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 September 30, 2008





OR





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




For
the Transition Period From ___ to ___





Commission
File Number 0-51344















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




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


Yes þ  No o





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


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




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


Yes o No þ





The
number of shares of the registrant's common stock, par value $0.01 per share,
outstanding as of November 10, 2008 was 16,835,867.











Table of
Contents




DESERT
CAPITAL REIT, INC.


FORM
10-Q


For
the Quarter Ended September 30, 2008




INDEX




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








Table of
Contents


Part I.  Financial InformationItem 1. Consolidated Financial
    StatementsDESERT CAPITAL REIT, INC.Consolidated
      Balance SheetsSeptember
      30,
            
            
            December
      31,2008
            
            
            2007(unaudited)ASSETSMortgage
      investments - net of allowance for loan losses of $17,161,528 at September
      30, 2008 and $25,444,130 at December 31, 2007
            
            $
            84,683,584
            
            
            $
            118,017,926Loans
      held for sale
            
            
            -
            
            
            
            2,139,200Real
      estate owned
            
            
            29,835,588
            
            
            
            15,652,282Equity
      investments in real estate
            
            
            2,463,247
            
            
            
            -Notes
      receivable from related party - net of allowance for loan losses of
      $2,124,731 at September 30, 2008 and $0 at December 31,
    2007
            
            
            12,600,269
            
            
            
            15,500,000Building
      and equipment - net
            
            
            6,936,870
            
            
            
            7,235,939Land
            
            
            1,820,000
            
            
            
            1,820,000Cash
      and cash equivalents
            
            
            154,253
            
            
            
            162,753Restricted
      cash
            
            
            1,180,789
            
            
            
            -Interest
      receivable
            
            
            635,943
            
            
            
            1,464,261Deferred
      financing costs
            
            
            949,350
            
            
            
            975,043Other
      investments
            
            
            1,928,000
            
            
            
            1,928,000Other
      assets
            
            
            1,166,503
            
            
            
            818,715Total
      assets
            
            $
            144,354,396
            
            
            $
            165,714,119LIABILITIES
      AND STOCKHOLDERS' EQUITYCredit
      facility
            
            $
            1,836,900
            
            
            $
            2,139,200Mortgage
      payable
            
            
            7,961,804
            
            
            
            8,132,769Junior
      subordinated notes payable
            
            
            30,928,000
            
            
            
            30,928,000Dividends
      payable
            
            
            430,052
            
            
            
            1,675,814Deferred
      income taxes
            
            
            423,914
            
            
            
            738,423Accounts
      payable and accrued expenses
            
            
            1,381,941
            
            
            
            1,052,637Total
      liabilities
            
            
            42,962,611
            
            
            
            44,666,843Preferred
      stock, $0.01 par value: 15,000,000 shares authorized, none
      outstanding
            
            
            -
            
            
            
            -Common
      stock, $0.01 par value: 100,000,000 shares authorized; 16,835,867 and
      16,724,549shares
      issued and outstanding on September 30, 2008, and December 31, 2007,
      respectively
            
            
            168,359
            
            
            
            167,246Additional
      paid-in capital
            
            
            165,723,370
            
            
            
            164,370,179Accumulated
      deficit
            
            
            (64,499,944
            )
            
            
            (43,490,149
            )Total
      stockholders' equity
            
            
            101,391,785
            
            
            
            121,047,276Total
      liabilities and stockholders' equity
            
            $
            144,354,396
            
            
            $
            165,714,119The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.





1
 Table of
Contents


DESERT CAPITAL REIT, INC.Consolidated
      Statements of Operations(unaudited)Three Months Ended
      September 30,
              
              
              Nine Months Ended
      September 30,2008
              
              
              2007
              
              
              2008
              
              
              2007INTEREST
      INCOME:Mortgage
      investments
              
              $
              1,493,342
              
              
              $
              4,410,062
              
              
              $
              5,495,202
              
              
              $
              15,488,818Other
      interest
              
              
              311,112
              
              
              
              170,633
              
              
              
              1,351,161
              
              
              
              478,800Total
      interest income
              
              
              1,804,454
              
              
              
              4,580,695
              
              
              
              6,846,363
              
              
              
              15,967,618Interest
      expense
              
              
              693,251
              
              
              
              1,032,804
              
              
              
              2,388,555
              
              
              
              3,043,706Net
      interest income
              
              
              1,111,203
              
              
              
              3,547,891
              
              
              
              4,457,808
              
              
              
              12,923,912Provision
      for loan losses
              
              
              7,228,360
              
              
              
              1,585,080
              
              
              
              12,895,456
              
              
              
              1,798,431Net
      interest income after provision for loan loss
              
              
              (6,117,157
              )
              
              
              1,962,811
              
              
              
              (8,437,648
              )
              
              
              11,125,481NON-INTEREST
      INCOME:Loan
      brokerage fees
              
              
              -
              
              
              
              1,223,177
              
              
              
              -
              
              
              
              5,696,746Service
      and other loan fees
              
              
              -
              
              
              
              231,893
              
              
              
              -
              
              
              
              1,017,923Other
              
              
              221,229
              
              
              
              342,198
              
              
              
              843,696
              
              
              
              794,441Total
      non-interest income
              
              
              221,229
              
              
              
              1,797,268
              
              
              
              843,696
              
              
              
              7,509,110NON-INTEREST
      EXPENSE:Impairment
      of real estate owned
              
              
              1,931,132
              
              
              
              -
              
              
              
              4,737,938
              
              
              
              -Compensation
              
              
              -
              
              
              
              546,610
              
              
              
              -
              
              
              
              1,563,377Management
      fees
              
              
              421,728
              
              
              
              505,986
              
              
              
              1,267,601
              
              
              
              3,286,149Professional
      fees
              
              
              202,736
              
              
              
              502,819
              
              
              
              992,471
              
              
              
              1,380,165Insurance
              
              
              197,529
              
              
              
              116,039
              
              
              
              482,550
              
              
              
              323,328Depreciation
              
              
              121,716
              
              
              
              195,641
              
              
              
              364,025
              
              
              
              586,923Advertising
              
              
              -
              
              
              
              350,453
              
              
              
              148
              
              
              
              691,313Other
              
              
              325,283
              
              
              
              432,048
              
              
              
              883,717
              
              
              
              1,199,127Total
      non-interest expense
              
              
              3,200,124
              
              
              
              2,649,596
              
              
              
              8,728,450
              
              
              
              9,030,382Net
      income before taxes
              
              
              (9,096,052
              )
              
              
              1,110,483
              
              
              
              (16,322,402
              )
              
              
              9,604,209Income
      tax expense (benefit)
              
              
              (219,462
              )
              
              
              369,915
              
              
              
              (350,026
              )
              
              
              567,103Net
      income
              
              $
              (8,876,590
              )
              
              $
              740,568
              
              
              $
              (15,972,376
              )
              
              $
              9,037,106Earnings
      per share - basic
              
              $
              (0.53
              )
              
              $
              0.04
              
              
              $
              (0.95
              )
              
              $
              0.56Earnings
      per share - diluted
              
              $
              (0.53
              )
              
              $
              0.04
              
              
              $
              (0.95
              )
              
              $
              0.56Weighted
      average outstanding shares - basic
              
              
              16,825,212
              
              
              
              16,707,393
              
              
              
              16,805,341
              
              
              
              16,053,992Weighted
      average outstanding shares - diluted
              
              
              16,825,212
              
              
              
              16,747,103
              
              
              
              16,805,341
              
              
              
              16,087,252The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
 
  2
 Table of
Contents


DESERT CAPITAL REIT, INC.Consolidated
      Statements of Cash Flows(unaudited)Nine Months Ended
      September 30,2008
              
              
              2007OPERATING
      ACTIVITIESNet
      income (loss)
              
              $
              (15,972,376
              )
              
              $
              9,037,106Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
              
              
              389,718
              
              
              
              612,616Stock
      based compensation
              
              
              185,360
              
              
              
              200,000Provision
      for loan losses
              
              
              12,895,456
              
              
              
              1,798,431Impairment
      of real estate owned
              
              
              4,737,938
              
              
              
