30, 2008 we had granted awards for 80,000 restricted shares under
the Plan. The fair value of the shares on the grant dates were $10 and $15 per
share.  All shares of restricted stock were fully vested as of
December 31, 2007.  Restricted stock expense for the three and six
months ended June 30, 2008 was zero, compared to $58,333 and $116,667
respectively for the same period in 2007.





11
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Note
9 - Building and Equipment





Building
and equipment as of June 30, 2008 and December 31, 2007 are as
follows:




June
      30, 2008
            
            December
      31, 2007Building
            
            $
            7,811,281
            
            $
            7,746,325Equipment
            
            
            7,527
            
            
            7,527Furniture
      and fixtures
            
            
            411,328
            
            
            411,328Software
            
            
            92,038
            
            
            92,038Cost
      basis
            
            
            8,322,174
            
            
            8,257,218Less
      accumulated depreciation
            
            
            (1,263,589
            )
            
            (1,021,279Building
      and equipment, net
            
            $
            7,058,585
            
            $
            7,235,939




We own an
office building in Henderson, Nevada, which serves as our corporate
headquarters. The building is 40,000 square feet, and as of June 30, 2008, was
100% leased to related (62.5%) and third parties (37.5%) under noncancelable
leases, which expire in 2010.  See Note 6 – Commitments and Related
Parties.





Note
10 - Income taxes





We
elected to be taxed as a REIT, under Sections 856 through 860 of the Internal
Revenue Code, beginning with our taxable year ended December 31, 2004. To
qualify as a REIT, we must meet certain organizational and operational
requirements, including a requirement to distribute at least 90% of our ordinary
taxable income to stockholders. As a REIT, we generally are not subject to
federal income tax on taxable income that we distribute to our stockholders. If
we failed to qualify as a REIT in any taxable year, we would then be subject to
federal income taxes on our taxable income at regular corporate rates and we
would not be permitted to qualify for treatment as a REIT for federal income tax
purposes for four years following the year during which qualification was lost
unless the Internal Revenue Service granted us relief under certain statutory
provisions. Such an event could materially adversely affect our net income and
net cash available for distributions to stockholders. However, we intend to
continue to operate in the foreseeable future in such a manner so that we will
qualify as a REIT for federal income tax purposes.




Our
taxable REIT subsidiary  is subject to federal, state, and local taxes. For
the three and six months ended June 30, 2008 we recorded a tax benefit of
$87,000 and $131,000 respectively, compared to an income tax expense of $127,000
and $197,000 respectively for the same period in 2007, attributable to our
taxable REIT subsidiary. Our provision for income tax expense (benefit) was
calculated using an effective tax rate of 34% and was comprised of the following
components:





Three
      months ended June 30,
            
            Six
      months ended June 30,2008
            
            2007
            
            2008
            
            2007Current
      provision (benefit)
            $
            (48,849
            )
            
            $
            106,832
            
            
            $
            (76,280
            )
            
            $
            106,832Deferred
      provision (benefit)
            
            (38,611
            )
            
            
            20,179
            
            
            
            (54,285
            )
            
            
            90,356Total
      income tax provision (benefit)
            $
            (87,460
            )
            
            $
            127,011
            
            
            $
            (130,565
            )
            
            $
            197,188





Note
11 - Earnings per Share





Earnings
per share is computed in accordance with SFAS No. 128, Earnings per Share. Basic
earnings per share is calculated by dividing net income by the weighted average
number of shares of common stock outstanding during each period. Diluted
earnings per share is calculated by dividing net income by the weighted average
number of shares outstanding plus the additional dilutive effect of unvested
restricted stock during each period.  As of June 30, 2008, there were
no unvested shares outstanding under our stock incentive plan. As of June 30,
2007 there were 26,667 unvested shares outstanding under our stock incentive
plan.





The
following is a reconciliation of the denominator of the basic and diluted
earnings per share computations for the three and six months ended June 30, 2008
and 2007:




For the Three Months
      EndedJune 30, 2008
            
            
            June 30, 2007Basic
      and Diluted
            
            
            Basic
            
            
            DilutedNet
      income
            
            $
            (7,901,678)
            
            
            $
            4,350,186
            
            
            $
            4,350,186Weighted
      average number of common shares outstanding
            
            
            16,807,867
            
            
            
            16,127,702
            
            
            
            16,127,702Dilutive
      effect of unvested restricted shares
            
            
            -
            
            
            
            -
            
            
            
            26,685Total
      weighted average common shares outstanding
            
            
            16,807,867
            
            
            
            16,127,702
            
            
            
            16,154,387Earnings
      per common share
            
            $
            (0.47)
            
            
            $
            0.27
            
            
            $
            0.27






12
 Table of Contents




For
      theSixMonths
      EndedJune 30, 2008
            
            
            June 30, 2007Basic
      and Diluted
            
            
            Basic
            
            
            
            DilutedNet
      income
            
            $
            (7,095,786
            )
            
            $
            8,296,537
            
            
            $
            8,296,537Weighted
      average number of common shares outstanding
            
            
            16,795,296
            
            
            
            15,722,839
            
            
            
            15,722,839Dilutive
      effect of unvested restricted shares
            
            
            -
            
            
            
            -
            
            
            
            30,000Total
      weighted average common shares outstanding
            
            
            16,795,296
            
            
            
            15,722,839
            
            
            
            15,752,839Earnings
      per common share
            
            $
            (0.42
            )
            
            $
            0.53
            
            
            $
            0.53





Note
12 – Common Stock and Dividends





Our Board
of Directors declares dividends monthly to stockholders of record at the close
of business on the last day of each month.  The dividends are
generally paid on the 15th of the
following month. The following table lists the declaration dates and per share
amounts for the first six months of 2008 and 2007:




2008
            
            
            2007January
      31
            
            $
            0.100
            
            
            $
            0.100February
      29, and February 28 respectively
            
            
            0.025
            
            
            
            0.100March
      31
            
            
            0.025
            
            
            
            0.100April
      30
            
            
            0.025
            
            
            
            0.100May
      31
            
            
            0.025
            
            
            
            0.100June
      30
            
            
            0.025
            
            
            
            0.100Total
            
            $
            0.225
            
            
            $
            0.600




Note
13 - Debt





Credit
Facility


We have a
$7.5 million secured revolving credit facility with a term of one year
that expires February 22, 2009.  At June 30, 2008 and December
31, 2007, we had $3.6 million and $2.1 million outstanding, respectively. We
draw on the facility for short-term funding requirements. Amounts drawn under
this facility bear interest at an interest rate equal to the prime rate plus 75
basis points, with a floor of 7.0%, and must be repaid within 90
days.  Amounts drawn under this facility are secured by the
corresponding loan that is being funded by the advance. The interest rate on
this facility at June 30, 2008 was 7.0%. The principal amount of loans pledged
as collateral for this facility on June 30, 2008 was $20.9 million. The balance
outstanding at June 30, 2008, was originated in January 2008, and was not repaid
within the 90-day time period required by terms of the credit
facility.  The bank sent us a notice of default and granted us an
extension to September 16, 2008 to pay the outstanding principal balance in full
and waived default-rate interest during this time. We have agreed to pay
50% of principal repayments on our mortgage investments and sales of real estate
owned to the bank to satisfy the outstanding principal balance of the
facility.  Any future advances on the credit facility are at the sole
discretion of the bank.





Mortgage
Loans Payable


We have a
mortgage loan payable to a bank, with an outstanding principal balance of $6.4
million and $6.5 million as of June 30, 2008 and December 31, 2007,
respectively.  This loan bears interest at a rate equal to the prime
rate, with a floor of 6.75%. Principal and interest are payable monthly and the
note matures in 2026, with no prepayment penalty. The interest rate on June 30,
2008 was 6.75%. The mortgage is secured by our office building in Henderson,
Nevada. We were in compliance with all financial covenants related to this
loan as of June 30, 2008.





