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 September 30, 2009
 
 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
      W. Galleria Drive, Suite 200, Henderson, NV 89014(Address
      of principal executive office)(Zip
      Code)Registrant's
      telephone number, including area code:(800) 419-2855Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period that the
      registrant was required to file such reports), and (2) has been subject to
      such filing requirements for the past 90 days.
              Yes
      [ X ] No [  ]
              
              Indicate
      by check mark whether the registrant has submitted electronically and
      posted on its corporate Web site, if any, every Interactive Data File
      required to be submitted and posted pursuant to Rule 405 of Regulation S-T
      (§232.405 of this chapter) during the preceding 12 months (or such shorter
      period that the registrant was required to submit and post such
      files).
              Yes
      [  ] No [  ]
              
              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 definition of “large accelerated filer,” “accelerated
      filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
      (check one):
              
              Large
      accelerated filer [
      ]                                                                      Accelerated
      filer [ ]
              
              Non-accelerated
      filer [
      ]                                                                        Smaller
      reporting company [X]
              (Do
      not check if a smaller reporting company)
              
              Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Act).
              Yes
      [ ] No [X]
              
              The
      number of shares of the registrant’s common stock, par value $0.01 per
      share, outstanding as of November 16, 2009 was
  16,849,954.


Table of Contents










INDEXPagePart I. Financial
      Information
            1Item 1. Consolidated Financial
      Statements
            1a) Consolidated Balance Sheets as of September 30, 2009
      (unaudited) and December 31, 2008
            1b)
      Consolidated Statements of Operations (unaudited) for the three and nine
      months ended September 30, 2009 and 2008
            2c) Consolidated Statements of Cash Flows (unaudited) for the
      nine months ended September 30, 2009 and
      2008
            3d) Condensed Notes to Consolidated Financial Statements
      (unaudited)
            4Item 2. Management's Discussion and Analysis of Financial
      Condition and Results of Operations
            20Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk
            29Item 4T. Controls and
      Procedures
            29Part II. Other
      Information
            30Item 1. Legal Proceedings
            30Item 1A. Risk Factors
            30Item 2. Unregistered Sales of Equity Securities and Use of
      Proceeds
            30Item
      3. Defaults Upon Senior Securities
            30Item 4. Submission of Matters to a Vote of Security
      Holders
            30Item 5. Other Information
            30Item 6. Exhibits
            30Signatures
            31Certification 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 Information


DESERT
      CAPITAL REIT, INC.Consolidated
      Balance Sheets(in
      thousands, except share amounts)September
      30,
            
            
            December
      31,2009
            
            
            2008(unaudited)ASSETSMortgage
      investments - net of allowance for loan losses of $15,631
    atSeptember
      30, 2009 and $20,805 at December 31, 2008
            
            $
            36,578
            
            
            $
            69,538Real
      estate owned
            
            
            2,310
            
            
            
            19,979Investments
      in real estate
            
            
            18,426
            
            
            
            7,167Assets
      held for sale
            
            
            9,041
            
            
            
            -Notes
      receivable from related party - net of allowance for loan losses of $1,797
      atSeptember
      30, 2009 and $2,125 at December 31, 2008
            
            
            12,928
            
            
            
            12,600Building
      and equipment - net
            
            
            6,802
            
            
            
            6,815Land
            
            
            1,820
            
            
            
            1,820Cash
      and cash equivalents
            
            
            1,177
            
            
            
            351Restricted
      cash
            
            
            -
            
            
            
            1,278Interest
      receivable - includes related party interest of $7 atSeptember
      30, 2009 and $452 at December 31, 2008
            
            
            33
            
            
            
            531Deferred
      financing costs
            
            
            989
            
            
            
            941Other
      investments
            
            
            928
            
            
            
            928Accounts
      receivable, net
            
            
            203
            
            
            
            197Other
      assets
            
            
            1,030
            
            
            
            484Total
      assets
            
            $
            92,265
            
            
            $
            122,629LIABILITIES
      AND STOCKHOLDERS' EQUITYNotes
      payable
            
            $
            1,661
            
            
            $
            1,360Mortgages
      payable
            
            
            7,651
            
            
            
            7,893Junior
      subordinated notes payable
            
            
            30,928
            
            
            
            30,928Management
      and servicing fees payable, related party
            
            
            1,613
            
            
            
            148Liabilities
      held for sale
            
            
            2,584
            
            
            
            -Accounts
      payable and accrued expenses
            
            
            1,934
            
            
            
            2,413Shares
      subject to redemption
            
            
            1,859
            
            
            
            -Total
      liabilities
            
            
            48,230
            
            
            
            42,742Commitments
      and Contingencies - Note 13Preferred
      stock, $0.01 par value: 15,000,000 shares authorized, none
      outstanding
            
            
            -
            
            
            
            -Common
      stock, $0.01 par value: 100,000,000 shares authorized; 16,849,954
      sharesissued
      and outstanding on September 30, 2009 and 16,835,867
shareson
      December 31, 2008
            
            
            169
            
            
            
            168Additional
      paid-in capital
            
            
            163,898
            
            
            
            165,723Accumulated
      deficit
            
            
            (120,339
            )
            
            
            (86,004
            )Equity
      available to common stockholders
            
            
            43,728
            
            
            
            79,887Noncontrolling
      interest
            
            
            307
            
            
            
            -Total
      stockholders' equity
            
            
            44,035
            
            
            
            79,887Total
      liabilities and stockholders' equity
            
            $
            92,265
            
            
            $
            122,629The
      accompanying notes are an integral part of these consolidated financial
      statements.


1




Table of Contents
              DESERT CAPITAL REIT, INC.Consolidated
      Statements of Operations(in
      thousands, except share amounts)(unaudited)Three
      Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008INTEREST
      INCOME (LOSS)Mortgage
      investments
            
            $
            76
            
            
            $
            1,493
            
            
            $
            372
            
            
            $
            5,495Other
      interest
            
            
            227
            
            
            
            311
            
            
            
            680
            
            
            
            1,351Total
      interest income
            
            
            303
            
            
            
            1,804
            
            
            
            1,052
            
            
            
            6,846Interest
      expense
            
            
            670
            
            
            
            698
            
            
            
            1,846
            
            
            
            2,397Net
      interest income (loss)
            
            
            (367
            )
            
            
            1,106
            
            
            
            (794
            )
            
            
            4,449Provision
      for loan losses
            
            
            3,931
            
            
            
            7,228
            
            
            
            9,610
            
            
            
            12,895Net
      interest loss after provision for loan losses
            
            
            (4,298
            )
            
            
            (6,122
            )
            
            
            (10,404
            )
            
            
            (8,446
            )NON-INTEREST
      INCOMERental
      income
            
            
            170
            
            
            
            226
            
            
            
            525
            
            
            
            675Net
      gain on sales of real estate ownedand
      real estate investments
            
            
            78
            
            
            
            -
            
            
            
            75
            
            
            
            -Gain
      on sales of mortgage investments
            
            
            
            
            
            
            18
            
            
            
            
            
            
            
            18Other
            
            
            102
            
            
            
            (23
            )
            
            
            279
            
            
            
            150Total
      non-interest income
            
            
            350
            
            
            
            221
            
            
            
            879
            
            
            
            843NON-INTEREST
      EXPENSEImpairments
      of real estate
            
            
            2,453
            
            
            
            1,931
            
            
            
            8,238
            
            
            
            4,738Equity
      in loss of unconsolidated real estate investments
            
            
            309
            
            
            
            -
            
            
            
            8,979
            
            
            
            -Loss
      on sales of mortgage investments
            
            
            -
            
            
            
            -
            
            
            
            18
            
            
            
            -Loss
      on disposal of assets
            
            
            -
            
            
            
            -
            
            
            
            88
            
            
            
            -Management
      and servicing fees
            
            
            544
            
            
            
            422
            
            
            
            2,055
            
            
            
            1,268Professional
      fees
            
            
            145
            
            
            
            203
            
            
            
            594
            
            
            
            992Insurance
            
            
            166
            
            
            
            197
            
            
            
            487
            
            
            
            482Depreciation
            
            
            104
            
            
            
            122
            
            
            
            333
            
            
            
            364Property
      Taxes
            
            
            507
            
            
            
            (36
            )
            
            
            662
            
            
            
            273Other
            
            
            377
            
            
            
            356
            
            
            
            1,088
            
            
            
            602Total
      non-interest expense
            
            
            4,605
            
            
            
            3,195
            
            
            
            22,542
            
            
            
            8,719Loss
      from continuing operations before taxes
            
            
            (8,553
            )
            
            
            (9,096
            )
            
            
            (32,067
            )
            
            
            (16,322
            )Income
      tax benefit (expense)
            
            
            (32
            )
            
            
            219
            
            
            
            17
            
            
            
            350Net
      loss from continuing operations
            
            
            (8,585
            )
            
            
            (8,877
            )
            
            
            (32,050
            )
            
            
            (15,972
            )Loss
      from discontinued operations
            
            
            (2,352
            )
            
            
            -
            
            
            
            (2,805
            )
            
            
            -Net
      loss
            
            
            (10,937
            )
            
            
            (8,877
            )
            
            
            (34,855
            )
            
            
            (15,972
            )Less:  Net
      loss attributable to noncontrolling interest
            
            
            25
            
            
            
            -
            
            
            
            520
            
            
            
            -Net
      loss available to common stockholders
            
            $
            (10,912
            )
            
            $
            (8,877
            )
            
            $
            (34,335
            )
            
            $
            (15,972
            )Net
      loss per share - basic and dilutedLoss
      from continuing operations
            
            
            (0.51
            )
            
            
            (0.53
            )
            
            
            (1.87
            )
            
            
            (0.95
            )Discontinued
      operations
            
            
            (0.14
            )
            
            
            -
            
            
            
            (0.17
            )
            
            
            -Net
      loss available to common stockholders
            
            $
            (0.65
            )
            
            $
            (0.53
            )
            
            $
            (2.04
            )
            
            $
            (0.95
            )Weighted
      average outstanding shares - basic and diluted
            
            
            16,844,041
            
            
            
            16,825,212
            
            
            
            16,834,830
            
            
            
            16,805,341The
      accompanying notes are an integral part of these consolidated financial
      statements.


2


Table of ContentsDESERT CAPITAL REIT, INC.Consolidated
      Statements of Cash Flows(in
      thousands)(unaudited)Nine Months Ended September
    30,2009
            
            
            2008OPERATING
      ACTIVITIESNet
      loss
            
            $
            (34,855
            )
            
            $
            (15,972
            )Adjustments
      to reconcile net loss to net cash (used) inprovided
      by operating activities:Loss
      (gain) on sales of mortgage investments
            
            
            18
            
            
            
            (18
            )Gain
      on sale of real estate owned and investments in real
estate
            
            
            (75
            )
            
            
            -Depreciation
      and amortization
            
            
            333
            
            
            
            390Stock
      based compensation
            
            
            54
            
            
            
            185Loss
      from discontinued operations, net of tax
            
            
            2,805
            
            
            
            -Provision
      for loan loss
            
            
            9,610
            
            
            
            12,895Loss
      on disposal of assets
            
            
            88
            
            
            
            -Impairment
      of real estate
            
            
            8,238
            
            
            
            4,738Equity
      in loss of unconsolidated real estate investments
            
            
            8,979
            
            
            
            -Provision
      for deferred taxes
            
            
            -
            
            
            
            (314
            )Mortgage
      loans originated for sale
            
            
            -
            
            
            
            (6,332
            )Mortgage
      loan sales
            
            
            -
            
            
            
            7,134Net
      change in:Interest
      receivable
            
            
            498
            
            
            
            828Other
      assets
            
            
            (415
            )
            
            
            (348
            )Accrued
      and Other Liabilities
            
            
            1,726
            
            
            
            53Net
      cash (used) provided by operating activities of continuingoperations
            
            
            (2,996
            )
            
            
            3,239Net
      cash used by operating activities of discontinued
    operations
            
            
            (1,559
            )
            
            
            -Net
      cash (used) provided by operating activities
            
            
            (4,555
            )
            
            
            3,239INVESTING
      ACTIVITIESInvestment
      in real estate mortgages
            
            
            -
            
            
            
            (10,474
            )Proceeds
      from repayments of real estate mortgages
            
            
            -
            
            
            
            10,116Proceeds
      from sales of real estate mortgages
            
            
            275
            
            
            
            3,164Proceeds
      received on equity investments in real estate
            
            
            291
            
            
            
            -Proceeds
      from sale of real estate owned and investments in real
    estate
            
            
            1,633
            
            
            
            -Proceeds
      from repayment of note receivable from related party
            
            
            -
            
            
            
            775Acquisition
      of building and equipment
            
            
            (408
            )
            
            
            (65
            )Net
      cash provided by investing activities of continuingoperations
            
            
            1,791
            
            
            
            3,516Net
      cash used by investing activities of discontinued
    operations
            
            
            (21
            )
            
            
            -Net
      cash provided by investing activities
            
            
            1,770
            
            
            
            3,516FINANCING
      ACTIVITIESDecrease
      (Increase) in restricted cash
            
            
            1,278
            
            
            
            (1,181
            )Principal
      repayments of mortgage loan
            
            
            (242
            )
            
            
            (171
            )Net
      increase (decrease) in notes payable
            
            
            301
            
            
            
            (302
            )Issuance
      of common stock
            
            
            -
            
            
            
            383Deferred
      financing costs
            
            
            (48
            )
            
            
            -Redemption
      of common stock shares
            
            
            (20
            )
            
            
            -Dividends
      on common stock
            
            
            -
            
            
            
            (5,416
            )Offering
      costs paid
            
            
            -
            
            
            
            (77
            )Net
      cash provided (used) by financing activities of continuingoperations
            
            
            1,269
            
            
            
            (6,764
            )Net
      cash provided by financing activities of discontinued
      operations
            
            
            2,342
            
            
            
            -Net
      cash provided (used) by financing activities
            
            
            3,611
            
            
            
            (6,764
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            826
            
            
            
            (9
            )Cash
      and cash equivalents at beginning of period
            
            
            351
            
            
            
            163Cash
      and cash equivalents at end of period
            
            $
            1,177
            
            
            $
            154


















Supplemental
      disclosure of cash flow information:Nine Months Ended September
    30,2009
            
            
            2008Cash
      paid for interest
            
            $
            2,037
            
            
            $
            2,513Cash
      paid for taxes
            
            
            67
            
            
            
            -Common
      stock issued for dividend reinvestment program
            
            
            -
            
            
            
            867Common
      stock dividends declared but not paid
            
            
            -
            
            
            
            430Foreclosed
      assets acquired in exchange for loans, net of impairments
            
            
            12,698
            
            
            
            21,384Asset
      held for sale transferred from mortgage investments, net
            
            
            10,023
            
            
            
            -Charge
      off of foreclosure costs
            
            
            195
            
            
            
            -Real
      estate assets owned contributed to equityinvestments
      in real estate
            
            
            13,116
            
            
            
            2,463Real
      estate assets owned contributed to investments in real
    estate
            
            
            14,940
            
            
            
            -Noncontrolling
      interest
            
            
            828
            
            
            
            -Equity
      investments sold in exchange for reduction in receivable
            
            
            25
            
            
            
            -Offering
      costs incurred but not paid
            
            
            -
            
            
            
            17The
      accompanying notes are an integral part of these consolidated financial
      statements.





3
 Table of Contents


Desert Capital REIT, INC.


