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 March 31, 2011





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





DCR LOGO





DESERT CAPITAL REIT, INC.


(Exact Name of Registrant as specified in its charter)


Maryland
20-0495883(State or other jurisdiction of incorporation or organization)
( I.R.S Employer Identification No.)1291 W. Galleria Drive, Suite 200, Henderson, NV 89014(Address of principal executive office)(Zip Code)Registrant's telephone number, including area code:(800) 419-2855SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:NoneSECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:Common Stock, par value $0.01 per share(Title of class)





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 [X] No [ ]





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).


Yes [  ] No [  ]





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





Large accelerated filer [ ]                                                                      Accelerated filer [ ]





Non-accelerated filer [ ]                                                                        Smaller reporting company [X]


(Do not check if a smaller reporting company)








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


Yes [ ] No [X]





The aggregate market value of the registrant’s voting stock held by non-affiliates:  no established market exists for the registrant’s common stock.





The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of May 10, 2011 was 16,849,954.











Table of Contents





INDEXPagePart I. Financial Information
1Item 1. Consolidated Financial Statements
1a) Consolidated Balance Sheets as of March 31, 2011 (unaudited) and December 31, 2010
1b) Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2010 and 2011
2c) Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2010 and 2011
3d) Condensed Notes to Consolidated Financial Statements (unaudited)
4Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
14Item 3. Quantitative and Qualitative Disclosures About Market Risk
22Item 4T. Controls and Procedures
22Part II. Other Information
22Item 1. Legal Proceedings
22Item 1A. Risk Factors
23Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
23Item 3. Defaults Upon Senior Securities
23Item 4. Reserved
23Item 5. Other Information
24Item 6. Exhibits
24Signatures
25Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO and CFO Pursuant to Section 906








Table of Contents
  Part I. Financial InformationDESERT CAPITAL REIT, INC.Consolidated Balance Sheets(in thousands, except share amounts)March 31,


December 31,2011


2010(unaudited)ASSETSMortgage investments - net of allowance for loan losses of $671 atMarch 31, 2011 and $761 at December 31, 2010

$
5,538


$
5,379Real estate owned


3,318



3,318Investments in real estate


3,425



4,310Buildings and equipment - net


8,080



8,219Land


2,894



2,894Cash and cash equivalents


1,038



1,733Interest receivable


27



25Deferred costs


125



266Other investments


-



928Prepaid default costs


122



176Accounts receivable - net of allowance for doubtful accounts of $87 at


86



23March 31, 2011 and zero at December 31, 2010Other assets


496



274Total assets

$
25,149


$
27,545LIABILITIES AND STOCKHOLDERS' DEFICITNotes payable

$
7,572


$
7,462Mortgages payable


5,867



5,934Junior subordinated notes payable


30,000



30,928Management and servicing fees payable, related party


33



22Accounts payable and accrued expenses


1,906



1,453Federal income tax liability


3,368



3,368Contingent liability on guarantee


4,731



4,731Shares subject to redemption


2,201



2,201Total liabilities


55,678



56,099Commitments and Contingencies - Note 12Preferred stock, $0.01 par value: 15,000,000 shares authorized, none outstanding


-



-Common stock, $0.01 par value: 100,000,000 shares authorized; 16,849,954 sharesissued and outstanding


169



169Additional paid-in capital


163,556



163,556Accumulated deficit


(194,339)



(192,392)Deficit available to common stockholders


(30,614)



(28,667)Noncontrolling interests


85



113Total stockholders' deficit


(30,529)



(28,554)Total liabilities and stockholders' deficit

$
25,149


$
27,545The accompanying notes are an integral part of these consolidated financial statements.
  1
 Table of Contents
  DESERT CAPITALREIT, INC.Consolidated Statements of Operations(in thousands, except share amounts)Three Months Ended March 31,2011


2010(unaudited)


(unaudited)INTEREST INCOME:Mortgage investments

$
80


$
77Other interest


-



222Total interest income


80



299Interest expense


729



915Net interest loss


(649)



(616)Recoveries of loan losses


(90)



(535)Net interest loss after provision for loan losses


(559)



(81)NON-INTEREST INCOME:Net gain on sales of real estate owned and real estateinvestments


35



-Rental income


216



316Total non-interest income


251



316NON-INTEREST EXPENSE:Impairments of real estate


28



952Equity in loss of unconsolidated real estate investments


271



845Management and servicing fees


253



501Professional fees


483



740Insurance


163



179Depreciation


139



171Property taxes


68



184Other


262



166Total non-interest expense


1,667



3,738Loss from continuing operations before taxes


(1,975)



(3,503)Income tax expense


-



128Net loss from continuing operations


(1,975)



(3,631)Less:  Net loss attributable to noncontrolling interests


28



791Net loss attributable to common stockholders

$
(1,947)


$
(2,840)Net loss per share - basic and diluted

$
(0.12)