We
assumed a first lien mortgage payable to a bank upon foreclosure of a 10,330
square foot office building in Houston, Texas in November 2007 to preserve our
interest in the property. At June 30, 2008 and December 31, 2007, the loan had
an outstanding principal balance of $1.6 million and $1.7 million respectively,
bears interest equal to the prime rate minus 50 basis points (4.75% at June
30, 2008), and matures in April 2011, with no prepayment
penalty.  Principal and interest are payable monthly.  We
were in compliance with all financial covenants related to this loan as of June
30, 2008.





13
 Table of Contents


Junior
Subordinated Notes


In June
2006 we completed the issuance of $30 million in unsecured trust preferred
securities through a newly formed Delaware statutory trust, which is our
wholly owned subsidiary.  The securities bear interest at a floating rate
based on the three-month LIBOR plus 400 basis points, which sets for three
months at one month after a calendar quarter, which was 6.9% on June 30,
2008.




The trust
preferred securities require quarterly interest distributions. The trust
preferred securities mature in July 2036 and are redeemable, at our option, in
whole or in part, with no prepayment premium any time after July 30,
2011.




The
Statutory Trust issued $928,000 aggregate liquidation amount of common
securities, representing 100% of the voting common stock of the Statutory Trust
to us. The Statutory Trust used the proceeds from the sale of the trust
preferred securities and the common securities to purchase our junior
subordinated notes.  The terms of the junior subordinated notes match the
terms of the trust preferred securities.  The notes are subordinate and
junior in right of payment to all present and future senior indebtedness and
certain other of our financial obligations.




Our
interest in the Statutory Trust is accounted for using the equity method and the
assets and liabilities of the Statutory Trust are not consolidated into our
financial statements.  Interest on the junior subordinated notes is
included in interest expense on our consolidated income statements while the
junior subordinated notes are presented as a separate item in our consolidated
balance sheet.





Our
covenants contain customary default provisions and require us to maintain
financial ratios at quarterly determination dates, including a minimum tangible
net worth requirement.  Our ability to incur additional subordinated
debt is also limited.  In June 2008 we entered into an agreement with
the holders of the trust preferred securities to modify the tangible net worth
covenant contained in our indenture through December 31, 2008.  In
exchange for the modification we agreed to establish a cash reserve account into
which we must make monthly deposits of 25% of our net income until such time as
the balance of the reserve account is at least equal to $2.1
million.  In addition, in the event that the aggregate amount of the
dividends that we pay during any month exceeds the amount that we deposit into
the reserve account during such month, we must also deposit into the reserve
account 25% of each principal payment we receive in respect of any of our
mortgage loans until the amount of the short-fall has been deposited into the
reserve account.  We must replace the reserve account with a letter of
credit in the face amount of $2.1 million as security for the trust preferred
securities.  At June 30, 2008, the balance in such reserve account was
$143,000, which is reflected in restricted cash on our balance
sheet.  At June 30, 2008, we were in compliance with the modified
covenant.




Note 14 - Fair Value of Financial
Instruments





SFAS No.
107 requires disclosure of the estimated fair value of an entity’s assets and
liabilities considered to be financial instruments. Effective January 1, 2008,
SFAS No. 157 defines fair value, expands disclosure requirements around fair
value and specifies a hierarchy of valuation techniques based on whether the
inputs to those valuation techniques are observable or
unobservable.  Observable inputs reflect market data obtained from
independent sources, while unobservable inputs reflect the Company’s market
assumptions.  These two types of inputs create the following fair
value hierarchy:





·
            Level
      1 – Quoted prices for identical instruments
      in active markets.


·
            Level
      2 – Quoted prices for similar instruments in
      active markets; quoted prices for identical or similar instruments in
      markets that are not active; model –derived valuations in which all
      significant inputs and significant value drivers are observable in active
      markets.


·
            Level
      3 – Valuations derived from valuation techniques in which one or more
      significant inputs or significant value drivers are
      unobservable.





This
hierarchy requires us to use observable market data, when available, and to
minimize the use of unobservable inputs when determining fair
value.  Under SFAS No. 157, we are required to take into account our
own credit risk when measuring the fair value of our
liabilities.  Fair value is best determined based upon quoted market
prices. However, in many instances there are no quoted market prices for various
financial instruments. In cases where quoted market prices are not available,
fair values are based on estimates using present value or other valuation
techniques. Those techniques are significantly affected by the assumptions used,
including the discount rate, estimates of future cash flows and realization of
collateral. Accordingly, the fair value estimates may not be realized in an
immediate settlement of the instrument. SFAS No. 107 excludes certain
financial instruments and all nonfinancial instruments from its disclosure
requirements. Accordingly, the aggregate fair value amounts presented may not
necessarily represent the underlying economic value.





Fair
Value under SFAS No. 157, is applied prospectively effective January 1, 2008;
therefore, the fair value of December 31, 2007 was computed under the guidance
of SFAS 107.





Table of Contents


The
following table summarizes the carrying values and the estimated fair values of
financial instruments as of June 30, 2008 and December 31, 2007.




June 30, 2008
            
            
            December 31, 2007Carrying
      Value
            
            
            Estimated
      Fair Value
            
            
            Carrying
      Value
            
            
            Estimated
      Fair ValueFinancial
      assets:Cash
      and cash equivalents
            
            $
            340,706
            
            
            $
            340,706
            
            
            $
            162,753
            
            
            $
            162,753Interest
      receivable
            
            
            999,309
            
            
            
            997,978
            
            
            
            1,464,261
            
            
            
            1,464,261Note
      receivable - related party
            
            
            15,112,500
            
            
            
            11,980,692
            
            
            
            15,500,000
            
            
            
            13,718,381Mortgage
      investments - net
            
            
            92,122,462
            
            
            
            91,608,498
            
            
            
            118,017,926
            
            
            
            118,017,926Loans
      held-for-sale
            
            
            3,569,000
            
            
            
            3,569,000
            
            
            
            2,139,200
            
            
            
            2,139,200Financial
      liabilities:Credit
      facility
            
            
            3,569,000
            
            
            
            3,563,239
            
            
            
            2,139,200
            
            
            
            2,139,200Mortgages
      payable
            
            
            8,012,475
            
            
            
            8,011,789
            
            
            
            8,132,769
            
            
            
            8,132,769Junior
      subordinated notes
            
            
            30,928,000
            
            
            
            20,103,200
            
            
            
            30,928,000
            
            
            
            30,928,000






We used
the following methods and assumptions in estimating the fair value of each class
of financial instrument:




·
            Cash and cash
      equivalents: The carrying values of cash and short-term
      instruments approximate fair
values.


·
            Interest
      receivable: Carrying values adjusted for a risk free discount
      factor.


·
            Note receivable – related
      party:Fair value is estimated using discounted cash flow analyses
      of a risk free rate of return for a similar period, the fixed amount of
      the note receivable and an estimated risk of default based on similar
      business operations and history of
operations.


·
            Mortgage
      investments-net: At June 30, 2008 the fair value was computed based
      on the probability of collection of the cash flow, a risk free rate of
      return on all estimated cash flows, the estimated realization of
      collateral, based on recent history and the fixed interest rate of the
      loans.  For December 31, 2007, the carrying value of these
      instruments, net of the allowance for loan losses, approximates the fair
      value due to their short-term maturities. Fair values for loans which are
      delinquent and /or in foreclosure are determined by the underlying
      collateral security the loans.


·
            Loans held-for-sale:
      Loans held-for-sale are carried at the lower of cost or market, therefore
      the carrying values of these instruments approximate fair
      value.