              -Gain
      on sale of loans
              
              
              (18,449
              )
              
              
              -Deferred
      tax benefit
              
              
              (314,509
              )
              
              
              -Mortgage
      loans originated for sale
              
              
              (6,332,000
              )
              
              
              (35,177,750
              )Mortgage
      loan sales
              
              
              7,134,300
              
              
              
              37,045,750Net
      change in:Interest
      receivable
              
              
              828,318
              
              
              
              173,271Other
      assets
              
              
              (347,508
              )
              
              
              (407,516
              )Deferred
      origination fees
              
              
              -
              
              
              
              (281,545
              )Accounts
      payable
              
              
              53,150
              
              
              
              (936,997
              )Net
      cash provided by operating activities
              
              
              3,239,398
              
              
              
              12,063,366INVESTING
      ACTIVITIESInvestment
      in real estate mortgages
              
              
              (10,474,094
              )
              
              
              (62,126,066
              )Proceeds
      from repayments of real estate mortgages
              
              
              10,116,204
              
              
              
              47,856,291Proceeds
      from sales of real estate mortgages
              
              
              3,164,323
              
              
              
              -Proceeds
      from repayment of note receivable from related party
              
              
              775,000
              
              
              
              -Other
      investments
              
              
              -
              
              
              
              (1,000,000
              )Acquisition
      of building and equipment
              
              
              (64,956
              )
              
              
              (197,653
              )Net
      cash provided by (used in) investing activities
              
              
              3,516,477
              
              
              
              (15,467,428
              )FINANCING
      ACTIVITIESNet
      borrowings on credit facility
              
              
              (302,300
              )
              
              
              (1,868,000
              )Restricted
      Cash
              
              
              (1,180,789
              )
              
              
              -Principal
      repayments of mortgage loans
              
              
              (170,965
              )
              
              
              (51,119
              )Issuance
      of common stock
              
              
              382,508
              
              
              
              26,601,286Dividends
      on common stock
              
              
              (5,416,284
              )
              
              
              (10,485,194
              )Offering
      costs paid
              
              
              (76,545
              )
              
              
              (2,851,759
              )Shares
      redeemed and retired
              
              
              -
              
              
              
              (3,431,775
              )Net
      cash provided by (used in) financing activities
              
              
              (6,764,375
              )
              
              
              7,913,439Net
      increase (decrease) in cash and cash equivalents
              
              
              (8,500
              )
              
              
              4,509,377Cash
      and cash equivalents at beginning of period
              
              
              162,753
              
              
              
              2,434,948Cash
      and cash equivalents at end of period
              
              $
              154,253
              
              
              $
              6,944,325Supplemental
      disclosures of cash flow information:Cash
      paid for interest
              
              $
              2,512,876
              
              
              $
              3,040,757Cash
      paid for taxes
              
              
              -
              
              
              
              668,824Supplemental
      schedule of non-cash investing and financing:Common
      stock issued for dividend reinvestment program
              
              $
              866,897
              
              
              $
              3,792,461Common
      stock dividends declared but not paid
              
              
              430,052
              
              
              
              1,695,609Offering
      costs incurred but not paid
              
              
              17,002
              
              
              
              16,464Foreclosed
      real estate acquired in exchange for loans
              
              
              21,384,491
              
              
              
              12,596,559Real
      estate assets owned contributed to equity investments in real
      estate
              
              
              2,463,247
              
              
              
              -The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
 
  3
 Table of
Contents


DESERT CAPITALREIT, INC.Consolidated
      Statements of Changes in Stockholders' Equity(unaudited)Number
      of Shares
              
              
              
              Par
      Value
              
              
              
              Additional
      Paid-in Capital
              
              
              
              Accumulated
      Deficit
              
              
              
              TotalBalance
      at December 31, 2007
              16,724,549
              
              
              $
              167,246
              
              
              $
              164,370,179
              
              
              $
              (43,490,149)
              
              
              $
              121,047,276Issuance
      of common stock
              111,318
              
              
              
              1,113
              
              
              
              1,433,932
              
              
              
              -
              
              
              
              1,435,045Dividends
      on common stock
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (5,037,419)
              
              
              
              (5,037,419)Offering
      costs
              -
              
              
              
              -
              
              
              
              (80,741)
              
              
              
              -
              
              
              
              (80,741)Net
      income
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (15,972,376)
              
              
              
              (15,972,376)Balance
      at September 30, 2008
              16,835,867
              
              
              $
              168,359
              
              
              $
              165,723,370
              
              
              $
              (64,499,944)
              
              
              $
              101,391,785The
      accompanying condensed notes are an integral part of these consolidated
      financial statements.
  4
 Table of
Contents




Desert CapitalREIT, INC.


Condensed
Notes to Unaudited Consolidated Financial Statements


September
30, 2008





Note
1 – Organization





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




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





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





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





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





Basis
of Presentation


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





Note
2 - Summary of Significant Accounting Policies





Principles
of Consolidation


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





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





5
 Table of
Contents


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





Reclassifications


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





Revenue
Recognition


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





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





Loans
Held for Sale


Loans
held for sale are recorded at the lower of cost or market value.  As
of September 30, 2008, an outstanding loan with a balance of $1.3 million
previously classified as loans held for sale was reclassified into mortgage
investments. During  November 2008, the loan became
nonperforming.





Real
Estate Owned


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





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.





Equity
Investments in Real Estate


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





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





On a
periodic basis, management assesses whether there are any indicators that the
fair value of our investments in equity investments in real estate may be
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.





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Recent
Accounting Developments


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





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




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





In
September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair
value, establishes a framework for measuring fair value and expands disclosures
about fair value measurements.  SFAS 157 applies under other accounting
pronouncements that require or permit fair value measurements. Accordingly, SFAS
157 does not require any new fair value measurements. SFAS 157 is effective for
fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years.  This statement has modified the methodology for the
measurement of “Fair Value of Financial Instruments.”  This change has
had a significant impact on the estimated fair value of our junior subordinated
notes.  In October 2008, the FASB issued FSP No. FAS 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active(“FSP No.
FAS 157-3”), which clarifies the application of SFAS No. 157 in a market
that is not active. The adoption of FSP No. FAS 157-3, which was effective upon
issuance for prior periods for which the financial statements had not been
issued, did not have a material impact on the Company’s financial condition,
results of operations or cash flows.  See Note 13 - Fair Value of
Financial Instruments.





Note
3 - Mortgage Investments





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





September
      30, 2008
            
            
            December
      31, 2007Acquisition
      and development loans
            
            $
            79,306,649
            
            
            $
            107,598,051Construction
      loans
            
            
            8,129,563
            
            
            
            17,665,105Commercial
      property loans
            
            
            14,408,900
            
            
            
            18,198,900Balance
      per loan portfolio
            
            
            101,845,112
            
            
            
            143,462,056Allowance
      for loan losses
            
            
            (17,161,528)
            
            
            
            (25,444,130)Mortgage
      investments - net
            
            $
            84,683,584
            
            
            $
            118,017,926





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As of
September 30, 2008 and December 31, 2007, 13% and 22%, respectively, of the
principal balance of the outstanding mortgage notes were secured by second
liens. As of September 30, 2008 and December 31, 2007, the portfolio had a
weighted average contractual interest rate of 12.5% and 13.4%,
respectively.





Our
mortgage portfolio is primarily concentrated in the Southwestern United States.
As of September 30, 2008 and December 31, 2007, 82% and 87%, respectively, of
the principal balance of our portfolio was invested throughout Nevada,
California, and Arizona. Our borrowers’ ability to repay our notes is dependent
upon the real estate and general economic conditions in these
areas.





We have a
significant concentration of credit risk with our largest
borrowers.  At September 30, 2008, the aggregate original principal
balance of loans to our four largest borrowers was $50.2 million representing
approximately 49.3% of the original principal balance of our mortgage
investments and 59.3% of the carrying balance of our mortgage
investments.