Condensed
Notes to Unaudited Consolidated Financial Statements


September
30, 2009




Note
1 - Organization


We are a
Maryland corporation, formed in December 2003 as a real estate investment trust
(“REIT”).  When we first began conducting business, we specialized in
the financing of real estate projects by providing short-term mortgage loans to
homebuilders and commercial developers in markets where we believed we possessed
requisite skills and market knowledge, which were primarily in the western
United States. We historically invested in 12 to 18 month, first and second lien
mortgage loans, consisting of acquisition and development, construction, and
commercial property loans to both local and national developers and
homebuilders. We derived our revenues primarily from interest payments received
from mortgage investments funded with our equity capital and borrowed
funds.




We
generated a spread between the interest income on mortgage loans and the
interest expense on any borrowings used to finance the loans. However,
the increased level of non-performing loans combined with our lack of capital
and liquidity has caused us to curtail our investing activities and focus our
efforts on capital and asset preservation.  We did not originally
intend to own real estate; however, market conditions since 2007 have created a
situation where, in many cases, foreclosure is the most attractive option
available to us. As we continue to foreclose on mortgage loans, we have
adjusted our portfolio strategy to include land ownership and investments in
real estate ventures.  We use two primary strategies for generating
cash flows and resolving our non-performing loans and real estate owned which
include sale of foreclosed properties and contribution of foreclosed properties
to joint ventures.




During
the first quarter, certain of our related parties made changes to their legal
names in conjunction with a corporate branding initiative. Specifically, our
Advisor, Sandstone, became CM Group, LLC (“CM Group”) and Consolidated Mortgage,
LLC became CM Capital Services, LLC (“CM Capital”).   In
addition, CM Securities, LLC (“CM Securities”) acquired the business
of  CMC Financial Services, Inc. The ownership of these entities was
not affected.




All of
our loan origination and loan servicing activities were conducted through CM
Capital, which was our wholly-owned subsidiary from October 2005 through
November 2007 at which time it was sold to CM Group, a related
party.  To the extent we have funds available to invest in new loans,
CM Capital will continue to originate and service loans for us.  CM
Capital is also the asset manager with respect to our direct and indirect real
property interests.




We are
externally managed by CM Group.  CM Group’s majority owner is Todd
Parriott, our CEO, and certain other of our officers have ownership
interests.  See Note 11 – 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.




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




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 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, 2008.  In 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 nine months ended September 30, 2009 are not
necessarily indicative of results that may be expected for the entire year
ending December 31, 2009.




4
 Table of Contents


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 and majority owned subsidiaries for which we
control. All significant intercompany balances and transactions have been
eliminated in consolidation.




Our
interest in Desert Capital TRS Statutory Trust I, 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.  In
addition we use the equity method to account for other 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 (LLCs) formed for the purpose of developing properties upon
which we have foreclosed.




Reclassifications


Certain
reclassifications have been made in the presentation of the quarter ended and
nine months ended September 30, 2008 and year ended December 31, 2008
consolidated financial statements, specifically within the consolidated
statements of operations within the caption “management and servicing fees,” and
within the consolidated balance sheets within the caption “management and
servicing fees payable, related party.” These reclassifications were made to
reflect such items consistent with our 2009 presentation and had no impact on
our cash flow from investing activities, net income, or balance sheets as
previously reported.




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 contractual term of
the investment and recorded on the accrual basis under the effective interest
method. Income recognition is suspended for mortgage investments at the earlier
of the date at which payments become 90 days past due or when, in the opinion of
management, a full recovery of interest and principal becomes doubtful. Interest
accrued but not collected is reversed at the time a loan is classified as
non-performing.  Income recognition is resumed when the mortgage
investment becomes contractually current and performance is demonstrated to be
resumed.




Restricted
Cash


Restricted
cash includes accounts held by trust agents, escrow companies, lenders and
banks. We currently have one restricted cash balance.  We established
a restricted cash reserve account and paid our junior subordinated interest
payments from this account, as part of the modification entered into on our
junior subordinated debt.   Changes in the restricted cash are
reflected as financing activities in the statement of cash flows.  See
Note 11.




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 and charge-offs.  We generally do not expect prepayments due to the
nature of the mortgage loans.




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 an LLC.  In the case where we are one of several investors
in a larger loan, such loans are foreclosed upon using an LLC to facilitate
foreclosing our lender interest along with private investors who hold the
remaining loan balance and have similar economic interests. We record real
estate held directly or through an LLC at the lower of the recorded amount of
our related mortgage loan being foreclosed (net of any impairment charge), 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.  Costs relating to the development or improvement of the
assets are capitalized, where appropriate, and costs relating to holding the
assets are charged to expense.




On a
periodic basis, management assesses whether there are any indicators that the
fair value of our investments in real estate owned may be 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 is measured as the excess of the
carrying amount of the investment over the fair value of the
investment.




5
 Table of Contents


Investments
in Real Estate


Certain
real estate assets acquired through foreclosure are being held for investment or
have been contributed to operating real estate investment ventures with
investors/developers who provide additional financing, development expertise and
operational management expertise.  We evaluate our investments in real
estate on a regular basis to determine if any events have occurred that impact
the accounting for investments or are indicators of impairment as
follows:




Upon
contribution to a venture or establishment of an LLC at foreclosure, we evaluate
our investments in partially owned entities to determine whether an entity is a
variable interest entity (VIE), and if so, whether we are the primary
beneficiary of the VIE.   We evaluate (1) the sufficiency of
the fair value of the entities’ equity investments at risk to absorb losses,
(2) that as a group the holders of the equity investments at risk have
(a) the direct or indirect ability through voting rights to make decisions
about the entities’ significant activities, (b) the obligation to absorb
the expected losses of the entity and their obligations are not protected
directly or indirectly, (c) the right to receive the expected residual
return of the entity and their rights are not capped, and (3) substantially
all of the entities’ activities do not involve or are not conducted on behalf of
an investor that has disproportionately fewer voting rights in terms of its
obligation to absorb the expected losses or its right to receive expected
residual returns of the entity, or both.




We
periodically assess whether events have occurred that would require us to
reevaluate consolidation criteria including changes in the operating agreements,
debt structure guarantees, or commitments or changes in the ownership
percentages in the LLCs in which we are a member.




We
account for our investments in unconsolidated real estate ventures under the
equity method of accounting when we have concluded that either the entity is not
a VIE or that we are not the primary beneficiary of the VIE and we exercise
significant influence, but do not control these entities under the provisions of
the entities’ governing agreements.  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.




If
we determine that the entity is not a VIE, we own less than 20%, and we do not
exercise significant influence, we account for these investments under the cost
method of accounting.




Management
periodically assesses the recoverability of our equity method and cost method
investments. Our investments are non-publicly traded investments. As such, if an
identified event or change in circumstances requires an impairment evaluation,
management assesses fair value based on valuation methodologies, including
discounted cash flows, estimates of sales proceeds and external appraisals, as
appropriate. We consider the assumptions that we believe hypothetical
marketplace participants would use in evaluating estimated future cash flows
when employing the discounted cash flows and estimates of sales proceeds
valuation methodologies. If an investment is considered to be impaired and the
decline in value is other than temporary, we record a charge to
earnings.




Noncontrolling
Interests


Noncontrolling
(i.e., minority) ownership interests in subsidiaries held by parties other than
the parent, and the amount of consolidated net income is clearly identified,
labeled, and presented in the consolidated financial statements within equity,
but separate from the parent’s equity.  Net income attributable to
noncontrolling interests is excluded from the determination of consolidated net
income.   Prior to first quarter of 2009, we did not have any
noncontrolling interests.




Allowance
for Loan Losses


The
allowance for loan losses represents management’s estimate of probable losses
inherent in our portfolio of loans. The allowance for loan losses is reflected
in our financial statements based upon individual review of the loans and the
specific borrowers credit quality 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 the estimate of
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.   Individual valuations of non-performing loans
are performed and specific allowances for losses may be established for
non-performing 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.




In cases
where loans are restructured, the restructuring is considered a troubled debt
restructuring and is evaluated accordingly for impairment based upon the
expected present value of the cash flows of the loan as restructured compared to
the present value of cash flows as required under the original terms of the
loan.




Asset held for sale


We
classify the assets and liabilities of a business as held for sale when
management approves and commits to a formal plan of sale, an active marketing
plan to sell the asset has been initiated and it is probable that the sale will
be completed within one year. Assets and liabilities identified as held for sale
are classified separately on our balance sheet and the related results of
operations are reported as discontinued operations on our statement of
operations. While these classifications do not have an effect on total assets,
net equity or net income, they affect the classifications within each statement.
Additionally, a determination to classify an asset as held for sale affects
depreciation expense as long-lived assets are not depreciated while classified
as held for sale.
  Assets
and liabilities classified as held for sale are carried at the lower of their
carrying amount or fair value net of estimated selling costs.  Losses
are recognized immediately where the carrying value exceeds fair value and gains
are recognized at the time of sale.  Future costs associated with a
disposal activity are recognized in the period in which the cost is
incurred.


6
 Table of Contents


Fair Value
 We
measure or monitor many of our assets and liabilities on a fair value basis.
Fair value would be used on a recurring basis for assets and liabilities in
which fair value is the primary basis of accounting, however we do not have any
assets for which fair value is used on a recurring basis. Additionally, fair
value is used on a non-recurring basis to evaluate assets for impairment and for
disclosure purposes. Examples of these non-recurring uses of fair value include
our mortgage loan portfolio, real estate owned and investments in real estate
ventures, our debts, certain loans held for sale accounted for on a lower of
cost or market basis, and long-lived assets. Fair value is defined as the price
that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement
date.  Depending on the nature of the asset or liability, we use
various valuation techniques and assumptions when estimating fair
value.
  We
applied the following fair value hierarchy:
  Level
1 – Assets or liabilities for which the identical item is traded on an active
exchange, such as publicly-traded instruments or futures contracts.
 Level
2 – Assets and liabilities valued based on observable market data for similar
instruments.
 Level
3 – Assets or liabilities for which significant valuation assumptions are not
readily observable in the market; instruments valued based on the best available
data, some of which is internally developed, and considers risk premiums that a
market participant would require.
  When
determining the fair value measurement for assets and liabilities required or
permitted to be recorded at fair value, we consider the principal or most
advantageous market in which it would transact and considers assumptions that
market participants would use when pricing the asset or liability.
  Recent Accounting Developments
 ASC
topic 105 incorporates the July 2009, FASB issuance of SFAS
No. 168,Codification and the Hierarchy of Generally Accepted Accounting
Principles, which establishes the FASB Accounting Standards Codification
(the “Codification” or “ASC”) and supersedes all existing accounting standards
as the single source of authoritative non-governmental U.S. GAAP.  All
other accounting literature not included in the Codification is considered
non-authoritative, except for additional authoritative rules and interpretive
releases of the SEC and applicable only to SEC registrants.  The
Codification is organized by topic, subtopic, section, and paragraph, each of
which is identified by a numerical designation.  This statement
applies beginning in the third quarter 2009.  All accounting
references have been updated, and therefore SFAS references have been replaced
with ASC references.
  Effective
beginning our second quarter 2009, theFinancial Instruments Topic, Accounting Standards Codification (ASC)
825-10-65-1 requires disclosures about fair value of financial instruments in
quarterly reports as well as in annual reports. These additional disclosures had
no material impact on the Company’s financial statements.  See Note 12 for
these disclosures.
  In
December 2007, the FASB issued Codification No. 810, Non-controlling Interests
in Consolidated Financial Statements ("ASC 810"), which requires all entities to
report noncontrolling (minority) interests in subsidiaries as equity in the
consolidated financial statements. We adopted ASC 810 on June 28, 2009, and the
adoption did not have a material impact on our financial position and results of
operations.
  In
November 2008, the FASB issued Codification No. 323, Equity Method Investment
Accounting Considerations ("ASC 323"). ASC 323 clarifies accounting for certain
transactions and impairment considerations involving the equity method,
including initial measurement, decrease in investment value and change in level
of ownership or degree of influence. ASC 323 is effective on a prospective basis
for fiscal years beginning on or after December 15, 2008. We adopted ASC 323 on
June 28, 2009, and the adoption did not have an impact on our financial
statements.
  In
May 2009, the FASB issued ASC 855, Subsequent
Events, which establishes general standards of accounting and disclosure
for events that occur after the balance sheet date but before the financial
statements are issued. We adopted this standard July 1, 2009 and have provided
the new disclosures as required in Note 16.
  In
August 2009, the FASB issued Accounting Standards Update (ASU)
No. 2009-04, Accounting
for Redeemable Equity Instruments. The adoption of ASU 2009-04 will not
have a material impact on our condensed consolidated financial
statements.
  In
August 2009, the FASB issued ASU No. 2009-05, Fair
Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair
Value.  This update provides clarification for the fair value
measurement of liabilities in circumstances in which a quoted price in an active
market for an identical liability is not available. ASU also clarifies that when
estimating a fair value of a liability, a reporting entity is not required to
include a separate input or adjustment to other inputs relating to the existence
of a restriction that prevents the transfer of the liability.  This
update is effective for interim periods beginning after August 28, 2009. We
do not expect the adoption of this standard to have a material effect on our
financial position or results of operations.
  In
September 2009, the FASB issued ASU No. 2009-12, Investments
in Certain Entities That Calculate Net Asset Value per Share (or its
Equivalent). This ASU provides amendments for the fair value measurement
of investments to create a practical expedient to measure the fair value of an
investment in certain entities on the basis of the net asset value per share of
the investment (or its equivalent) determined as of the reporting entity’s
measurement date. Therefore, certain attributes of the investment (such as
restrictions on redemption) and transaction prices from principal-to-principal
or brokered transactions will not be considered in measuring the fair value of
the investment if the practical expedient is used. The amendment in this ASU
also requires disclosures by major category of investment about the attributes
of those investments, such as the nature of any restrictions on the investor’s
ability to redeem its investments at measurement date, any unfunded commitments,
and the investment strategies of the investees. The amendments in this ASU are
effective for interim and annual periods ending after December 15, 2009.
Early application is permitted. We are currently evaluating this new ASU and
anticipate that it will not have a significant impact on our financial position
or results of operations.


7
 Table of Contents


Note
3 – Mortgage Investments


Mortgage
investments represent first and second lien positions on acquisition and
development, construction and commercial property loans. As of September 30,
2009, 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 loan term.