·
            Credit
      facility: For June 30, 2008 our credit standing was taken into
      consideration, as well as the excess assigned collateral, and a risk-free
      rate of return.  For December 31, 2007, carrying values
      approximate fair values due to the variable interest rate this facility
      bears.


·
            Mortgage loan payable:
      For June 30, 2008 our credit standing was taken into consideration, as
      well as the assigned collateral which was considered more than adequate,
      the estimated risk to the lender of the collateral to the loan balance and
      a risk-free rate of return, all of which were factors in the computation
      of fair value.  For December 31, 2007, carrying values
      approximate fair values due to the variable interest rate this facility
      bears.


·
            Junior subordinated
      notes: Our junior subordinated notes do not trade in an active
      market and, therefore observable price quotations are not
      available.  In the absence of observable price quotations, fair
      value is determined based on discounted cash flow models using current
      interest rates.





The
following table presents our assets and liabilities that are measured at fair
value for each of the fair-value hierarchy levels on a nonrecurring basis at
June 30, 2008.  Level 1 data was not used in the fair value
measure.  (See previous summary.)








Estimated
      Fair Value
            
            
            Level
      2
            
            
            Level
      3Financial
      Assets:Interest
      receivable
            
            $
            997,978
            
            
            $
            997,978
            
            
            $
            -Note
      receivable – related party
            
            
            11,980,692
            
            
            
            -
            
            
            
            11,980,692Mortgage
      investments – net
            
            
            91,608,498
            
            
            
            -
            
            
            
            91,608,498Loans
      held-for-sale
            
            
            3,569,000
            
            
            
            3,569,000
            
            
            
            -Financial
      LiabilitiesCredit
      facility
            
            
            3,563,239
            
            
            
            3,563,239
            
            
            
            -Mortgages
      payable
            
            
            8,011,789
            
            
            
            8,011,789
            
            
            
            -Junior
      subordinated notes
            
            
            20,103,200
            
            
            
            -
            
            
            
            20,103,200





15
 Table of Contents


Item 2.  Management’s Discussion and Analysis of
Financial Condition and Results of Operations




Overview





Desert
Capital REIT, Inc. and its subsidiaries (“Desert Capital,” “we,” “us,” ”our” and
“company”) is a Maryland corporation formed in December 2003 as a real estate
investment trust (“REIT”) that specializes in the financing of real estate
projects by providing short-term mortgage loans to homebuilders and commercial
developers in markets where we believe we possess requisite skills and market
knowledge. We generally invest in 12- to 18-month, first and second lien
mortgage loans, consisting of acquisition, development and construction loans to
both local and national developers and homebuilders. We derive our revenues
primarily from interest payments received from mortgage investments funded with
our equity capital and borrowed funds. Our principal business objective is to
generate net income for distribution to our stockholders from the spread between
interest income on our mortgage assets and the costs of financing the
acquisition of these assets. This spread, net of operating expenses, provides
both operating capital and distributable income. The growth of our business
depends on our access to external sources of capital. Our profitability depends
on our ability to obtain that capital at a cost we can absorb while still
generating an attractive risk-adjusted return on the loans we acquire using the
proceeds of our financings. Our business also depends on our ability to locate
suitable investments to keep our capital fully deployed at favorable rates. We
are externally managed and advised by Sandstone Equity Investors, LLC
(“Sandstone” or “Advisor”), a related party. Officers and majority owners of
Sandstone are also our executive officers.  See Note 6 - Commitments
and Related Parties - of the Notes to the Consolidated Financial
Statements.





Our
operating results are affected by a number of factors, including:


·
            volatility
      in the real estate market;


·
            our
      level of nonperforming assets, foreclosures and related loan
      losses;


·
            our
      ability to maintain a spread on interest income on loans and borrowed
      funds;


·
            our
      ability to identify suitable borrowers with attractive real estate
      projects; and


·
            our
      ability to formulate and execute resolution strategies for our troubled
      assets.





Recent
Developments and Trends





The
effects of the slowdown in housing sales, collapse of the sub-prime residential
mortgage market, and the tightening of the credit markets have continued into
2008, and continue to constrain the performance of our portfolio. During 2007,
we experienced significant loan losses and impairments, and through the second
quarter of 2008, such losses have continued. With the prolonged correction of
the market we may continue to face challenges through 2008 and
beyond.





For the
three and six months ended June 30, 2008, our net loss was $7.9 million and $7.1
million, respectively, compared to net income of $4.4 million and $8.3 million
for the three and six months ended June 30, 2007. The primary contributors to
this decline were:





·
            an
      increase in nonperforming loans and a decrease in interest income due to
      the continued erosion of market
conditions;


·
            operations
      related to Consolidated Mortgage’s loan origination and servicing
      activities were included in our results of operations for the three and
      six months ended June 30, 2007, but not for the three and six months ended
      June 30, 2008 due to the sale of Consolidated Mortgage  in
      November 2007; and


·
            noncash
      charges related to impairments of loans and real estate owned increased to
      $8.2 million and $8.5 million, respectively for the three and six months
      ended June 30, 2008, compared to $109,000 and $213,000 for the same
      periods in 2007.





Although
the real estate and credit market disruptions have presented challenges for us,
we have an operational structure with relatively low debt obligations. At June
30, 2008, our debt to total capital was 27.6%.  We will continue to
explore additional investment and business opportunities as they arise; however,
due to the current credit market disruption, our investment opportunities may be
limited.  Approximately 70% of our portfolio, including performing and
non-performing loans and real estate owned, is located in Clark County, Nevada,
which is also the location of our executive offices.  As we continue
to foreclose on mortgage loans, we have adjusted our portfolio strategy to
include land ownership, and our physical proximity to these assets facilitates
this undertaking.  We expect that the current difficult real estate
and credit market conditions will continue to have an adverse effect on our
operations for the remainder of 2008.





Loan
Portfolio Information





As of
June 30, 2008 we had a total of 65 loans in our portfolio, of which 16 were
performing loans and 49 were nonperforming. The carrying value of our performing
loans was $44.9 million at June 30, 2008. Due to the uncertainty of the
collection of principal balances upon maturity of certain loans, we recorded an
allowance for loan loss related to these performing loans of $3.7 million. Our
balance on these loans ranged from $20,000 to $14.4 million. Of the 16 loans, 12
were first lien loans totaling $39.3 million and four were second lien
loans totaling $9.2 million.





16
 Table of Contents


The
increase in nonperforming loans continues to impact our revenues due to the
default in interest payments and our provision for loan losses due to the
impairment of our loans. The 49 nonperforming loans in our portfolio were from
nine separate borrowers and had an original loan balance of $58.0 million. We
provided an allowance for loan loss related to these nonperforming loans of
$10.8 million, leaving a net carrying balance of $47.3 million at June 30,
2008. Our balance on these loans ranged from $2,800 to $9.5 million.  Of
the 49 loans, 45 were first lien loans totaling $50.9 million and four were
second lien loans totaling $7.1 million.  These loans are the
subject of pending foreclosure proceedings.





Our
mortgage loan portfolio is primarily concentrated in the Southwestern United
States and is comprised primarily of mortgage notes secured by first liens. As
of June 30, 2008 and December 31, 2007, 83% and 87%, respectively, of the
principal balance of our portfolio was invested throughout Nevada, California,
and Arizona, and 85% and 78% , respectively, was secured by first
liens.





We intend
to minimize potential losses of our impaired loans and achieve the greatest
capital realization with respect to each nonperforming loan. We continue to
execute on the following resolution strategies with respect to our
nonperforming loans:





·
            Cash Sale of the Underlying
      Collateral – If we determine through a thorough review process that
      it is advantageous to sell the property that secures a nonperforming loan
      at a loss rather than to continue to hold the property and incur
      additional costs, we may sell the property for
  cash.