$
(0.17)Weighted average outstanding shares - basic and diluted


16,849,954



16,849,954The accompanying notes are an integral part of these consolidated financial statements.
  2
 Table of Contents
   DESERT CAPITALREIT, INC.Consolidated Statements of Cash Flows(in thousands)(unaudited)Three Months EndedMarch 31,2011


2010OPERATING ACTIVITIESNet loss

$
(1,975)


$
(3,631)Adjustments to reconcile net loss to net cash used inoperating activities:Gain on sales of real estate


(35)



-Depreciation and amortization


280



281Provision for loan loss


(90)



(535)Impairments of real estate


28



952Equity in loss of unconsolidated real estate investments


271



845Net change in:Interest receivable


(2)



(144)Other assets


(231)



295Accrued and other liabilities


685



(215)Net cash used in operating activities


(1,069)



(2,152)INVESTING ACTIVITIESInvestment in real estate mortgages


(300)



-Proceeds from repayments of real estate mortgages


231



-Proceeds from sales of equity investments in real estate


-



133Proceeds from sale of real estate owned and investments in real estate


621



517Acquisition of building and equipment


-



(37)Net cash provided by investing activities


552



613FINANCING ACTIVITIESProceeds from notes payable


-



1,000Repayments of notes payable


(111)



-Principal increases on mortgage loan


-



208Principal repayments of mortgage loan


(67)



(87)Deferred financing costs


-



(51)Net cash (used in) provided by financing activities


(178)



1,070Net increase in cash and cash equivalents


(695)



(469)Cash and cash equivalents at beginning of period


1,733



553Cash and cash equivalents at end of period

$
1,038


$
84Supplemental disclosure of cash flow information:Cash paid for interest

$
380


$
2,989Foreclosed assets acquired in exchange for loans, net of impairments


-



1,432The accompanying notes are an integral part of these consolidated financial statements.
  3
 Table of Contents


Desert Capital REIT, INC.


Condensed Notes to Unaudited Consolidated Financial Statements


March 31, 2011





Note 1 - Organization


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





In late 2007, we began experiencing a significant level of borrower defaults, and in 2008 and 2009 virtually all our borrowers defaulted on their loans with us.  As of March 31, 2011, we had foreclosed on the property underlying our original mortgage loans on all but three loans.  Due to the development stage of the properties at the time of foreclosure, which was primarily undeveloped or partially developed land, none of these properties  are income producing and many have significant operating costs such as property taxes.  The combination of significantly reduced interest income from performing loans, increased costs related to the ownership of non-income producing property, ongoing day-to-day operating costs of the Company, and the depressed real estate market, has had a materially adverse impact on our financial condition and has severely impacted our ability to conduct business as originally intended. With limited revenue from our investment portfolio, we have been forced to incur debt and sell properties as needed to generate operating capital and fund debt payments.





When we began our investment strategy in 2004, we stated our intent to either list our stock on a national exchange or begin the liquidation of our portfolio by December 2011.  Due to the collapse of the real estate market beginning in late 2007 and continuing into 2011, our business strategy, which was to invest in performing mortgage loans on a continuous basis, was cut short due to our lack of capital.  We have been unable to make significant investments in mortgages since early 2008, and our investment portfolio of mortgage loans that existed at that time has been substantially foreclosed, resulting in a portfolio of real estate investments that are non-income producing and are valued at amounts significantly less than the original loan amounts.  Given the financial condition of the Company, listing our stock on a national exchange is no longer a viable consideration.  At this time, we are in the process of liquidating our assets as needed for liquidity purposes, or when we receive offers that are attractive in this market environment.  On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors. Under the involuntary petition, a Trustee has not been requested or appointed.  Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.





We are externally managed by CM Group (our “Advisor”).  CM Group’s majority owner is Todd Parriott, our CEO.  See Note 10 – Related Parties.  We manage our business as a single business segment.





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.





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





Basis of Presentation


The accompanying unaudited consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and rules of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The accompanying unaudited consolidated interim financial statements should be read in conjunction with the financial statements and the related management's discussion and analysis of financial condition and results of operations filed on Form 10-K for the fiscal year ended December 31, 2010.  In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included.  The results of operations for the three months ended March 31, 2011 are not necessarily indicative of results that may be expected for the entire year ending December 31, 2011.  The consolidated balance sheet at December 31, 2010 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.





Note 2 - Summary of Significant Accounting Policies





Principles of Consolidation


The accompanying consolidated financial statements include our accounts and the accounts of our wholly-owned and majority owned subsidiaries and controlled entities.  Investments in which we own greater than 50% of the voting control or we effectively control through other interests, are consolidated.   All significant intercompany balances and transactions have been eliminated in consolidation.