The
following table represents our mortgage investments (dollars in
thousands)


September
      30, 2009Loan
      Type
                
                Number
      of Loans
                
                
                Balance
                
                
                Allowance
      for Loan Losses
                
                
                Net
      Balance
                
                
                Weighted
      Average Interest Rate (1)
                
                
                Portfolio
      PercentageAcquisition
      and development loans
                
                
                15
                
                
                $
                49,914
                
                
                $
                15,421
                
                
                $
                34,493
                
                
                
                12.2
                %
                
                
                95.6
                %Construction
      loans
                
                
                2
                
                
                
                2,288
                
                
                
                210
                
                
                
                2,078
                
                
                
                8.2
                %
                
                
                4.4
                %Commercial
      property loans
                
                
                1
                
                
                
                7
                
                
                
                -
                
                
                
                7
                
                
                
                6.5
                %
                
                
                0.0
                %Total
      mortgage investments
                
                
                18
                
                
                $
                52,209
                
                
                $
                15,631
                
                
                $
                36,578
                
                
                
                12.0
                %
                
                
                100.0
                %December
      31, 2008Loan
      Type
                
                Number
      of Loans
                
                
                Balance
                
                
                Allowance
      for Loan Losses
                
                
                Net
      Balance
                
                
                Weighted
      Average Interest Rate (1)
                
                
                Portfolio
      PercentageAcquisition
      and development loans
                
                
                28
                
                
                $
                72,507
                
                
                $
                17,885
                
                
                $
                54,622
                
                
                
                12.3
                %
                
                
                80.3
                %Construction
      loans
                
                
                7
                
                
                
                3,428
                
                
                
                636
                
                
                
                2,792
                
                
                
                9.7
                %
                
                
                3.8
                %Commercial
      property loans
                
                
                2
                
                
                
                14,408
                
                
                
                2,284
                
                
                
                12,124
                
                
                
                14.0
                %
                
                
                15.9
                %Total
      mortgage investments
                
                
                37
                
                
                $
                90,343
                
                
                $
                20,805
                
                
                $
                69,538
                
                
                
                12.5
                %
                
                
                100.0
                %(1)
      Represents the stated rate of the loan.
  The
following table presents our mortgage investments by geographic location
(dollars in thousands):


September
      30, 2009
              
              
              December
      31, 2008Location
              
              Balance
              
              
              Allowance
      for Loan Losses
              
              
              Net
      Balance
              
              
              Original
      Balance Portfolio Percentage
              
              
              Balance
              
              
              Allowance
      for Loan Losses
              
              
              Net
      Balance
              
              
              Original
      Balance Portfolio PercentageNevada
              
              $
              13,575
              
              
              $
              6,898
              
              
              $
              6,677
              
              
              
              26.0
              %
              
              $
              51,532
              
              
              $
              17,268
              
              
              $
              34,264
              
              
              
              57.1
              %California
              
              
              13,274
              
              
              
              5,000
              
              
              
              8,274
              
              
              
              25.4
              %
              
              
              13,274
              
              
              
              998
              
              
              
              12,276
              
              
              
              14.7
              %Texas
              
              
              10,425
              
              
              
              210
              
              
              
              10,215
              
              
              
              20.0
              %
              
              
              10,425
              
              
              
              210
              
              
              
              10,215
              
              
              
              11.5
              %Arizona
              
              
              7,540
              
              
              
              2,614
              
              
              
              4,926
              
              
              
              14.4
              %
              
              
              7,711
              
              
              
              1,420
              
              
              
              6,291
              
              
              
              8.5
              %Missouri
              
              
              7,395
              
              
              
              909
              
              
              
              6,486
              
              
              
              14.2
              %
              
              
              7,401
              
              
              
              909
              
              
              
              6,492
              
              
              
              8.2
              %Total
              
              $
              52,209
              
              
              $
              15,631
              
              
              $
              36,578
              
              
              
              100.0
              %
              
              $
              90,343
              
              
              $
              20,805
              
              
              $
              69,538
              
              
              
              100.0
              %
 
 The
following table presents details on performing, non-performing and impaired
loans and related allowance for loan losses as of September 30, 2009 and
December 31, 2008 (dollars in thousands):


September
      30, 2009
              
              
              December
      31, 2008Number
      of Loans
              
              
              Balance
              
              
              Number
      of Loans
              
              
              BalanceNon-performing
      loans with a related allowance
              
              
              11
              
              
              $
              33,926
              
              
              
              24
              
              
              $
              65,903Non-performing
      loans without a related allowance
              
              
              4
              
              
              
              12,136
              
              
              
              5
              
              
              
              17,822Related
      allowance for loan losses on non-performing loans
              
              
              -
              
              
              
              (14,417
              )
              
              
              -
              
              
              
              (20,805
              )Total
      non-performing loans
              
              
              15
              
              
              $
              31,645
              
              
              
              29
              
              
              $
              62,920Performing
      loans with a related allowance
              
              
              2
              
              
              
              6,140
              
              
              
              -
              
              
              
              -Performing
      loans without a related allowance
              
              
              1
              
              
              $
              7
              
              
              
              8
              
              
              $
              6,618Related
      allowance for loan losses on performing loans
              
              
              -
              
              
              
              (1,214
              )
              
              
              -
              
              
              
              -Total
      performing loans
              
              
              3
              
              
              $
              4,933
              
              
              
              
              
              
              $
              6,618Total
              
              
              18
              
              
              $
              36,578
              
              
              
              37
              
              
              $
              69,538
 8
 Table of Contents
 Interest
income recognized on impaired loans for the three months ended September 30,
2009 and 2008 was $0 and $121,000, respectively.  Interest income
recognized on impaired loans for the nine months ended September 30, 2009 and
2008 was $4,000 and $1.3 million, respectively.




During
the nine months ended September 30, 2009 we sold property collateralizing two of
our mortgage investments in loans with a carrying value of $293,000 for cash
proceeds of $275,000, resulting in an $18,000 loss on sale.  During
the nine month period ended September 30, 2008, we sold our portion of seven
mortgage loans with a carrying balance of $3.2 million for cash proceeds of $3.2
million.




In April
2009, we foreclosed on a nonperforming loan collateralized by an operating
business with an aggregate original loan balance of $14.4 million.  On
the date of foreclosure, we valued the real estate property and related business
at $10.0 million, resulting in a charge to our allowance for loan losses of $4.4
million; see also Note 14 – Acquisition.




At the
acquisition date and as of September 30, 2009, we have classified the real
estate property and related business as an asset held for sale. The related
results of operations are reported as discontinued operations on our
consolidated statement of operations for the three and nine months ended
September 30, 2009; see also Note 15 – Discontinued Operations.




The
following is a roll forward of the allowance for loan losses for the three and
nine months ended September 30, 2009 and 2008, and year ended December 31, 2008
(dollars in thousands):


Three
      Months Ended
                
                
                Nine
      Months Ended
                
                
                Year
      EndedSeptember
      30,
                
                
                September 30,
                
                
                December
      31,2009
                
                
                
                2008
                
                
                
                2009
                
                
                
                2008
                
                
                
                2008Balance,
      beginning
                
                $
                15,144
                
                
                $
                14,443
                
                
                $
                20,805
                
                
                $
                25,444
                
                
                $
                25,444Provision
      for loan loss
                
                
                3,999
                
                
                
                5,104
                
                
                
                9,937
                
                
                
                10,771
                
                
                
                21,491Amounts
      charged off
                
                
                -
                
                
                
                -
                
                
                
                (4,377
                )
                
                
                (300
                )
                
                
                (5,600
                )Transfers
      to real estate ownedand
      investments in real estate
                
                
                (3,512
                )
                
                
                (2,385)
                
                
                
                (10,734
                )
                
                
                (18,753
                )
                
                
                (20,530
                )Balance,
      ending
                
                $
                15,631
                
                
                $
                17,162
                
                
                $
                15,631
                
                
                $
                17,162
                
                
                $
                20,805
 During
the nine months ended September 30, 2009, we foreclosed on properties with a
fair value of $15.2 million which was comprised of loans with an aggregate
original balance of $23.4 million. We transferred $11.6 million to real
estate owned and $3.6 million to investments in real estate.  See also
Note 4 – Real Estate Owned and Note 5 – Investments in Real
Estate.




Note
4 – Real Estate Owned


During
the nine months ended September 30, 2009, properties with an aggregate original
balance of $19.7 million were foreclosed and classified as real estate
owned.  These properties had a fair value of $11.6 million. In
addition, we disposed of approximately $35,000 of real estate owned for cash
proceeds of $32,000, resulting in a $3,000 loss on the sale.  We did
not dispose of any real estate owned through sale during the nine month period
ending September 30, 2008.




During
the nine months ended September 30, 2009, we reclassified property valued at
$28.1 million from real estate owned to investments in real estate, when we
determined that the LLCs in which we were a member, became operating entities.
During 2008 we contributed property valued at a total of $6.7 million to three
joint ventures, in each of which we have between a 13% and a 50%
non-controlling ownership interest.  See also Note 5 – Investments in
Real Estate.




The
following is a summary of the changes in real estate owned during the nine
months ended September 30, 2009 (dollars in thousands):


Balance
      December 31, 2008
                
                $
                19,979Foreclosures
                
                
                11,612Real
      estate consolidated as noncontrolling interest
                
                
                828Impairments
                
                
                (1,831
                )Sales
      of real estate owned
                
                
                (35
                )Adjustments
      to foreclosure costs
                
                
                (187
                )Real
      estate reclassified to investment in real estate, including noncontrolling
      interest
                
                
                (28,056
                )Balance
      September 30, 2009
                
                $
                2,310
  The
following is a summary of the carrying value of our real estate owned as of
September 30, 2009 and December 31, 2008 (dollars in
thousands):


September
      30,
              
              
              December
      31,Description
              Location
              
              2009
              
              
              2008Undeveloped
      land
              NV,
      AZ, CA
              
              $
              810
              
              
              $
              13,947Single
      family residential lots
              NV,
      AZ
              
              
              -
              
              
              
              1,707Office
      building
              NV,
      TX
              
              
              1,500
              
              
              
              2,613Other
              NV
              
              
              -
              
              
              
              1,712Total
              
              
              $
              2,310
              
              
              $
              19,979
 9
 Table of Contents
 Note
5 – Investments in Real Estate


Investments
Accounted for under the Cost Method


As of
September 30, 2009 and December 31, 2008 we had $3.2 million and $1.0 million,
respectively, in real estate investments that we accounted for under the cost
method.   During the nine months ended September 30, 2009, we
evaluated certain of our assets that we held in real estate owned and determined
that activities occurring within the LLCs in which we are a member constituted
those of an operating entity.  We reclassified $3.0 million of these
assets, previously classified as real estate owned, into cost method investments
after we determined that our ownership percentages in those properties was less
than 20% and we do not exercise significant influence.  Upon
reclassification of these investments, accruals related to expenses within these
LLCs were reclassified and offset as adjustments to the carrying value on these
assets in the amount of $131,000.  During the nine months ended
September 30, 2009, we have evaluated the carrying value of our cost method
investments for impairment and have concluded that the decrease in value of our
cost method investments is other than temporary resulting in an impairment of
$824,000.




Investments
Accounted for under the Equity Method




Other
Equity Method Investments


We held
$4.3 million in other real estate investments that we accounted for under the
equity method of accounting at September 30, 2009 and $0 at December 31,
2008.   During the nine months ended September 30, 2009, we
evaluated certain of our assets that we held in real estate owned and determined
that activities occurring within the LLCs in which we are a member, constituted
those of an operating entity.  We reclassified $13.1 million of these
assets, previously classified as real estate owned, into equity method
investments in real estate after we determined that our ownership percentages in
those properties was greater than 20% but less than 50%.  Upon
reclassification of these investments, accruals related to expenses within these
LLCs were reclassified and offset as adjustments to the carrying value of these
assets in the amount of $576,000.  In addition, during the nine months
ended September 30, 2009, we recognized a loss on our equity in these real
estate investments of $8.3 million, a direct result of impairments on the assets
due to a decrease in the fair value of the underlying properties and our share
of certain losses within the LLCs.




Joint
Ventures


During
the year ended December 31, 2008, we entered into three joint venture agreements
with a third-party homebuilder for the construction of single family homes in
Las Vegas, Nevada.  We contributed property to the joint ventures, which we
had previously acquired through foreclosure and classified as real estate
owned.  These ventures are accounted for under the equity method of
accounting because we have between a 13% and a 50% non-controlling ownership
interest.  Our venture partner manages the operations of the joint
ventures.  All major decisions require the approval of both joint venture
partners, 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 in the three ventures in an aggregate amount of
$6.7 million, the carrying value of the lots which approximated fair value at
the time of the formation of the joint venture.  We have no responsibility
to provide additional funding to the ventures.  Additional funding for the
construction of homes and sales of such will be provided by our venture partner
or incurred by the joint venture.  Our share of losses, if any, would be
limited to the value of lots contributed.  During the first nine months of
2009, five homes were constructed and sold to homeowners.  We received
cash proceeds of $291,000 from these sales, resulting in a decrease of an
outstanding receivable of $25,000 and a return of $266,000 of our equity
investments.  During the nine months ended September 30, 2009, we
recognized a loss of $2.0 million related to our joint ventures of which
$712,000 was reflected as a loss in equity and $1.3 million was reflected
as an impairment of our contribution due to a decrease in the value of
the lots contributed.  These losses are a direct result of
the continued pressure on the sales prices of new homes for which we have agreed
to lower the lot release prices to allow the developer to lower the sales prices
of the homes being developed in the joint venture.  The carrying value of
the joint ventures, net of impairments, at September 30, 2009 was
$3.9 million.




Fully
Consolidated Investments in Real Estate


At
September 30, 2009, we held $7.0 million in fully consolidated real estate
investments. We did not hold any fully consolidated investments in real estate
at December 31, 2008.  During the nine months ended September 30,
2009, we evaluated certain of our assets that we held in real estate owned and
determined that activities occurring within the LLCs in which we are a member,
constituted those of an operating entity.  We reclassified $11.9
million of these assets, including our acquisition of an $828,000 non
controlling interest, previously classified as real estate owned, into fully
consolidated investments in real estate after we determined that our ownership
percentages in those properties was greater than 50% and that we controlled the
entity.  During the nine months ended September 30, 2009, we
recognized impairments in these real estate investments of $4.3
million.




During
the nine months of 2009, we consolidated the equity and net operating income and
expenses of one entity in which we have less than 100%
ownership.   The noncontrolling interest of 8.8% had an original
value of $828,000,  and at September 30, 2009 has a carrying value of
$307,000, and is reflected separately on the balance sheet.




10
 Table of Contents


The
following provides a summary of the changes in investments in real estate
during the nine months ended September 30, 2009 (dollars in
thousands):


Fully
      Consolidated
                    Investments
                  
                  
                  Equity
      Method Joint Ventures
                  
                  
                  Other
      Equity Investments
                  
                  
                  Cost
      Method Investments
                  
                  
                  TotalBalance
      December 31, 2008
                  
                  $
                  -
                  
                  
                  $
                  6,167
                  
                  
                  $
                  -
                  
                  
                  $
                  1,000
                  
                  
                  
                  7,167Assets
      reclassified from real estate owned
                  
                  
                  11,103
                  
                  
                  
                  -
                  
                  
                  
                  13,116
                  
                  
                  
                  3,009
                  
                  
                  
                  27,228Assets
      reclassified from mortgage investments
                  
                  
                  841
                  
                  
                  
                  -
                  
                  
                  
                  56
                  
                  
                  
                  188
                  
                  
                  
                  1,085Consolidation
      of noncontrolling interest
                  
                  
                  828
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  828Sales
      of real estate investments
                  
                  
                  (1,500
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (23
                  )
                  
                  
                  (1,523
                  )Sales
      of joint venture property
                  
                  
                  -
                  
                  
                  
                  (266
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (266
                  )Impairments
      on real estate investments
                  
                  
                  (4,304
                  )
                  
                  
                  (1,279
                  )
                  
                  
                  -
                  
                  
                  
                  (824
                  )
                  
                  
                  (6,407
                  )Other
      adjustments to carrying value
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (576
                  )
                  
                  
                  (131
                  )
                  
                  
                  (707
                  )Equity
      in loss on real estate investments
                  
                  
                  -
                  
                  
                  
                  (712
                  )
                  
                  
                  (8,267
                  )
                  
                  
                  -
                  
                  
                  
                  (8,979
                  )Balance
      September 30, 2009
                  
                  $
                  6,968
                  
                  
                  $
                  3,910
                  
                  
                  $
                  4,329
                  
                  
                  $
                  3,219
                  
                  
                  $
                  18,426
 The
following is a summary of our investments in real estate at September 30, 2009
and December 31, 2008 (dollars in thousands):


September
      30,
              
              
              December
      31,Description
              Location
              
              2009
              
              
              2008Undeveloped
      land
              NV,
      AZ
              
              $
              6,571
              
              
              $
              -Single
      family residential lots
              NV,
      AZ
              
              
              5,131
              
              
              
              6,167Office
      building
              NV
              
              
              1,230
              
              
              
              -Other
              NV,
      OR, AZ
              
              
              5,494
              
              
              
              1,000Total
              
              
              $
              18,426
              
              
              $
              7,167


At
September 30, 2009, our investments in real estate were held in 25 limited
liability companies, and our ownership percentage ranged from negligible to
100%.