·
            New Borrower Assumption
      –If we can identify new qualified borrowers to assume the initial loan
      amount, we will convert the nonperforming loan into a performing
      loan.


·
            Equity Investments in Real
      Estate –We may contribute real estate assets to an operating joint
      venture usually structured as a limited liability company (“LLC”) with
      other private investors in a loan or with a new investor to provide
      additional financing and development expertise to complete the
      project.  Once the project is completed and sold, we will
      distribute the sales proceeds according to the LLC agreement. This
      strategy may significantly reduce our ownership in the
      property.


·
            “Mothballing” or Holding the
      Property – If we are unable to implement any of the strategies
      discussed above, or if we determine that it may be advantageous to hold
      the property based upon local real estate market conditions, we will hold
      the property for an undetermined period of time directly or through LLCs.
      This is a temporary strategy, which at the appropriate time will be
      replaced with one of the other options. In most instances, we do not
      intend to become long-term property
  owners.




Real
Estate Owned





Real
estate owned consists of property acquired through foreclosures on mortgage
loans.  Our interests in real estate owned may be held directly by us,
or through limited liability companies.  In the case where we are one
of several investors in a larger loan, such loans are foreclosed upon using a
limited liability company to facilitate foreclosing our lender interest along
with private investors who hold the remaining loan balance and have similar
economic interests.   At June 30, 2008, we held real estate
through 13 limited liability companies and our ownership percentage ranged from
12.4% to 100%. We recorded real estate held directly or through limited
liability companies at the lower of the recorded amount of our related mortgage
loan being foreclosed (net of any impairment reserve), or our economic interest
in the property's estimated fair value, less estimated costs to sell, with fair
value based on appraisals and local market conditions.





At June
30, 2008 and December 31, 2007, we had a carrying balance in real estate owned
of $29.2 million and $15.7 million, respectively. Real estate owned consisted of
72% undeveloped land, 10% single family residential lots, 15% existing
commercial buildings and 3% other.





During
the six months ended June 30, 2008, we foreclosed on properties with an
aggregate original loan balance of $34.9 million, with a related allowance for
loan loss of $16.4 million, and additional capitalized costs of
$273,000.  We did not sell any real estate owned during the six-month
period ending June 30, 2008. We did, however, contribute 44 lots valued at $2.5
million to a joint venture in which we have a 50% noncontrolling ownership
interest.





Equity
Investments in Real Estate





In order
to minimize potential losses and facilitate our resolution strategy with respect
to nonperforming loans, we have contributed real estate assets acquired through
foreclosure to operating joint ventures with investors/developers who provide
additional financing and development expertise.





17
 Table of Contents


In March
2008, we formed a joint venture with a homebuilder for the construction of 44
single family homes in Las Vegas, Nevada. We contributed 44 lots to the joint
venture, which we had previously acquired through foreclosure and classified as
real estate owned. This venture is accounted for under the equity method of
accounting since we have a 50% noncontrolling ownership interest. Our venture
partner manages the operations of the joint venture. All major decisions require
the approval of both joint venturers, and voting rights and the sharing of
profits and losses are in proportion to the ownership percentages of each joint
venture partner. We recorded our initial investment at $2.5 million, the
carrying value of the lots, and we will record our net equity in income and cash
contributions and distributions.  There were no reportable operations for
the three and six months ended June 30, 2008.  We have no
responsibility to provide additional funding to the venture. Additional funding
for the construction of homes and sales of such will be provided by our venture
partner.  Our share of losses, if any, would be limited to the value
of lots contributed.





Sale
of Consolidated Mortgage





In
November 2007, our subsidiary, TRS, sold all of the issued and outstanding
units of Consolidated Mortgage to Sandstone, for the following
consideration:





·
            293,001
      of our common stock with a value of $4.4 million based on the last
      offering of its common stock at a per share price of $15 per
      share.  We subsequently retired the 293,001 shares of
      stock.


·
            $105,000
      in cash.


·
            A
      $15.5 million promissory note payable by Consolidated Mortgage to the
      order of TRS. The note bears interest at 9.0% per
      annum.  Principal and interest payments are due quarterly
      beginning on March 31, 2008.  The note matures in December
      2017.  The note is secured by all of the outstanding membership
      units of Consolidated Mortgage.   We earned interest of
      $344,000 and 697,000 for the three and six months ended June 30,
      2008.





In
addition to the consideration received, we will receive a contingent
installment payment from Consolidated Mortgage on loans we fund in the future.
The $8.25 million contingent payment is payable as
follows:  Sandstone will pay or cause Consolidated Mortgage to pay to
TRS, on the last day of each calendar quarter, an amount equal to: (i) 1% of the
principal amount of all mortgage loans originated or brokered by Consolidated
Mortgage or any of its affiliates and funded by us during such calendar quarter
for the first $200 million of mortgage loans funded during each calendar year;
and (ii) 0.5% of the principal amount of all mortgage loans originated or
brokered by Consolidated Mortgage and funded by us during such calendar quarter
in excess of $200 million during each calendar year, commencing on December 31,
2007 and continuing on the last day of each calendar quarter thereafter, until
TRS has received $8.25 million.  TRS’ right to receive the Installment
Payment is secured by all of the outstanding membership units of Consolidated
Mortgage.   For the three and six month periods ending June 30,
2008, we recognized income of $3,000 and $134,000 respectively, related to the
contingent installment payment, of which $63,000 remained unpaid at June 30,
2008.




We also
entered into a loan origination agreement with Consolidated Mortgage and
Sandstone, which terminates one month after the last day of the month in which
the Installment Payment is paid in full.  During the term of the Loan
Origination Agreement, we will have the right to fund all mortgage loans
identified by Consolidated Mortgage or any affiliate of Sandstone or
Consolidated Mortgage that becomes engaged in the business of originating or
brokering commercial loans. During the six months ended June 30, 2008, we funded
$13.8 million in loans originated by Consolidated Mortgage.





Due to
the sale of Consolidated Mortgage in November 2007, its operations are not
reflected in our 2008 financial statements.  Included in our
Consolidated Statement of Operations for the three and six month periods ending
June 30, 2007 was $154,000 and $304,000, respectively of net interest income,
$3.9 million and $6.4 million, respectively of non-interest income, $2.3 million
and $4.0 million, respectively of non-interest expense and $1.7 million and $2.7
million of net income before taxes related to the operations of Consolidated
Mortgage, which are not presented as discontinued operations, because
Consolidated Mortgage continues to originate and service loans for us, and we
share certain members of our management team in common.




Consolidated
Mortgage was not in compliance with certain financial covenants contained in the
$15.5 million promissory note payable to TRS at December 31, 2007, March 31,
2008 and June 30, 2008.  Our board of directors has formed a special
committee of independent directors to review the financial covenants and approve
a strategy to resolve the defaulted status of the loan.  Subsequent to
June 30, 2008, the special committee has granted Consolidated Mortgage a limited
waiver until October 10, 2008 either to enter into an amendment to the loan
agreement to modify such financial covenants upon terms and conditions and in
form and substance satisfactory to TRS or demonstrate that Consolidated Mortgage
is in compliance with the loan agreement and will be in compliance with the loan
agreement at December 31, 2008.  Consolidated Mortgage has timely made
all principal and interest payments due under the promissory note, and we do not
believe the promissory note is impaired.





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Results
of Operations for the three months ended June 30, 2008 compared to the three
months ended June 30, 2007





Revenues




Interest
income is generated on mortgage investments, loans held for sale and our note
receivable from Consolidated Mortgage. Interest income decreased $3.4 million,
or 59.9 %, to $2.3 million for the quarter ended June 30, 2008 from $5.7 million
for the quarter ended June 30, 2007. Our original loan balance of nonperforming
loans and real estate owned increased to $112.9 million as of June 30, 2008 from
$42.1 million as of June 30, 2007. The increased balance of nonperforming
loans and real estate owned lowered the average yield on the total portfolio to
5.9% in the second quarter of 2008 from 13.0% in the second quarter of
2007.




