Table of Contents


UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549


_______________




FORM
10-Q


(Mark
One)


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




For the
Quarterly Period Ended June 30, 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 August 13, 2009 was 16,849,954.






Table of Contents







INDEXPagePart I. Financial
      Information
            1Item 1. Consolidated Financial
      Statements
            1a) Consolidated Balance Sheets as of June 30, 2009 (unaudited)
      and December 31, 2008
            1b) Consolidated Statements of Operations (unaudited) for the
      three and six months ended June 30, 2009 and
      2008
            2c) Consolidated Statements of Cash Flows (unaudited) for
      the six months ended June 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
            16Item 3. Quantitative and Qualitative Disclosures About
      Market Risk
            22Item 4T. Controls and
      Procedures
            23Part II. Other
      Information
            23Item 1. Legal
      Proceedings
            23Item 1A. Risk
      Factors
            23Item 2. Unregistered Sales of Equity Securities and Use
      of Proceeds
            23Item 3. Defaults Upon Senior
      Securities
            23Item 4. Submission of Matters to a Vote of Security
      Holders
            23Item 5. Other
      Information
            23Item 6. Exhibits
            24Signatures
            25Certification 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




ITEM 1.Consolidated Financial StatementsDESERT CAPITAL REIT, INC.Consolidated
      Balance Sheets(in
      thousands, except share amounts)June
      30,
              
              
              December
      31,2009
              
              
              2008(unaudited)ASSETSMortgage
      investments - net of allowance for loan losses of $15,144 at June 30, 2009
      and $20,805 at December 31, 2008
              
              $
              41,663
              
              
              $
              69,538Real
      estate owned
              
              
              2,646
              
              
              
              19,979Investments
      in real estate
              
              
              21,391
              
              
              
              7,167Asset
      held for sale
              
              
              10,132
              
              
              
              -Notes
      receivable from related party - net of allowance for loan losses of $1,866
      at June 30, 2009 and $2,125 at December 31, 2008
              
              
              12,859
              
              
              
              12,600Building
      and equipment - net
              
              
              6,838
              
              
              
              6,815Land
              
              
              1,820
              
              
              
              1,820Cash
      and cash equivalents
              
              
              49
              
              
              
              351Restricted
      cash
              
              
              1,540
              
              
              
              1,278Interest
      receivable - includes related party interest of $0 at  June 30,
      2009 and $452 at December 31, 2008
              
              
              26
              
              
              
              531Deferred
      financing costs
              
              
              998
              
              
              
              941Other
      investments
              
              
              928
              
              
              
              928Other
      assets
              
              
              518
              
              
              
              681Total
      assets
              
              $
              101,408
              
              
              $
              122,629LIABILITIES
      AND STOCKHOLDERS' EQUITYNotes
      payable
              
              $
              2,647
              
              
              $
              1,360Mortgages
      payable
              
              
              7,726
              
              
              
              7,893Junior
      subordinated notes payable
              
              
              30,928
              
              
              
              30,928Management
      and servicing fees payable, related party
              
              
              1,527
              
              
              
              148Liabilities
      held for sale
              
              
              215
              
              
              
              -Accounts
      payable and accrued expenses
              
              
              1,588
              
              
              
              2,413Shares
      subject to redemption
              
              
              1,411
              
              
              
              -Total
      liabilities
              
              
              46,042
              
              
              
              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;
      16,833,954 issued and outstanding on June 30, 2009 and 16,835,867
      shareson
      December 31, 2008
              
              
              168
              
              
              
              168Additional
      paid-in capital
              
              
              164,293
              
              
              
              165,723Accumulated
      deficit
              
              
              (109,427
              )
              
              
              (86,004
              )Equity
      available to common stockholders
              
              
              55,034
              
              
              
              79,887Noncontrolling
      interest
              
              
              332
              
              
              
              -Total
      stockholders' equity
              
              
              55,366
              
              
              
              79,887Total
      liabilities and stockholders' equity
              
              $
              101,408
              
              
              $
              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 June 30,
              
              
              Six
      Months Ended June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008INTEREST
      INCOME (LOSS)Mortgage
      investments
              
              $
              76
              
              
              $
              1,786
              
              
              $
              296
              
              
              $
              4,002Other
      interest
              
              
              226
              
              
              
              492
              
              
              
              453
              
              
              
              1,040Total
      interest income
              
              
              302
              
              
              
              2,278
              
              
              
              749
              
              
              
              5,042Interest
      expense
              
              
              557
              
              
              
              842
              
              
              
              1,176
              
              
              
              1,695Net
      interest income (loss)
              
              
              (255
              )
              
              
              1,436
              
              
              
              (427
              )
              
              
              3,347Provision
      for loan losses
              
              
              4,665
              
              
              
              5,356
              
              
              
              5,679
              
              
              
              5,667Net
      interest loss after provision for loan losses
              
              
              (4,920
              )
              
              
              (3,920
              )
              
              
              (6,106
              )
              
              
              (2,320
              )NON-INTEREST
      INCOMERental
      income
              
              
              166
              
              
              
              224
              
              
              
              355
              
              
              
              448Other
              
              
              103
              
              
              
              23
              
              
              
              177
              
              
              
              174Total
      non-interest income
              
              
              269
              
              
              
              247
              
              
              
              532
              
              
              
              622NON-INTEREST
      EXPENSEImpairments
      of real estate owned
              
              
              408
              
              
              
              2,806
              
              
              
              1,495
              
              
              
              2,807Impairments
      on real estate investments
              
              
              4,290
              
              
              
              -
              
              
              
              4,290
              
              
              
              -Equity
      in loss of unconsolidated real estate investments
              
              
              8,670
              
              
              
              -
              
              
              
              8,670
              
              
              
              -Loss
      on sales of real estate owned
              
              
              -
              
              
              
              -
              
              
              
              3
              
              
              
              -Loss
      on sales of mortgage investments
              
              
              18
              
              
              
              
              
              
              
              18Loss
      on disposal of assets
              
              
              88
              
              
              
              -
              
              
              
              88
              
              
              
              -Management
      and servicing fees
              
              
              470
              
              
              
              424
              
              
              
              1,511
              
              
              
              846Professional
      fees
              
              
              191
              
              
              
              502
              
              
              
              449
              
              
              
              790Insurance
              
              
              161
              
              
              
              172
              
              
              
              321
              
              
              
              285Depreciation
              
              
              107
              
              
              
              122
              
              
              
              229
              
              
              
              242Other
              
              
              206
              
              
              
              290
              
              
              
              866
              
              
              
              558Total
      non-interest expense
              
              
              14,609
              
              
              
              4,316
              
              
              
              17,940
              
              
              
              5,528Loss
      from continuing operations before taxes
              
              
              (19,260
              )
              
              
              (7,989
              )
              
              
              (23,514
              )
              
              
              (7,226
              )Income
      tax benefit
              
              
              41
              
              
              
              87
              
              
              
              49
              
              
              
              130Net
      loss from continuing operations
              
              
              (19,219
              )
              
              
              (7,902
              )
              
              
              (23,465
              )
              
              $
              (7,096
              )Loss
      from discontinued operations, net of tax
              
              
              (453
              )
              
              
              -
              
              
              
              (453
              )
              
              
              -Net
      loss
              
              
              (19,672
              )
              
              
              (7,902
              )
              
              
              (23,918
              )
              
              
              (7,096
              )Less:  Net
      loss attributable to noncontrolling interest
              
              
              482
              
              
              
              -
              
              
              
              495
              
              
              
              -Net
      loss available to common stockholders
              
              $
              (19,190
              )
              
              $
              (7,902
              )
              
              $
              (23,423
              )
              
              $
              (7,096
              )Net
      loss per share - basic and dilutedLoss
      from continuing operations
              
              
              (1.11
              )
              
              
              (0.47
              )
              
              
              (1.36
              )
              
              
              (0.42
              )Discontinued
      operations
              
              
              (0.03
              )
              
              
              -
              
              
              
              (0.03
              )
              
              
              -Net
      loss available to common stockholders
              
              $
              (1.14
              )
              
              $
              (0.47
              )
              
              $
              (1.39
              )
              
              $
              (0.42
              )Weighted
      average outstanding shares - basic and diluted
              
              
              16,834,690
              
              
              
              16,807,867
              
              
              
              16,835,275
              
              
              
              16,795,296The
      accompanying notes are an integral part of these consolidated financial
      statements.