Note
6 - Stock Based Compensation


The Board
of Directors adopted the 2004 Stock Incentive Plan of Desert Capital REIT, Inc.
(the “Plan”), and we have reserved 1,000,000 shares of common stock for issuance
under the Plan. As of September 30, 2009 we had granted awards for 124,000
restricted shares in aggregate to our Board of Directors and certain executive
officers under the Plan, including 16,000 shares granted in August
2009. The fair value was estimated to be $3.29 per share.  The
shares were granted in annual grants to our directors.




Restricted
stock expense for the three and nine months ended September 30, 2009 and 2008
was $54,000 and $185,000, respectively.




Note
7 - Premises and Equipment


Premises
and equipment are as follows (dollars in thousands):


September
      30, 2009
              
              
              December
      31, 2008Premises
      and improvements
              
              $
              7,474
              
              
              $
              7,811Equipment
              
              
              100
              
              
              
              100Furniture
      and fixtures
              
              
              421
              
              
              
              411Construction
      in progress
              
              
              385
              
              
              
              -8,380
              
              
              
              8,322Less
      accumulated depreciation
              
              
              (1,578
              )
              
              
              (1,507
              )Premises
      and equipment, net
              
              $
              6,802
              
              
              $
              6,815


During
the nine months ended September 30, 2009, we recorded $385,000 of construction
in progress related to tenant improvements on our office building in Henderson,
Nevada, which serves as our corporate headquarters.  These tenant
improvements were related to office space that we rent to related
parties.  These improvements will be placed in service during the
fourth quarter 2009.




11
 Table of Contents


Note
8 – Loss per share


Basic
loss per share includes no dilution and is calculated by dividing net loss
available to common shareholders by the weighted average number of shares of
common stock outstanding during each period. Diluted loss per share reflects the
potential dilution of securities that could share in the earnings or losses of
the entity.  Due to the net loss in all periods presented, the
calculation of diluted per share amounts would create  an
anti-dilutive result and therefore is not presented. As of September 30, 2009
and 2008, there were no unvested shares outstanding under our stock incentive
plan.




The
following table shows loss attributable to common stockholders (dollars and
shares in thousands):




For
      the Three Months Ended
            
            
            For
      the Nine Months EndedSeptember
      30,
            
            
            September
      30,
            
            
            September
      30,
            
            
            September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Net
      loss available to common stockholders:Loss
      from continuing operations, net of loss attributable to noncontrolling
      interest
            
            $
            (8,560
            )
            
            $
            (8,877
            )
            
            $
            (31,530
            )
            
            $
            (15,972
            )Loss
      from discontinued operations, net
            
            
            (2,352
            )
            
            
            -
            
            
            
            (2,805
            )
            
            
            -Net
      loss available to common stockholders:
            
            $
            (10,912
            )
            
            $
            (8,877
            )
            
            $
            (34,335
            )
            
            $
            (15,972
            )Weighted
      average number of common sharesoutstanding
      basic and diluted
            
            
            16,844
            
            
            
            16,825
            
            
            
            16,835
            
            
            
            16,805Loss
      from continuing operations
            
            $
            (0.51
            )
            
            $
            (0.53
            )
            
            $
            (1.87
            )
            
            $
            (0.95
            )Discontinued
      operations
            
            
            (0.14
            )
            
            
            -
            
            
            
            (0.17
            )
            
            
            -Basic
      and diluted loss per common share
            
            $
            (0.65
            )
            
            $
            (0.53
            )
            
            $
            (2.04
            )
            
            $
            (0.95
            )





Note
9 – Dividends and Redemption Requests




Declaration
      Date
                Distribution
      Date
                
                2008January
      31
                February
      15
                
                $
                0.100February
      29
                March
      14
                
                
                0.025March
      31
                April
      15
                
                
                0.025April
      30
                May
      15
                
                
                0.025May
      31
                June
      13
                
                
                0.025June
      30
                July
      15
                
                
                0.025July
      30
                August
      15
                
                
                0.025August
      30
                September
      15
                
                
                0.025September
      30
                October
      15
                
                
                0.025Total
                
                
                $
                0.300
  Upon the
death of a stockholder, at the option of the stockholder’s estate, the estate
has a limited right of redemption with respect to the common
stock.  This right of redemption has been accounted for as a
liability.  At September 30, 2009, we had redemption requests of
164,000 shares of common stock totaling $1.9 million.




Note
10 – Debt


Bank
Note


We had a
$7.5 million secured bank note with a term of one year, which was originally a
credit facility established for short-term funding needs and bears
interest at a rate equal to the prime rate plus 75 basis points, with a
floor of 7.0%.  The interest rate at September 30, 2009 was
7.0%.  At September 30, 2009 and December 31, 2008, we had an
outstanding balance of $179,000 and $1.4 million, respectively. Certain of our
assets are collateral for this note and their value exceeded the note balance on
September 30, 2009. In January 2008, $1.0 million was borrowed, and was not
repaid within the 90-day time required by terms of the bank note. The bank
granted us an extension to February 22, 2009, the original maturity date of the
note, to pay the $1.0 million defaulted principal balance and waived
default-rate interest through the date of the extension.  Our bank
note matured and we were unable to repay the outstanding balance in accordance
with the terms of the agreement. In March 2009, the bank reduced the maximum
amount of the note to its balance at the time of modification, or $1.2 million,
extended the maturity of the note for an additional 12 months and modified
certain of the covenants. In addition, we agreed to the following minimum
principal payments which have been paid:  $100,000 by March 31, 2009
and $25,000 by June 30, 2009.  In September 2009, we entered into
another modification whereby a principal payment in the amount of $50,000 is due
on November 30, 2009, and the remaining balance of the note is due on December
5, 2009.  We have made principal payments in the aggregate amount of
$981,000 since the modification dates of March 31, 2009 and September 17,
2009.  The related loan agreement contains customary default
provisions and requires us to maintain certain financial ratios at quarterly
determination dates.  Our ability to incur additional debt is also
limited.  At September 30, 2009 and as of the date of this filing, we
are not in compliance with certain of the covenants under this loan
agreement.  As of the date of this filing we have paid the balance on
this note.




12
 Table of Contents


Other
Notes Payable


At
September 30, 2009, our balance of notes payable included two debt agreements
totaling $1.5 million. We set aside interest reserves with a balance of $241,000
at September 30, 2009, which have been reflected as a reduction in the note
balance, resulting in a net note balance of $1.2
million.   Interest is accrued and paid on the principal amount
of the notes, or $1.5 million.  The interest rates on these notes
range from 10% to 11%, and payments will be made monthly from the interest
reserve account with a balloon payment of the principal balance due at
maturity.  The debt is collateralized by certain of our real estate
investments with a carrying value of $5.5 million.  The proceeds from
the notes of $1.5 million, less closing costs, funding of the interest reserves
and other fees were $1.0 million at the date of closing, and were disbursed to
CM Capital and classified as prepaid expenses on our balance sheet, and were
included in other assets.  At September 30, 2009 this balance of the
prepaid expense was $874,000 and is used for the payment of ownership costs,
such as property taxes and legal fees, and servicing and property management
fees paid to our related party loan servicer and asset manager, CM
Capital.




During
the second quarter of 2009, we entered into an uncollateralized note payable
agreement with a third party.  The principal balance on the note is
$250,000 and bears an annual interest rate of 10%.




The
following table presents a summary of our other notes payable (dollars in
thousands):


Interest
      Rate
              
              Maturity
      Date
              
              Original
      Note Balance
              
              
              Interest
      Reserves
              
              
              Carrying
      Balance10%
              
              2/23/2011
              
              $
              1,247
              
              
              $
              (192
              )
              
              $
              1,05511%
              
              8/18/2011
              
              
              226
              
              
              
              (49
              )
              
              
              17710%
              
              6/30/2012
              
              
              250
              
              
              
              -
              
              
              
              250$
              1,723
              
              
              $
              (241
              )
              
              $
              1,482


Mortgage
Loans Payable


We have a
mortgage loan from a bank, with an outstanding principal balance of $6.1 million
and $6.3 million as of September 30, 2009 and December 31, 2008,
respectively.  This loan bears interest at a rate equal to the prime
rate, with a floor of 6.75% and a ceiling of 7.75%. Principal and interest are
payable monthly and the note matures in 2026, with no prepayment penalty. The
interest rate on September 30, 2009 and December 31, 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 September 30,
2009.




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. The loan had an
outstanding principal balance of $1.5 million as of September 30, 2009 and $1.6
million as of December 31, 2008.  The note bears interest equal to the
prime rate minus 50 basis points (2.75% at June 30, 2009), and matures in
April 2011, with no prepayment penalty.  Principal and interest are
payable monthly.




Junior
Subordinated Notes Payable


In June
2006, we issued $30.0 million in unsecured trust preferred securities through a
newly formed Delaware statutory trust, Desert Capital TRS Statutory Trust
I, 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 reset
each calendar quarter, which was 4.50% and 7.47% on September 30, 2009 and
December 31, 2008, respectively.




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.




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




13
 Table of Contents


Our
junior subordinated notes contain customary default provisions and require us to
maintain certain financial ratios at quarterly determination dates, including a
minimum tangible net worth requirement.  Our ability to incur
additional 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 would 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 were required to replace the reserve account with
a letter of credit in the face amount of $2.1 million as security for the trust
preferred securities prior to December 31, 2008; however, we were unable to do
so.  During the nine months ended September 30, 2009, the reserve
account was used to fund interest payments on the securities, and at September
30, 2009, the balance had been depleted.  At September 30, 2009,
interest payable on the securities was $230,000.




At
September 30, 2009 and December 31, 2008, we were not in compliance with all
covenants as modified.   On April 3, 2009, we received a written
notice of the tangible net worth default from the holders of the preferred
securities, which was not cured.  On July 27, 2009, we received a
written Notice of Event of Default and Acceleration from the holders of the
preferred securities that because our tangible net worth was less than $100
million, a default had occurred under the our junior subordinated indenture
which had continued for more than 30 days and had caused an event of default to
occur under the junior subordinated indenture.  The notice further
stated that as a result of the occurrence of such event of default, the
principal amount of our obligations under the junior subordinated indenture,
together with any and all other amounts payable thereunder had been accelerated
and declared to be immediately due and payable by the holders of the preferred
securities.  The notice further stated that the holders of the
preferred securities, may at their option, pursue all available rights and
remedies.  Prior to the acceleration of the obligations, no default in
the payment of principal or interest had occurred under the junior subordinated
indenture.  On July 27, 2009, we also received a copy of a written
notice to the trustee under our junior subordinated notes from the holders of
the preferred securities directing the trustee to withdraw the amount on deposit
in the reserve account and apply such amount to the payment of amounts due and
owing to the holders of the preferred securities.




We have
been in negotiations with the holders of the preferred securities to negotiate a
restructuring of obligations to the holders of the preferred securities. Our
negotiations to restructure our obligations have not been successful to date and
there can be no assurance that such efforts will be successful.




Note
11 - Commitments and Related Parties


CM Group
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.  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 for the three
and nine months ended September 30, 2009 was $358,000 and $1.1 million,
respectively, and $422,000 and $1.3 million for the three and nine months ended
September 30, 2008, respectively. At September 30, 2009, $1.3 million of first
tier management compensation was included in accounts payable and accrued
expenses.




The
second-tier management compensation is a tiered percentage of the amount of our
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
calculated on 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 for the three and
nine months ended September 30, 2009 and 2008 was zero.




During
2008, the composition of our investment portfolio changed dramatically from a
performing loan portfolio to a defaulted loan and foreclosed property portfolio.
Our Advisor, CM Group, receives a management fee for general management of the
day-to-day operations of the REIT. With the changing composition of our assets,
the functions being performed by our Advisor, and to a larger degree, CM
Capital, our loan originator and servicer, increased and changed significantly.
CM Capital’s function as loan servicer has historically been to collect interest
payments from the borrowers and to distribute interest payments to the
investors.  As compensation for this service, the borrower would pay
CM Capital a servicing fee. As the borrowers began defaulting on their loans, CM
Capital was no longer able to collect the servicing fees on defaulted loans. At
the same time, CM Capital began to perform more complex functions related to the
defaulted loans and ultimately the foreclosed property, such as soliciting
investor votes on the handling of defaulted loans, handling foreclosure
proceedings, processing and paying carrying costs, negotiating with borrowers
and builders, structuring joint venture agreements, selling property and
designing and executing other workout strategies on behalf of the investors. In
December 2008, CM Capital services determined that it could no
longer advance the carrying costs and workout/resolution costs related to
the properties on which it had foreclosed on behalf of the investors, and sent a
letter to the investors (owners) of the foreclosed properties giving the
investors the option to assume the responsibility for their own asset management
functions, or pay CM Capital to provide such services. DCR received such a
letter, and in March 2009, agreed to have CM Capital provide asset management
services on its behalf. In exchange for such services, we agreed to pay CM
Capital servicing fees based on the following: A real estate owned processing
fee upon the date of foreclosure in an amount not to exceed 5% of the
outstanding loan balance on the date of default, of which 1% is due and payable
upon the transfer of title and the remainder is due upon the sale or other
disposition of the property plus a yearly servicing fee of either 1% of the
original loan balance if the workout strategy is simple or 2% of the original
loan balance if the workout strategy is complex, calculated from the date of
foreclosure. For the three and nine months ended September 30, 2009, these fees
totaled $186,000 and $956,000, and were included in management and servicing
fees in the consolidated statement of operations.  At September 30, 2009,
$325,000 was payable and included in management and servicing fees payable on
the consolidated balance sheets.




14
 Table of Contents


To
facilitate payment of certain carrying costs and servicing and property
management fees, during the nine months ended September 30, 2009, we incurred
debt totaling 2.0 million, of which $500,000 has been repaid leaving an
outstanding principal balance of $1.5 million. CM Capital served as our debt
placement agent and servicer, for which we paid placement fees of
$78,000.  In addition, we funded interest reserves related to the
notes payable of $368,000, which are being held in a trust account by Preferred
Trust Company, an entity owned by certain of our officers.  The
proceeds, less closing costs, funding of the interest reserves and other fees
were prepaid to our servicer to be used for the payment of costs associated with
being a land owner and servicing and property management fees payable to CM
Capital.  The balance of the prepaid account at September 30, 2009 was
$874,000.