Non-interest
income decreased $3.2 million, or 92.9%, to $247,000 for the quarter ended June
30, 2008 from $3.5 million for the quarter ended June 30, 2007 primarily due to
the sale of Consolidated Mortgage in November 2007. During the quarter ended
June 30, 2007, we recognized loan brokerage fees and servicing fees of $3.2
million related to the activities of Consolidated Mortgage.





Expenses




Interest
expense consists of interest on our mortgage loans, credit facility, and junior
subordinated notes payable. Interest expense decreased 17.3%, to $842,000 during
the second quarter of 2008 from $1.0 million for the second quarter of 2007.
This decrease was a result of a decrease in the average interest rate on our
variable rate debt to 7.6% in the second quarter of 2008, from 8.9% in the
second quarter of 2007.  There was no material change in the average
outstanding debt balance during the second quarter of 2008 compared to the
second quarter of 2007.




The
provision for loan losses was $5.4 million for the quarter ended June 30, 2008
compared to $109,000 for the quarter ended June 30, 2007.  The
increase in the provision was due to a decline in the real estate and credit
markets, causing the collateral securing our loans to decrease in value. We
reviewed all of our mortgage investments as of June 30, 2008, and provided a
specific allowance for loan losses on 29 loans.  Four of the 29 loans
accounted for 77.8% of the current quarter provision for loan
losses.





Non-interest
expense increased $759,000 or 21.3%, to $4.3 million for the second quarter of
2008 compared to $3.6 million for the second quarter of 2007. This increase is
almost entirely attributable a $2.8 million impairment of real estate owned in
the second quarter of 2008.  Excluding the impairment of real estate
owned, non-interest expense decreased $2.0 million or 57.5% to $1.5 million for
the second quarter of 2008, compared to $3.6 million for the same period in
2007.  This decrease is due to the sale of Consolidated Mortgage and
the expenses associated with its operations which were included in the second
quarter of 2007.  There was also a decrease in the second-tier
compensation paid to our Advisor due to the decrease in portfolio
performance.




Results
of Operations for the six months ended June 30, 2008 compared to the six months
ended June 30, 2007





Revenues




Interest
income is generated on mortgage investments, loans held for sale and our note
receivable from Consolidated Mortgage. Interest income decreased $6.3 million,
or 55.7%, to $5.0 million for the six months ended June 30, 2008 from $11.4
million for the six months ended June 30, 2007. Our balance of nonperforming
loans and real estate owned increased to $112.9 million as of June 30, 2008 from
$42.1 million as of June 30, 2007. The increased balance of nonperforming
loans and real estate owned lowered the average yield on our total portfolio to
6.2 % in the first six months of 2008 from 13.0% in the first six months of
2007.




Non-interest
income decreased $5.1 million, or 89.1%, to $622,000 for the six months ended
June 30, 2008 from $5.7 million for the six months ended June 30, 2007 primarily
due to the sale of Consolidated Mortgage in November 2007. During the six months
ended June 30, 2007, we recognized loan brokerage fees and servicing fees of
$5.3 million related to the activities of Consolidated Mortgage.





Expenses




Interest
expense consists of interest on our mortgage loans, credit facility, and junior
subordinated notes payable. Interest expense decreased 15.7%, to $1.7 million
during the first six months of 2008 from $2.0 million in the first six months of
2007. This decrease was a result of a decrease in the average interest rate on
our variable rate debt to 7.6% in the first six months of 2008, from 8.9% in the
first six months of 2007.  There was no material change in the average
outstanding debt balance during the first six months of 2008 compared to the
first six months of 2007.




The
provision for loan losses was $5.7 million for the six months ended June 30,
2008 compared to $213,000 for the six months ended June 30, 2007.  The
increase in the provision was due to a decline in the real estate and credit
markets, causing the collateral securing our loans to decrease in
value.  During the six months ended June 30, 2008, we provided a
specific allowance for loan losses on 30 loans, four of which accounted for
73.5% of the total provision for loan losses.





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 Table of Contents


Non-interest
expense decreased $852,000 or 13.4%, to $5.5 million for the six months ended
June 30, 2008 compared to $6.4 million for the six months ended June 30, 2007.
After removing the effect of a $2.8 million impairment charge included in
non-interest expense for the six months ended June 30, 2008, non-interest
expense decreased $3.7 million or 57.3% compared to the same period in
2007.  This decrease is due to the sale of Consolidated Mortgage and
the expenses associated with its operations which were included in the first six
months of 2007.  There was also a decrease in the second-tier
compensation paid to our Advisor due to the decrease in portfolio
performance.





Taxable Income





REIT
taxable income is calculated according to the requirements of the Internal
Revenue Code. The following table reconciles our net income to REIT taxable
income for the three and six months ended June 30, 2008 and 2007:





Three
      Months Ended June 30,
            
            
            Six
      Months Ended June 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      income (loss)
            
            $
            (7,901,678
            )
            
            $
            4,350,186
            
            
            $
            (7,095,786
            )
            
            $
            8,296,537Adjustments
      to net income (loss):Provision
      for loan losses
            
            
            5,356,108
            
            
            
            108,949
            
            
            
            5,667,096
            
            
            
            213,351Impairment
      of real estate
            
            
            2,805,749
            
            
            
            -
            
            
            
            2,806,806
            
            
            
            -Actual
      losses on sale of real estate or loans
            
            
            -
            
            
            
            -
            
            
            
            (299,965
            )
            
            
            -Net
      adjustment for TRS income
            
            
            120,190
            
            
            
            (460,166
            )
            
            
            180,539
            
            
            
            (383,375
            )REIT
      taxable income
            
            $
            380,369
            
            
            $
            3,998,969
            
            
            $
            1,258,690
            
            
            $
            8,126,513




Our
income calculated for tax purposes differs from income calculated in
accordance with GAAP primarily because the financial statements of the REIT and
its taxable REIT subsidiaries are consolidated for GAAP purposes while they are
not consolidated for tax purposes. The distinction between taxable income and
GAAP income is important to our stockholders because distributions are declared
on the basis of REIT taxable income. While we generally will not be
required to pay income taxes on our REIT taxable income as long as we satisfy
the REIT provisions of  the Internal Revenue Code, each year we will
be required to complete a U.S. federal income tax return wherein taxable income
is calculated. This taxable income level will determine the minimum level of
distribution we must pay to our stockholders. There are limitations associated
with REIT taxable net income. For example, this measure does not reflect net
capital losses during the period and, thus, by itself is an incomplete measure
of our financial performance over any period. As a result, our REIT taxable
income should be considered in addition to, and not as a substitute for, our
GAAP-based net income as a measure of our financial performance.





Liquidity and Capital
Resources




Our
principal sources of working capital and funds for additional investments
primarily include: principal and interest collections on existing mortgage loan
investments, proceeds from the sale of foreclosed assets and proceeds from the
disposition of non-performing loans.  We believe these sources of funds
will be sufficient to meet our short-term liquidity needs which are comprised
primarily of dividend payments, payments on our junior subordinated notes
payable, mortgage payments on the two buildings we own, and general working
capital needs. With a debt to total capital ratio of 27.6% as of June 30, 2008,
we believe our balance sheet strength will enable us to work through this
challenging real estate market.  We expect cash flows from operating
activities to increase as the market conditions improve and we are able to
implement our resolution strategy on our real estate investments.





Cash
Flows





Net cash
provided by operating activities for the six months ended June 30, 2008 was
$767,000 compared to $9.7 million for the six months ended June 30, 2007. The
decrease in net cash flow from operating activities is due to a decrease in net
income and the net activity in mortgage loans originated for sale and mortgage
loans sales.