Our interest in Desert Capital TRS Statutory Trust I, a trust formed for the purpose of issuing trust preferred securities, is accounted for using the equity method and the assets and liabilities are not consolidated into our financial statements due to our determination that Desert Capital TRS Statutory Trust I is a variable interest entity in which we are not the primary beneficiary.  In addition we use the equity method to account for other investments in real estate developments and ventures for which we have 50% or less of the voting control and the ability to exercise significant influence over operating and financial policies, but do not control.  We use the cost method to account for investments in real estate developments for which we have less than 20% ownership and we do not exercise significant influence.


4
 Table of Contents




Reclassifications


Certain reclassifications have been made in the presentation of the three months ended March 31, 2010 consolidated financial statements, specifically within the consolidated statements of cash flows within the caption “Proceeds from notes payable.” The reclassification was made to reflect such items consistent with our 2011 presentation and had no impact on our, net income, stockholder’s equity, or balance sheets as previously reported.





Mortgage Investments


Mortgage investments are intended to be held to maturity and, accordingly are carried at cost, net of any unamortized deferred fees and costs, and any allowance for loan losses and charge-offs.  We generally do not expect prepayments due to the nature of the mortgage loans.





Real Estate Owned


Real estate owned consists of property acquired through foreclosures on mortgage loans.  Our interests in real estate owned may be held directly by us, or through an LLC which is generally the case where we are one of several investors in a larger loan, and such loans are foreclosed upon using an LLC to facilitate foreclosing our lender interest along with private investors who hold the remaining loan balance and have similar economic interests. We record real estate held directly or through an LLC at the lower of the recorded amount of our related mortgage loan being foreclosed (net of any impairment charge), or our economic interest in the property's estimated fair value, less estimated costs to sell, with fair value based on appraisals and local market conditions.  Costs relating to the development or improvement of the assets are capitalized, where appropriate, and costs relating to holding the assets are charged to expense.





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





Investments in Real Estate


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





ASC 810, Consolidation, provides guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and the determination of which business enterprise, if any, should consolidate the VIE (the “primary beneficiary”).  Upon contribution to a venture or establishment of an LLC at foreclosure, we evaluate our investments in partially owned entities and consider whether the entity is a VIE by considering whether (1) the equity investors (if any) lack one or more of the essential characteristics of a controlling financial interest, (2) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support or (3) the equity investors have voting rights that are not proportionate to their economic interests and the activities of the entity involve or are conducted on behalf of an investor with a disproportionately small voting interest.





If we determine that the entity is a VIE, we evaluate whether we are the primary beneficiary of the VIE.   We evaluate (1) who has the power to direct matters that most significantly impact the activities of the VIE and (2) who has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE.   We continually assess whether events have occurred that would require us to reevaluate consolidation criteria including changes in the operating agreements, debt structure guarantees, or commitments or changes in the ownership percentages in the LLCs in which we are a member.





We account for our investments in unconsolidated real estate ventures under the equity method of accounting when we have concluded that either the entity is not a VIE or that we are not the primary beneficiary of the VIE and we exercise significant influence, but do not control these entities.  These investments are recorded initially at lower of cost or fair value, as investments in real estate entities, and subsequently adjusted for equity in earnings and cash contributions and distributions.





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





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





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





5
 Table of Contents


Note 3 - Mortgage Investments


Mortgage investments represent first lien positions on acquisition and development, construction and commercial property loans. As of March 31, 2011 all of our loans had fixed interest rates and provided for payment of interest only with a “balloon” payment of principal payable in full at the end of the loan term.





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





March 31, 2011Loan Type

Number of Loans


Balance


Allowance for Loan Losses


Net Balance


Weighted Average Interest Rate

Portfolio PercentageAcquisition and development loans


2


$
6,140


$
(671)


$
5,469



5.0
%
(1)


98.9
%Construction loans


1



69



-



69



12.3
%



1.1
%Total mortgage investments


3


$
6,209


$
(671)


$
5,538



5.1
%



100.0
%December 31, 2010Loan Type

Number of Loans


Balance


Allowance for Loan Losses


Net Balance


Weighted Average Interest Rate


Portfolio PercentageAcquisition and development loans


2


$
6,140


$
(761)


$
5,379



5.0
%
(1)


100.0
%Total mortgage investments


2


$
6,140


$
(761)


$
5,379



5.0
%



100.0
%(1) Represents the stated rate of the loan, as modified
  The following table presents our mortgage investments by geographic location (dollars in thousands):





March 31, 2011


December 31, 2010Location

Balance


Allowance for loan losses


Net Balance


Original Balance Portfolio Percentage


Balance


Allowance for loan losses


Net Balance


Original Balance Portfolio PercentageArizona

$
6,140


$
(671)


$
5,469



98.9
%

$
6,140


$
(761)


$
5,379



100.0
%Utah


69



-



69



1.1
%


-



-



-



0.0
%$
6,209


$
(671)


$
5,538



100.0
%

$
6,140


$
(761)


$
5,379



100.0
%
  The following table presents details on performing, non-performing and impaired loans and related allowance for loan losses as of March 31, 2011 and December 31, 2010 (dollars in thousands):




March 31, 2011


December 31, 2010Number of Loans


Balance


Number of Loans


BalancePerforming loans without a related allowance


1


$
69



-



-Performing loans with a related allowance


2



6,140



2



6,140Related allowance for loan losses on performing loans


-



(671
)


-



(761)Total perorming loans with a related allowance


2



5,469



2



5,379Total loans


3


$
5,538



2


$
5,379
  Interest income recognized on non-performing loans and loans accounted for as troubled debt restructures for the three months ended March 31, 2011 and 2010 was $77,000.