2
 Table of Contents


DESERT CAPITAL REIT, INC.Consolidated
      Statements of Cash Flows(in
      thousands)(unaudited)Six
      Months Ended June 30,2009
            
            
            2008OPERATING
      ACTIVITIESNet
      loss
            
            $
            (23,423
            )
            
            $
            (7,096
            )Adjustments
      to reconcile net loss to net cash (used) in provided by operating
      activities:Loss
      on sales of real estate owned and mortgage investments
            
            
            21
            
            
            
            -Depreciation
      and amortization
            
            
            229
            
            
            
            259Provision
      for loan loss
            
            
            5,679
            
            
            
            5,667Loss
      on disposal of assets
            
            
            88
            
            
            
            -Impairment
      of real estate
            
            
            5,785
            
            
            
            2,807Equity
      in loss of unconsolidated real estate investments
            
            
            8,670
            
            
            
            -Loss
      from discontinued operations, net of tax
            
            
            (453
            )
            
            
            -Provision
      for deferred taxes
            
            
            -
            
            
            
            (54
            )Mortgage
      loans originated for sale
            
            
            -
            
            
            
            (6,332
            )Mortgage
      loan sales
            
            
            -
            
            
            
            4,902Net
      change in:Interest
      receivable
            
            
            505
            
            
            
            465Other
      assets
            
            
            306
            
            
            
            9Accrued
      and Other Liabilities
            
            
            1,294
            
            
            
            140Net
      cash (used) provided by operating activities of continuing
      operations
            
            
            (1,299
            )
            
            
            767Net
      cash used by operating activities of discontinued
    operations
            
            
            (88
            )
            
            
            -Net
      cash (used) provided by operating activities
            
            
            (1,387
            )
            
            
            767INVESTING
      ACTIVITIESInvestment
      in real estate mortgages
            
            
            -
            
            
            
            (8,201
            )Proceeds
      from repayments of real estate mortgages
            
            
            -
            
            
            
            7,236Proceeds
      from sales of real estate mortgages
            
            
            275
            
            
            
            2,700Investment
      in asset held for sale, net
            
            
            107
            
            
            
            -Proceeds
      received on equity investments in real estate
            
            
            184
            
            
            
            -Proceeds
      from sale of real estate owned
            
            
            32
            
            
            
            -Proceeds
      from repayment of note receivable from related party
            
            
            -
            
            
            
            388Acquisition
      of building and equipment
            
            
            (340
            )
            
            
            (65
            )Net
      cash provided by investing activities of continuing
    operations
            
            
            258
            
            
            
            2,058Net
      cash used by investing activities of discontinued
    operations
            
            
            (4
            )
            
            
            -Net
      cash provided by investing activities
            
            
            254
            
            
            
            2,058FINANCING
      ACTIVITIESNet
      (repayments) borrowings on bank note
            
            
            (400
            )
            
            
            1,430Increase
      in restricted cash
            
            
            (262
            )
            
            
            (143
            )Principal
      repayments of mortgage loan
            
            
            (167
            )
            
            
            (120
            )Increase
      in notes payable
            
            
            1,687
            
            
            
            -Issuance
      of common stock
            
            
            -
            
            
            
            383Deferred
      financing costs
            
            
            (57
            )
            
            
            -Redemption
      of common stock shares
            
            
            (20
            )
            
            
            -Dividends
      on common stock
            
            
            -
            
            
            
            (4,156
            )Offering
      costs paid
            
            
            -
            
            
            
            (41
            )Net
      cash provided (used) by financing activities of continuing
      operations
            
            
            781
            
            
            
            (2,647
            )Net
      cash provided by financing activities of discontinued
      operations
            
            
            50
            
            
            
            -Net
      cash provided (used) by financing activities
            
            
            831
            
            
            
            (2,647
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            (302
            )
            
            
            178Cash
      and cash equivalents at beginning of period
            
            
            351
            
            
            
            163Cash
      and cash equivalents at end of period
            
            $
            49
            
            
            $
            341




Supplemental
      disclosure of cash flow information:
              
              Six
      Months Ended June 30,2009
              
              
              2008Cash
      paid for interest
              
              $
              1,347
              
              
              $
              1,791Cash
      paid for taxes
              
              
              45
              
              
              
              -Common
      stock issued for dividend reinvestment program
              
              
              -
              
              
              
              867Common
      stock dividends declared but not paid
              
              
              -
              
              
              
              428Foreclosed
      assets acquired in exchange for loans, net of impairments
              
              
              11,612
              
              
              
              18,775Asset
      held for sale transferred from mortgage investments, net
              
              
              10,023
              
              
              
              -Charge
      off of foreclosure costs
              
              
              195
              
              
              
              -Real
      estate assets owned contributed to equity investments 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
              
              
              19
              
              
              
              -Offering
      costs incurred but not paid
              
              
              -
              
              
              
              53The
      accompanying notes are an integral part of these consolidated financial
      statements.


3
 Table of Contents


Desert CapitalREIT, INC.


Condensed
Notes to Unaudited Consolidated Financial Statements


June
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 substantially 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 three primary strategies for
generating cash flows and resolving our non-performing loans and real estate
owned which include sale of foreclosed properties, assumption of non-performing
loans by new borrowers with acceptable credit 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 property 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 our
opinion, all adjustments (consisting only of normal recurring accruals)
considered necessary for a fair presentation have been included.  The
results of operations for the three and six months ended June 30, 2009 are not
necessarily indicative of results that may be expected for the entire year
ending December 31, 2009.




Note
2 - Summary of Significant Accounting Policies


Principles
of Consolidation


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




Our
interest in Desert Capital TRS Statutory Trust I, a trust formed for the purpose
of issuing trust preferred securities,  is accounted for using the
equity method and the assets and liabilities are not consolidated into our
financial statements due to our determination that Desert Capital TRS Statutory
Trust I is a variable interest entity in which we are not the primary
beneficiary under Financial Accounting Standards Board (FASB) Interpretation No.
46R, Consolidation
of Variable Interest Entities – An Interpretation of ARB No. 51,(FIN
46R).  In addition we use the equity method to account for our
investment in three 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.




As of
June 30, 2009, we consolidated one investment in real estate that is less
than wholly-owned, but which we control. Net operating results of the 8.8%
noncontrolling interest are reflected in net loss attributable to noncontrolling
interests.




Reclassifications


Certain
reclassifications have been made in the investing activities section of the
consolidated statement of cash flow for the six months ended June 30,
2008.  Specifically, within the captions “Investment in real estate
mortgages” and “Proceeds from repayment/sale of real estate mortgages,” changes
have been made to reflect gross receipts and gross payments of mortgage
investments.     In addition, certain reclassifications
have been made in the presentation of the quarter ended and six months ended
June 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.




4
 Table of Contents


Revenue
Recognition


Interest
income on our mortgage investments is recognized over the contractual term of
the investment and recorded on the 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.




Restricted
Cash


Restricted
cash includes accounts held by lenders and banks. We have two restricted cash
balances. We established a restricted cash reserve account and pay our junior
subordinated debt payments from this account, as part of the modification
entered into on our junior subordinated debt.   Changes in the
restricted cash related to this reserve account are reflected as financing
activities in the statement of cash flows.  In addition, we
established a restricted cash account for the payment of certain of our
investments in real estate expenses through our related party servicer and
property manager, CM Capital.   Changes in this restricted cash
account are reflected as operating activities in the statement of cash
flows.  See Note 11.  Restricted cash is excluded from cash
for the purpose of preparing the statements of cash flows.




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 shall be measured as the excess of
the carrying amount of the investment over the fair value of the
investment.




Investments
in Real Estate


Certain
real estate assets acquired through foreclosure are being held for investment or
have been contributed to operating joint 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:




We
evaluate our investments in partially owned entities in accordance with
FIN 46R, to determine whether an entity is a variable interest entity
(VIE), and if so, whether we are the primary beneficiary of the
VIE.   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, 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 assess
whether events have occurred that would require us to reevaluate consolidation
criteria under APB Opinion No. 18, The
Equity Method of Accounting for Investments in Common Stock, (APB
18).  As a part of this evaluation, we consider our 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 pursuant to EITF 04-05. These
investments are recorded initially at cost or impaired value, as investments in
real estate entities, and subsequently adjusted for equity in earnings and cash
contributions and distributions in accordance with AICPA (American Institute of
Certified Public Accountants) Statement of Position No. 78-9, Accounting
for Investments in Real Estate Ventures.




We also
assess our ownership interest in LLCs and assess the events occurring within the
LLC to determine if they qualify as triggering events for reclassification from
real estate owned to cost method investments.  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.