Net cash
provided by investing activities for the six months ended June 30, 2008 was $2.1
million compared to ($18.3) million of cash used in investing activities for the
six months ended June 30, 2007.  The increase in net cash flow from
investing activities was a result of a decrease in the amount of investments in
real estate mortgages.  We expect cash flows from investing activities
to continue to decrease as outstanding loans are paid off and we use the
proceeds to reinvest into new investments in real estate mortgages.





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Net cash
used in financing activities for the six months ended June 30, 2008, was ($2.6)
million compared to $8.8 million of cash provided by financing activities for
the six months ended June 30, 2007.  The decrease in cash flow from
financing activities is primarily a result of the decrease in the issuance of
common stock during the first six months of 2008 compared to the first six
months of 2007.  We do not expect cash flow from financing activities
to increase significantly due to the suspension and expiration of the offering
of shares of our common stock during the first quarter of 2008.





Since we
rely primarily on repayment of outstanding loans to provide capital, the
significant level of defaults on our outstanding loans has reduced the funds we
have available for investing in new loans.  Additional defaults on our
outstanding loans could further reduce the funds we have available for
investing in new loans. Extended foreclosure proceedings may also result in
significant delays in the return of invested funds. These circumstances
have reduced and may further reduce our capital resources and impair our ability
to invest in new loans. Nonperforming mortgage investments and real estate owned
as of June 30, 2008 had a carrying balance of $47.3 million and $29.2 million
respectively. We also had performing loans as of June 30, 2008 with a
carrying balance of $44.9 million.





It is
likely that nonperforming loans and real estate assets will produce minimal, if
any, current earnings until they are sold or an alternative resolution option
becomes available. The disposition of these assets cannot be predicted; however
our Advisor believes that over time the proceeds generated from the resolution
of these nonperforming and real estate assets will provide capital for
reinvestment into performing assets or reduction in outstanding debt as deemed
appropriate by our Advisor. While we believe our assets are fairly stated, our
balance sheet contains significant estimates related to the allowance for loan
losses and the impairment of real estate owned.  With the volatility
in the current real estate market, our estimates on any individual asset or on
the portfolio as a whole may vary. These estimates are based upon a
thorough evaluation by our Advisor of collectability based on prevailing
economic conditions, historical experience, unique characteristics of the loan,
borrowers’ financial condition, industry trend and an estimated net realizable
value of any underlying collateral in relation to the real estate loan
amount.




Our
operating costs are relatively low.  We have no employees, a
relatively low debt level, low overhead costs and low net carrying costs
associated with our assets.  Our operating revenues are used primarily
to pay our operating expenses and make distributions to our
stockholders.  In order to continue to qualify as a REIT and to avoid
corporate-level tax on the income we distribute to our stockholders, we are
required to distribute at least 90% of our REIT taxable income on an annual
basis. In general, our liquidity requirements consist of new loan fundings,
operating expenses, and principal and interest payment obligations on our
debt.  Since we are not currently publicly offering our equity
securities for sale, we will utilize principal and interest collections on
existing mortgage loan investments, proceeds from the sale of foreclosed assets
and proceeds from the disposition of nonperforming loans as our primary sources
of funds to invest in new loans, pay operating expenses, service our debt, and
pay dividends to our stockholders as available.  We believe that these
cash resources are sufficient to satisfy our immediate liquidity requirements,
and we do not anticipate a need to raise funds from other than these sources
within the next 12 months.  We believe we have sufficient financial
resources to continue our operations into the foreseeable
future.  However, given the current market conditions, there can be no
assurance that we will be able to continue to generate funds through these
sources.  A reduction in the availability of the above sources of
funds could have a material adverse effect on our financial condition and
results of operations.





Contractual
Obligations





The
following table sets forth information about certain of our contractual
obligations as of June 30, 2008:


Payments
      due by PeriodTotal
            
            
            Less
      than 1 year (1)
            
            
            1 –
      3 years
            
            
            3 –
      5 years
            
            
            More
      than 5 yearsLong-Term
      Debt ObligationsJunior
      subordinated notes
            
            $
            30,928,000
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            30,928,000Mortgages
            
            
            8,012,475
            
            
            
            132,962
            
            
            
            2,193,528
            
            
            
            731,835
            
            
            
            4,954,150Short-Term
      Debt Obligations
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -
            
            
            
            -Line
      of Credit
            
            
            3,569,000
            
            
            
            3,569,000
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            42,509,475
            
            
            $
            3,701,962
            
            
            $
            2,193,528
            
            
            $
            731,835
            
            
            $
            35,882,150





(1)
Amount represents balance of obligation for the remainder of the 2008
year.





Critical
Accounting Policies and Management Estimates





Our
discussion and analysis of financial condition and results of operations is
based on our financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States, known as GAAP.
These accounting principles require us to make some complex and subjective
decisions and assessments.  Our most critical accounting policies involve
decisions and assessments, which could significantly affect our reported assets,
liabilities and contingencies, as well as our reported revenues and
expenses.  We believe that all of the decisions and assessments upon which
our financial statements are based were reasonable at the time made based upon
information available to us at that time.  We evaluate these decisions and
assessments on an ongoing basis.  Actual results may differ from these
estimates under different assumptions or conditions.  We have identified
our most critical accounting policies to be the following:




21
 Table of Contents


Use
of Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results may ultimately differ from those
estimates.





Revenue
Recognition





Interest
income on our mortgage investments is recognized over the life of the investment
and recorded on the accrual basis. Income recognition is suspended for mortgage
investments at the earlier of the date on which payments become 90 days past due
or when, in the opinion of management, a full recovery of income and principal
becomes doubtful. Income recognition is resumed when the loan becomes
contractually current and performance is demonstrated to be
resumed.





Fees
generated upon the funding of loans held for sale are recognized when the loan
is funded.  There are no gains or losses realized upon the sale of
loans held for sale.





Prior to
our sale of Consolidated Mortgage in November 2007, we recognized revenues
related to the loan origination and loan servicing activities of Consolidated
Mortgage. Loan origination fees and certain direct origination costs associated
with mortgage investments that were funded by us, were deferred and recognized
as an adjustment to yield over the lives of the related loans using the
straight-line method. Loan brokerage fees generated by Consolidated Mortgage
were nonrefundable fees for brokering loans to third party investors. Loan
brokerage fees were recognized once the loans associated with the fees were
funded and recorded by the third party investors. Consolidated Mortgage also
charged fees, which were recorded as non-interest income, to service loans
brokered to third party investors, as well as other miscellaneous fees during
the loan term. These service and other loan fees were recognized throughout the
life of the loan as they were earned.




Mortgage
Investments




Mortgage
investments are intended to be held to maturity and, accordingly are carried at
cost, net of any unamortized deferred fees and costs, and any allowance for loan
losses. The carrying value of these investments is adjusted for origination
discounts/premiums, nonrefundable fees and direct costs for originating loans
which are amortized into income over the terms of the loans using the effective
yield method adjusted for the effects of estimated prepayments based on
Statement of Financial Accounting Standards  (“SFAS”) No. 91,
“Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases” (“SFAS
No. 91”).





Loans
Held for Sale




Loans
held for sale represent short term investments in loans where we intend to sell
all or part to third party investors within 90 days. These loans are carried at
the lower of cost or market value.





Real
Estate Owned





Real
estate owned consists of property acquired through foreclosures on mortgage
loans.  Our interests in real estate owned may be held directly by us,
or through limited liability companies.  In the case where we are one
of several investors in a larger loan, such loans are foreclosed upon using a
limited liability company to facilitate foreclosing our lender interest along
with private investors who hold the remaining loan balance and have similar
economic interests. We recorded real estate held directly or through limited
liability companies at the lower of the recorded amount of our related mortgage
loan being foreclosed (net of any impairment reserve), or our economic interest
in the property's estimated fair value, less estimated costs to sell, with fair
value based on appraisals and local market conditions.