During the three months ended March 31, 2011 we funded a loan for $300,000 with cash proceeds received from sales of real estate investments. At March 31, 2011, $231,000 of the balance had been repaid to us with interest and a balance of $69,000 remained.


6
 Table of Contents





During the three months ended March 31, 2010, we foreclosed on properties with a fair value of $1.4 million which were comprised of loans with aggregate original balances of $2.9 million.  We transferred $1.4 million to real estate owned and $7,000 to investments in real estate.





At March 31, 2011 and December 31, 2010, we had restructured loans in our portfolio of $6.1 million and have provided allowance for loan losses of $671,000 and $761,000 respectively.





The following is a roll forward of the allowance for loan losses for the three months ended March 31, 2011 and 2010, and the year ended December 31, 2010 (dollars in thousands):




Three Months Ended


Year EndedMarch 31,


March 31,


December 31,2011


2010


2010Balance, beginning

$
761


$
6,669


$
6,669Provision for loan loss


-



-



2,207Accretion of troubled debt restructure loans


(90)



(464)



(884)Amounts charged off


-



-



(3,260)Transfers to real estate owned


-



(1,516)



(3,971)Balance, ending

$
671


$
4,689


$
761


Note 4 – Real Estate Owned


We did not foreclose on any properties and did not sell any real estate owned properties during the first quarter 2011.  During the first quarter 2010, properties with aggregate original balances of $2.9 million were foreclosed and classified as real estate owned.  These properties had a fair value of $1.4 million at the time of foreclosure.  We recognized impairments of $423,000 during the three months ended March 31, 2010 and disposed of real estate owned with a carrying value of $517,000 for cash proceeds of $517,000, resulting in no gain or loss on the sale.





The following is a summary of the carrying value of our real estate owned as of March 31, 2011 and December 31, 2010 (dollars in thousands):




March 31,


December 31,Description
Location

2011


2010Undeveloped land
TX, MO

$
2,125


$
2,125Single family residential lots
MO


1,193



1,193Total


$
3,318


$
3,318





Note 5 – Investments in Real Estate


Cost Method Investments


As of March 31, 2011 and December 31, 2010, we had $159,000 in real estate investments that we accounted for under the cost method.  During the first quarter 2010, we foreclosed on the collateral securing loans with a carrying value of $7,000 and classified the assets as cost method investments.  We concluded that our share of certain losses within the LLCs was other than temporary resulting in impairments of $28,000 and $24,000 for the three months ended March 31, 2011 and March 31, 2010, respectively.





Equity Method Investments


We held zero and $227,000 in other real estate investments that we accounted for under the equity method of accounting at March 31, 2011 and December 31, 2010, respectively.  During the three months ended March 31, 2011 and March 31, 2010, we recognized a loss on our equity in these real estate investments of $227,000 and $42,000, respectively, due to our share of certain losses within the LLCs.  We also sold property with a carrying value of $53,000 for cash proceeds of $53,000 resulting in no gain or loss on sale during the three months ended March 31, 2010.





Equity Method Joint Ventures


We are currently engaged in two joint venture agreements with a third-party homebuilder for the construction of single family homes in Las Vegas, Nevada.   These ventures, to which we contributed real estate that we had acquired through foreclosure, are accounted for under the equity method of accounting.  Our venture partner manages the operations of the joint ventures.  All major decisions require the approval of both joint venture partners, and voting rights and the sharing of profits and losses are in proportion to the ownership percentages of each joint venture partner.  We have no responsibility to provide additional funding to the ventures.  Additional funding for the construction of homes and sales of such will be provided by our venture partner or incurred by the joint venture.  Our share of losses is limited to the value of the lots contributed.





The carrying value of the joint ventures, net of impairments, at March 31, 2011 and December 31, 2010 was $774,000.  During the three months ended March 31, 2010, two homes were constructed and sold to homeowners and we received consideration of $80,000 from these sales.  For the three months ended March 31, 2011 and March 31, 2010, we recognized a loss in our equity in these real estate investments of $44,000 and $803,000, respectively, a direct result of our share of losses within the ventures.