The
dealer-manager of our offering of common stock, CM Securities, directs and
oversees the sale of our equity securities. CM Securities receives a marketing
support fee and sales commissions based on the number of shares of common stock
it sells. CM Securities 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 CM
Securities is controlled by our Advisor, it is our affiliate. CM Group acquired
ownership of CM Securities on November 21, 2007 and prior to November 21, 2007,
CM Securities was owned by our CEO.  Due to the general collapse of
the real estate market beginning in late 2007, and the impact of declining real
estate values on our mortgage investments, our Board of Directors suspended the
sale of Desert Capital REIT shares as of February 22, 2008.  As a
result, CM Securities did not earn any sales commissions or marketing support
fees for the three months and nine months ended September 30,
2009.  CM Securities earned gross sales commissions and marketing
support fees for the three and nine months ended September 30, 2008 of $0 and
$36,000, respectively.


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
CEO, Todd Parriott 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,  secured by the property. 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 foreclosed on the property, and our investment
in the loan was converted to membership units representing a 37.6% interest in
the limited liability company.  In September 2007, the limited
liability company borrowed $13.7 million from private trust deed investors to
repay the first position lien-holder, and we guaranteed this debt.  We
receive a fee for guaranteeing this debt and for the three and nine months ended
September 30, 2009, we earned $103,000 and $274,000, respectively, in guarantee
fees.   At September 30, 2009, we have recorded an aggregate
impairment of $11.9 million related to this property, resulting in a net
carrying value of zero.





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 non-performing loan
with an outstanding balance of $1.96 million to CM Equity.   No
gain or loss was recognized on the sale as we provided 100% financing on the
sale.  The loan had a fixed interest rate of 8.25% and was scheduled
to mature in November 2009.   The loan became non-performing in the
fourth quarter of 2008.  In January 2009, CM Equity deeded the
property back to us, and currently the property is being held as real estate
owned in the amount of $564,000 net of impairment charges of $1.4
million.




In
November 2007, our wholly owned subsidiary, Desert Capital TRS, Inc, (TRS),
sold all of the issued and outstanding units of CM Capital to CM Group, 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 bearing interest at 9% per annum with
      principal and interest payments 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 CM
      Capital.




In
addition to the consideration received, we receive a contingent installment
payment from CM Capital on loans we fund. The $8.25 million contingent
payment (the “Installment Payment”) is payable  as follows: CM
Group will pay or cause CM Capital 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 CM Capital 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 CM Capital 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 CM Capital.   For the three and nine months
ended September 30, 2009, we did not recognize any income.  For the
nine months ended September 2008, we recognized income of $94,000 related to the
contingent installment payment.




15
 Table of Contents


We also
entered into a loan origination agreement with CM Capital and CM Group, which
terminates one month after the last day of the month in which the Installment
Payment is paid in full.   Under terms of the original Loan
Origination Agreement we had the right to fund all mortgage loans identified by
CM Capital or any affiliate of CM Group or CM Capital that becomes engaged in
the business of originating or brokering commercial loans. 
However, we currently do not have cash available for new investments in
loans and on September 1, 2009, the loan origination agreement was modified
to remove this right of first refusal.  During the nine months ended
September 30, 2009, we did not fund any loans originated by CM
Capital.




During
2008, CM Capital was not in compliance with certain financial covenants
contained in the loan agreement related to the $15.5 million promissory note
payable to TRS.  In August 2008, our Board of Directors formed a
special committee of independent directors to review the financial covenants and
approve a strategy to resolve the defaulted status of the loan. We granted CM
Capital a limited waiver, 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 CM Capital is in
compliance with the loan agreement and will be in compliance with the loan
agreement at December 31, 2008.  In October 2008, the Special
Committee and CM Capital agreed to modify the loan terms, and in November 2008
we executed documents to evidence the modification.  Under the terms
of the modification, principal payments on the note were deferred for two years,
and the interest rate was reduced from 9% to 6% per annum effective as of July
1, 2008.  Additionally, the working capital financial covenant was
replaced with the requirement to maintain a cash balance of $250,000 at the end
of each quarter, and the first measurement period for the fixed charge coverage
ratio was moved from December 31, 2007 to December 31, 2008.  Based on
the modified terms of the promissory note, the modification resulted in an
impairment based on the present value of the expected future cash flows under
the modified terms.  Accordingly, and included in the $12.9 million
note receivable balance, we have provided an allowance for loan loss of $1.8
million to reflect this impairment.  As of December 31, 2008 and
September 30, 2009, CM Capital was in compliance with the modified financial
covenants set forth above.   We earned interest of $226,000 and
$670,000 during the three and nine months ended September 30, 2009 and $226,000
and $923,000 for the three and nine months ended September 30, 2008,
respectively.  At September 30, 2009, $7,000 was
receivable.




In
connection with our ownership of an operating business (See also Note 14 –
Acquisition), 3MO, LLC entered into a $2.6 million note payable agreement for
working capital purposes during the third quarter 2009.   This
note bears interest at an annual  rate of 11.25% and matures in
September of 2010.   CM Capital was our loan originator and
servicer on this note for which we paid origination and servicing fees of
$135,000.  In addition we funded interest reserves related to the note
payable of $301,000, which are being held in a trust account by Preferred Trust
Company, an entity owned by certain of our officers.




Subsequent
to September 30, 2009, the $2.6 million note was increased to $4.0 million and
the additional funds will be used for working capital purposes.  We
paid $67,000 in origination and servicing fees to CM Capital on this increase
and also funded interest reserves of $150,000 in a trust account held by
Preferred Trust Company.




Also,
during the nine months ended September 30, 2009, 3MO, LLC entered into an
uncollateralized note payable agreement for working capital purposes with
Residential Capital Mortgage Corporation (RCMC), an entity owned by certain of
our officers, in the amount of $50,000.  This note bore a weekly
interest rate of 1.5%.  As of September 30, 2009, this loan has been
paid off.




We lease
office space to CM Group, CM Securities, CM Capital, RCMC and PBX, LLC (an
entity owned by certain of our officers) under cancelable operating
leases by either party on thirty days written notice.  Total rents
received from related parties for the three and nine months ended September 30,
2009 were $129,000 and $388,000.  Rents received from related parties
for the three and nine months ended September 30, 2008 were $138,000 and
$413,000, respectively.




16
 Table of Contents


Note
12 - Fair Value of Financial Instruments


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. We take into account our own credit risk when measuring the fair
value of our liabilities.




The
following table summarizes the carrying values and the estimated fair values of
financial instruments as of September 30, 2009 and December 31, 2008 (dollars in
thousands):




September
      30, 2009
              
              
              December
      31, 2008Carrying
      Value
              
              
              Estimated
      Fair Value
              
              
              Carrying
      Value
              
              
              Estimated
      Fair ValueFinancial
      assets:Cash,
      cash equivalents and restricted cash
              
              $
              1,177
              
              
              $
              1,177
              
              
              $
              1,629
              
              
              $
              1,629Interest
      receivable
              
              
              33
              
              
              
              33
              
              
              
              531
              
              
              
              531Note
      receivable - related party
              
              
              12,928
              
              
              
              10,975
              
              
              
              12,600
              
              
              
              11,024Mortgage
      investments - net
              
              
              36,578
              
              
              
              36,356
              
              
              
              69,538
              
              
              
              68,773Financial
      liabilities:Bank
      note
              
              
              179
              
              
              
              179
              
              
              
              1,360
              
              
              
              1,274Notes
      payable
              
              
              1,482
              
              
              
              1,233
              
              
              
              -
              
              
              
              -Mortgages
      payable
              
              
              7,651
              
              
              
              7,080
              
              
              
              7,893
              
              
              
              7,264Junior
      subordinated notes
              
              
              30,928
              
              
              
              24,578
              
              
              
              30,928
              
              
              
              27,493





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




●
            
            Cash,
      cash equivalents and restricted cash: The carrying values of
      cash and short-term instruments approximate fair
      values.●
            
            Interest
      receivable: Carrying values approximate fair values due to
      their short term nature.●
            
            Note
      receivable – related party:Fair value is estimated using
      discounted cash flow analyses based on a rate reflective of the current
      market environment 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.  We considered these
      inputs as Level 3.●
            
            Mortgage
      investments-net:  At September 30, 2009 and December 31,
      2008 the fair value of fixed rate loans currently classified as
      performing, 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.  At September 30, 2009 and December 31,
      2008, substantially all of our impaired loans were evaluated based on the
      fair value of their underlying collateral based upon the most recent
      appraisal available to management or recent transaction prices for similar
      collateral, and as such, the carrying values of these instruments, net of
      allowance for loan losses, approximates the fair value.  Fair value
      inputs on performing and non-performing loans are considered Level
      3.●
            
            Bank
      note:  The value of our variable rate-term borrowing,
      classified as Level 3, were estimated using a cash flow analysis, taking
      our credit standing into consideration, as well as the excess assigned
      collateral, and a rate reflective of the current market
      environment.●
            
            Mortgage
      loans payable and notes payable:  For September 30, 2009
      and December 31, 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
      rates reflective of the current market environment, all of which
      were factors in the computation of fair value and were considered Level 3
      inputs.●
            
            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 which incorporate
      the effects of our own credit risk in the fair value of the
      liability.  The cash flow assumptions were based on the contractual
      cash flows based on our anticipation that we will pay the debt according
      to its contractual terms, and were considered Level
      3 inputs.


We
do not have any assets or liabilities that are measured at fair value on a
recurring basis.  The following table presents our assets and
liabilities that are measured at fair value on a nonrecurring basis at September
30, 2009.  Level 1 and Level 2 data were not used in the fair value
measurements.


Estimated
      Fair Value
              
              
              Level
      3Impaired
      mortgage investments
              
              
              31,645
              
              
              
              31,645Investments
      in real estate
              
              
              18,426
              
              
              
              18,426Real
      estate owned
              
              
              2,310
              
              
              
              2,310
 17
 Table of Contents
 Note
13 – Commitments and Contingencies


We previously
funded $11.9 million of loans that were secured by a property on which
we have foreclosed.  We foreclosed with the other lenders on the loan in a
limited liability company, Warm Jones, LLC, and converted our $11.9 million
investment in the loan into a 37.6% membership interest in Warm Jones,
LLC.  We foreclosed subject to the first lien debt and in September 2007,
Warm Jones, LLC borrowed $13.7 million to repay the first lien debt.  We
guaranteed this debt to minimize our loss related to the investment.  Under
the original terms of the indebtedness, the note was due in October 2008 and was
subsequently modified to extend the maturity to February 2010.  The
beneficiaries under the guarantee have the right to make demand on us under the
guarantee to pay the entire $13.7 million if the borrower defaults on the
note.  We have determined that our potential liability related to the
guarantee was approximately $101,000 as of September 30, 2009 and December 31,
2008, which was included in accrued expenses in our consolidated balance
sheets.




On July
27, 2009, we received a written Notice of Event of Default and Acceleration from
the holders of the preferred securities that because our tangible net worth was
less than $100 million, a default had occurred under our junior subordinated
indenture which had continued for more than 30 days and had caused an event of
default to occur under the junior subordinated indenture.  The notice
further stated that as a result of the occurrence of such event of default, the
principal amount of all of our obligations under the junior subordinated
indenture, together with any and all other amounts payable thereunder had been
accelerated and declared to be immediately due and payable by the holders of the
preferred securities.  The notice further stated that the holders of
the preferred securities, may at their option, pursue all available rights and
remedies.  We have been in negotiations with the holders of the
preferred securities to restructure the terms of the junior subordinated
notes.  Our negotiations to date have been unsuccessful.  To
the extent we are unable to restructure our obligations to the holders of the
preferred securities or other remedies under the junior subordinated notes and
related junior subordinated indenture are exercised and enforced, it would have
a material adverse effect on our financial condition.




Note
14 - Acquisition


On April
22, 2009, we formed a subsidiary of our TRS, 3MO, LLC, to foreclose on a
nonperforming loan collateralized by an operating business, a gentlemen’s club
in Las Vegas, Nevada with an aggregate original loan balance of $14.4
million.  Upon foreclosure we measured the fair value of the real
estate property and related business at $10.0 million.




At the
acquisition date and as of September 30, 2009, we have classified the real
estate property and related business as assets and liabilities held for
sale.  The related results of operations are reported as discontinued
operations on our consolidated statement of operations for the three and nine
months ended September 30, 2009.  See Note 15– Discontinued
Operations.




The
following table summarizes the estimated fair value of the nets assets acquired
and liabilities assumed at the foreclosure date (dollars in
thousands):


EstimatedDescription
              
              fair
      valueAsset
      acquired:Land,
      building and equipment
              
              $
              10,036Inventory
              
              
              35Prepaid
      expenses
              
              
              16Total
      assets acquired
              
              
              10,087Liabilities
      assumed:Accounts
      payable and accrued expenses
              
              
              64Total
      liabilities assumed
              
              
              64Estimated
      fair value of net assets acquired
              
              $
              10,023EstimatedDescription
              
              fair
      valueFair
      value of consideration transferred:Commercial
      real estate loan
              
              $
              10,023Total
      fair value of consideration transferred
              
              $
              10,023
 Presenting
an unaudited pro forma income statement as if the acquisition of the business
occurred on the first day of the year presented would be impracticable since
this estimate would require us to make assumptions in a prior period that cannot
be independently substantiated due to our intent of the acquisition of the
business as being held for sale.  We are actively marketing the
property and operating the business for sale.




18
 Table of Contents


Note
15 – Discontinued Operations


Assets
and liabilities of the business, a gentlemen’s club, acquired on April 22, 2009,
as stated in Note 14 - Acquisition, have been classified as held for sale as of
September 30, 2009 as we are actively marketing the business for
sale.  Assets and liabilities identified as held for sale are
classified separately on our consolidated balance sheet and the related results
of operations are reported as discontinued operations on our consolidated
statement of operations for the three and nine months ended September 30,
2009.




Operating
costs and expenses incurred during the three months and nine months ended
September 30, 2009, related to our asset held for sale, totaled $2.7 million and
$3.4 million, respectively.  These expenses included a $1.6 million
impairment due to a decrease in the fair value of the asset as of September 30,
2009.




As of
September 30, 2009 and through the date of this filing, 3MO, LLC entered into a
$4.0 million note payable agreement.  See also Note 11 – Commitments
and Related Parties.




Subsequent
to September 30, 2009, we entered into an agreement with a third party to lease
the facilities, thus ceasing our operations of the business.  The
lease provides for monthly rent of $40,000 and includes a $10 million
option to purchase the property.  As we continue to actively pursue
the sale of the business, we have classified the business as held for
sale.




The
following assets and liabilities have been segregated and are included in assets
and liabilities held for sale in the consolidated balance sheet as of September
30, 2009 (dollars in thousands):




September
      30, 2009Cash
              
              $
              278Accounts
      receivable
              
              
              29Inventory
              
              
              33Fixed
      assets, net
              
              
              8,500Other
      assets
              
              
              201Assets
      held for sale
              
              $
              9,041Accounts
      payable and accrued expenses
              
              $
              211Note
      payable
              
              
              2,373Liabilities
      held for sale
              
              $
              2,584
  Forthe
      Three Months Ended
              
              
              For
      the Nine Months EndedSeptember
      30, 2009
              
              
              September
      30, 2009Revenue
              
              $
              2,143
              
              
              $
              3,334Cost
      of goods sold
              
              
              1,788
              
              
              
              2,634Operating
      cost and expenses
              
              
              2,654
              
              
              
              3,442Total
      operating cost and expenses
              
              
              4,442
              
              
              
              6,076Operating
      loss
              
              
              (2,299
              )
              
              
              (2,742
              )Interest
      expense
              
              
              53
              
              
              
              63Loss
      from discontinued operations
              
              $
              (2,352
              )
              
              $
              (2,805
              )


Note
16 – Subsequent Events


In October
2009, we acquired properties through foreclosure or deed in lieu of foreclosure,
with aggregate original loan balances of $11.7 million and $863,000 in
associated impairments, and classified the net balances as REO and investments
in real estate.