On a
periodic basis, management assesses whether there are any indicators that the
fair value of our investments in real estate owned may be other than temporarily
impaired. An investment is considered impaired if the fair value of the
investment, as estimated by management, is less than the carrying value of the
investment. To the extent impairment has occurred, the loss shall be measured as
the excess of the carrying amount of the investment over the fair value of the
investment.





Equity
Investments in Real Estate





To
facilitate our resolution strategy with respect to nonperforming loans, we have
contributed real estate assets acquired through foreclosure to operating joint
ventures with investors/developers who provide additional financing and
development expertise.





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 Table of Contents


We
evaluate our investments in partially owned entities in accordance with
FIN 46R. We account for our investments in unconsolidated real estate
ventures under the equity method of accounting as it is not the primary
beneficiary for a “variable interest entity,” or a “VIE,” and the Company
exercises significant influence, but does not control these entities under the
provisions of the entities’ governing agreements pursuant to EITF 04-05. These
investments are recorded initially at cost or impaired value, as investments in
real estate entities, and subsequently adjusted for equity in earnings and cash
contributions and distributions in accordance with AICPA (American Institute of
Certified Public Accountants) Statement of Position No. 78-9, Accounting for
Investments in Real Estate Ventures.





On a
periodic basis, management assesses whether there are any indicators that the
fair value of our investments in equity investments in real estate may be other
than temporarily impaired. An investment is considered impaired if the fair
value of the investment, as estimated by management, is less than the carrying
value of the investment. To the extent impairment has occurred, the loss shall
be measured as the excess of the carrying amount of the investment over the fair
value of the investment.





Allowance
for Loan Losses





An
allowance for loan losses is reflected in our financial statements based upon an
evaluation of known and inherent risks affecting our portfolio of mortgage
investments including, but not limited to, economic conditions, delinquency
status, value of collateral underlying the loan, credit losses to date on
underlying mortgages and any remaining credit protection. Management monitors
the delinquencies and defaults on mortgage investments and, if an impairment of
the related loan is noted, the carrying value of the related loan will be
reduced to fair value through a charge to the allowance for loan
losses.  We consider mortgages to be delinquent when principal or
interest is contractually past due or the loan is past its maturity
date.




The value
of the underlying collateral, which is based upon an appraisal at origination,
also requires estimates and assumptions as to market
conditions.  Updated appraisals are periodically obtained but in
recent months appraisals have not been readily available due to lack of
significant sales comparables and therefore estimates of fair value necessarily
include other factors.  Specific allowances for losses may be
established for nonperforming and potentially impaired loans based on a
comparison of the recorded carrying value of the loan to either the present
value of the loan’s expected cash flow, the loan’s estimated market price or the
estimated fair value of the underlying collateral. The allowance is increased by
charges to operations and decreased by charge-offs (net of recoveries). Loan
loss estimates are reviewed periodically and adjustments are reported in
earnings when they become known.  Because any decision regarding the
allowance for loan losses reflects a judgment about the probability of future
events, there is an inherent risk that such judgments will prove
incorrect.  In such event, actual losses may exceed (or be less than)
the amount of any allowance.  To the extent that we experience losses
greater than the amount of our allowances, we may incur a charge to our earnings
that will adversely affect our operating results and the amount of any
distributions payable to our stockholders.





Impairment
Policy





We have
adopted Statement of Financial Accounting Standards No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets” (SFAS No. 144). Impairment is
measured on a loan-by-loan basis on the fair value of the related collateral
since all loans subject to this measurement are collateral
dependent.





Income
Taxes





We
elected to be taxed as a REIT, under Sections 856 through 860 of the Internal
Revenue Code, beginning with our taxable year ended December 31, 2004. To
qualify as a REIT, we must meet certain organizational and operational
requirements, including a requirement to distribute at least 90% of our ordinary
taxable income to stockholders. As a REIT, we generally are not subject to
federal income tax on taxable income that we distribute to our stockholders. If
we failed to qualify as a REIT in any taxable year, we would then be subject to
federal income taxes on our taxable income at regular corporate rates and we
would not be permitted to qualify for treatment as a REIT for federal income tax
purposes for four years following the year during which qualification was lost
unless the Internal Revenue Service granted us relief under certain statutory
provisions. Such an event could materially adversely affect our net income and
net cash available for distributions to stockholders. However, we intend to
continue to operate in the foreseeable future in such a manner so that we will
qualify as a REIT for federal income tax purposes.





23
 Table of Contents


Recent
Accounting Developments





In
December 2007, Financial Accounting Standards Board (“FASB”) issued SFAS No.
160, “Noncontrolling Interests in Consolidated Financial Statements – an
amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires that
ownership interests in subsidiaries held by parties other than the parent, and
the amount of consolidated net income, be clearly identified, labeled, and
presented in the consolidated financial statements within equity, but separate
from the parent’s equity. It also requires that once a subsidiary is
deconsolidated, any retained noncontrolling equity investment in the former
subsidiary be initially measured at fair value. Sufficient disclosures are
required to clearly identify and distinguish between the interests of the parent
and the interests of the noncontrolling owners.  In addition to the
amendments to ARB 51, this Statement amends SFAS No. 128 “Earnings per Share”;
so that earnings-per-share data will continue to be calculated the same way
those data were calculated before SFAS No. 160 was issued. SFAS No. 160 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008.  Earlier adoption is
prohibited.  SFAS No. 160 shall be applied prospectively as of the
beginning of the fiscal year in which SFAS No. 160 is initially applied, except
for the presentation and disclosure requirements.  The presentation
and disclosure requirements shall be applied retrospectively for all periods
presented.  SFAS No. 160 will be effective for us beginning January 1,
2009.  We have evaluated SFAS No. 160 and have determined that we have
not entered any business arrangements or corporate joint ventures that would
require the application of SFAS No. 160 for noncontrolling
interests.





In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS No.
141R”).  This Statement replaces SFAS No. 141.  SFAS No.
141R establishes principles and requirements for how the acquirer of a business
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree.  SFAS No. 141R also provides guidance for recognizing and
measuring the goodwill acquired in the business combination and determines what
information to disclose to enable users of the financial statements to evaluate
the nature and financial effects of the business combination.  This
Statement applies prospectively to business combinations for which the
acquisition date is on or after the beginning of the first annual reporting
period beginning on or after December 15, 2008.  We do not expect the
adoption of SFAS 141R to have a material impact on our Consolidated Financial
Statements.




In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and
Financial Liabilities.” SFAS 159 permits entities to choose to measure financial
assets and liabilities (except for those that are specifically scoped out of the
Statement) at fair value.  The election to measure a financial asset
or liability at fair value can be made on an instrument-by-instrument basis and
is irrevocable.  The difference between carrying value and fair value
at the election date is recorded as a transition adjustment to opening retained
earnings.  Subsequent changes in fair value are recognized in
earnings.  The Company may decide whether to elect the fair value
option for each eligible item on various defined election dates.  We
did not elect to report any financial assets or liabilities at fair value under
SFAS No. 159 on January 1, 2008.





In
September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair
value, establishes a framework for measuring fair value and expands disclosures
about fair value measurements.  SFAS 157 applies under other accounting
pronouncements that require or permit fair value measurements. Accordingly, SFAS
157 does not require any new fair value measurements. SFAS 157 is effective for
fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years.  This statement has modified the methodology for the
measurement of “Fair Value of Financial Instruments.” This change has had a
significant impact on the estimated fair value of our financial instruments as
of June 30, 2008.  See Note 14 - Fair Value of Financial
Instruments.