7
 Table of Contents


Fully Consolidated Investments


At March 31, 2011 and December 31, 2010, we held $2.5 million and $3.1 million, respectively, in fully consolidated real estate investments.  As a direct result of the changes in our estimate of the fair value of the underlying properties, we recognized impairments on fully consolidated real estate investments of $505,000 during the three months ended March 31, 2010.  During three months ended 2011, we sold property for cash proceeds of $621,000 resulting in a $35,000 gain on sale for the three months ended March 31, 2011.





We have consolidated the equity and net operating income and expenses of six entities in which we have more than 50% ownership.   At March 31, 2011, our noncontrolling interests were between 7% and 36% had a carrying value of $365,000.





The following provides a summary of the changes in investments in real estate during the three months ended March 31, 2011 (dollars in thousands):




Fully





Other EquityConsolidated


Equity Method


Method


Cost MethodInvestments


Joint Ventures


Investments


Investments


TotalBalance December 31, 2010

$
3,078


$
818


$
227


$
187


$
4,310Sales of real estate investments


(586)



-



-



-



(586)Impairments on real estate investments


-



-



-



(28)



(28)Equity in loss on real estate investments


-



(44)



(227)



-



(271)Balance March 31, 2011

$
2,492


$
774


$
-


$
159


$
3,425
  The following is a summary of our investments in real estate at March 31, 2011 and December 31, 2010 (dollars in thousands):




Description
Location

March 31, 2011


December 31, 2010Undeveloped land
NV, AZ, CA

$
2,153


$
2,378Single family residential lots
NV


796



840Office building
NV


106



722Other
NV


370



370Total


$
3,425


$
4,310
  At March 31, 2011, our investments in real estate were held in 25 limited liability companies, and our ownership percentage ranged from negligible to 100%.





Investments in Variable Interest Entities


As discussed further in Note 13, we previously held a 37.6% equity investment in Warm Jones, LLC (Warm Jones) and have guaranteed a $13.7 million first lien mortgage loan that was borrowed by Warm Jones.  In addition, Warm Jones borrowed an additional $2.6 million, the proceeds of which were used to pay 12 months of interest on the first and second lien loans, and carrying costs associated with the property.  Both loans have matured and are in default.   During the fourth quarter 2010, our equity investment in Warm Jones was eliminated, a result of the foreclosure by the second lien holders; however we continue to carry a liability related to the guaranty which we have estimated to be $4.7 million at both March 31, 2011 and December 31, 2010.  The estimated value is based upon, among other things, our estimate of the fair value of the underlying property, net of costs to sell.





We determined that Warm Jones was a VIE under applicable accounting standards; however, we determined that we are not the primary beneficiary.  Our equity investment was eliminated in the fourth quarter 2010.  Although we have, as a result of the guarantee, the requirement to absorb losses that could be significant to the VIE, we do not have the power to direct the matters that most significantly impact the activities of the LLC, including the management and operations of the property owned by the LLC and disposal rights with respect to the property. Such rights and power are held by the first lien holder.





Note 6 - Stock Based Compensation


The Board of Directors adopted the 2004 Stock Incentive Plan of Desert Capital REIT, Inc. (the “Plan”), and we have reserved 1,000,000 shares of common stock for issuance under the Plan.  There was no restricted stock expense for the three months ended March 31, 2011 and March 31, 2010.





8
 Table of Contents


Note 7 – Loss per Share


Basic loss per share includes no dilution and is calculated by dividing net loss available to common shareholders by the weighted average number of shares of common stock outstanding during each period. Diluted loss per share reflects the potential dilution of securities that could share in the earnings or losses of the entity.  Due to the net loss in all periods presented, the calculation of diluted per share amounts would create an anti-dilutive result and therefore is not presented. As of March 31, 2011 and December 31, 2010, there were no unvested shares outstanding under our stock incentive plan.





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




For the three months endedMarch 31,2011


2010Net loss attributable to common stockholders

$
(1,947)


$
(2,840)Weighted average number of common sharesoutstanding basic and diluted


16,850



16,850Basic and diluted loss per common share

$
(0.12)


$
(0.17)
  Note 8 – Dividends and Redemption Requests


To maintain our status as a REIT, we are required to make dividend distributions, other than capital gain dividends, each year in an amount at least equal to 90% of our taxable income.  All dividend distributions are made at the discretion of our Board of Directors and depend on our earnings, our taxable earnings, financial condition, maintenance of REIT status and such other factors as the Board of Directors deems relevant.  In October 2008, due to substantial losses and the need for cash preservation, we suspended our monthly dividend.





Upon the death of a stockholder, at the option of the stockholder’s estate, the estate has a limited right of redemption with respect to the common stock.  This right of redemption, for the redemption requests received by March 31, 2011, has been accounted for as a liability.  At March 31, 2011, we had redemption requests of 276,000 shares of common stock totaling $2.2 million.