5
 Table of Contents


Noncontrolling
Interests


Effective
January 1, 2009, we adopted the provisions of FAS 160, which requires
that noncontrolling (i.e., minority) ownership interests in subsidiaries held by
parties other than the parent, and the amount of consolidated net income, be
clearly identified, labeled, and presented in the consolidated financial
statements within equity, but separate from the parent’s equity. It also
requires that once a subsidiary is deconsolidated, any retained noncontrolling
equity investment in the former subsidiary be initially measured at fair value.
Sufficient disclosures are required to clearly identify and distinguish between
the interests of the parent and the interests of the non-controlling
owners.  In addition to the amendments to ARB 51, this Statement
amends SFAS No. 128, Earnings
per Share (FAS 128), so that earnings-per-share will continue to be
calculated in the same manner as it was calculated before FAS 160 was
issued. Further, as a result of the adoption of FAS 160, net income
attributable to noncontrolling interests is now excluded from the determination
of consolidated net income.   The adoption of FAS 160 did not
have a material impact on our financial condition and results of
operations.  However, it did impact the presentation and disclosure of
noncontrolling interests in our consolidated financial statements. We did not
previously have any noncontrolling interests, thus the presentation and
disclosure requirements of retrospectively applying the effects to the financial
statements was not applicable to us.




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 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 in accordance with SFAS No. 114, Accounting
by Creditors for Impairment of a Loan, (FAS 114).  In
accordance with FAS 114, 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


In
accordance with SFAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets,(FAS
144), 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 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
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.




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 or 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. We have
not elected for any of our assets or liabilities to be accounted for under SFAS
No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities, (FAS
159).  Depending on the nature of the asset or liability, we
use various valuation techniques and assumptions when estimating fair value,
which are in accordance with SFAS No. 157, Fair
Value Measurements,(FAS 157), and FSP FAS 157-3, Determining
the Fair Value of a Financial Asset When the Market for that Asset is Not
Active, when applicable.




In
accordance with FAS 157, 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


In
December 2007, the FASB issued SFAS No. 141R, Business
Combinations, (FAS 141R).  This Statement replaces SFAS No.
141.  FAS 141R establishes principles and requirements for how the
acquirer of a business recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, and any non-controlling
interest in the acquiree.  FAS 141R also provides guidance for
recognizing and measuring the goodwill acquired in the business combination and
determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.  This statement applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15,
2008.  The adoption of FAS 141R did not have any effect on our
historical financial statements.  See Note 14 - Acquisition, for the
application of this standard to the business acquisition that occurred during
the six months ended June 30, 2009.




In April
2009, The FASB issued Staff Position No. FAS 107-1 and Accounting Principles
Board 28-1, Interim
Disclosures About Fair Value of Financial Instruments, (FSP FAS
107-1).  FSP FAS 107-1 extends the existing disclosure requirements
related to the fair value of financial instruments to interim periods that were
previously only required in annual financial statements.  Given that
FSP FAS 107-1 provides for additional disclosures, its adoption did not have any
impact on the Company’s consolidated financial statements.  The
disclosure requirements under FSP FAS 107-1 are included in Note 12 to the
consolidated financial statements.




6
 Table of Contents


In May
2009, the FASB issued SFAS No. 165, 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. This new standard was effective for interim or annual
periods beginning after June 15, 2009.  The Company adopted the
application of this statement and has provided the new disclosures as
required.




In
June 2009, the FASB issued SFAS No. 167, Amendments
to FASB Interpretation No. 46(R), to improve financial reporting by
enterprises involved with variable interest entities by addressing (1) the
effects on certain provisions of FIN 46R, as a result of the elimination of the
qualifying special-purpose entity concept in FASB Statement No. 166, Accounting
for Transfers of Financial Assets, and (2) constituent concerns about the
application of certain key provisions of FIN 46R, including those in which the
accounting and disclosures under the Interpretation do not always provide timely
and useful information about an enterprise’s involvement in a variable interest
entity. This statement is effective for financial statements issued for fiscal
years beginning after November 15, 2009, with earlier adoption prohibited.
We are currently assessing the potential impacts, if any, on our consolidated
financial statements.




In
June 2009, the FASB issued SFAS No. 168, The
“FASB Accounting Standards Codification” and the Hierarchy of Generally Accepted
Accounting Principles. This standard replaces SFAS No. 162, The
Hierarchy of Generally Accepted Accounting Principles, and establishes
only two levels of U.S. GAAP, authoritative and nonauthoritative. The FASB
Accounting Standards Codification (the “Codification”) will become the source of
authoritative, nongovernmental GAAP, except for rules and interpretive
releases of the SEC, which are sources of authoritative GAAP for SEC
registrants. All other nongrandfathered, non-SEC accounting literature not
included in the Codification will become nonauthoritative. This standard is
effective for financial statements issued for fiscal years and interim periods
ending after September 15, 2009.   We do not believe this
standard will have any impact on our consolidated financial statements, other
than our disclosures.




Note
3 - Mortgage Investments


Mortgage
investments represent first and second lien positions on acquisition and
development, construction and commercial property loans. As of June 30, 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 tables present our mortgage investments (dollars in
thousands):


June
      30, 2009Loan
      Type
              
              Number
      of Loans
              
              
              Balance
              
              
              Allowance
      for Loan Losses
              
              
              Net
      Balance
              
              
              Weighted
      Average Interest Rate (1)
              
              
              Portfolio
      PercentageAcquisition
      and development loans
              
              
              21
              
              
              $
              53,855
              
              
              $
              14,466
              
              
              $
              39,389
              
              
              
              12.3
              %
              
              
              94.8
              %Construction
      loans
              
              
              3
              
              
              
              2,945
              
              
              
              678
              
              
              
              2,267
              
              
              
              9.2
              %
              
              
              5.2
              %Commercial
      property loans
              
              
              1
              
              
              
              7
              
              
              
              -
              
              
              
              7
              
              
              
              6.5
              %
              
              
              0.0
              %Total
      mortgage investments
              
              
              25
              
              
              $
              56,807
              
              
              $
              15,144
              
              
              $
              41,663
              
              
              
              12.1
              %
              
              
              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):


June
      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
                
                $
                18,172
                
                
                $
                (10,317
                )
                
                $
                7,855
                
                
                
                32.0
                %
                
                $
                51,532
                
                
                $
                (17,268
                )
                
                $
                34,264
                
                
                
                57.1
                %California
                
                
                13,274
                
                
                
                (998
                )
                
                
                12,276
                
                
                
                23.4
                
                
                
                13,274
                
                
                
                (998
                )
                
                
                12,276
                
                
                
                14.7Texas
                
                
                10,425
                
                
                
                (210
                )
                
                
                10,215
                
                
                
                18.3
                
                
                
                10,425
                
                
                
                (210
                )
                
                
                10,215
                
                
                
                11.5Arizona
                
                
                7,540
                
                
                
                (2,710
                )
                
                
                4,830
                
                
                
                13.3
                
                
                
                7,711
                
                
                
                (1,420
                )
                
                
                6,291
                
                
                
                8.5Missouri
                
                
                7,396
                
                
                
                (909
                )
                
                
                6,487
                
                
                
                13.0
                
                
                
                7,401
                
                
                
                (909
                )
                
                
                6,492
                
                
                
                8.2Total
                
                $
                56,807
                
                
                $
                (15,144
                )
                
                $
                41,663
                
                
                
                100.0
                %
                
                $
                90,343
                
                
                $
                (20,805
                )
                
                $
                69,538
                
                
                
                100.0
                %


7
 Table of Contents


The
following tables present details on non-performing and impaired loans and
related allowance for loan losses as of June 30, 2009 and December 31, 2008
(dollars in thousands):


June
      30, 2009
              
              
              December
      31, 2008Number
      of Loans
              
              
              Balance
              
              
              Number
      of Loans
              
              
              BalanceNon-performing
      loans with a specific valuation allowance
              
              
              18
              
              
              $
              38,524
              
              
              
              24
              
              
              $
              65,903Non-performing
      loans without a specific valuation allowance
              
              
              4
              
              
              
              12,136
              
              
              
              5
              
              
              
              17,822Related
      allowance for loan losses on non-performing loans
              
              
              -
              
              
              
              (13,834
              )
              
              
              -
              
              
              
              (20,805
              )Total
      non-performing loans
              
              
              22
              
              
              $
              36,826
              
              
              
              29
              
              
              $
              62,920Performing
      loans - no related allowance
              
              
              1
              
              
              $
              7
              
              
              
              8
              
              
              $
              6,618Performing
      loans - related allowance
              
              
              2
              
              
              
              6,140
              
              
              
              -
              
              
              
              -Related
      allowance for loan losses on performing loans
              
              
              -
              
              
              
              (1,310
              )
              
              
              -
              
              
              
              -Total
      performing loans
              
              
              3
              
              
              $
              4,837
              
              
              
              8
              
              
              $
              6,618Total
              
              
              25
              
              
              $
              41,663
              
              
              
              37
              
              
              $
              69,538
  Interest
income recognized on impaired loans for the three months ended June 30, 2009 and
2008 was $4,000 and $396,000, respectively.  Interest income
recognized on impaired loans for the six months ended June 30, 2009 and 2008 was
$4,000 and $1.2 million, respectively.