Item 3.Quantitative and Qualitative Disclosures about Market
Risk





Market
risk refers to the risk of loss from adverse changes in the level of one or more
market prices, rate indices or other market factors. We are exposed to market
risk primarily from changes in interest rates that are very sensitive to a
variety of factors including political, economic and other factors outside of
our control.





Interest
rate risk arises primarily as a result of our core business activities of
acquiring mortgage loans and funding a portion of the purchases with borrowings
and the associated asset and liability management required to match maturities
of loans to funding sources. The principal objective of our asset and liability
management is to maximize net interest income while operating within acceptable
limits established for interest rate risk and maintaining adequate levels of
liquidity.





The
primary interest rate exposure to which we are subject relates to our mortgage
loan portfolio. Any change in the general level of interest rates in the market
can affect our net interest income and net income in either a positive or
negative manner. Net interest income is the difference between the income earned
from interest bearing assets less the expense incurred relating to interest
bearing liabilities. Fluctuations in the interest rate environment can also
affect our ability to acquire new loans, the value of our loans for sale
portfolio and our ability to sell the loans held for sale and the related income
associated with a sale. Our entire mortgage loan portfolio is comprised of fixed
rate investments while all of the debt that we have is variable rate
debt.





24
 Table of Contents


Based on
our loans and liabilities as of June 30, 2008, and assuming the balances of
these loans and liabilities remain unchanged for the subsequent twelve months, a
1% increase in interest rates would decrease our annual net income and cash
flows by approximately $326,000. This decrease is due to our fixed rate
investments and variable rate debt. Based on our loans and liabilities as of
June 30, 2008, and assuming the balances of these loans and liabilities remain
unchanged for the subsequent twelve months, a 1 % decrease in interest rates
would increase our annual net income and cash flows by approximately $326,000.
This increase again is due to our fixed rate investments and variable rate
debt.





In the
event of a significant rising interest rate environment and/or future economic
downturn, defaults could increase and result in credit losses to us, which could
adversely affect our liquidity and operating results. Further, such additional
delinquencies or defaults could have an adverse effect on the spreads between
interest-earning assets and interest-bearing liabilities.





We do not
intend to use any derivative instruments to manage our interest rate exposure.
Given the short time horizon of our anticipated investments and our related
borrowings, we do not believe a hedging strategy is necessary. In addition, our
actions are limited by rules with which REITs must comply.




Item 4T. Controls and Procedures




Under the
supervision and with the participation of our management, including
our chief executive officer
and chief financial officer, we evaluated the effectiveness of
the design and operation of our disclosure controls and procedures (as defined
in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended (the “Exchange Act”)). Based upon that evaluation,
 our chief executive officer
and chief financial officer concluded that, as of the end of the
period covered by this report and as a result of the material weakness in our
internal controls that was identified in connection with
our December 31, 2007 audit, described below, our disclosure controls and
procedures were not effective to ensure that information required to be
disclosed by us in the reports we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in applicable rules and forms.   However, notwithstanding the material
weakness that existed as of December 31, 2007, management has concluded that the
consolidated financial statements included in this Quarterly Report on Form 10-Q
present fairly, in all material respects, our financial position, results
of operations and cash flows in conformity with accounting principles
generally accepted in the United States.




The
material weakness that management identified was that we failed to design and
implement controls related to the interpretation and implementation of certain
accounting principles, primarily related to business combinations in
connection with the sale of Consolidated Mortgage and accounting for loan
impairment in connection with a troubled debt restructuring.  The fact that
these accounting principles were not properly applied, together
with certain other factors led our management to conclude that this
situation was an indication of a material weakness in our internal control over
financial reporting as of December 31, 2007.




We have
discussed the material weakness in our internal control over financial reporting
with the Audit Committee of our Board of Directors and with Hancock
Askew & Co. LLP, our independent registered public accounting firm. In
response, beginning in March 2008 and continuing during the second quarter
of 2008, we began taking measures to remediate the material weakness in our
internal control, which measures have included the following:




·
            expanding
      our external consulting expertise and engaging additional external
      consulting expertise; and




·
            expanding
      the capacity and expertise of our internal accounting
    staff.




During
the most recent quarter ended June 30, 2008, other than as discussed
above, there have been no significant changes in our internal control over
financial reporting or in other factors that have materially affected,
or are reasonably likely to materially affect, our internal control over
financial reporting. However, as discussed above, changes have been
implemented that will continue to occur subsequent to the period covered by
this Form 10-Q to add additional controls to continue to remediate and
correct the material weakness in internal control over financial
reporting.




Part II. Other Information





Item 1. Legal Proceedings


During
the period covered by this report, there were no material changes to legal
proceedings discussed in our Annual Report on Form 10-K for the year ended
December 31, 2007.





Item 1A. Risk Factors


During
the period covered by this report, there were no material changes to the risk
factors discussed in our Annual Report on Form 10-K for the year ended December
31, 2007.




Item 2.Unregistered Sales of Equity Securities and Use of
Proceeds


Our
second public offering of common stock was suspended by our board of directors
on February 22, 2008.  This decision was made in anticipation of the
expiration of the offering, which would not allow sales of shares to occur after
March 22, 2008 pursuant to the prospectus.





25
 Table of Contents


Item 3. Defaults Upon Senior Securities


None.




Item 4. Submission of Matters to a Vote of Security
Holders


None.





Item 5.
Other Information


None.




Item 6.
Exhibits


a)
Exhibits




3.1
            Third
      Amended and Restated Articles of Incorporation (included as Exhibit 3.1 to
      Form 10-K filed on March 31, 2008 and incorporated herein by
      reference).3.2
            Bylaws
      of the Company (included as Exhibit 3.2 to Amendment No.2 to the
      Registrant’s Registration Statement on Form S-11 (File No. 333-111643) and
      incorporated herein by reference).10.1
            Second
      Supplemental Indenture, dated as of June 6, 2008, between Desert Capital
      REIT, Inc., and The Bank of New York Trust Company, National Association
      (as successor to JP Morgan Chase Bank, National Association), as Trustee
      (included as Exhibit 10.1 to Form 8-K filed on June 6, 2008 and
      incorporated herein by reference.)31.1
            Certification
      of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*31.2
            Certification
      of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer, Pursuant to 18
      U.S.C Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002**






*Filed
herewith






**
Furnished herewith







26
 Table of Contents




SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.













DESERT
      CAPITAL REIT, INC.August
      13, 2008
            /s/ TODD B.
      PARRIOTTTodd
      B. Parriott,President
      and Chief Executive Officer
              (Principal
      Executive Officer)








August
      13, 2008
            /s/ STACY M.
      RIFFEStacy
      M. Riffe,Chief
      Financial Officer
              (Principal
      Accounting Officer)








27
 Table of Contents




EXHIBIT
INDEX




3.1
            Third
      Amended and Restated Articles of Incorporation (included as Exhibit 3.1 to
      Form 10-K filed on March 31, 2008 and incorporated herein by
      reference).3.2
            Bylaws
      of the Company (included as Exhibit 3.2 to Amendment No.2 to the
      Registrant’s Registration Statement on Form S-11 (File No. 333-111643) and
      incorporated herein by reference).10.1
            Second
      Supplemental Indenture, dated as of June 6, 2008, between Desert Capital
      REIT, Inc., and The Bank of New York Trust Company, National Association
      (as successor to JP Morgan Chase Bank, National Association), as Trustee
      (included as Exhibit 10.1 to Form 8-K filed on June 6, 2008 and
      incorporated herein by reference.)31.1
            Certification
      of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*31.2
            Certification
      of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer, Pursuant to 18
      U.S.C Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002**




*Filed
herewith




**
Furnished herewith