In
October 2009, we sold investments in real estate and a mortgage loan with
aggregate original loan balances of $178,000 and $37,000 in associated
impairments resulting in a net loss of $31,000.




In
November 2009, we entered into a note payable agreement with an unrelated third
party with an original principal amount of $983,000.  The note bears
interest at a rate of 11.0%, payable upon maturity in October 2011.  We
received loan proceeds after the payment of closing and servicing fees of
$60,000 and interest reserves of $216,000, in the amount of
$707,000.





We
evaluated subsequent events through November 16, 2009, the date the financial
statements were available to be issued. Events or transactions occurring after
September 30, 2009 but prior to November 16, 2009, that provided additional
evidence about conditions that existed at September 30, 2009, have been
recognized in the financial statements for the period ended September 30, 2009.
Events or transactions that provided evidence about conditions that did not
exist at September 30, 2009 but arose before the financial statements were
available to be issued have not been recognized in the financial statements for
the period ended September 30, 2009, but have been disclosed
herein.




19
 Table of Contents


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


The
following discussion of our financial condition and results of operations should
be read in conjunction with the financial statements and notes to those
statements included elsewhere in this document. This discussion may contain
certain forward-looking statements. Forward-looking statements are those that
are not historical in nature. They can often be identified by their inclusion of
words such as “will,” “anticipate,” “estimate,” “should,” “expect,” “believe,”
“intend” and similar expressions. Any projection of revenues, earnings or
losses, capital expenditures, distributions, capital structure or other
financial terms is a forward-looking statement.




Our
forward-looking statements are based upon our management’s beliefs, assumptions
and expectations of our future operations and economic performance, taking into
account the information currently available to us. Forward-looking statements
involve risks and uncertainties, some of which are not currently known to us,
that might cause our actual results, performance or financial condition to be
materially different from the expectations of future results, performance or
financial condition we express or imply in any forward-looking statements. Some
of the important factors that could cause our actual results, performance or
financial condition to differ materially from expectations are:




●
            
            economic
      conditions impacting the real estate market and credit
      markets;●
            
            changes
      in interest rates;●
            
            potential
      impacts of changes to our strategies without stockholder
      approval;●
            
            an
      increase in the number of our loans that become
      non-performing;●
            
            our
      ability to sell assets;●
            
            our
      inability to obtain liquidity;●
            
            additional
      impairments on our assets;●
            
            our
      inability to restructure our obligations under our junior subordinated
      notes; and●
            
            although
      we believe our proposed method of operations will be in conformity with
      the requirements for qualification as a REIT, we cannot assure you that we
      will qualify as a REIT or, if so qualified, will continue to qualify as a
      REIT. Our failure to qualify or remain qualified as a REIT could have
      material adverse effect on our performance and your
      investment.




We
undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
In light of these risks, uncertainties and assumptions, the events described by
our forward-looking statements might not occur. We qualify any and all of our
forward-looking statements by these cautionary factors.




For
a more detailed description of the risks affecting our financial condition and
results of operations, see “Risk Factors” in Item 1A of our Form 10-K filed on
March 31, 2009.




Overview


The third
quarter 2009 results reflect continued pressure from an uncertain economy and
the struggling housing market.  For the three and nine months ended
September 30, 2009, we reported a net loss of $10.9 million and $34.3 million,
respectively, compared to a net loss of $8.9 million and $16.0 million,
respectively, for the three and nine months ended September
30,   2008.  Contributing to the third quarter 2009 net
loss was a $3.9 million provision for loan losses, a $2.8 million impairment of
real estate owned and real estate investments, a $2.4 million loss on
discontinued operations, and a reduction in total interest income of $1.5
million. The original balance of performing loans declined from $35.2 million at
September 30, 2008 to $6.1 million at September 30, 2009, resulting in a
significant loss of interest income for the current quarter.




While our
entire portfolio of real estate investments continues to be negatively impacted
by market forces, we continue to take important steps to address our portfolio
issues and manage our cash position. The highlights of our actions during the
nine months ended September 30, 2009 are as follows:




●
            
            Foreclosed
      on the underlying real estate securing loans with an original balance of
      $37.8 million, including our foreclosure of the property resulting in the
      acquisition of a gentlemen’s club, our single largest asset within our
      portfolio which is classified as an asset held for sale on our balance
      sheet;●
            
            Placed
      $4.6 million of debt, including our placement of debt within our
      discontinued operations relating to the gentleman’s club, on specific
      assets to generate cash to be used for servicing and property management
      fees, real estate carrying and resolution costs and general operating
      expenses;●
            
            Sold
      real estate for cash proceeds of $1.9 million; and●
            
            Negotiated
      a modification of our bank note to extend the maturity date of the
      existing note.




As the
size of our real estate portfolio continues to increase due to continued
foreclosure activity, our costs related to real estate ownership also increase.
These costs include servicing and property management fees payable to CM
Capital, property taxes, legal fees, maintenance costs and resolutions
costs.  Because our portfolio of performing loans has shrunk to $6.1
million, our recurring cash flow is not sufficient to cover our general
operating costs, including real estate carrying costs.  As a result,
we determined that is was in the best interest of our company to leverage a
small portion of our real estate assets in order to raise necessary operating
capital. During the first nine months of 2009, we entered into $2.0 million of
debt, which was placed by CM Capital with individual trust deed investors. The
cash proceeds from this debt were prepaid to cover specific costs related to
carrying and resolving our real estate portfolio, as well as 12 to 24 months of
interest payments on the debt. We continue to closely monitor and manage our
liquidity position, understanding that this is of critical importance in the
current economic environment. With the addition of this debt, our ratio of
debt to total assets increased to 43.0% at September 30, 2009, an increase from
32.8% at December 31, 2008.




20
 Table of Contents


Although
the real estate and credit market disruptions continue to challenge us, we will
continue to explore portfolio resolution strategies that will offer both
operating liquidity and potential for longer term capital appreciation. We will
also explore additional investment and business opportunities as they arise and
as cash becomes available; however, due to the current credit market disruption,
our investment opportunities are limited primarily due to our lack of capital
available for investment.  Until we generate proceeds through the
resolution of our non-performing loans and sale of real estate, we will not have
cash available for new investments that will generate cash flows to us. We
expect that the current state of the real estate and credit markets will
continue to have an adverse effect on our operations throughout 2009 and
2010.





Our
Investments


We were
established as a mortgage REIT; however, as our borrowers began defaulting on
their obligations to us, our Advisor determined that, in many instances, the
best course of action was to foreclose on the underlying collateral and take
title to the property. Real estate owned and investments in real estate consist
of property acquired through foreclosure on mortgage loans. During the nine
months ended September 30, 2009, we foreclosed on 17 loans with an aggregate
original loan amount of $37.8 million, and a carrying value of $25.3 million,
including our foreclosure of the property and resulting acquisition of a
gentlemen’s club, our single largest asset within our portfolio, which is
classified as an asset held for sale on our balance sheet.




Our
interest in real estate owned and real estate investments may be held directly
by us, or through LLCs. If we are one of several investors in a larger mortgage
loan, such loans are foreclosed on using an LLC to facilitate foreclosing our
lender interest along with private investors who hold the remaining loan
balance. In these instances, our original investment in the loan is converted to
proportionate interests in the LLC. In cases where our ownership interest in an
LLC is greater than 50%, we analyze strategic alternatives to determine whether
the property should be sold, contributed to a joint venture for development
or held for future resolution.  We are also considering certain
other strategic initiatives, such as developing and/or operating the real
properties that we have acquired through foreclosure. In situations where our
ownership interest in an LLC is less than 50%, our ability to make strategic
decisions regarding the property is subject to the voting interests of a
majority of the members of the LLC, which may hinder our ability to execute our
desired strategy for the property.




We
account for assets within several different categories including mortgage loans,
real estate owned and investments in real estate, including cost, equity and
fully consolidated investments.




Mortgage
Loans


At
inception, our stated business plan was the investment in a variety of types of
mortgage loans.  As of September 30, 2009,  mortgage
investments still constituted a majority of our investments; however, because of
our lack of access to capital, during 2009 we have not originated any new
mortgage loans. We may not have funds available to make new investments in
mortgage loans until we are able to resolve some of our non-performing loans,
sell some of our real estate assets, or have access to the capital markets which
are currently closed to us.  At the time of origination, our mortgage
investments were short-term (12 to 18 months), balloon loans with fixed interest
rates. A substantial portion of these loans consisted of interest-carry loans,
meaning we provided the borrower with sufficient financing to enable it to make
the interest payments during the term of the loan. To date, all of the mortgage
loans which we have funded have been identified by CM Capital and we do not have
a contractual arrangement with any other mortgage originator. At September 30,
2009, 26.0% of our portfolio of mortgage investments was secured by properties
located in Nevada, and 25.4% was secured by properties located in
California.  In addition, we have a significant concentration of
credit risk with our largest borrowers.  At September 30, 2009, the
aggregate amount of loans to our five largest borrowers was $43.1 million
representing approximately 76% of our total investments in mortgage
loans.  All but $6.1 million of this amount was classified as
non-performing and $10.4 million was reserved in the allowance for loan
losses.




Real
Estate Owned


Real
estate owned consists of property acquired through foreclosure on mortgage
loans. As of September 30, 2009, we held $2.3 million in real estate owned,
which consists of 2 properties.




Investments
in Real Estate


Joint
Ventures


When we
pursue our resolution strategy of contributing foreclosed property to a joint
venture, we account for our resulting ownership as an equity investment in real
estate.  To date, we have entered into three joint venture
arrangements with one joint venture partner, and have contributed land with an
aggregate original carrying value of $6.7 million to the joint ventures. The
carrying value of these joint ventures at September 30, 2009 was $3.9 million.
Our joint venture partner, the developer, is constructing homes on each of the
three projects, and selling the completed homes to homeowners. Under terms of
the joint venture agreements, the developer funds the majority of the costs of
construction, and we receive our proportionate share of the lot contribution
price plus between 13% and 50% of the profits on the sale of each home,
depending on our ownership interest. We anticipate that the construction and
sale of all the homes in each of the joint venture projects will take from 18 to
60 months.  During the first nine months of 2009, five homes were
constructed and sold to homeowners, resulting in cash proceeds to us of
$291,000.




21
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Investments
accounted for under the Cost Method


In
situations where our interest in an LLC represents less than 20% and we do not
have significant influence or direct control over the LLC, we account for the
investment under the cost method of accounting.  During the nine
months ended September 30, 2009, we determined that investments we previously
held as real estate owned within LLCs, and with membership interests between
negligible and 15%, should be classified as an investments in real estate under
the cost method of accounting.  We reclassified these assets at their
fair value of $3.0 million.  The carrying value of our cost method
investments at September 30, 2009 was $3.2 million.




Investments
Accounted for Under the Equity Method


We
determined that investments we previously held as real estate owned within LLCs,
and with membership interests between 21% and 50%, should be classified as
investments in real estate under the equity method of accounting.  We
reclassified these assets from REO at their fair value of $13.1
million.  These assets had a carrying value of $4.3 million, net
of impairments of $8.3 million at September 30, 2009 and $0 at December 31,
2008.




Fully
Consolidated Investments in Real Estate


At
September 30, 2009, we held $7.0 million in fully consolidated  real
estate investments. We did not hold any fully consolidated investments in real
estate at December 31, 2008.  During the nine months ended September
30, 2009, we evaluated certain of our assets that we held in real estate owned
and determined that activities occurring within the LLCs in which we are a
member, constituted those of an operating entity.  We reclassified
$11.1 million of these assets, previously classified as real estate owned, into
fully consolidated investments in real estate after we determined we controlled
them.  We recognized impairments on these real estate investments of
$4.3 million during the nine months ended September 30, 2009.




If we
determine that we hold a controlling interest with less than 100% ownership , we
fully consolidate these investments on our balance sheet and reflect the
minority position as noncontrolling interest on the balance
sheet.   During the nine months ended September 30, 2009, we
determined that our 91% investment in an LLC should be fully consolidated and
classified as an investment in real estate.  The remaining 9% interest
is reflected separately as a non controlling interest.




Results
of Operations for the three months ended September 30, 2009 compared to the
three months ended September 30, 2008


Revenues:


Interest
income generated on our mortgage investments decreased by $1.4 million, or
94.8%, to $76,000 for the three months ended September 30, 2009 from $1.5
million for the three months ended September 30, 2008. This decrease was due to
an 85.7% decrease in the average balance of the performing loans in our
portfolio from $42.9 million for the three months ended September 30, 2008 to
$6.1 million for the three months ended September 30,
2009.




Other
interest income, including interest income on our related party note receivable
from CM Capital and income earned on loans held for sale, decreased by $84,000,
or 27.3%, to $227,000 for the three months ended September 30, 2009 from
$311,000 for the three months ended September 30, 2008.  Of this
decrease, $67,000 is related to the decrease in interest earned on loans held
for sale.  We earned $67,000 in interest on loans held for sale during
the three months ended September 30, 2008 and none during the three months ended
September 30, 2009 as we did not hold any loans for sale.




Expenses:


Interest
expense consists of interest on our notes payable, mortgage debt, bank note, and
junior subordinated notes payable. Interest expense decreased 4.0%, to $670,000
for the three months ended September 30, 2009 from $698,000 for the three months
ended September 30, 2008.   This decrease was primarily a result
of a decrease in the average interest rate on our variable rate debt to 5.8%
during the three months ended September 30, 2009 from 6.6% during the three
months ended September 30, 2008.




Non-interest
expense, including provision for loan losses, impairments on real estate owned
and real estate investments, equity in losses of unconsolidated investments in
real estate, and other expenses decreased $1.9 million or 29.8%, to $8.5 million
for the three months ended September 30, 2009 from $10.4 million for the three
months ended September 30, 2008.  The provision for loan losses
decreased by $3.3 million or 45.6% to $3.9 million for the three months ended
September 30, 2009 from $7.2 million for the three months ended September 30,
2008 as a result of the shift in our assets from mortgage investments to either
investments in real estate or real estate owned.  The mortgage investments
portfolio consisted of $36.6 million at September 30, 2009 compared to $84.6
million at September 30, 2008.  In addition, impairment of real estate
owned and investments in real estate and, equity in losses of unconsolidated
real estate increased $831,000, or 43.0% to $2.8 million for the three
months ended September 30, 2009 from $1.9 million for the three months ended
September 30, 2008.  The increase is due to an impairment on our
contribution of one of our joint ventures of $1.3 million as a result of
the continued pressure on the sales prices of new homes.  These decreases
were offset by an increase in other expenses of $564,000 to $884,000 for the
three months ended September 30, 2009 from $320,000 in the same period in
2008.  The increase is primarily due to an increase in property taxes
of approximately $507,000, including a $395,000 property tax accrual for a real
estate property we foreclosed on in early October 2009.




Loss from
discontinued operations during the three months ended September 30, 2009 of $2.4
million is directly related to a $1.6 million impairment as a result of a
decrease in the fair value of our assets of our operating business along with
costs incurred to operate the business.