During
the six months ended June 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 six month period ended June 30, 2008, we sold a mortgage loan for $2.7
million which had a carrying value of $2.7 million.  No gain or loss
was recognized on sales during the first six months of 2008.




In April
2009, we foreclosed on a nonperforming loan collateralized by an operating
business with an aggregate original loan balance of $14.4 million; see also Note
14 - Acquisition.  Upon foreclosure, we initially measured the fair
value of the real estate property and business acquired at $12.1 million, but
after further examination, we now value the real estate property and related
business at $10.0 million. We charged off the allowance related to this loan in
the amount of $4.4 million.




At the
acquisition date and as of June 30, 2009, we have classified the real estate
property and related business as an asset held for sale and have measured its
assets in accordance with FAS 144.  The related results of operations
are reported as discontinued operations on our consolidated statement of
operations for the three months ended June 30, 2009; see also Note 15 –
Discontinued Operations.




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


Three
      Months Ended
              
              
              Six
      Months Ended
              
              
              Year
      EndedJune 30,
              
              
              June 30,
              
              
              December
      31,2009
              
              
              2008
              
              
              2009
              
              
              2008
              
              
              2008Balance,
      beginning
              
              $
              15,152
              
              
              $
              24,854
              
              
              $
              20,805
              
              
              $
              25,444
              
              
              $
              25,444Provision
      for loan
      loss
              
              
              4,732
              
              
              
              5,356
              
              
              
              5,938
              
              
              
              5,667
              
              
              
              21,491Amounts
      charged off
              
              
              (4,377
              )
              
              
              -
              
              
              
              (4,377
              )
              
              
              (300
              )
              
              
              (5,600
              )Transfers
      to real estate owned
              
              
              (363
              )
              
              
              (15,767
              )
              
              
              (7,222
              )
              
              
              (16,368
              )
              
              
              (20,530
              )Balance,
      ending
              
              $
              15,144
              
              
              $
              14,443
              
              
              $
              15,144
              
              
              $
              14,443
              
              
              $
              20,805
 Note
4 – Real Estate Owned
 During
the six months ended June 30, 2009, we foreclosed on properties with a fair
value of $11.6 million which is comprised of loans with an aggregate
original balance of $18.8 million and transferred them to real estate
owned.  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 six month period ending June 30, 2008.
  During
the six months ended June 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 summary provides an analysis of the changes in real estate owned
during the six months ended June 30, 2009 (dollars in
thousands):


Balance
      December 31, 2008
              
              $
              19,979Foreclosures
              
              
              11,612Real
      estate consolidated as noncontrolling interest
              
              
              828Impairments
              
              
              (1,495
              )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
      June 30, 2009
              
              $
              2,646
  The
following is a summary of the carrying value of our real estate owned as of June
30, 2009 and December 31, 2008 (dollars in thousands):


Description
            Location
            
            June
      30, 2009
            
            
            December
      31, 2008Undeveloped
      land
            NV,
      AZ, CA
            
            $
            1,054
            
            
            $
            13,947Single
      family residential lots
            NV,
      AZ
            
            
            -
            
            
            
            1,707Office
      building
            NV,
      TX
            
            
            1,592
            
            
            
            2,613Other
            NV
            
            
            -
            
            
            
            1,712Total
            
            
            $
            2,646
            
            
            $
            19,979




8
 Table of Contents


Note
5 – Investments in Real Estate


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 six months of
2009, three homes were constructed and sold to homeowners.  We
received cash proceeds of $184,000 from these sales, resulting in a decrease of
an outstanding receivable of $19,000 and a return of $165,000 of our equity
investments.  During the six months ended June 30, 2009, we recognized
a loss in our equity in these joint ventures of $712,000, a direct result of
impairments on the assets due to a decrease in the value of  lots
contributed.




Investments
Accounted for under the Cost Method


As of
June 30, 2009 and December 31, 2008 we had $3.3 million and $1.0 million,
respectively, in real estate investments that we accounted for under the cost
method.   During the six months ended June 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.  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 $622,000.




Investments
Accounted for under the Equity Method


We held
$4.6 million in other equity real estate investments that we accounted for under
the equity method of accounting at June 30, 2009 and $0 at December 31,
2008.   During the six months ended June 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 $13.2 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, we recognized a loss
on our equity in these real estate investments of $8.0 million, a direct result
of impairments on the assets due to a decrease in value of the underlying
properties fair value and our share of certain losses within the
LLCs.




Fully
Consolidated Investments in Real Estate


At June
30, 2009, we held $8.3 million in fully consolidated real estate investments,
including a noncontrolling interest in an LLC with an original value of
$828,000.  We did not hold any fully consolidated investments in real
estate at December 31, 2008.  During the six months ended June 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, 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.  We recognized impairments in these real estate investments of
$3.7 million.




During
the six months of 2009, we consolidated the equity and net operating income and
expenses of one entity, which had previously been classified as real estate
owned, after we determined that certain events within the LLC, specifically the
addition of debt, changed our current classification from that of real estate
owner to that of an operating entity. Accordingly, we have consolidated
this entity and reflected the non-controlling interest under the provisions of
Statement of Financial Accounting Standards (SFAS) No. 160, Non-controlling
Interests in Consolidated Financial Statements – an amendment of ARB No.
51, (FAS 160).




The
following summary provides an analysis of the changes in investments in
real estate during the six months ended June 30, 2009 (dollars in
thousands):


Fully
              
              
              
              
              
              Other
      EquityConsolidated
              
              
              Equity
      Method
              
              
              Method
              
              
              Cost
      MethodInvestments
              
              
              Joint
      Ventures
              
              
              Investments
              
              
              Investments
              
              
              TotalBalance
      December 31, 2008
              
              $
              -
              
              
              $
              6,167
              
              
              $
              -
              
              
              $
              1,000
              
              
              $
              7,167Assets
      reclassified from real estate owned
              
              
              11,103
              
              
              
              -
              
              
              
              13,116
              
              
              
              3,009
              
              
              
              27,228Consolidation
      of noncontrolling interest
              
              
              828
              
              
              
              
              
              
              
              
              
              
              
              -
              
              
              
              828Sales
      of joint venture property
              
              
              -
              
              
              
              (165
              )
              
              
              -
              
              
              
              -
              
              
              
              (165
              )Impairments
      on real estate investments
              
              
              (3,668
              )
              
              
              
              
              
              
              
              
              
              
              (622
              )
              
              
              (4,290
              )Other
      adjustments to carrying value
              
              
              -
              
              
              
              
              
              
              
              (576
              )
              
              
              (131
              )
              
              
              (707
              )Equity
      in loss on real estate investments
              
              
              -
              
              
              
              (712
              )
              
              
              (7,958
              )
              
              
              -
              
              
              
              (8,670
              )Balance
      June 30, 2009
              
              $
              8,263
              
              
              $
              5,290
              
              
              $
              4,582
              
              
              $
              3,256
              
              
              $
              21,391




The
following is a summary of our investments in real estate at June 30, 2009 and
December 31, 2008 (dollars in thousands):


June
      30,
              
              
              December
      31,Description
              Location
              
              2009
              
              
              2008Undeveloped
      land
              NV,
      AZ, CA
              
              $
              8,698
              
              
              $
              -Single
      family residential lots
              NV,
      AZ
              
              
              6,785
              
              
              
              6,167Office
      building
              NV,
      TX
              
              
              302
              
              
              
              -Other
              NV
              
              
              5,606
              
              
              
              1,000Total
              
              
              $
              21,391
              
              
              $
              7,167
  At June
30, 2009, our investments in real estate were held in 27 limited liability
companies, and our ownership percentage ranged from negligible to
100%.