Note 9 – Debt


Notes Payable


At March 31, 2011 and December 31, 2010, notes payable included debt agreements totaling $1.9 million and $1.8 million, respectively, net of interest reserves with a balance of $125,000 and $167,000 at March 31, 2011 and December 31, 2010, respectively, which have been reflected as a reduction in the note balances.  Interest is accrued and paid on the principal amount of the notes, or $2.0 million at March 31, 2011 and December 31, 2010.  The interest rates on these notes range from 10% to 13%, and payments are made monthly from the interest reserve account with a balloon payment of the principal balance due at maturity.  The debt is collateralized by certain of our real estate investments with a carrying value at March 31, 2011 of $2.2 million.  The proceeds from the notes, less closing costs, funding of the interest reserves and other fees, were disbursed to our affiliate, CM Capital and classified as prepaid default costs on our balance sheets, and at March 31, 2011 and December 31, 2010, the balance of the prepaid default costs was $122,000 and $176,000, respectively, and will be used for the payment of ownership costs, such as property taxes and legal fees, and servicing and property management fees to our related party loan servicer and property manager, CM Capital.   Notes payable with a carrying balance of $369,000 were in default as of March 31, 2011.  We have not paid interest during the time the note has been in default and we expect the first lienholders to foreclose on the properties, thus eliminating our interest in the real estate investment.  The underlying real estate serves as recourse for this debt.





In November 2007, we assumed a first lien mortgage payable to a bank upon foreclosure of a 10,330 square foot office building in Houston, Texas.  In July 2010, we entered into a settlement agreement with the bank whereby the bank took title to the property at an agreed upon value of $1.3 million, and we entered into a new promissory note for the remaining balance of $331,000.  At the time of the settlement, the loan had an outstanding principal balance of $1.6 million and the property had a carrying value of $1.2 million.  The new note bears an annual interest rate of 6% with a maturity date of June 2011.  Principal and interest payments are made monthly and as of March 31, 2011 and December 31, 2010, the principal balance on this note was $83,000 and $194,000, respectively.




We had a $5.0 million note secured by the land and building of 3MO, LLC, a property foreclosed upon in 2009.   The annual interest rate on this note was 11.25%.    In September 2010, this note was refinanced and increased to a $6.0 million note payable secured by the land and building of 3MO, LLC.   CM Capital was our loan originator and servicer on this note for which we paid origination and servicing fees of $51,000 during 2010 relating to the $1.0 million increase. The refinanced note bears interest at an annual rate of 12.00% and matures in September 2011.   CM Capital was also our loan servicer on this note for which we paid servicing fees of $180,000.  We funded interest reserves related to the $6.0 million note payable, and the remaining balance of interest reserves was $400,000 and $579,000 at March 31, 2011 and December 31, 2010, respectively.  The net note balance at March 31, 2011 and December 31, 2010 was $5.6 million and $5.4 million, respectively.





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




December 31, 2010


2011 Activity


March 31, 2011Interest Rate

Maturity Date

Note Balance


Interest Reserves


Carrying Balance


Principal Advances


Principal Payoffs


Net Interest Reserve Payments (Fundings)


Note Balance


Interest Reserves


Carrying Balance11
%
December 2010

$
369


$
-


$
369


$
-


$
-


$
-


$
369


$
-


$
36911
%
August 2011


226



(18)



208



-



-



6



226



(12)



21411-13
%
December 2011


1,169



(149)



1,020



-



-



36



1,169



(113)



1,05610
%
June 2012


250



-



250



-



-



-



250



-



250Subtotal Notes Payable


2,014



(167)



1,847



-



-



42



2,014



(125)



1,8896
%
June 2011


194



-



194



-



(111)



-



83



-



8312
%
September 2011


6,000



(579)



5,421



-



-



179



6,000



(400)



5,600Total Notes Payable

$
8,208


$
(746)


$
7,462


$
-


$
(111)


$
221


$
8,097


$
(525)


$
7,572





Mortgage Loan Payable


We have a mortgage loan from a bank with an outstanding principal balance of $5.9 million as of March 31, 2011 and December 31, 2010, which is secured by our office building in Henderson, Nevada.  The loan bears interest at a rate equal to the prime rate, with a floor of 6.75% and a ceiling of 7.75%. Principal and interest are payable monthly and the note matures in 2026, with no prepayment penalty. The interest rate on March 31, 2011 was 6.75%.





The mortgage note is collateralized by the Henderson, Nevada office building, and both Desert Capital REIT and Desert Capital TRS have guaranteed the debt in the event of nonpayment or in the event that the value of the building is not sufficient to cover the outstanding mortgage debt.  Based on a recent appraisal, the market value of the building is less than the outstanding mortgage balance; therefore, the bank has the ability to declare the entire principal balance of the note immediately due and payable.  We are in discussions with the bank due to our default of certain financial covenants but have not received a formal notice of default.  In December 2010, we recorded an impairment of $3.3 million related to the land and office building, which resulted in a carrying value of $4.8 million, or $1.2 million below that of the outstanding debt balance.  Our determination of carrying value was based on the current value of tenant leases.