22
 Table of Contents


Results
of Operations for the nine months ended September 30, 2009 compared to the nine
months ended September 30, 2008


Revenues:


Interest
income generated on our mortgage investments decreased by $5.1 million, or
93.2%, to $372,000 for the nine months ended September 30, 2009 from $5.5
million for the nine months ended September 30, 2008. This decrease was due to
an 89.5% decrease in the average balance of the performing loans in our
portfolio from $58.9 million for the nine months ended September 30, 2008 to
$6.2 million for the nine months ended September 30, 2009.  Our
interest income was also negatively impacted by the significant increase in
non-performing loans. The increased balance of non-performing loans lowered the
average yield on the entire portfolio to 0.2% for the nine months ended
September 30, 2009 from 6.1% for the nine months ended September 30,
2008.




Other
interest income, including interest income on our related party note receivable
from CM Capital and income earned on loans held for sale, decreased by $671,000,
or 49.7%, to $680,000 for the nine months ended September 30, 2009 from $1.4
million for the nine months ended September 30, 2008.  Approximately
$254,000 of this decrease was due to the modification of the related party note
receivable due from CM Capital.  The interest rate was reduced in late
2008 from 9% to 6%.  In addition, $381,000 was related to the decrease
in interest earned on loans held for sale.  We earned $381,000 in
interest on loans held for sale during the nine months ended September 30, 2008
and none during the nine months ended September 30, 2009 as we did not hold any
loans for sale in 2009.




Expenses:


Interest
expense consists of interest on our notes payable, mortgage debt, bank note, and
junior subordinated notes payable. Interest expense decreased $551,000 or 23.0%,
to $1.8 million for the nine months ended September 30, 2009 from $2.4 million
for the nine months ended September 30, 2008.   This decrease was
a result of a decrease in the average interest rate on our variable rate debt to
5.4% during the nine months ended September 30, 2009 from 7.3% during the nine
months ended September 30, 2008.




Non-interest
expense, including provision for loan losses, impairments on real estate owned
and real estate investments, equity in losses of unconsolidated investments in
real estate and other expenses increased $10.5 million or 48.8%, to $32.2
million for the nine months ended September 30, 2009 from $21.6 million for the
nine months ended September 30, 2008. The primary increase in non-interest
expense was due to the increase in the impairments on our real estate
investments, including our investments that we account for using the equity
method of accounting.  Equity in losses of unconsolidated real estate
investments increased by $9.0 million, up 100% from the prior year during the
same period.  We also recognized an impairment on our contribution of
one of our joint ventures of $1.3 million as a result of the continued pressure
on the sales prices of new homes.  In addition, we recognized $7.0 million
in impairments on our other investments in real estate and real estate owned, an
increase of $2.2 million or 46.9% from $4.7 million the prior year during the
same period.  The increases in the impairments and equity in losses of
our investments in real estate was due to a further decline in real estate,
causing the value of our real estate to decline.  These increases were
slightly offset by a decrease of $3.3 million, or 25.5%, in our provision for
loan losses from $12.9 million for the nine months ended September 30, 2008 to
$9.6 million for the nine months ended September 30, 2009, as a result of a
shift in our portfolio assets to either real estate owned or investments in real
estate as we continue to foreclose on properties.




We also
experienced an increase in management and servicing fees of $787,000, or 62.1%
from $1.3 million for the nine months ended September 30, 2008.   This
increase was a direct result of the accrual of an annual asset management fee
paid to CM Capital, our related party servicer, pursuant to the agreement
entered into for the management of our foreclosed properties.




Other
expenses increased by $875,000 to $1.7 million for the nine months ended
September 30, 2009 from $875,000 for the same period in 2008.  The
increase is due primarily to increases in our property tax
expense.  Property tax expense for the nine months ended September 30,
2009 was $631,000 as compared to $273,000 for the nine months ended September
30, 2008.   In addition, the liability related to our guaranty of
indebtedness of $101,000 was included in other expense during the first quarter
of 2009.




Loss from
discontinued operations during the nine months ended September 30, 2009 of $2.8
million was directly related to a $1.6 million impairment, as a result of a
decrease in the fair value of the operating assets, along with costs incurred to
operate the business.




23
 Table of Contents


Taxable
Income


Our
income (loss) calculated for tax purposes differs from income (loss) calculated
in accordance with GAAP primarily because of the provision for loan losses and
the impairment of real estate recorded for GAAP purposes, which differs from
items recorded for tax purposes.  In addition, the financial
statements of the REIT and its taxable REIT subsidiaries are consolidated for
GAAP purposes while they are not consolidated for tax purposes.  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.




The
following table represents a reconciliation of our GAAP income to our REIT
taxable income (dollars in thousands):




Three
      Months Ended September 30,
              
              
              Nine
      Months Ended September 30,2009
              
              
              2008
              
              
              2009
              
              
              2008GAAP
      net (loss)
              
              $
              (10,937
              )
              
              $
              (8,877
              )
              
              $
              (34,855
              )
              
              $
              (15,972
              )Adjustments
      to GAAP net income (loss):Noncontrolling
      interest
              
              
              25
              
              
              
              -
              
              
              
              520
              
              
              
              -Provision
      for loan losses
              
              
              3,931
              
              
              
              5,104
              
              
              
              9,610
              
              
              
              10,771Impairment
      of real estate
              
              
              2,453
              
              
              
              1,931
              
              
              
              8,238
              
              
              
              4,738Equity
      in losses of real estate investments
              
              
              309
              
              
              
              -
              
              
              
              8,979
              
              
              
              -Actual
      losses on real estate and loans
              
              
              (3,113
              )
              
              
              (411
              )
              
              
              (11,202
              )
              
              
              (711
              )Net
      adjustment for TRS loss
              
              
              2,808
              
              
              
              2,341
              
              
              
              3,834
              
              
              
              2,521REIT
      taxable income (loss)
              
              $
              (4,524
              )
              
              $
              88
              
              
              $
              (14,876
              )
              
              $
              1,347


Liquidity
and Capital Resources


Our
primary sources of funds for liquidity have historically consisted of net
interest income from mortgage loans, proceeds from repayment of mortgage loans
and proceeds from the sale of our common stock. With the significant
deterioration in the performance of our loan portfolio, and the substantial
increase in real estate owned due to foreclosures, our sources of funds from
normal portfolio operations have been virtually eliminated. In addition, due to
the general collapse of the real estate market beginning in late 2007, and the
impact of declining real estate values on our mortgage investments, our Board of
Directors determined that it was in the best long-term interest of our company
and its stockholders to suspend the sale of our common stock as of February 22,
2008. Because of the erosion of our cash flow, we are closely monitoring and
managing our liquidity position, understanding that this is of critical
importance in the current economic environment. Our primary sources of
liquidity are now comprised of proceeds from the sale of real estate investments
and proceeds from the issuance of debt.




Net cash
used by operating activities during 2009 was $4.6 million, which was primarily
due to the substantial loss of interest income due to the deterioration of our
loan portfolio, the increase in servicing and property management fees and
carrying costs related to our foreclosed assets, and our loss from discontinued
operations.  At September 30, 2009, the original loan balance of our
mortgage investments was $52.2 million (of which $6.1 million was performing),
investments in real estate had a carrying balance of $18.4 million, and real
estate owned had a carrying balance of $2.3 million. It is likely that
non-performing mortgage loans and real estate assets will produce minimal, if
any, current earnings and will be uses of cashflow until they are sold or an
alternative resolution becomes available. Additionally, we will continue to
incur carrying, servicing and property management costs on our real estate
investments until we have disposed of the assets. We anticipate that we will
continue to foreclose on the assets underlying our non-performing portfolio
throughout the remainder of 2009, which will result in added costs related to
property ownership. While the disposition of any of our assets cannot be
predicted, our Advisor believes that over time our non-performing mortgage loans
and real estate assets will be resolved and that the proceeds generated from the
resolution of these assets will provide capital for operating expenses,
reinvestment into performing assets or reduction in outstanding debt.  As
of September 30, 2009, we have reviewed our mortgage and real estate investments
and have recorded a provision for loan losses, equity in losses of
unconsolidated investments in real estate and an impairment of real estate owned
as needed to reflect the impaired value of our investments. However, with the
current uncertainty in the real estate market, the amount of further losses on
any individual asset or on the portfolio as a whole may vary. These estimates
are based upon a thorough evaluation by our Advisor based on prevailing
economic conditions, historical experience, unique characteristics of the asset,
industry trends and an estimated net realizable value of the asset.





Net cash
provided by investing activities for the nine months ended September 30, 2009,
was $1.8 million. As we evaluate resolution strategies on our investment
portfolio, we determined that it is in our and our stockholders’ best interest
to sell certain assets. Given the recent and ongoing state of the real estate
market, sales opportunities are limited, but during 2009, we sold investments
for net cash proceeds of $2.2 million. We will continue to evaluate assets for
resolution on a case-by-case situation, and anticipate selling additional assets
to generate cash for working capital purposes.




24
 Table of Contents


With the
continued loss of recurring cash flow, combined with the increase in carrying
costs related to our growing non-performing real estate portfolio, our Advisor
made the determination that it was in the best interest of the Company to incur
additional debt to help fund these costs. For the nine months ended September
30, 2009, net cash provided by financing activities was $3.6 million. We entered
into three note payable agreements with an aggregate gross principal amount of
$2.0 million for cash proceeds, net of interest reserves, of $1.5
million.  During the quarter we paid off the principal balance on one
of the notes from the sales proceeds of the underlying property.  The
cash proceeds from the issuance of this debt is held by our servicer and asset
manager, CM Capital, and is classified as prepaid foreclosure costs on our
balance sheet for the purpose of the payment of our expenses as a land owner,
including property taxes, legal expenses, and servicing and property management
fees. At September 30, 2009, the balance in prepaid foreclosure costs was
$874,000.  In addition, we set aside cash of $241,000 for the payment
of interest during the term of the debt which are being held in a trust account
by Preferred Trust Company, an entity owned by certain of our
officers.  The outstanding principal balances of these notes bear
interest at 10% to 11% per annum, which is payable monthly. For the foreseeable
future, as we continue to incur servicing and property management fees and other
expenses related to the ownership of non-income-producing real estate, we
anticipate incurring additional debt to fund such expenses.




In
April 2009, we foreclosed on the operating business and real estate
securing a defaulted loan with an original principal balance of $14.4
million.  We are actively marketing the business and real estate for
sale and have reflected the business as discontinued operations in our financial
statements; however, we have continued to operate the business in order to
retain value in the property as an operating business until sold. Operating
costs related to the business include marketing, repair and maintenance,
payroll, liquor and beverage inventory and other general operating
expenses.  From the date of foreclosure through September 30, 2009, we
have funded $1.5 million in operating expenses. The business is operating
in a cash deficit; therefore, to fund the necessary operating expenses, we have
leveraged the business and real property to obtain up to $4.0 million of
debt. This debt has been, and will continue to be issued in tranches, and
at September 30, 2009, the balance was $2.4 million. We believe the proceeds of
this debt will be sufficient to operate the business until a resolution can be
reached. We have been in negotiations over the past several months with parties
interested in buying or operating the business.  In October 2009, we
entered into a lease agreement with an operator of similar
businesses.  The agreement provides for monthly rent of $40,000 plus
30% of net profits, if any, and contains an option to purchase the facility for
$10.0 million at any time during the four-year term of the
agreement.  On November 16, 2009, the effective date of the
lease, the operator/lessee assumed operations of the business, including the
responsibility to fund all operating costs of the business.




In June
2006, we issued $30.0 million in unsecured trust preferred securities, which are
reflected on our balance sheet as junior subordinated notes
payable.   Since December 31, 2008, we have not been in
compliance with certain covenants under the modified terms of the indenture. On
April 3, 2009, we received a notice of default and were given 30 days to cure.
Due to our inability to cure the default, it matured into an event of
default.  In July 2009, the Trustee and the holders of the trust
preferred securities notified us that as a result of the occurrence of such
event of default, the principal amount of our obligations under the junior
subordinated indenture, together with any and all other amounts payable
thereunder had been accelerated and declared to be immediately due and
payable.  The notice further stated that the holders of the preferred
securities, may at their option, pursue all available rights and
remedies.  Prior to the acceleration of the obligations, no default in
the payment of principal or interest had occurred under the junior subordinated
indenture.  On July 27, 2009, we also received a copy of a written
notice to the trustee under our junior subordinated notes from the holders of
the preferred securities directing the trustee to withdraw the amount on deposit
in the reserve account and apply such amount to the payment of amounts due and
owing to the holders of the preferred securities.




We have
been in negotiations with the Trust Preferred Securities Holders to restructure
obligations with the holders of the preferred securities. Our negotiations to
date have not been successful and there can be no assurance that such efforts
will be successful.  To the extent we are unable to restructure our
obligations or other remedies are exercised and enforced, it will have a
material adverse effect on our financial condition.




At
September 30, 2009, the balance on our secured bank note was $179,000.
Subsequent to the balance sheet date, this balance was paid in full from the
proceeds from a separate debt issuance with unrelated third
parties.




Upon the
death of a stockholder, the stockholder’s estate has a limited right of
redemption with respect to its common stock, and at September 30, 2009, we had
received redemption requests of 164,000 shares of common stock totaling $1.9
million.




In order
to continue to qualify as a REIT, we are required to distribute on an annual
basis to our stockholders at least 90% of our REIT taxable income (excluding the
dividends paid deduction and any net capital gain), 90% of our net income from
foreclosure property less the tax imposed on such income, and any excess noncash
income.  Over the past several months, we have found it necessary to
foreclose upon and sell certain properties that secured loans that we made
to third parties.  Although these activities have generated cash
proceeds, they generally have not resulted in income for federal
income tax purposes, and many have produced losses.  Accordingly, the
recent foreclosures and sales generally have not increased (and
in many cases may have actually decreased) the amounts that we are required
to distribute annually.  After we make any required annual distributions,
we may use any remaining cash to invest in other properties, pay operating
expenses or satisfy payment obligations with respect to our indebtedness, or we
may choose to distribute some or all of it to our stockholders. 
However, we are not required to distribute the remaining cash to
comply with REIT qualification requirements. During 2008, our Board of
Directors made the decision to preserve cash by reducing the monthly dividend
from $0.10 to $0.025 for the months of February through September. In October
2008, the Board of Directors determined that it was in the best long-term
interest of the company to suspend the dividend until market conditions and the
cash position of the Company improves, or until distributions are necessary to
maintain our REIT status.




25
 Table of Contents


In
summary, our ongoing operating costs and obligations primarily include the
following:


principal
  and interest payments on our debt;
        property
  ownership expenses, including property taxes, servicing fees and asset
  management fees;
        stock
  redemptions related to the death of stockholders;
        board
  fees;
        legal
  and professional expenses; and
        advisory
  fees.


Due to
our limited sources of operating revenue, recurring cash flow will not be
sufficient to satisfy our operating costs and obligations. To fund our cash
shortfall, we expect to sell investment assets and incur additional debt against
our real estate owned assets. Given current market conditions, we may not be
able to liquidate assets at a price we believe to be reasonable, or at all, or
be able to incur debt on attractive terms.  For the foreseeable
future, we do not anticipate having cash available for investing in new
loans.