9
 Table of Contents


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 June 30, 2009 we have granted awards for
108,000 restricted shares in aggregate to our Board of Directors and certain
executive officers under the Plan. The shares were granted in annual grants
to our directors.
  There
was no restricted stock expense for the three and six months ended June 30, 2009
and 2008.


Note
7 - Premises and Equipment


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


June
      30, 2009
              
              
              December
      31, 2008Premises
      and improvements
              
              $
              7,468
              
              
              $
              7,811Equipment
              
              
              100
              
              
              
              100Furniture
      and fixtures
              
              
              421
              
              
              
              411Construction
      in progress
              
              
              322
              
              
              
              -8,311
              
              
              
              8,322Less
      accumulated depreciation
              
              
              (1,473
              )
              
              
              (1,507
              )Premises
      and equipment, net
              
              $
              6,838
              
              
              $
              6,815
 Note
8 – Loss per share


Loss per
share is computed in accordance with FAS 128. Basic loss per share is calculated
by dividing net loss by the weighted average number of shares of common stock
outstanding during each period. Diluted loss per share is calculated by dividing
net loss by the weighted average number of shares outstanding plus the
additional dilutive effect of unvested restricted stock during each
period.  As of June 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 Six Months EndedJune
      30, 2009
            
            
            June
      30, 2008
            
            
            June
      30, 2009
            
            
            June
      30, 2008Net
      loss available to common stockholders:Loss
      from continuing operations
            
            $
            (18,737
            )
            
            $
            (7,902
            )
            
            $
            (22,970
            )
            
            $
            (7,096
            )Loss
      from discontinued operations, net
            
            
            (453
            )
            
            
            -
            
            
            
            (453
            )
            
            
            -Net
      loss available to common stockholders
            
            $
            (19,190
            )
            
            $
            (7,902
            )
            
            $
            (23,423
            )
            
            $
            (7,096
            )Weighted
      average number of common shares outstandingbasic
      and diluted
            
            
            16,835
            
            
            
            16,808
            
            
            
            16,835
            
            
            
            16,795Loss
      from continuing operations
            
            $
            (1.11
            )
            
            $
            (0.47
            )
            
            $
            (1.36
            )
            
            $
            (0.42
            )Discontinued
      operations
            
            
            (0.03
            )
            
            
            -
            
            
            
            (0.03
            )
            
            
            -Basic
      and diluted loss per common share
            
            $
            (1.14
            )
            
            $
            (0.47
            )
            
            $
            (1.39
            )
            
            $
            (0.42
            )




Note
9 - Dividends and Redemption Requests


To
maintain our status as a REIT, we are required to make dividend distributions,
other than capital gain dividends, each year in an amount at least equal to 90%
of our taxable income.  All dividend distributions are made at the
discretion of our Board of Directors and depend on our earnings, both tax and
GAAP, financial condition, maintenance of REIT status and such other factors as
the Board of Directors deems relevant.  No dividends were paid during
six months ended June 30, 2009.  The following table lists the
dividend declaration dates and per share amounts for the six months ended
2008:


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
              
              0.025Total
              
              $
              0.225
  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 under SFAS No.
150, “Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity,” and at June 30, 2009, we had redemption requests of 124,000
shares of common stock totaling $1.4 million.




10
 Table of Contents


Note
10 – Debt




Bank
Note


We had a
$7.5 million secured bank note with a term of one year that matured in
February 2009.  The note, which was originally a credit facility, was
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 June 30, 2009 was
7.0%.  At June 30, 2009 and December 31, 2008, we had an outstanding
balance of $960,000 and $1.4 million, respectively. Certain of our assets are
collateral for this note and their value exceeds the note balance on June 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 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 agreed to reduce the maximum amount of the note to its balance at
the time of modification, or $1.2 million, extend the maturity of the note for
12 months and to modify certain of the covenants. In addition, we agreed to the
following minimum principal payments:  $100,000 by March 31, 2009 and
$25,000 by June 30, 2009, $50,000 by November 30, 2009, $100,000 by December 31,
2009, and any remaining balance is due on February 22, 2010.  We have
made principal payments in the aggregate amount of $200,000 since the
modification date of March 31, 2009.  All interest payments are due in
accordance with the original terms of the loan. 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 June 30, 2009 and as of the
date of this filing, we are not in compliance with certain of the covenants
under this loan agreement.




Other
Notes Payable


During
the first three months of 2009, we entered into two debt agreements totaling
$1.8 million. We set aside interest reserves with a balance of $275,000 at June
30, 2009, which have been reflected  as a reduction in the note balance,
resulting in a net note balance of $1.5 million.   Interest is
accrued and paid on the principal amount of the notes, or $1.8
million.  The interest rates on these notes range from 10% to 13%, 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 owned with a carrying value of $5.5
million.  The proceeds from the notes of $1.8 million, less closing
costs, funding of the interest reserves and other fees were $1.2 million at the
date of closing, and were classified as restricted cash on our balance
sheet.  At June 30, 2009 this balance was $1.1 million. The cash 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 property manager, CM Capital.   During the six
months ended June 30, 2009, we recorded $60,000 of interest expense related to
this debt.




During
second quarter of 2009, we entered into an uncollateralized note payable
agreement with a third party.  The principal balance on the note is
$200,000 and bears interest at a rate of 10%.  Subsequent to June 30,
2009, we paid down the principal balance on the note in the amount of
$100,000.




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
              
              
              $
              (223
              )
              
              $
              1,02413%
              
              3/13/2010
              
              
              515
              
              
              
              (52
              )
              
              
              46310%
              
              9/12/2009
              
              
              200
              
              
              
              -
              
              
              
              200$
              1,962
              
              
              $
              (275
              )
              
              $
              1,687
  Mortgage
Loans Payable


We have a
mortgage loan from a bank, with an outstanding principal balance of $6.2 million
and $6.3 million as of June 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 June 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 June 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 to preserve our
interest in the property. The loan had an outstanding principal balance of $1.5
million as of June 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 5.04% and 7.47% on June 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.




11
 Table of Contents


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.




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.  At June 30, 2009, the balance in such reserve account was
$425,000, which is reflected as restricted cash on our balance
sheet.  At June 30, 2009, interest payable on the securities was
$255,000.




At June
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 are in
negotiations with the holders of the preferred securities to negotiate a
restructuring of obligations to the holders of the preferred securities,
although 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 six months ended June 30, 2009 was $365,000 and $742,000, respectively, and
$424,000 and $846,000 for the three and six months ended June 30, 2008,
respectively. At June 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
six months ended June 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 an annual fee equal to 2.5% of the original loan amount of the
foreclosed properties, calculated from the date of foreclosure. For the three
and six months ended June 30, 2009, this fee totaled $106,000 and $769,000, and
is included in management and servicing fees in the consolidated statement of
operations.  At June 30, 2009, $198,000 is payable and included in
management and servicing fees payable on the consolidated balance
sheets.




In order
to facilitate payment of certain carrying costs and servicing and property
management fees, during the six months ended June 30, 2009, we incurred debt
totaling $1.8 million. CM Capital served as our debt placement agent and
servicer, for which we paid placement fees of $64,000.  In addition,
we funded interest reserves related to the notes payable of $317,000, which are
being held in a trust account by CM Capital.  The net proceeds, less
closing costs, funding of the interest reserves and other fees of
$1.2  million at the date of closing were classified as restricted
cash on our balance sheet for the purpose of the payment of costs associated
with being a land owner and servicing and property management fees payable to CM
Capital.  The balance of the restricted cash account at June 30, 2009
is $1.1 million. The cash is being held by CM Capital for our benefit in a trust
account.




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 six months ended June 30, 2009.  CM
Securities earned gross sales commissions and marketing support fees for the
three and six months ended June 30, 2008 of $0 and $36,000,
respectively.  CM Securities paid a substantial portion of these fees
to third party broker dealers.




12
 Table of Contents


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 six months ended
June 30, 2009, we earned $103,000 and $171,000, respectively, in guarantee
fees.   At June 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 $1.2 million net of impairment charges of
$760,000.




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 six months
ended June 30, 2009, we recognized no income.  For the three and six
months ended June 2008, we recognized income of $3,000 and $134,000,
respectively related to the contingent installment payment.