Junior Subordinated Notes Payable


In June 2006, we issued $30.0 million in unsecured trust preferred securities through a Delaware statutory trust, Desert Capital TRS Statutory Trust I, which is our wholly-owned subsidiary.  The securities bear interest at a floating rate based on the three-month LIBOR plus 400 basis points, which resets each calendar quarter, and was 4.31% on March 31, 2011 and 4.30% at December 31, 2010.  The trust preferred securities require quarterly interest distributions. The trust preferred securities had an original maturity of July 2036.





Desert Capital TRS Statutory Trust I issued $928,000 aggregate liquidation amount of common securities, representing 100% of the voting common stock of the Statutory Trust to us. Due to the status of the notes, we impaired our investment in the Statutory Trust to zero in the first quarter 2011.The Statutory Trust used the proceeds from the sale of the trust preferred securities and the common securities to purchase our junior subordinated notes.  The terms of the junior subordinated notes match the terms of the trust preferred securities.  The notes are subordinate and junior in right of payment to all present and future senior indebtedness and certain other of our financial obligations.





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





Our junior subordinated notes contain customary default provisions and require us to maintain certain financial ratios at quarterly determination dates, including a minimum tangible net worth requirement.  During 2009, we were not in compliance with all of the covenants contained in our junior subordinated notes.   On April 3, 2009, we received a written notice of a tangible net worth default from the holders of the preferred securities, which was not cured.  On July 27, 2009, we received a written Notice of Event of Default and Acceleration from the holders of the preferred securities that because our tangible net worth was less than $100 million, a default had occurred under our junior subordinated indenture which had continued for more than 30 days and had caused an event of default to occur under the junior subordinated indenture.  The notice further stated that as a result of the occurrence of such event of default, the principal amount of our obligations under the junior subordinated indenture, together with any and all other amounts payable thereunder had been accelerated and declared to be immediately due and payable by the holders of the preferred securities.  The notice further stated that the holders of the preferred securities, may at their option, pursue all available rights and remedies.  Prior to the acceleration of the obligations, no default in the payment of principal or interest had occurred under the junior subordinated indenture.





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In March 2010, we entered into a standstill agreement with the holders of the trust preferred securities pursuant to which such holders  agreed not to exercise any rights or remedies against us to enforce the agreements or collect the debt in exchange for (i) payment of the interest payments due October 31, 2009 in the amount of $344,000 within one business day following our receipt of the executed standstill agreement, which we paid on March 9, 2010, (ii) payment of  the interest payment due January 31, 2010 in the amount of $328,000 on or before March 31, 2010, which we paid on March 31, 2010 and (iii)  continued payment of the quarterly interest payments due under the junior subordinated notes in accordance with the terms of the junior subordinated indenture, including our April 30, 2010 and July 30, 2010 payments, which we paid. We did not make our October 30, 2010 payment prior to the expiration of the 30 day grace period; therefore, we are no longer in compliance with the standstill agreement.  We have been in discussions with the holders of the trust preferred securities; however, such discussions stalled in February 2011, and in February, 2011, we received notice that the holders of $25.0 million of the trust preferred securities had filed a lawsuit against us for collection of the debt.   On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the holders of our trust preferred securities. Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.  At March 31, 2011 and December 31, 2010, interest payable on the securities was $933,000 and $589,000, respectively.





Note 10 - Related Parties


CM Group is our Advisor and oversees our day-to-day operations including asset, liability and capital management. In lieu of paying salaries to officers, we compensate our Advisor pursuant to an advisory agreement that entitles it to first-tier management compensation, second-tier management compensation, and reimbursement of expenses.  The majority owner of our Advisor is also our chief executive officer. The annual first-tier management compensation is 1% of the first $200 million of gross average invested assets plus 0.8% of the gross average invested assets in excess of $200 million, to be paid quarterly.   The first-tier management compensation for the three months ended March 31, 2011 and March 31, 2010 was $192,000 and $339,000, respectively, and zero remained payable at March 31, 2011.   No second-tier compensation was paid for the three months ended March 31, 2011 or 2010.





In February 2011, we entered into an agreement with CM Group, pursuant to the terms of the Advisory Agreement, and, to protect our interest in CM Capital, agreed to prepay first-tier management compensation to CM Group in the amount of $215,000, which we paid in February 2011.  The balance of this prepaid first-tier management compensation was $132,000 at March 31, 2011.