As of
September 30, 2008, we had 48 loans in our portfolio, of which 33 loans from 11
separate borrowers were on nonaccrual status.  The aggregate balance
of these nonperforming loans was $104.9 million of which our portion was $66.7
million, with the remaining balance being held by private investors.  
Our balance on these loans ranged from $8,900 to $9.5 million. Of the 33
nonperforming loans, 28 were first lien loans totaling $54.5 million and five
were second lien loans totaling $12.2 million.





Nonperforming
and impaired loans


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





September
      30, 2008Balance
            
            Allowance
      for
              loan
      losses
            
            Balance,
      net
              of
      allowanceNonperforming
      loans – no related allowance
            
            $
            18,219,805
            
            $
            -
            
            $
            18,219,805Nonperforming
      loans – related allowance
            
            
            48,456,407
            
            
            (16,228,689)
            
            
            32,227,718Subtotal
      nonperforming loans
            
            
            66,676,212
            
            
            (16,228,689)
            
            
            50,447,523Performing
      loans – no related allowance
            
            
            32,673,900
            
            
            -
            
            
            32,673,900Performing
      loans – related allowance
            
            
            2,495,000
            
            
            (932,839)
            
            
            1,562,161Subtotal
      performing loans
            
            
            35,168,900
            
            
            (932,839)
            
            
            34,236,061Total
            
            $
            101,845,112
            
            $
            (17,161,528)
            
            $
            84,683,584





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





During
the nine month period ended September 30, 2008, we sold our portion of seven
loans with a carrying balance of $3.2 million for cash proceeds of $3.2
million.





Subsequent
to September 30, 2008, and prior to the issuance of this report, four performing
loans with a carrying balance of $23.9 million were placed on nonaccrual
status.





Note
4 – Real Estate Owned





At
September 30, 2008, we held real estate through 14 limited liability companies,
and our ownership percentage ranged from 10% to 100%.





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During
the nine months ended September 30, 2008, we foreclosed on properties with an
aggregate original loan balance of $39.4 million, net of related allowance for
loan loss of $18.3 million and additional capitalized costs of
$273,000.  We did not dispose of any real estate owned through sale
during the nine month period ending September 30, 2008. During March 2008 we
contributed 44 lots valued at $2.5 million to a joint venture in which we have a
50% noncontrolling ownership interest.  (See Note 5 - Equity
Investments in Real Estate.)





At
September 30, 2008 and December 31, 2007, we had a balance in real estate owned
of $29.8 million and $15.7 million, respectively.  The following
summary provides an analysis of the changes in real estate owned during the nine
months ended September 30, 2008:





Real
      Estate OwnedBalance
      December 31, 2007
            
            $
            15,652,282Foreclosures
            
            
            21,384,491Impairments
            
            
            (4,737,938
            )Real
      estate contributed as equity in joint ventures
            
            
            (2,463,247
            )Balance
      September 30, 2008
            
            $
            29,835,588





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





Description
            
            Location
            
            September 30, 2008
            
            
            December 31, 2007Undeveloped
      land
            
            AZ,
      CA, NV
            
            $
            19,407,452
            
            
            $
            6,960,794Single
      family residential lots
            
            AZ,
      NV
            
            
            2,878,001
            
            
            
            5,595,927Office
      building
            
            NV,
      TX
            
            
            4,303,707
            
            
            
            2,190,204Other
            
            NV,
      UT
            
            
            3,246,428
            
            
            
            905,357$
            29,835,588
            
            
            $
            15,652,282





Note
5 – Equity Investments in Real Estate





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





Note
6 - Commitments and Related Parties





Sandstone
is our Advisor and oversees our day-to-day operations including asset,
liability and capital management. In lieu of paying salaries to officers, we
compensate our Advisor pursuant to an advisory agreement that entitles it to
first-tier management compensation, second-tier management compensation, and
reimbursement of expenses. Sandstone replaced Burton as our advisor in November
2007 in conjunction with the sale of Consolidated Mortgage. The officers and
majority owners of our Advisor are also our executive officers. The annual
first-tier management compensation is 1% of the first $200 million of gross
average invested assets plus 0.8% of the gross average invested assets in excess
of $200 million, to be paid quarterly. The first-tier management compensation
payable under our current advisory agreement with Sandstone is calculated in the
same manner as the base management fee payable under our prior advisory
agreement with Burton.  The first-tier management compensation for the
three and nine months ended September 30, 2008 was $422,000 and $1.3 million,
respectively, compared to $416,000 and $1.2 million, respectively for the same
periods in 2007.  At September 30, 2008, $281,000 of compensation due
to our Advisor was included in accounts payable and accrued expenses in the
consolidated balance sheet. The second-tier management compensation is a tiered
percentage of the amount of our net income (taxable income) excluding provision
for loan loss and capital losses, before deducting second-tier compensation less
a threshold return, which is the net income that would produce an annualized
return on our average invested assets equal to the 10-year U.S. Treasury
rate plus 1.0%. The tiered percentage is the weighted average of 20% of the
first $200 million of average invested assets and 10% of the excess over $200
million of average invested assets. The second-tier management compensation is
calculated quarterly and any positive quarterly amount is paid by us, along with
the first-tier management compensation, within 15 days of receipt of the
computations. Second-tier management compensation payable under our current
advisory agreement with Sandstone is calculated in the same manner as the
incentive compensation payable under our prior advisory agreement with
Burton.  Second-tier management compensation for the three and nine
months ended September 30, 2008 was zero, compared to $(69,000) and $617,000,
respectively for the same periods in 2007.





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Consolidated
Mortgage previously had a management agreement in place with ARJ Management
(“ARJ”), a company of which our president and chief executive officer, Todd
Parriott, is president, director and controlling shareholder, pursuant to
which ARJ was paid a management fee equal to 33% of Consolidated Mortgage's
pre-tax net income. The fee was calculated and paid monthly. The management
agreement with ARJ was mutually terminated by the parties thereto as of November
21, 2007 in connection with the sale of Consolidated Mortgage.  The
management fee for the three and nine months ended September 30, 2007 was
$157,000 and $1.5 million, respectively.





The
dealer-manager of our offering of common stock, CMC Financial Services, Inc.
(“CMCFS”), directs and oversees the sale of our equity securities. CMCFS
receives a marketing support fee and sales commissions based on the number of
shares of common stock it sells. CMCFS contracts with third party broker-dealers
to have a larger sales distribution of equity securities and compensates them
out of the sales commissions and marketing support fees it receives from us.
Because Sandstone owns CMCFS, it is our affiliate. CMCFS earned gross sales
commissions and marketing support fees for the three and nine months ended
September 30, 2008 of zero and $36,000, respectively, compared to $595,000 and
$2.5 million, respectively for the same periods in 2007. There was no
amount payable on September 30, 2008 for the gross sales commissions and
marketing support fees.  CMCFS paid a substantial portion of these
fees to third party broker dealers.  Sandstone acquired ownership of
CMCFS on November 21, 2007.  Our Board of Directors suspended the sale
of Desert Capital REIT shares as of February 22, 2008.  This decision
was made in anticipation of the expiration of the offering, which would not
allow sales of shares to occur after March 22, 2008 pursuant to the
Prospectus.





CMCFS
also has an agreement with Consolidated Mortgage to provide investors for loans
brokered and serviced by Consolidated Mortgage for a fee equal to 25 basis
points of every dollar raised. The fee was calculated and paid
monthly.  We sold Consolidated Mortgage in November 2007 and are no
longer a party to this agreement.  The fee pursuant to this agreement
for the three and nine months ended September 30, 2007 was $110,000 and
$367,000.





In
September 2005, a third-party borrower asked us to enter into a land banking
transaction, meaning that we would purchase a tract of land, and simultaneously
enter into an option contract with the borrower, pursuant to which the borrower
would purchase smaller parcels of the initial tract from us over time at a
specified price, until it had purchased the entire initial tract.  Due
to the rules with which we must comply to maintain our REIT status, actual title
to that land had to be owned by a separate entity and could not be held by the
Company.  As an accommodation to us and the third-party borrower, Todd
Parriott and Jonathan Arens formed a company, CM Land, LLC, for the specific
purpose of holding title to that land.  We funded $11.9 million of
loans to CM Land, LLC secured by the property. In May 2007, the borrower
did not exercise its option under the contract to purchase the remaining portion
of the land.  As a result, we took title to the property
directly.  Prior to taking title to the property in May 2007, we
earned and received interest on the loans of $826,000.  We have
recorded an aggregate impairment of $5.2 million related to this property,
leaving a balance of $6.7 million, which is included in real estate
owned.