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.   During the term of the Loan
Origination Agreement we have 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. During the six months
ended June 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, we evaluated the promissory note in
accordance with FAS 114, and determined that 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 $1.9
million to reflect this impairment.  As of December 31, 2008 and June
30, 2009, CM Capital was in compliance with the modified financial covenants set
forth above.   We earned interest of $223,000 and $444,000 during the
three and six months ended June 30, 2009 and $344,000 and $697,000 for the three
and six months ended June 30, 2008, respectively.




During
the six months ended June 30, 2009, we entered into an uncollateralized note
payable agreement with Residential Capital Mortgage Corporation (RCMC), an
entity owned by certain of our officers, for working capital purposes, related
to the operation of the gentlemen’s club on which we foreclosed in April 2009 in
the principal amount of $50,000.  See Note 14 -
Acquisition.  This note bears interest at a weekly interest rate of
1.5%, and is due upon the sale of our acquired business.  The note is
classified within our liabilities held for sale on our balance
sheet.




We lease
office space to CM Group, CM Securities, CM Capital, and RCMC under
non-cancelable operating leases which expire in July 2010.  Total
rents received from related parties for the three and six months ended June 30,
2009 and 2008 were $130,000 and $259,000, respectively.




Note
12 - Fair Value of Financial Instruments


Fair
Value under FAS 157 is applied prospectively effective January 1,
2008.  Under FAS 157, we are required to take into account our own
credit risk when measuring the fair value of our liabilities.  Fair
value is best determined based upon quoted market prices. However, in many
instances there are no quoted market prices for various financial instruments.
In cases where quoted market prices are not available, fair values are based on
estimates using present value or other valuation techniques. Those techniques
are significantly affected by the assumptions used, including the discount rate,
estimates of future cash flows and realization of collateral. Accordingly, the
fair value estimates may not be realized in an immediate settlement of the
instrument.




13
 Table of Contents


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


June 30, 2009
              
              
              December 31, 2008Carrying
      Value
              
              
              Estimated
      Fair Value
              
              
              Carrying
      Value
              
              
              Estimated
      Fair ValueFinancial
      assets:Cash,
      cash equivalents and restricted cash
              
              $
              1,589
              
              
              $
              1,589
              
              
              $
              1,629
              
              
              $
              1,629Interest
      receivable
              
              
              26
              
              
              
              26
              
              
              
              531
              
              
              
              531Note
      receivable - related party
              
              
              12,859
              
              
              
              10,172
              
              
              
              12,600
              
              
              
              11,024Mortgage
      investments - net
              
              
              41,663
              
              
              
              41,447
              
              
              
              69,538
              
              
              
              68,773Financial
      liabilities:Bank
      note
              
              
              960
              
              
              
              863
              
              
              
              1,360
              
              
              
              1,274Notes
      payable
              
              
              1,687
              
              
              
              1,629
              
              
              
              -
              
              
              
              -Mortgages
      payable
              
              
              7,726
              
              
              
              7,137
              
              
              
              7,893
              
              
              
              7,264Junior
      subordinated notes
              
              
              30,928
              
              
              
              24,590
              
              
              
              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 June 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 June 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 June 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 June 30,
2009.  Level 1 and Level 2 data were not used in the fair value
measurements.


Estimated
      Fair Value
              
              
              Level
      3Impaired
      mortgage investments
              
              
              36,826
              
              
              
              36,826Investments
      in real estate
              
              
              21,391
              
              
              
              21,391Real
      estate owned
              
              
              2,646
              
              
              
              2,646
  Note
13 – Commitments and Contingencies


We
guaranteed approximately $13.7 million of indebtedness of Warm Jones, LLC, a
limited liability company in which we own a 37.6% membership
interest.  Under the original terms of the indebtedness, the note was
due in October 2008 and subsequently modified, extending 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 pursuant to FASB Interpretation No. 45 (FIN 45), “Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others,” is approximately $101,000 as of
June 30, 2009 and December 31, 2008, and is 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.  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
January 1, 2009, we adopted FAS 141R, which defines a business as an integrated
set of activities and assets that is capable of being conducted and managed for
the purpose of providing a return directly to investors.  All entities
constituting a business (as defined) are subject to FAS 141R, including real
estate acquired through foreclosure with operations of a business currently in
place, not vacant land.




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 initially measured the fair value of the
real estate property and related business at $12.1 million, but after
further examination, we now value the real estate property and related business
at $10.0 million.




At the
acquisition date and as of June 30, 2009, we have classified the real estate
property and related business as an asset held for sale and have measured its
assets in accordance with FAS 144.  The related results of operations
are reported as discontinued operations on our consolidated statement of
operations for the three months ended June 30, 2009.  See Note 15–
Discontinued Operations.




14
 Table of Contents


The
following table summarizes the estimated fair value of the nets assets acquired
and liabilities assumed at the foreclosure date:


Description
              
              Estimated 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
              $
              10,023




The fair
value of the consideration transferred to acquire the real estate property,
related business and the assets acquired and liabilities assumed at the
conversion date was $10.0 million.




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.




Note
15 – Discontinued Operations


Assets of
the business acquired on April 22, 2009, as stated in Note 14 - Acquisition,
have been classified as held for sale as of June 30, 2009.  Assets
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 months
ended June 30, 2009.




During
the six months ended June 30, 2009, we entered into an uncollateralized
note payable agreement with  RCMC, an entity owned by certain of our
officers, for working capital purposes, related to the operation of the
gentlemen's club on which we foreclosed in April 2009 in the principal amount of
$50,000.  This note bears interest at a weekly interest rate of 1.5%,
and is due upon the sale of our acquired business.  The note is
classified within our liabilities held for sale on our balance
sheet.




Subsequent
to June 30, 2009 we entered into three uncollateralized note payable agreements
with unrelated third parties in the aggregate principal amount
of  $345,000 for working capital purposes related to the operation of
the gentlemen's club on which we foreclosed.  The notes bear interest
at weekly  interest rates of 0.625% and
1.5%.




The
following assets and liabilities have been segregated and are included in assets
and liabilities held for sale, as accounted for under FAS 144, in the
consolidated balance sheet as of June 30, 2009 (dollars in
thousands):


June
      30, 2009Accounts
      receivable
              
              $
              37Inventory
              
              
              27Fixed
      assets, net
              
              
              10,040Other
      assets
              
              
              28Assets
      held for sale
              
              $
              10,132Accounts
      payable and accrued expenses
              
              $
              165Note
      payable
              
              
              50Liabilities
      held for sale
              
              $
              215Three
      months endedJune
      30, 2009Revenue
              
              $
              1,191Cost
      of goods sold
              
              
              846Operating
      cost and expenses
              
              
              788Total
      operating cost and expenses
              
              
              1,634Operating
      loss
              
              
              (443
              )Interest
      expense
              
              
              10Loss
      from discontinued operations
              
              $
              (453
              )
  Note 16
- Subsequent Events


We
entered into a note payable agreement with an unrelated third party with an
original principal amount of $140,000 in July 2009.  The note bears
interest at a rate of 10%, payable upon maturity in July 2012.  We
received loan proceeds after the payment of closing fees in the amount of
$127,000.




In August
2009, we acquired property through foreclosure or deed in lieu of foreclosure,
with original loan balances of $171,000 and $115,000 in associated impairments,
and classified the net balance as real estate owned.




In August
2009, we granted 16,000 restricted shares to our Board of
Directors.




We
evaluated subsequent events through August 13, 2009, the date the financial
statements were available to be issued. Events or transactions occurring after
June 30, 2009 but prior to August 13, 2009, that provided additional evidence
about conditions that existed at June 30, 2009, have been recognized in the
financial statements for the period ended June 30, 2009. Events or transactions
that provided evidence about conditions that did not exist at June 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 June 30, 2009, but
have been disclosed herein.




15
 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
second quarter 2009 results reflect continued pressure from an uncertain economy
and the struggling housing market.  For the three and six months ended
June 30, 2009, we reported a net loss of $19.2 million and $23.4 million,
respectively, compared to a net loss of $7.9 million and $7.1 million,
respectively, for the three and six months ended June 30,
2008.  Contributing to the second quarter 2009 net loss was a $4.7
million provision for loan losses, a $408,000 impairment of real estate owned,
and a $13.0 million impairment of real estate investments coupled with a
reduction in total interest income of $2.0 million. The original balance of
performing loans declined from $48.5 million at June 30, 2008 to $6.1 million at
June 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 first and second
quarter actions are as follows:




●
            
            Foreclosed
      on the underlying real estate securing loans with an original balance of
      $33.2 million, including our foreclosure and 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
      $1.8 million of debt on specific assets to generate cash to be used for
      servicing and property management fees and real estate carrying and
      resolution costs;●
            
            Sold
      real estate for cash proceeds of $275,000; 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 six months in 2009, we entered into $1.8 million of
debt, which was placed by CM Capital with individual trust deed investors. The
cash proceeds from this debt were set aside 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 40.7% at June 30, 2009, an increase from 32.8%
at December 31, 2008.