Contractual
Obligations


The
following table sets forth information about certain of our contractual
obligations as of September 30, 2009 (dollars in thousands):




Total
                
                
                Less
      than 1 year
                
                
                1
      - 3 years
                
                
                3
      - 5 years
                
                
                More
      than 5 yearsLong-Term
      Debt ObligationsJunior
      subordinated notes
                
                $
                30,928
                
                
                $
                30,928
                (1)
                
                $
                -
                
                
                $
                -
                
                
                $
                -Mortgages
                
                
                7,651
                
                
                
                318
                
                
                
                1,815
                
                
                
                495
                
                
                
                5,023Notes
      payable
                
                
                1,482
                
                
                
                -
                
                
                
                1,482
                
                
                
                -
                
                
                
                -Short-Term
      Debt ObligationsBank
      note
                
                
                179
                
                
                
                179
                
                
                
                -
                
                
                
                -
                
                
                
                -Total
                
                $
                40,240
                
                
                $
                31,425
                
                
                $
                3,297
                
                
                $
                495
                
                
                $
                5,023


(1)Due to
an uncured event of default, we received notice in July 2009 that the
outstanding principal balance had been accelerated and was immediately due and
payable.






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:




The
following is a summary of the more judgmental and complex accounting estimates
and principles. In each area, we have identified the variables most important in
the estimation process. We have used the best information available to make the
estimations necessary to value the related assets and liabilities. Actual
performance that differs from our estimates and future changes in the key
variables could change future valuations and impact net income.




26
 Table of Contents


Revenue
Recognition


We
recognize interest income from investments in mortgage loans over the estimated
life of the underlying financial instrument on an accrual basis.




Income
recognition is suspended for mortgage investments at the earlier of the date at
which payments become 90 days past due or when, in the opinion of management, a
full recovery of interest and principal becomes doubtful. Interest accrued but
not collected is reversed at the time a loan is classified as
non-performing.  Income recognition is resumed when the mortgage
investment becomes contractually current and performance is demonstrated to be
resumed.  Loans whose contractual terms have been restructured in a
manner which grants a concession to a borrower experiencing financial
difficulties, without compensation on restructured loans, are classified as
non-performing until the loan is performing for an adequate period of time under
the restructured agreement. In situations where we do not receive adequate
compensation, the restructuring is considered a troubled debt restructuring and
is evaluated accordingly for impairment based upon the expected present value of
the cash flows of the loan as restructured compared to the present value of cash
flows as required under the original terms of the loan.




The
evaluation of a loan as performing is based upon the borrower meeting the terms
of the agreement including making interest payments on a monthly
basis.  All of our loans have fixed interest rates and provided for
payment of interest only with a “balloon” payment of principal payable in full
at the end of the loan term.  In such cases, we make assumptions as to
the borrower’s ability to repay the loans based upon our knowledge of the market
and the borrower’s financial status.  Changes in our assumptions as to
the borrower’s ability to repay would have an impact on the amount of income we
recognize.




Allowance
for Loan Losses


The
allowance for loan losses represents management’s estimate of probable losses
inherent in our portfolio of loans. The allowance for loan losses is reflected
in our financial statements based upon individual review of the loans, the
specific borrowers’ credit quality and mortgages 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 the estimate of 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.   Individual valuations on
non-performing loans are performed and specific allowances for losses may be
established for non-performing 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, if
the loan is collateral dependent, 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 estimated fair value of real estate and 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.




Real
Estate Owned


Real
estate properties acquired through, or in lieu of, loan foreclosure are
initially recorded at the lower of the recorded amount of our related mortgage
loan being foreclosed (net of any specific allowance for loan loss or loan
impairment charge), or our economic interest in the property’s estimated fair
value less estimated costs to sell. Any valuation adjustments required at the
time of foreclosure are charged to the allowance for loan losses. After
foreclosure, the properties are carried at the lower of carrying value or fair
value less estimated costs to sell. Any subsequent valuation adjustments,
operating expenses or income, and gains and losses on disposition of such
properties are recognized in current operations. The valuation allowance is
established based on our assessment of whether there are any indicators that the
fair value is less than the carrying value as adjusted for current market
trends.  Because any decision regarding the valuation of real estate
owned 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 amounts
recorded.  To the extent that we experience additional deterioration
in fair value of such properties, 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.




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 Table of Contents


Investments
in Real Estate


Variable
Interest Entities (VIE) are to be consolidated by its primary beneficiary (PB).
The PB is the party that absorbs a majority of the VIE’s anticipated losses
and/or a majority of the expected returns.




We
evaluate our investments in real estate to determine whether they are VIEs. For
each of these investments, we have evaluated (1) the sufficiency of the
fair value of the entities’ equity investments at risk to absorb losses,
(2) that as a group the holders of the equity investments at risk have
(a) the direct or indirect ability through voting rights to make decisions
about the entities’ significant activities, (b) the obligation to absorb
the expected losses of the entity and their obligations are not protected
directly or indirectly, (c) the right to receive the expected residual
return of the entity and their rights are not capped, (3) substantially all
of the entities’ activities do not involve or are not conducted on behalf of an
investor that has disproportionately fewer voting rights in terms of its
obligation to absorb the expected losses or its right to receive expected
residual returns of the entity, or both.




Entities
that issue junior subordinated notes are considered VIEs. However, it is not
appropriate to consolidate these entities  as equity interests are
variable interests only to the extent that the investment is considered to be at
risk. Since our investments were funded by the entities that issued the junior
subordinated notes, they are not considered to be at risk.




We have
determined that all of our investments in real estate are not VIEs. As such, we
have continued to account for these loans and investments as a loan or joint
venture, as appropriate.  As we continue to enter into joint ventures,
we will assess whether our investments in real estate are considered
VIEs.




Investments
in real estate are carried at the lower of cost or fair value. Our decisions
regarding the impairment of our investments in real estate are subjective.
Because any decision regarding the impairment losses reflects a judgment about
the estimated fair value of real estate and 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 impairments taken.  To the extent that we experience
losses greater than the amount of our impairments, 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.




Acquisitions


Acquisitions
of property are accounted for utilizing the purchase method for business
combinations, and accordingly, the acquired properties’ results of
operations would be included in our results of operations from the respective
dates of acquisition. Appraisals, estimates of cash flows and valuation
techniques are used to allocate the purchase price of acquired property between
land, land improvements, buildings and improvements, furniture, fixtures and
equipment and identifiable intangibles such as amounts related to in-place
leases.


We
acquired a property that we have classified as held for sale based our plan to
actively market the property. When a property is identified as held for sale,
fair value less cost to sell is estimated. If fair value less cost to sell is
less than the carrying amount of the asset an impairment charge is recorded for
the estimated loss. Depreciation expense is no longer recorded once a property
has met the held for sale criteria. The related carrying value of the property
is recorded as held for sale in the consolidated balance sheet and operations of
the property that are sold or classified as held for sale are recorded as part
of discontinued operations for all periods presented. For the nine months ended
September 30, 2009, no impairment losses on properties held for sale were
recognized




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
operate in the foreseeable future in such a manner so that we will qualify as a
REIT for federal income tax purposes.




We
maintain domestic taxable REIT subsidiaries, which may be subject to U.S.
federal, state and local income taxes. Current and deferred taxes are provided
for on the portion of earnings (losses) recognized by us with respect to our
interest in domestic taxable REIT subsidiaries. Deferred income tax assets and
liabilities are computed based on temporary differences between the GAAP
consolidated financial statements and the federal and state income tax basis of
assets and liabilities as of the consolidated balance sheet date. We evaluate
the realizability of our deferred tax assets and recognize a valuation allowance
if, based on the weight of available evidence, it is more likely than not that
some portion or all of our deferred tax assets will not be realized. When
evaluating the realizability of our deferred tax assets, we consider estimates
of expected future taxable income, existing and projected book/tax differences,
tax planning strategies available, and the general and industry specific
economic outlook. This realizability analysis is inherently subjective, as it
requires management to forecast our business and general economic environment in
future periods. Changes in our estimate of deferred tax asset realizability, if
any, are included in income tax expense on the consolidated statements of
income.




We
adopted ASC 740, Income
taxes, relating to the accounting for uncertainty in income taxes on
January 1, 2007. A tax position is recognized as a benefit only if it is
“more likely than not” that the tax position would be sustained in a tax
examination, with a tax examination being presumed to occur. The amount
recognized is the largest amount of tax benefit that is greater than 50% likely
of being realized on examination. For tax positions not meeting the “more likely
than not” test, no tax benefit is recorded.   We have recorded a
liability in the amount of $55,000.  Changes in estimates and
probabilities related to such calculation may have an impact on our financial
statements.




28
 Table of Contents


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.




Based on
our loans and liabilities as of September 30, 2009, 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 $324,000. This decrease is due to our
fixed rate investments and variable rate debt. Based on our loans and
liabilities as of September 30, 2009, 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 $324,000. 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


As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of management, including our
principal executive officer and principal financial officer, of the
effectiveness of the design and operation of the Company’s disclosure controls
and procedures pursuant to Securities Exchange Act of 1934 Rule 13a-15 (Exchange
Act).  Disclosure controls and procedures are designed to ensure that
information required to be disclosed in reports filed or submitted under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC rules and forms and that such information is
accumulated and communicated to management, including the Chief Executive
Officer and Chief Financial Officer, to allow timely decisions regarding
required disclosures.





As
indicated below, we reported  material weaknesses related to the
entrance into related party agreements as disclosed in our Quarter Report on
Form 10-Q for the quarters ending March 31 and June 30, 2009:




●
            
            Inadequate
      controls over the approval process for related party
      transactions.We entered into agreements with a related
      party without obtaining the requisite authorization from our Board of
      Directors resulting in inadequate controls and disclosures over related
      party transactions at March 31, 2009.   These agreements
      were subsequently approved and ratified by our Board of
      Directors.●
            
            Inadequate
      controls over the period-end financial reporting
      process.  Our controls were not adequately designed or
      operating effectively to provide reasonable assurance that our financial
      statements could be prepared in accordance with GAAP, specifically,
      ineffective communication between operating and financial personnel
      regarding the execution of new related party debt
      agreements.   As a result, and subsequent to our quarter
      end closing, management assessed and determined that an adjustment of
      approximately $912,000 was necessary which resulted in changes in
      non-interest expense and liabilities, and is reflected in our Quarterly
      report on Form 10-Q for the period ending March 31,
      2009.




Remediation


In the
three months ended September 30, 2009, the following specific remediation
efforts were put into place to address the material weaknesses that existed at
March 31, 2009, June 30, 2009 and continue to exist at September 30, 2009,
relating to the entrance into related party agreements:




●
            
            We
      continue to foster awareness and understanding of standards and principles
      for accounting and financial reporting among our finance and non-finance
      functions, as well as our related party entities. This includes
      (1) an integrated approach to monitoring financial and operational
      activities; (2) clarification of specific accounting and corporate
      governance policies and procedures; and (3) continuous monitoring of
      compliance with policies and procedures.  In addition, we will
      continue to monitor the processes and controls to ensure sustainment of
      the improvements made to our control environment.  We will
      continue to implement process changes to address the material weaknesses
      identified.




A
material weakness is a control deficiency, or combination of control
deficiencies, that result in a reasonable possibility that a material
misstatement of the annual or interim financial statements will not be prevented
or detected on a timely basis.




We
believe that the consolidated financial statements in this Quarterly Report on
Form 10-Q fairly present, in all material respects, with the exception as stated
above, our consolidated financial condition as of September 30, 2009 and
December 31, 2008 and consolidated statements of operations and cash flows
for the three and nine month periods ended September 30, 2009 and 2008, in
conformity with GAAP.




We
believe that our controls over financial reporting were not effective at
September 30, 2009.   Assuming effective controls and
procedures are maintained during the quarter ending December 31, 2009, the
Company expects that it will have remediated the related material
weaknesses.




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 Table of Contents


In
addition, there were no other changes in our internal control over financial
reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the
Exchange Act) that occurred during the quarter ended September 30, 2009 that has
materially affected, or is reasonable likely to materially affect, the
Corporation’s internal control over financial reporting.





Part II. Other Information




Item 1. Legal Proceedings


In September
2009, because of our prior ownership of CM Capital, we were named in a
lawsuit brought by an individual arising from such
individual's investment in certain promissory notes in the aggregate amount
of $100,000.  Named as defendants in the lawsuit, in addition to the
Company, are the following: Todd Parriott, Chief Executive
Officer, CMC Securities, LLC, CM Capital Services, LLC (formerly known
as Consolidated Mortgage, LLC), Desert Capital REIT, Inc., Benjamin
Williams and Strategic Financial Companies, LLC.  Plaintiff alleges,
among other things, that in recommending that the plaintiff invest
in such promissory notes, CM Capital Services and CM Securities, their
agents, principals and employees, and Benjamin Williams made untrue statements
of a material fact to the plaintiff and omitted to state material facts to
the plaintiff.  Plaintiff seeks, among other
things, monetary damages, interest, costs and attorneys'
fees.  We believe that the claims asserted in the lawsuit are without
merit.  We also deny all other allegations of wrongdoing and intend to
vigorously defend the lawsuit.





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, 2008.




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


None.




Item 3. Defaults Upon Senior
Securities


None.




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


We held
our annual meeting of stockholders on September 9, 2009 and a quorum was present
by proxy.  The purpose of this meeting was to vote on the
following:




(1)  Election
of Directors. Seven directors were elected and the votes cast were
as follows:




For
            
            
            Against
            
            
            Withheld
            
            
            Abstain
            
            
            Total
      Shares VotedTodd
      B. Parriott
            
            
            8,508,337
            
            
            
            45.860
            
            
            
            572,253
            
            
            
            2,116
            
            
            
            9,128,566Robert
      B. Beville
            
            
            8,529,049
            
            
            
            36,835
            
            
            
            560,566
            
            
            
            2,116
            
            
            
            9,128,566G.
      Steven Dawson
            
            
            8,514,046
            
            
            
            39,638
            
            
            
            572,766
            
            
            
            2,116
            
            
            
            9,128,566James
      L. George
            
            
            8,516,593
            
            
            
            41,942
            
            
            
            567,915
            
            
            
            2,116
            
            
            
            9,128,566Thomas
      L. Gustafson
            
            
            8,519,405
            
            
            
            41,942
            
            
            
            565,103
            
            
            
            2,116
            
            
            
            9,128,566Stacy
      M. Riffe
            
            
            8,520,046
            
            
            
            36,908
            
            
            
            569,496
            
            
            
            2,116
            
            
            
            9,128,566Charles
      Wolcott
            
            
            8,528,996
            
            
            
            26,910
            
            
            
            570,544
            
            
            
            2,116
            
            
            
            9,128,566







(2)  Ratification
of Auditors.  Hancock Askew & Co. LLP was ratified as our
independent registered public accounting firm for the fiscal year ending
December 31, 2009, 8,251,668 shares voted for, 290,101 shares voted
against, 666 shares abstained, and 586,131 shares withheld.





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
      the Registrant’s 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)
      (the “Registration Statement”) and incorporated herein by
      reference).21.1
            
            List
      of Subsidiaries31.1*
            
            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
            +Compensation
      Plan


30
 Table of Contents


SIGNATURES






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






November
      16, 2009
            DESERT
      CAPITAL REIT, INC.
              By:
      /s/Todd B. Parriott
              Todd
      B. Parriott, Chief Executive Officer, President and Chief Investment
      Officer and Chairman of the Board (Principal Executive
      Officer)November
      16, 2009
            DESERT
      CAPITAL REIT, INC.
              By:
      /s/Stacy M. Riffe
              Stacy
      M. Riffe, Chief Financial Officer, (Principal Accounting
      Officer)








31