CM
Equity, LLC (“CM Equity”) was formed in June 2007 for the purpose of investing
in, developing, co-developing, operating, owning and financing commercial and
residential real estate projects. Some of the executive officers of CM
Equity are the same as our executive officers, and our Advisor is also the
manager of CM Equity.  In November 2007, we sold a nonperforming loan
with an outstanding balance of $1.95 million to CM Equity.   We
provided 100% financing on the sale.  The loan bears a fixed interest
rate of 8.25% and matures in November 2009.  No gain or loss was
recognized on the sale. We earned interest of $40,000 and $121,000 respectively
for the three and nine months ended September 30, 2008, of which $40,000 was
reflected in interest receivable at September 30, 2008.





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





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


·
            $105,000
      in cash.


·
            A
      $15.5 million promissory note payable by Consolidated Mortgage to the
      order of TRS.  The note bears interest at 9.0% per
      annum.  Principal and interest payments are due quarterly
      beginning on March 31, 2008.  The note matures in December
      2017.  The note is secured by all of the outstanding membership
      units of Consolidated Mortgage.  We earned interest of $226,000
      and $923,000 for the three and nine months ended September 30,
      2008.





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In
addition to the consideration received, we receive a contingent installment
payment from Consolidated Mortgage on loans we fund. The $8.25 million
contingent payment (the “Installment Payment”) is payable  as
follows: Sandstone will pay or cause Consolidated Mortgage to pay to TRS,
on the last day of each calendar quarter, an amount equal to: (i) 1% of the
principal amount of all mortgage loans originated or brokered by Consolidated
Mortgage or any of its affiliates and funded by us during such calendar quarter
for the first $200 million of mortgage loans funded during each calendar year;
and (ii) 0.5% of the principal amount of all mortgage loans originated or
brokered by Consolidated Mortgage and funded by us during such calendar quarter
in excess of $200 million during each calendar year, commencing on December 31,
2007 and continuing on the last day of each calendar quarter thereafter, until
TRS has received $8.25 million.  TRS’ right to receive the Installment
Payment is secured by all of the outstanding membership units of Consolidated
Mortgage.   For the nine month period ending September 30, 2008,
we recognized income of $94,000 related to the contingent installment payment,
of which zero remained receivable at September 30, 2008.





We also
entered into a loan origination agreement with Consolidated Mortgage and
Sandstone, which terminates one month after the last day of the month in which
the Installment Payment is paid in full.   During the term of the
Loan Origination Agreement we have the right to fund all mortgage loans
identified by Consolidated Mortgage or any affiliate of Sandstone or
Consolidated Mortgage that becomes engaged in the business of originating or
brokering commercial loans. During the nine months ended September 30, 2008, we
funded $16.8 million of loans originated by Consolidated
Mortgage.





At
December 31, 2007, March 31, 2008, June 30, 2008 and September 30, 2008,
Consolidated Mortgage 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, and granted
Consolidated Mortgage 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 Consolidated
Mortgage 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 Consolidated Mortgage 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 Statement of Financial
Accounting Standards No. 114 (“SFAS 114”), “Accounting by Creditors for
Impairment of a Loan” 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 we have provided an allowance for
loan loss of $2.1 million to reflect this impairment.





We lease
office space to Sandstone, CMCFS, Consolidated Mortgage, and Residential Capital
Mortgage (an entity owned by certain of our officers) under noncancelable
operating leases which expire in July 2010.  For the three and nine
months ended September 30, 2008 we recognized $138,000 and $413,000 of related
party rental income compared to $81,000 and $241,000, respectively for the same
period in 2007.





Note
7 - Stock Based Compensation





Our Board
of Directors has adopted the 2004 Stock Incentive Plan of Desert Capital REIT,
Inc. (the “Plan”). Our directors, officers or any affiliate, and individual
consultants or advisors are eligible for stock based compensation under the
Plan. We have authorized 1,000,000 shares of common stock under the Plan. As
of September 30, 2008 we had granted 108,000 shares in aggregate under the
Plan, and all shares were fully vested.   In August 2008, 28,000
shares were granted to our Board of Directors.  Because there was no
ongoing offering of our shares on the August grant date, the fair value was
estimated to be the June 30, 2008 book value per share of
$6.62.  Restricted stock expense for the three and nine months ended
September 30, 2008 was $185,000, compared to $83,000 and $200,000 respectively
for the same period in 2007.





11
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Note
8 - Building and Equipment





Building
and equipment as of September 30, 2008 and December 31, 2007 were as
follows:





September
      30, 2008
            
            
            December
      31, 2007Building
            
            $
            7,811,281
            
            
            $
            7,746,325Equipment
            
            
            7,527
            
            
            
            7,527Furniture
      and fixtures
            
            
            411,328
            
            
            
            411,328Software
            
            
            92,038
            
            
            
            92,038Cost
      basis
            
            
            8,322,174
            
            
            
            8,257,218Less
      accumulated depreciation
            
            
            (1,385,304)
            
            
            
            (1,021,279)Building
      and equipment, net
            
            $
            6,936,870
            
            
            $
            7,235,939




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





Note
9 - Income taxes





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




Our
taxable REIT subsidiary is subject to federal, state, and local taxes. Our
provision for income tax expense (benefit) was calculated using an effective tax
rate of 34% and was comprised of the following components:





Three
      months ended September 30,
            
            Nine
      months ended September 30,2008
            
            
            
            2007
            
            
            
            2008
            
            
            
            2007Current
      provision (benefit)
            
            $
            40,763
            
            
            $
            226,637
            
            
            $
            (35,517
            )
            
            $
            333,469Deferred
      provision (benefit)
            
            
            (260,225
            )
            
            
            143,278
            
            
            
            (314,509
            )
            
            
            233,634Total
      income tax provision (benefit)
            
            $
            (219,462
            )
            
            $
            369,915
            
            
            $
            (350,026
            )
            
            $
            567,103





Note
10 - Earnings per Share





Earnings
per share is computed in accordance with SFAS No. 128, Earnings per Share. Basic
earnings per share is calculated by dividing net income by the weighted average
number of shares of common stock outstanding during each period. Diluted
earnings per share is calculated by dividing net income by the weighted average
number of shares outstanding plus the additional dilutive effect of unvested
restricted stock during each period.  As of September 30, 2008, there
were no unvested shares outstanding under our stock incentive plan. As of
September 30, 2007 there were 40,000 unvested shares outstanding under our stock
incentive plan.





12
 Table of
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The
following is a reconciliation of the denominator of the basic and diluted
earnings per share computations for the three and nine months ended September
30, 2008 and 2007:




For the Three Months
      EndedSeptember30,
      2008
            
            
            September30,
      2007Basic
      and Diluted
            
            
            Basic
            
            
            DilutedNet
      income
            
            $
            (8,876,590)
            
            
            $
            740,568
            
            
            $
            740,568Weighted
      average number of common shares outstanding
            
            
            16,825,212
            
            
            
            16,707,393
            
            
            
            16,707,393Dilutive
      effect of unvested restricted shares
            
            
            -
            
            
            
            -
            
            
            
            39,710Total
      weighted average common shares outstanding
            
            
            16,825,212
            
            
            
            16,707,393
            
            
            
            16,747,103Earnings
      per common share
            
            $
            (0.53)
            
            
            $
            0.04
            
            
            $
            0.04





For
      theNineMonths
      EndedSeptember
      30, 2008
            
            
            September
      30, 2007Basic
      and Diluted
            
            
            
            Basic
            
            
            
            DilutedNet
      income
            
            $
            (15,972,376)
            
            
            $
            9,037,106
            
            
            $
            9,037,106Weighted
      average number of common shares outstanding
            
            
            16,805,341
            
            
            
            16,053,992
            
            
            
            16,053,992Dilutive
      effect of unvested restricted shares
            
            
            -
            
            
            
            -
            
            
            
            33,260Total
      weighted average common shares outstanding
            
            
            16,805,341
            
            
            
            16,053,992
            
            
            
            16,087,252Earnings
      per common share
            
            $
            (0.95)
            
            
            $
            0.56
            
            
            $
            0.56




Note
11 – Common Stock and Dividends




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




Declaration Date
            
            2008
            
            
            2007January
      31
            
            $
            0.100
            
            
            $
            0.100February
      29, and February 28 respectively
            
            
            0.025
            
            
            
            0.100March
      31
            
            
            0.025
            
            
            
            0.100April
      30
            
            
            0.025
            
            
            
            0.100May
      31
            
            
            0.025
            
            
            
            0.100June
      30
            
            
            0.025
            
            
            
            0.100July
      31
            
            
            0.025
            
            
            
            0.100August
      30
            
            
            0.025
            
            
            
            0.100September
      30
            
            
            0.025
            
            
            
            0.100Total
            
            $
            0.300
            
            
            $
            0.900




On
October 31, 2008, we announced the suspension of our monthly dividend, effective
immediately.