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.





With the
decline in real estate values that were brought on by pressures in the subprime
and credit markets, the performance of our portfolio and the value of our
investments have been severely impacted. In response, our Board of Directors
determined that it was in our and our stockholders’ best long-term interest to
suspend the sale of our common stock as of February 22, 2008, and to reduce the
monthly dividend from $0.10 to $0.025 per share. In October 2008, our Board
further determined it was necessary to eliminate the monthly dividend for cash
preservation purposes.




16
 Table of Contents


Our
Investments


Real
Estate Owned


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 consists of property acquired through
foreclosure on mortgage loans. During the six months ended June 30, 2009, we
foreclosed on ten loans with an aggregate original loan amount of $33.2 million,
and a carrying value of $21.6 million, including our foreclosure and 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.




Investments
in Real Estate


Our
interest in real estate owned 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.




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
original carrying value of $6.7 million to the joint ventures. The current
carrying value of these joint ventures is $5.3 million. Our joint venture
partner, the developer, will construct homes on each of the three projects, and
sell the completed homes to homeowners. Under terms of the joint venture
agreements, the developer will fund the majority of the costs of construction,
and we will 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 six months of 2009, three homes were constructed
and sold to homeowners, resulting in cash proceeds to us of
$184,000.




Investments
accounted for under the Cost Method


In
situations where our interest in an LLC represents less than 20% and we do have
direct control over the LLC, we account for the investment under the cost method
of accounting.  During the six months ended June 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 carrying value of
$3.0 million.  The current carrying value of our cost method
investments is $3.3 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 at their carrying value of $13.1
million.  We held other real estate investments for which we accounted
for under the equity method with a carrying value of $4.6 million,  at
June 30, 2009 and $0 at December 31, 2008.




Fully
Consolidated Investments in Real Estate


We held
$8.3 million in fully consolidated  real estate investments. We did
not hold any fully consolidated investments in real estate at December 31,
2008.  During the six months ended June 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,
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 them.  We
recognized impairments on these real estate investments of $3.7
million.




If our
interest is such that we have determined we hold a controlling interest after
evaluation under FIN 46 or APB 18, we fully consolidate these investments on our
balance sheet and reflect the minority position as noncontrolling interest on
the balance sheet.   During the six months ended June 30, 2009,
we determined that an investment we held as real estate owned within an LLC, and
with a membership interest of 91%, should be consolidated and classified as an
investment in real estate.




Mortgage
Loans


At the
time of our inception, our stated business plan was the investment in a variety
of types of mortgage loans.  As of December 31, 2008, mortgage
investments still constituted a majority of our investments; however, because of
our current lack of access to capital, during 2009 we have not originated any
new mortgage loans. We will 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 are short-term (12 to 18 months), balloon loans with fixed interest
rates. A substantial portion of these loans consists of interest-carry loans,
meaning we provide the borrower with sufficient financing to enable it to make
the interest payments during the term of the loan. The interest-carry nature of
our mortgage loans means that we may not be able to determine that a loan is
non-performing until the balloon payment is due.  To date, all of the
mortgage loans which we have funded have been identified by CM Capital. We do
not have a contractual arrangement with any other mortgage originator. Our Board
of Directors has not established any limits upon the geographic concentration of
mortgage loans that we may acquire.  At June 30, 2009, 32.0% of our
portfolio of mortgage investments was located in Nevada.  In addition,
we have a significant concentration of credit risk with our largest
borrowers.  At June 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 $6.4 million was reserved in
the allowance for loan losses.




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


Revenues:


Interest
income is generated on our mortgage investments and our related party note
receivable from CM Capital. Interest income decreased by $2.0 million, or 86.7%,
to $302,000 for the three months ended June 30, 2009 from $2.3 million for the
three months ended June 30, 2008. This decrease was due to an 89.2% decrease in
the average balance of the performing loans in our portfolio from $56.9 million
for the three months ended June 30, 2008 to $6.1 million for the three months
ended June 30, 2009.




Other
interest income decreased by $266,000, or 54.1%, to $226,000 for the three
months ended June 30, 2009 from $492,000 for the three months ended June 30,
2008.  Approximately $120,000 of this decrease is 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 there was a $143,000 decrease in interest income on
our loans held for sale.  We did not hold any loans for sale in
2009.




17
 Table of Contents


Expenses:


Interest
expense consists of interest on our notes payable, mortgage debt, bank note, and
junior subordinated notes payable. Interest expense decreased 33.9%, to $557,000
for the three months ended June 30, 2009 from $842,000 for the three months
ended June 30, 2008.   This decrease was a result of a decrease
in the average interest rate on our variable rate debt to 5.5% from 7.6% during
the three months ended June 30, 2008.




Non-interest
expense, including provision for loan losses, impairments on real estate owned
and real estate investments, and equity in losses of unconsolidated investments
in real estate increased $9.5 million or 98.2%, to $19.2 million for the three
months ended June 30, 2009 from $9.7 million for the three months ended June 30,
2008. The primary increases in non-interest expense were due to the increases in
the impairments on our real estate investments, including our investments that
we account for using the equity method of accounting.  Our equity in
the losses of unconsolidated real estate investments increased by $8.7 million,
up 100% from the prior year during the same period.  The increase is
due to the reclassification of certain of our real estate investments from real
estate owned to either equity method or other investments in real
estate.  In addition, we recognized $4.3 million in impairments on our
other investments in real estate, up 100% from the same period in the prior
year.  The increases in the impairments and equity in losses of our
investments in real estate were due to a further decline in the real estate and
credit markets, causing the value of our real estate to
decline.  These increases were slightly offset by a decrease of $2.4
million, or 85.5% from $2.8 million in the impairment of real estate owned for
the three months ended June 30, 2009 as compared to June 30, 2008.




Results
of Operations for thesixmonths ended June 30, 2009 compared to thesixmonths ended June 30, 2008


Revenues:


Interest
income is generated on our mortgage investments and our related party note
receivable from CM Capital. Interest income decreased by $4.3 million, or 85.1%,
to $749,000 for the six months ended June 30, 2009 from $5.0 million for the six
months ended June 30, 2008. This decrease was due to a 90.8% decrease in the
average balance of the performing loans in our portfolio from $66.8 million for
the six months ended June 30, 2008 to $6.2 million for the six months ended June
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 1.05%
for the six months ended June 30, 2009 from 6.2% for the six months ended June
30, 2008.




Other
interest income decreased by $587,000, or 56.4%, to $453,000 for the six months
ended June 30, 2009 from $1.0 million for the six months ended June 30,
2008.  Approximately $253,000 of this decrease is 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 there was a $314,000 decrease in interest income on
our loans held for sale.  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 30.6%, to $1.2
million for the six months ended June 30, 2009 from $1.7 million for the six
months ended June 30, 2008.   This decrease was a result of a
decrease in the average interest rate on our variable rate debt to 5.7% from
7.6% during the six months ended June 30, 2008.




Non-interest
expense, including provision for loan losses, impairments on real estate owned
and real estate investments, and equity in losses of unconsolidated investments
in real estate increased $12.3 million or 110.0%, to $23.5 million for the six
months ended June 30, 2009 from $11.2 million for the six months ended June 30,
2008. The primary increases in non-interest expense were due to the increases in
the impairments on our real estate investments, including our investments that
we account for using the equity method of accounting.  Our equity in
the losses of unconsolidated real estate investments increased by $8.7 million,
up 100% from the prior year during the same period.  The increase is
due to the reclassification of certain of our real estate investments from real
estate owned to either equity method or other investments in real
estate.  In addition, we recognized $4.3 million in impairments on our
other investments in real estate, up 100% from 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 in our real estate owned of $1.3 million, or 46.7%
during the six months ended June 30, 2009, from $2.8 million during the six
months ended June 30, 2008.




We also
experienced an increase in management and servicing fees of $665,000, or 78.6%
from $846,000 for the six months ended June 30, 2008.   The increase
of $665,000 in management and servicing fees was a direct result of the accrual
of a 2.5% annual servicing fee paid to CM Capital, our related party servicer,
pursuant to the agreement entered into for the servicing of our foreclosed
properties.