13
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Contents


Note
12 - Debt





Credit
Facility


We have a
$7.5 million secured revolving credit facility with a term of one year
that expires February 22, 2009.  At September 30, 2008 and
December 31, 2007, we had $1.8 million and $2.1 million outstanding,
respectively. We draw on the facility for short-term funding requirements.
Amounts drawn under this facility bear interest at an interest rate equal to the
prime rate plus 75 basis points, with a floor of 7.0%, and must be repaid
within 90 days.  Amounts drawn under this facility are secured by the
corresponding loan that is being funded by the advance. The interest rate on
this facility at September 30, 2008 was 7.0%. The principal amount of loans
pledged as collateral for this facility on September 30, 2008 was $18.7 million.
Of the balance outstanding at September 30, 2008, $1.3 million was originated in
January 2008, and was not repaid within the 90-day time period required by terms
of the credit facility.  The bank granted us an extension to December
16, 2008 to pay the $1.3 million defaulted principal balance and has waived
default-rate interest through the date of the extension. We have agreed to
pay 50% of principal repayments on our mortgage investments and sales of real
estate owned to the bank to satisfy the outstanding principal balance of the
facility. Any future advances on the credit facility are at the sole discretion
of the bank.





Mortgage
Loans Payable


We have a
mortgage loan payable to a bank, with an outstanding principal balance of $6.3
million and $6.5 million as of September 30, 2008 and December 31, 2007,
respectively.  This loan bears interest at a rate equal to the prime
rate, with a floor of 6.75%. Principal and interest are payable monthly and the
note matures in 2026, with no prepayment penalty. The interest rate on September
30, 2008 was 6.75%. The mortgage is secured by our office building in Henderson,
Nevada. We were in compliance with all financial covenants related to this
loan as of September 30, 2008.





We
assumed a first lien mortgage payable to a bank upon foreclosure of a 10,330
square foot office building in Houston, Texas in November 2007 to preserve our
interest in the property. At September 30, 2008 and December 31, 2007, the loan
had an outstanding principal balance of $1.6 million and $1.7 million
respectively, and bears interest at a rate equal to the prime rate minus 50
basis points (4.5% at September 30, 2008), and matures in April 2011, with no
prepayment penalty.  Principal and interest are payable
monthly.  We were in compliance with all financial covenants related
to this loan as of September 30, 2008.





Junior
Subordinated Notes


In June
2006 we completed the issuance of $30 million in unsecured trust preferred
securities through a newly formed Delaware statutory trust, which is our
wholly owned subsidiary.  The securities bear interest at a floating rate
based on the three-month LIBOR plus 400 basis points, which sets for three
months at one month after a calendar quarter, which was 6.8% on September 30,
2008.




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




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




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





Our
covenants contain customary default provisions and require us to maintain
financial ratios at quarterly determination dates, including a minimum tangible
net worth requirement.  Our ability to incur additional subordinated
debt is also limited.  In June 2008 we entered into an agreement with
the holders of the trust preferred securities to modify the tangible net worth
covenant contained in our indenture through December 31, 2008.  In
exchange for the modification we agreed to establish a cash reserve account into
which we must make monthly deposits of 25% of our net income until such time as
the balance of the reserve account is at least equal to $2.1
million.  In addition, in the event that the aggregate amount of the
dividends that we pay during any month exceeds the amount that we deposit into
the reserve account during such month, we must also deposit into the reserve
account 25% of each principal payment we receive in respect of any of our
mortgage loans until the amount of the short-fall has been deposited into the
reserve account.  We must replace the reserve account with a letter of
credit in the face amount of $2.1 million as security for the trust preferred
securities.  At September 30, 2008, the balance in such reserve
account was $1.2 million, which is reflected in restricted cash on our balance
sheet.  At September 30, 2008, we were in compliance with all
covenants as modified.




14
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Note 13 - Fair Value of Financial
Instruments





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





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


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


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





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





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





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




September 30, 2008
            
            
            December 31, 2007Carrying
      Value
            
            
            Estimated
      Fair Value
            
            
            Carrying
      Value
            
            
            Estimated
      Fair ValueFinancial
      assets:Cash
      , cash equivalents and restricted cash
            
            $
            1,335,042
            
            
            $
            1,335,042
            
            
            $
            162,753
            
            
            $
            162,753Interest
      receivable
            
            
            635,943
            
            
            
            635,943
            
            
            
            1,464,261
            
            
            
            1,464,261Note
      receivable - related party
            
            
            12,600,269
            
            
            
            10,749,755
            
            
            
            15,500,000
            
            
            
            13,718,381Mortgage
      investments - net
            
            
            84,683,584
            
            
            
            84,056,937
            
            
            
            118,017,926
            
            
            
            118,017,926Loans
      held-for-sale
            
            
            -
            
            
            
            -
            
            
            
            2,139,200
            
            
            
            2,139,200Financial
      liabilities:Credit
      facility
            
            
            1,836,900
            
            
            
            1,836,226
            
            
            
            2,139,200
            
            
            
            2,139,200Mortgages
      payable
            
            
            7,961,804
            
            
            
            7,969,124
            
            
            
            8,132,769
            
            
            
            8,132,769Junior
      subordinated notes
            
            
            30,928,000
            
            
            
            19,572,122
            
            
            
            30,928,000
            
            
            
            30,928,000




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




·
            Cash,cash equivalentsand 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
      of a risk free rate of return for a similar period, the fixed amount of
      the note receivable and an estimated risk of default based on similar
      business operations and history of
operations.


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


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











15
 Table of
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·
              Credit
      facility: For September 30, 2008 our credit standing was taken
      into consideration, as well as the excess assigned collateral, and a
      risk-free rate of return.  For December 31, 2007, carrying
      values approximate fair values due to the variable interest rate this
      facility bears.
 ·
              Mortgage loan payable:
      For September 30, 2008 our credit standing was taken into consideration,
      as well as the assigned collateral which was considered more than
      adequate, the estimated risk to the lender of the collateral to the loan
      balance and a risk-free rate of return, all of which were factors in the
      computation of fair value.  For December 31, 2007, carrying
      values approximate fair values due to the variable interest rate this
      facility bears.
 ·
              Junior subordinated
      notes: Our junior subordinated notes do not trade in an active
      market and, therefore observable price quotations are not
      available.  In the absence of observable price quotations, fair
      value is determined based on discounted cash flow




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





Estimated
      Fair Value
            
            
            Level
      2
            
            
            Level
      3Financial
      Assets:Interest
      receivable
            
            $
            635,943
            
            
            $
            635,943
            
            
            $Note
      receivable – related party
            
            
            10,749,755
            
            
            
            
            
            
            
            10,749,755Mortgage
      investments – net
            
            
            84,056,937
            
            
            
            
            
            
            
            84,056,937Financial
      LiabilitiesCredit
      facility
            
            
            1,836,226
            
            
            
            1,836,226Mortgages
      payable
            
            
            7,969,124
            
            
            
            7,969,124Junior
      subordinated notes
            
            
            19,572,122
            
            
            
            
            
            
            
            19,572,122








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




Overview





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





The
effects of the slowdown in housing sales, collapse of the sub-prime residential
mortgage market, and the tightening of the credit markets which began in 2007
have continued throughout 2008, and continue to affect adversely the performance
of our portfolio.  As the economy has weakened and credit has become
more difficult to obtain, many of our borrowers who develop and sell real estate
projects have been unable to complete their projects, obtain takeout financing
or have been otherwise adversely impacted.  Moreover, declining real
estate values in the principal markets in which we operate has in many cases
eroded the current value of the collateral underlying our loans. During 2007, we
experienced significant loan losses and impairments, and through the third
quarter of 2008, such losses have continued. With the prolonged correction of
the market we expect to continue to face challenges for the foreseeable
future.  This may result in a further increase in defaults on our
mortgage loans and we might be required to record additional reserves based on
decreases in market values or we may be required to restructure loans or
foreclose on the collateral securing the loans.





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


·
            volatility
      in the real estate and credit
markets;


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


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


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


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





16
 Table of
Contents


For the
three and nine months ended September 30, 2008, our net loss was $8.9 million
and $16.0 million, respectively, compared to net income of $741,000 and $9.0
million for the three and nine months ended September 30, 2007. The primary
contributors to this decline were:





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


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


·
            noncash
      charges related to impairments of loans and real estate owned increased to
      $9.2 million and $17.6 million, respectively for the three and nine months
      ended September 30, 2008, compared to $1.6 million and $1.8 million
      for the same periods in 2007.





Although
the real estate and credit market disruptions have presented challenges for us,
we have an operational structure with relatively low debt obligations. At
September 30, 2008, our debt to total capital was 28.7%.  We will
continue to explore additional investment and business opportunities as they
arise; however, due to the current credit market disruption, our investment
opportunities, and cash available for investments, may be
limited.  Approximately 64% of our portfolio, including performing and
non-performing loans and real estate owned, is located in Clark County, Nevada,
which is also the location of our executive offices.  As we continue
to foreclose on mortgage loans, we have adjusted our portfolio strategy to
include land ownership, and our physical proximity to these assets facilitates
this undertaking.  We expect that the current difficult real estate
and credit market conditions will continue to have an adverse effect on our
operations for the remainder of 2008 and into 2009.





Loan
Portfolio Information





As of
September 30, 2008 we had a total of 48 loans in our portfolio, of which
15 were performing loans and 33 were nonperforming. The balance of our
performing loans was $35.2 million at September 30, 2008. Due to the
uncertainty of the collection of principal balances upon maturity of certain
loans, we recorded an allowance for loan loss related to these performing loans
of $933,000. Our balance on these loans ranged from $20,000 to $14.4 million. Of
the 15 performing loans, 14 were first lien loans totaling $34.3 million and
one was second lien loan totaling $845,000.





Subsequent
to September 30, 2008, four performing loans with a carrying balance of $23.9
million were placed on nonaccrual status.





The
increase in nonperforming loans continues to impact our revenues due to the
default in interest payments and our provision for loan losses due to the
impairment of our loans. The 33 nonperforming loans in our portfolio were from
11 separate borrowers and had an original loan balance of $66.7 million. We
provided an allowance for loan loss related to these nonperforming loans of
$16.2 million, leaving a net carrying balance of $50.5 million at September
30, 2008. Our balance on these loans ranged from $8,900 to $9.5 million.
 Of the 33 loans, 28 were first lien loans totaling $54.5 million and five
were second lien loans totaling $12.2 million.





Our
mortgage loan portfolio is primarily concentrated in the Southwestern United
States and is comprised primarily of mortgage notes secured by first liens. As
of September 30, 2008 and December 31, 2007, 82% and 87%, respectively, of the
principal balance of our portfolio was invested throughout Nevada, California,
and Arizona, and 87% and 78%, respectively, was secured by first
liens.





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





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


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


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


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





17
 Table of
Contents


Real
Estate Owned





Real
estate owned consists of property acquired through foreclosures on mortgage
loans.  Our interests in real estate owned may be held directly by us,
or through limited liability companies.  In the case where we are one
of several investors in a larger loan, such loans are foreclosed upon using a
limited liability company to facilitate foreclosing our lender interest along
with private investors who hold the remaining loan balance and have similar
economic interests.   At September 30, 2008, we held real estate
through 14 limited liability companies and our ownership percentage ranged from
10% to 100%. We recorded real estate held directly or through limited liability
companies at the lower of the recorded amount of our related mortgage loan being
foreclosed (net of any impairment reserve), or our economic interest in the
property's estimated fair value, less estimated costs to sell, with fair value
based on appraisals and local market conditions.





At
September 30, 2008 and December 31, 2007, we had a balance in real estate owned
of $29.8 million and $15.7 million, respectively. Real estate owned consisted of
65% undeveloped land, 10% single family residential lots, 14% existing
commercial buildings and 11% other.





During
the nine months ended September 30, 2008, we foreclosed on properties with an
aggregate original loan balance of $39.4 million, with a related allowance for
loan loss of $18.3 million, and additional capitalized costs of
$273,000.  We did not sell any real estate owned during the nine-month
period ending September 30, 2008. We did, however, contribute 44 lots valued at
$2.5 million to a joint venture in which we have a 50% noncontrolling ownership
interest.





Equity
Investments in Real Estate





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





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





Sale
of Consolidated Mortgage





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





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


·
            $105,000
      in cash.


·
            A
      $15.5 million promissory note payable by Consolidated Mortgage to the
      order of TRS. The note bears interest at 9.0% per
      annum.  Principal and interest payments are due quarterly
      beginning on March 31, 2008.  The note matures in December
      2017.  The note is secured by all of the outstanding membership
      units of Consolidated Mortgage.   We earned interest of
      $226,000 and $923,000 for the three and nine months ended September 30,
      2008.





In
addition to the consideration received, we will receive a contingent
installment payment from Consolidated Mortgage on loans we fund in the future.
The $8.25 million contingent payment is payable as
follows:  Sandstone will pay or cause Consolidated Mortgage to pay to
TRS, on the last day of each calendar quarter, an amount equal to: (i) 1% of the
principal amount of all mortgage loans originated or brokered by Consolidated
Mortgage or any of its affiliates and funded by us during such calendar quarter
for the first $200 million of mortgage loans funded during each calendar year;
and (ii) 0.5% of the principal amount of all mortgage loans originated or
brokered by Consolidated Mortgage and funded by us during such calendar quarter
in excess of $200 million during each calendar year, commencing on December 31,
2007 and continuing on the last day of each calendar quarter thereafter, until
TRS has received $8.25 million.  TRS’ right to receive the Installment
Payment is secured by all of the outstanding membership units of Consolidated
Mortgage.   For the nine month period ending September 30, 2008,
we recognized income of $94,000 related to the contingent installment payment,
of which zero remained unpaid at September 30, 2008.





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We also
entered into a loan origination agreement with Consolidated Mortgage and
Sandstone, which terminates one month after the last day of the month in which
the Installment Payment is paid in full.  During the term of the Loan
Origination Agreement, we will have the right to fund all mortgage loans
identified by Consolidated Mortgage or any affiliate of Sandstone or
Consolidated Mortgage that becomes engaged in the business of originating or
brokering commercial loans. During the nine months ended September 30, 2008, we
funded $16.8 million in loans originated by Consolidated Mortgage.





Due to
the sale of Consolidated Mortgage in November 2007, its operations are not
reflected in our 2008 financial statements.  Included in our
Consolidated Statement of Operations for the three and nine month periods ending
September 30, 2007 was $362,000 and $931,000, respectively of net interest
income, $1.5 million and $7.9 million, respectively of non-interest income, $1.7
million and $5.7 million, respectively of non-interest expense and $39,000 and
$2.8 million of net income before taxes related to the operations of
Consolidated Mortgage, which are not presented as discontinued operations,
because Consolidated Mortgage continues to originate and service loans for us,
and we share certain members of our management team in common.