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 June 30,
            
            
            Six
      Months Ended June 30,2009
            
            
            2008
            
            
            2009
            
            
            2008GAAP
      net (loss)
            
            $
            (19,672
            )
            
            $
            (7,902
            )
            
            $
            (23,918
            )
            
            $
            (7,096
            )Adjustments
      to GAAP net income (loss):Noncontrolling
      interest
            
            
            482
            
            
            
            -
            
            
            
            495
            
            
            
            -Provision
      for loan losses
            
            
            4,665
            
            
            
            5,356
            
            
            
            5,679
            
            
            
            5,667Impairment
      of real estate
            
            
            4,698
            
            
            
            2,806
            
            
            
            5,785
            
            
            
            2,807Equity
      in losses of real estate investments
            
            
            8,670
            
            
            
            -
            
            
            
            8,670
            
            
            
            -Actual
      losses on real estate and loans
            
            
            (4,377
            )
            
            
            -
            
            
            
            (8,046
            )
            
            
            (300
            )Net
      adjustment for TRS loss
            
            
            389
            
            
            
            120
            
            
            
            572
            
            
            
            181REIT
      taxable income (loss)
            
            $
            (5,145
            )
            
            $
            380
            
            
            $
            (10,763
            )
            
            $
            1,259






18
 Table of Contents


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 mortgage loans and real
estate owned, proceeds from the issuance of debt, and to a lesser degree,
proceeds from repayment of mortgage loans and net cash provided by operating
activities.




Net cash
used by operating activities during 2009 was $1.4 million, which was primarily
due to the substantial loss of interest income due to the deterioration of our
loan portfolio and the increase in servicing and property management fees and
carrying costs related to our foreclosed assets.  At June 30, 2009, the
original loan balance of our mortgage investments was $56.8 million, of which
$6.1 million was performing, investments in real estate had a carrying balance
of $21.4 million, and real estate owned had a carrying balance of $2.6 million.
It is likely that non-performing mortgage loans and real estate assets will
produce minimal, if any, current earnings 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 owned portfolio 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 further increases in 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 deemed
appropriate by our Advisor.  As of June 30, 2009, we have reviewed our
mortgage investments, investments in real estate and real estate owned 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 loan,
borrowers’ financial condition, industry trends and an estimated net realizable
value of any underlying collateral in relation to the real estate loan
amount.




We have a
$960,000 secured bank note that matures in February 2010.  The
note, initially a $7.5 million credit facility, was established for short-term
funding requirements, not for working capital purposes, and matured in February
2009. We were in default under terms of the note during 2008 and at the maturity
date in February 2009. In June 2009, we entered into a modification, extending
the maturity date to February 2010.  Under terms of the modification,
we were required to make principal payments of $25,000 on June 30, an amount
that has been paid, and are required to make $50,000 on November 30 and $100,000
on December 31, 2009, with the remaining balance, if any, due in February
2010.   Since entering into the modification and through June 30,
2009, we have made total principal payments of $200,000.  The
outstanding balance bears interest at an interest rate equal to the prime rate
plus 75 basis points, with a floor of 7%. The interest rate on this note at June
30, 2009 was 7% and the outstanding principal balance was $960,000. Under terms
of the note, interest payments are due monthly.  Currently we are
restricted from further borrowings under this note.  We are not in
compliance with certain covenants applicable to this note and are currently in
negotiations with the lender to modify such covenants.




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. During the six months ended June 30, 2009, in an effort to
facilitate the payment of certain of our expenses as a property owner, we
entered into two note payable agreements with an aggregate principal amount of
$1.8 million for net cash proceeds of $1.2 million.  This cash is
classified as restricted 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 to our related party, CM Capital. The
balance of this restricted cash is $1.1 million on June 30, 2009.  In
addition, we set aside cash of $317,000 for the payment of interest during the
term of the debt.  The outstanding principal balance of these notes
payable bears interest at 10% to 13% per annum and 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 June
2006, we issued $30.0 million in unsecured trust preferred securities, which are
reflected on our balance sheet as junior subordinated notes
payable.   At March 31, 2009, we were not 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.  Subsequent to June 30, 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 are in
negotiations with the Trust Preferred Securities Holders and will continue such
efforts to negotiate a restructuring of obligations to the holders of the
preferred securities, although 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 would have a
material adverse effect on our financial condition.




Upon the
death of a stockholder, the stockholder’s estate has a limited right of
redemption with respect to its common stock, and at June 30, 2009, we had
received redemption requests of 124,000 shares of common stock totaling $1.4
million.




In April
2009, we foreclosed on the operating business and real estate securing
a defaulted loan.  We are actively marketing the business and
real estate for sale; however, we intend to operate the business until we have
identified a qualified buyer. We anticipate providing funding to the business
for marketing, repair and maintenance and other general operating
expenses.  From the date of foreclosure through June 30, 2009, we have
funded $348,000 in operating expenses.  Subsequent to quarter end, we
entered into three note payable agreements with third parties in the amount of
$345,000 for working capital purposes.  We intend to incur additional
debt to fund the operations of the acquired business to the extent available in
the event that we cannot sell the property.




19
 Table of Contents


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.




We do not
expect that recurring cash flow, coupled with loan payoffs and proceeds from
asset sales, will be sufficient to satisfy our operating costs, which primarily
include board fees, management fees, legal and professional expenses, property
owner expenses and principal and interest payments on our debt, and accordingly,
we expect to liquidate investment assets and incur additional debt against our
real estate owned assets to satisfy our obligations. 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 June 30, 2009 (dollars in thousands):


Payments
      due by PeriodTotal
            
            
            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
            
            $
            7,726
            
            
            
            314
            
            
            
            1,838
            
            
            
            487
            
            
            
            5,087Notes
      payable
            
            $
            1,024
            
            
            
            -
            
            
            
            1,024
            
            
            
            -
            
            
            
            -Short-Term
      Debt ObligationsBank
      note
            
            $
            960
            
            
            
            960
            
            
            
            -
            
            
            
            -
            
            
            
            -Notes
      payable
            
            $
            663
            
            
            
            663
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            41,301
            
            
            $
            32,865
            
            
            $
            2,862
            
            
            $
            487
            
            
            $
            5,087


(1)Junior
subordinated notes payable were in default at June 30, 2009 and on July 27, 2009
we received notice 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.




Revenue
Recognition


We
recognize interest income from investments in mortgage loans over the estimated
life of the underlying financial instrument and recorded on the 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.




20
 Table of Contents


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 in accordance with FAS 114.  In
accordance with FAS 114, 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.




Investments
in Real Estate


In
December 2003, the FASB issued FIN 46R, which requires a VIE 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 under the provisions of FIN 46 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 in accordance with
FAS 141R, 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. On January
1, 2009 we adopted FAS 141R, which prospectively changes the requirements
for how an acquirer recognizes and measures the identifiable assets acquired,
the liabilities assumed, any noncontrolling interest in the acquiree and the
goodwill acquired.  FAS 141R also enhances the disclosures to enable
the evaluation of the nature and financial effects of the business combination
and requires that pre-acquisition costs be expensed as incurred.  We
have applied the provisions of FAS 141R to our acquisition.




We
acquired a property that we have classified as held for sale based on the
criteria within FAS 144. 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 six months ended
June 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.




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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 FASB Interpretation 48, “Accounting
for Uncertainty in Income Taxes”, as of 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.




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 June 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 $325,000. This decrease is due to our fixed rate
investments and variable rate debt. Based on our loans and liabilities as of
June 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
$325,000. 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.





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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 period
ending March 31,
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 June 30, 2009, the following specific remediation
efforts were put into place to address the material weaknesses that existed at
March 31, 2009 and continue to exist at June 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 June 30, 2009 and
December 31, 2008 and consolidated statements of operations and cash flows
for the three and six month periods ended June 30, 2009 and 2008, in conformity
with GAAP.




We
believe that our controls over financial reporting were not effective at
June 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.




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 June 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


During
the period covered by this report, there were no material changes to legal
proceedings discussed in our Annual Report on Form 10-K for the year ended
December 31, 2008.




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. DefaultsUpon Senior
Securities


None.




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


None.




Item 5.Other Information


None.




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 Table of Contents


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







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 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.






August
      13, 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)August
      13, 2009
            DESERT
      CAPITAL REIT, INC.
              By:/s/Stacy
      M. Riffe
              Stacy
      M. Riffe, Chief Financial Officer, (Principal Accounting
      Officer)







25