At
December 31, 2007, March 31, 2008, June 30, 2008 and September 30, 2008,
Consolidated Mortgage 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, and granted
Consolidated Mortgage 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 Consolidated
Mortgage 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 Consolidated Mortgage 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 Statement of Financial
Accounting Standards No. 114 (“SFAS 114”), “Accounting by Creditors for
Impairment of a Loan” 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 we have provided an allowance for
loan loss of $2.1 million to reflect this impairment.





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





Revenues




Interest
income is generated on mortgage investments, loans held for sale and our note
receivable from Consolidated Mortgage. Interest income decreased $2.8 million,
or 60.6 %, to $1.8 million for the quarter ended September 30, 2008 from $4.6
million for the quarter ended September 30, 2007. Our original loan balance of
nonperforming loans and real estate owned increased to $133.2 million as of
September 30, 2008 from $50.1 million as of September 30, 2007. The
increased balance of nonperforming loans and real estate owned lowered the
average yield on the total portfolio to 5.9% in the third quarter of 2008 from
9.1% in the third quarter of 2007.




Non-interest
income decreased $1.6 million, or 87.7%, to $221,000 for the quarter ended
September 30, 2008 from $1.8 million for the quarter ended September 30, 2007
primarily due to the sale of Consolidated Mortgage in November 2007. During the
quarter ended September 30, 2007, we recognized loan brokerage fees and
servicing fees of $1.5 million related to the activities of Consolidated
Mortgage.





Expenses




Interest
expense consists of interest on our mortgage loans payable, credit facility, and
junior subordinated notes payable. Interest expense decreased 32.9%, to $693,000
during the third quarter of 2008 from $1.0 million for the third quarter of
2007. This decrease was a result of a decrease in the average interest rate on
our variable rate debt to 6.6% in the third quarter of 2008, from 9.4% in the
third quarter of 2007.  There was no material change in the average
outstanding debt balance during the third quarter of 2008 compared to the third
quarter of 2007.





The
provision for loan losses was $7.2 million for the quarter ended September 30,
2008 compared to $1.6 million for the quarter ended September 30,
2007.  The increase in the provision was primarily due to a decline in
the real estate and credit markets, causing the collateral securing our loans to
decrease in value. We reviewed all of our mortgage investments as of
September 30, 2008, and provided a specific allowance for loan losses on six
loans.  We also recorded a $2.1 million provision related to the
modification agreement with respect to our note receivable from Consolidated
Mortgage.  Under terms of the modification agreeement, principal
payments were deferred for two years and the annual interest rate was reduced
from 9% to 6% for the remaining term of the promissory note.





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Non-interest
expense increased $551,000 or 20.8%, to $3.2 million for the third quarter of
2008 compared to $2.6 million for the third quarter of 2007. This increase is
almost entirely attributable to a $1.9 million impairment of real estate owned
in the third quarter of 2008.  Excluding the impairment of real estate
owned, non-interest expense decreased $1.4 million or 52.1% to $1.3 million for
the third quarter of 2008, compared to $2.6 million for the same period in
2007.  This decrease is due to the sale of Consolidated Mortgage and
the expenses associated with its operations which were included in the third
quarter of 2007.





Results
of Operations for the nine months ended September 30, 2008 compared to the nine
months ended September 30, 2007





Revenues




Interest
income is generated on mortgage investments, loans held for sale and our note
receivable from Consolidated Mortgage. Interest income decreased $9.1 million,
or 57.1%, to $6.8 million for the nine months ended September 30, 2008 from
$16.0 million for the nine months ended September 30, 2007. Our balance of
nonperforming loans and real estate owned increased to $133.2 million as of
September 30, 2008 from $50.1 million as of September 30, 2007. The
increased balance of nonperforming loans and real estate owned lowered the
average yield on our total portfolio to 6.1 % in the first nine months of 2008
from 11.4% in the first nine months of 2007.




Non-interest
income decreased $6.7 million, or 88.8%, to $844,000 for the nine months ended
September 30, 2008 from $7.5 million for the nine months ended September 30,
2007 primarily due to the sale of Consolidated Mortgage in November 2007. During
the nine months ended September 30, 2007, we recognized loan brokerage fees and
servicing fees of $6.7 million related to the activities of Consolidated
Mortgage.





Expenses




Interest
expense consists of interest on our mortgage loans, credit facility, and junior
subordinated notes payable. Interest expense decreased 21.5%, to $2.4 million
during the first nine months of 2008 from $3.0 million in the first nine months
of 2007. This decrease was a result of a decrease in the average interest rate
on our variable rate debt to 7.3% in the first nine months of 2008, from 8.5% in
the first nine months of 2007.  There was no material change in the
average outstanding debt balance during the first nine months of 2008 compared
to the first nine months of 2007.





The
provision for loan losses was $12.9 million for the nine months ended September
30, 2008 compared to $1.8 million for the nine months ended September 30,
2007.  The increase in the provision was due to a decline in the real
estate and credit markets, causing the collateral securing our loans to decrease
in value.  During the nine months ended September 30, 2008, we
provided a specific allowance for loan losses on 36 loans.  We also
recorded a $2.1 million provision related to the modification of terms on our
note receivable from Consolidated Mortgage as discussed above.





Non-interest
expense decreased $302,000 or 3.3%, to $8.7 million for the nine months ended
September 30, 2008 compared to $9.0 million for the nine months ended September
30, 2007. After removing the effect of a $4.7 million impairment charge included
in non-interest expense for the nine months ended September 30, 2008,
non-interest expense decreased $5.0 million or 55.8% compared to the same period
in 2007.  This decrease is due to the sale of Consolidated Mortgage
and the expenses associated with its operations which were included in the first
nine months of 2007.  Management fees decreased 61.4% or $2.0 million
for the nine months ended September 30, 2008 as a result of no performance-based
compensation being paid in 2008.





Taxable Income





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





Three
      Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      income (loss)
            
            $
            (8,876,590
            )
            
            $
            740,568
            
            
            $
            (15,972,376
            )
            
            $
            9,037,106Adjustments
      to net income (loss):Provision
      for loan losses
            
            
            5,103,629
            
            
            
            1,585,080
            
            
            
            10,770,725
            
            
            
            1,798,431Impairment
      of real estate
            
            
            1,931,132
            
            
            
            -
            
            
            
            4,737,938
            
            
            
            -Actual
      losses on sale of real estate or loans
            
            
            (410,918
            )
            
            
            (548,524
            )
            
            
            (710,833
            )
            
            
            (548,524Net
      adjustment for TRS income
            
            
            2,341,218
            
            
            
            738,305
            
            
            
            2,521,707
            
            
            
            354,929REIT
      taxable income
            
            $
            88,471
            
            
            $
            2,515,429
            
            
            $
            1,347,161
            
            
            $
            10,641,942




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





Liquidity and Capital
Resources




Our
principal sources of working capital and funds for additional investments
primarily include: principal and interest collections on existing mortgage loan
investments, proceeds from the sale of foreclosed assets and proceeds from the
disposition of non-performing loans.  Due to the prolonged negative
condition of the credit markets and overall economy, our sources of cash
continue to be constrained.  Our borrowers are experiencing the
inability to secure takeout financing for our loans and prospective buyers of
our foreclosed property are unable to obtain financing.  Our
short-term liquidity needs are comprised primarily of dividend payments,
payments on our junior subordinated notes payable, mortgage payments on the two
buildings we own, and general working capital needs.  To conserve cash
during this tight credit market, we elected to suspend our dividend effective
with the November 2008 payment.  We will monitor the suspension of our
dividend on a quarter-by-quarter basis. Our debt to total capital ratio at
September 30, 2008 was 28.7%, which we believe should provide balance sheet
strength that will allow us to work through this challenging real estate market
and enable us to meet our short term liquidity needs.





Cash
Flows





Net cash
provided by operating activities for the nine months ended September 30, 2008
was $3.2 million compared to $12.1 million for the nine months ended September
30, 2007. The decrease in net cash flow from operating activities is due to a
decrease in net income and the net activity in mortgage loans originated for
sale and mortgage loan sales.





Net cash
provided by investing activities for the nine months ended September 30, 2008
was $3.5 million compared to $15.5 million of cash used in investing activities
for the nine months ended September 30, 2007.  The increase in net
cash flow from investing activities was a result of a decrease in the amount of
investments in real estate mortgages.  We expect cash flows from
investing activities to continue to decrease as outstanding loans are paid off
and we use the proceeds to reinvest into new investments in real estate
mortgages.





Net cash
used in financing activities for the nine months ended September 30, 2008, was
$6.8 million compared to $7.9 million of cash provided by financing activities
for the nine months ended September 30, 2007.  The decrease in cash
flow from financing activities is primarily a result of the decrease in the
issuance of common stock during the first nine months of 2008 compared to the
first nine months of 2007.  We do not expect cash flow from financing
activities to increase significantly due to the suspension and expiration of the
offering of shares of our common stock during the first quarter of
2008.





Since we
rely primarily on repayment of outstanding loans to provide capital, the
significant level of defaults on our outstanding loans has reduced the funds we
have available for investing in new loans.  Additional defaults on our
outstanding loans could further reduce the funds we have available for
investing in new loans. Extended foreclosure proceedings may also result in
significant delays in the return of invested funds. These circumstances
have reduced and may further reduce our capital resources and impair our ability
to invest in new loans. Nonperforming mortgage investments and real estate owned
as of September 30, 2008 had a carrying balance of $50.4 million and $29.8
million respectively. We also had performing loans as of September 30,
2008 with a carrying balance of $34.2 million. Subsequent to September 30,
2008, and prior to the issuance of this report, four performing loans with a
carrying balance of $23.9 million were placed on nonaccrual status.





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





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





Contractual
Obligations





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


Payments
      due by PeriodTotal
            
            
            Less
      than 1 year (1)
            
            
            1 –
      3 years
            
            
            3 –
      5 years
            
            
            More
      than 5 yearsLong-Term
      Debt ObligationsJunior
      subordinated notes
            
            $
            30,928,000
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            30,928,000Mortgages
            
            
            7,961,804
            
            
            
            66,721
            
            
            
            2,172,344
            
            
            
            723,610
            
            
            
            4,999,129Short-Term
      Debt ObligationsLine
      of Credit
            
            
            1,836,900
            
            
            
            1,836,900
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            40,726,704
            
            
            $
            1,903,621
            
            
            $
            2,172,344
            
            
            $
            723,610
            
            
            $
            35,927,129





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





Critical
Accounting Policies and Management Estimates





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




Use
of Estimates





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





Revenue
Recognition





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





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





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





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Mortgage
Investments




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





Loans
Held for Sale




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





Real
Estate Owned





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





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





Equity
Investments in Real Estate





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





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





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





Allowance
for Loan Losses





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




23
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The value
of the underlying collateral, which is based upon an appraisal at origination,
also requires estimates and assumptions as to market
conditions.  Updated appraisals are periodically obtained but in
recent months appraisals have not been readily available due to lack of
significant sales comparables and therefore estimates of fair value necessarily
include other factors.  Specific allowances for losses may be
established for nonperforming and potentially impaired loans based on a
comparison of the recorded carrying value of the loan to either the present
value of the loan’s expected cash flow, the loan’s estimated market price or the
estimated fair value of the underlying collateral. The allowance is increased by
charges to operations and decreased by charge-offs (net of recoveries). Loan
loss estimates are reviewed periodically and adjustments are reported in
earnings when they become known.  Because any decision regarding the
allowance for loan losses reflects a judgment about the probability of future
events, there is an inherent risk that such judgments will prove
incorrect.  In such event, actual losses may exceed (or be less than)
the amount of any allowance.  To the extent that we experience losses
greater than the amount of our allowances, we may incur a charge to our earnings
that will adversely affect our operating results and the amount of any
distributions payable to our stockholders.





Impairment
Policy





Impaired
loans are evaluated in accordance with SFAS No. 114 “Accounting by Creditors for
Impairment of a Loan” (SFAS No. 114). SFAS No. 114 requires that impaired loans
be evaluated based on a discounted cash flow analysis, or, if the loan is
considered collateral dependent, on the fair value of the collateral less costs
to sell. A specific allowance is established as a component of the allowance for
loan losses. For measuring impairment on real estate owned we have adopted SFAS
No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS
No. 144). Impairment is measured on a property-by-property basis on the fair
value of the related collateral since all loans subject to this measurement are
collateral dependent.





Income
Taxes





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





Item 3.Quantitative and Qualitative Disclosures about Market
Risk





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





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





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





Based on
our loans and liabilities as of September 30, 2008, and assuming the balances of
these loans and liabilities remain unchanged for the subsequent twelve months, a
1% increase in interest rates would decrease our annual net income and cash
flows by approximately $325,000. This decrease is due to our fixed rate
investments and variable rate debt. Based on our loans and liabilities as of
September 30, 2008, and assuming the balances of these loans and liabilities
remain unchanged for the subsequent twelve months, a 1 % decrease in interest
rates would increase our annual net income and cash flows by approximately
$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.





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





Item 4T. Controls and Procedures




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




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




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




·
            engaging
      external consulting expertise to assist with financial
      reporting;




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





·
            engaging
      consultants to assist us in documenting and improving our system of
      internal controls.




During
the most recent quarter ended September 30, 2008, other than as
discussed above, there have been no significant changes in our internal
control over financial reporting or in other factors that have materially
affected, or are reasonably likely to materially affect, our internal
control over financial reporting. However, as discussed above, changes have been
implemented that will continue to occur subsequent to the period covered by
this Form 10-Q to strengthen controls and to remediate and correct the
material weakness in internal control over financial reporting that was
identified at December 31, 2007.








Part II. Other Information





Item 1. Legal Proceedings


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





Item 1A. Risk Factors


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




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


None.





Item 3. Defaults Upon Senior Securities


None.




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


None.





Item 5. Other
Information


None.




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Item 6.
Exhibits


a)
Exhibits




3.1
            Third
      Amended and Restated Articles of Incorporation (included as Exhibit 3.1 to
      Form 10-K filed on March 31, 2008 and incorporated herein by
      reference).3.2
            Bylaws
      of the Company (included as Exhibit 3.2 to Amendment No.2 to the
      Registrant’s Registration Statement on Form S-11 (File No. 333-111643) and
      incorporated herein by reference).10.1
            Second
      Supplemental Indenture, dated as of June 6, 2008, between Desert Capital
      REIT, Inc., and The Bank of New York Trust Company, National Association
      (as successor to JP Morgan Chase Bank, National Association), as Trustee
      (included as Exhibit 10.1 to Form 8-K filed on June 6, 2008 and
      incorporated herein by reference.)10.2
            First
      Amendment to Loan Agreement*10.3
            Modification
      of Note Agreement*31.1
            Certification
      of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*31.2
            Certification
      of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer, Pursuant to 18
      U.S.C Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002**






*Filed
herewith





**
Furnished herewith









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SIGNATURES





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













DESERT
      CAPITAL REIT, INC.November
      13, 2008
            /s/ TODD B.
      PARRIOTTTodd
      B. Parriott,Chairman
      of the Board, Chief Executive Officer, President and Chief Investment
      Officer
              (Principal
      Executive Officer)








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








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EXHIBIT
INDEX




3.1
            Third
      Amended and Restated Articles of Incorporation (included as Exhibit 3.1 to
      Form 10-K filed on March 31, 2008 and incorporated herein by
      reference).3.2
            Bylaws
      of the Company (included as Exhibit 3.2 to Amendment No.2 to the
      Registrant’s Registration Statement on Form S-11 (File No. 333-111643) and
      incorporated herein by reference).10.1
            Second
      Supplemental Indenture, dated as of June 6, 2008, between Desert Capital
      REIT, Inc., and The Bank of New York Trust Company, National Association
      (as successor to JP Morgan Chase Bank, National Association), as Trustee
      (included as Exhibit 10.1 to Form 8-K filed on June 6, 2008 and
      incorporated herein by reference.)10.2
            First
      Amendment to Loan Agreement*10.3
            Modification
      of Note Agreement*31.1
            Certification
      of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*31.2
            Certification
      of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002*32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer, Pursuant to 18
      U.S.C Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002**




*Filed
herewith




**
Furnished herewith







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