During 2008, the composition of our investment portfolio changed dramatically from a performing loan portfolio to a defaulted loan and foreclosed property portfolio. With the changing composition of our assets, the functions being performed by our Advisor, and to a larger degree, CM Capital, our loan originator and servicer, increased and changed significantly. CM Capital’s function as loan servicer has historically been to collect interest payments from the borrowers and to distribute interest payments to the investors.  As compensation for this service, the borrower would pay CM Capital a servicing fee. As the borrowers began defaulting on their loans, CM Capital was no longer able to collect the servicing fees on defaulted loans. At the same time, CM Capital began to perform more complex functions related to the defaulted loans and ultimately the foreclosed property, such as soliciting investor votes on the handling of defaulted loans, handling foreclosure proceedings, processing and paying carrying costs, negotiating with borrowers and builders, structuring joint venture agreements, selling property and designing and executing other workout strategies on behalf of the investors. In December 2008, CM Capital determined that it could no longer advance the carrying costs and workout and resolution costs related to the properties on which it had foreclosed on behalf of the investors, and sent a letter to the investors (owners) of the foreclosed properties giving the investors the option to assume the responsibility for their own asset management functions, or pay CM Capital to provide such services. DCR received such a letter, and in March 2009, agreed to have CM Capital provide asset management services on our behalf. In exchange for such services, we agreed to pay CM Capital servicing fees based on the following: a real estate owned processing fee upon the date of foreclosure in an amount not to exceed 5% of the outstanding loan balance on the date of default, of which 1% is due and payable upon the transfer of title and the remainder is due upon the sale or other disposition of the property plus a yearly servicing fee of either 1% of the original loan balance if the workout strategy is considered simple or 2% of the original loan balance if the workout strategy is considered complex, calculated from the date of foreclosure. For the three months ended March 31, 2011 and March 31, 2010, these fees totaled $61,000 and $162,000, respectively, and were included in management and servicing fees in the consolidated statement of operations.  At March 31, 2011, $33,000 was payable and was included in management and servicing fees payable on the consolidated balance sheet.





To facilitate payment of certain carrying costs and servicing and property management fees, we leveraged certain assets. Each loan constituting a portion of the debt is secured by liens on the property whose costs and expenses are being financed by such loan. The outstanding principal balance on this debt was $2.0 million net of interest reserves of $125,000 at March 31, 2011.  Interest reserves of $125,000 and $167,000 related to the notes payable at March 31, 2011 and December 31, 2010, respectively, were being held in a trust account maintained with Preferred Trust Company, an entity partially owned by our Chief Executive Officer.  The proceeds, less closing costs, funding of the interest reserves and other fees were prepaid to our servicer, CM Capital, to be used for the payment of costs associated with being a land owner and servicing and property management fees payable to CM Capital.  The balance of the prepaid account at March 31, 2011 and December 31, 2010 was $122,000 and $176,000, respectively.





CM Capital was our loan originator and servicer on notes entered into and secured by the land and building of 3MO, LLC.  We paid CM Capital origination and servicing fees totaling $231,000 during 2010.  In addition we funded interest reserves related to this note payable for which the remaining balance was $400,000 at March 31, 2011.  The interest reserve is held in a trust account maintained with Preferred Trust Company, an entity partially owned by our Chief Executive Officer.  See also Note 9 – Debt.





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In connection with our sale of CM Capital to our Advisor in 2007, we received a $15.5 million promissory note payable by CM Capital to our TRS.  During 2008, CM Capital was not in compliance with certain financial covenants contained in the loan agreement related to the $15.5 million promissory note payable to TRS and in October 2008, a special committee of the independent members of our Board of Directors and CM Capital agreed to modify the loan terms and as a result principal payments on the note were deferred for two years, and the interest rate was reduced from 9% to 6% per annum effective as of July 1, 2008.  Additionally, the working capital financial covenant was replaced with the requirement to maintain a cash balance of $250,000 at the end of each quarter, and the first measurement period for the fixed charge coverage ratio was moved from December 31, 2007 to December 31, 2008.  Based on the modified terms of the promissory note, the modification resulted in an impairment based on the present value of the expected future cash flows under the modified terms.  The modification was accounted for as a troubled debt restructure and resulted in an impairment of $2.1 million in 2008.  During 2010, a $70,000  recovery of the $2.1 million impairment was recorded due to the passage of time and the accompanying accretion of the restructure discount.  No recovery was recorded for the three months ended March 31, 2011.





During 2010, CM Capital continued to fail to comply with certain financial covenants contained in the loan agreement relating to our $15.5 million note receivable.   Our Board of Directors formed a special committee of our independent directors to review the financial covenants and negotiate a strategy to resolve the defaulted status of the loan as a result of CM Capital’s non compliance.  In June 2010, we entered into a forbearance agreement with CM Capital whereby we agreed to give CM Capital ninety days to address the covenant default on our $15.5 million note receivable.  Subsequent to June 30, 2010, the independent members of our Board of Directors agreed to extend the forbearance agreement for an additional 90 days, and to further evaluate the financial strength of CM Capital.  Due to the continued default, management determined that it was appropriate to record an impairment to the note receivable of $3.0 million as of June 30, 2010. CM Capital notified us in October 2010 that it would be discontinuing interest payments until it returned to profitability. In addition, under terms of the modified promissory note, CM Capital was to resume principal payments beginning on December 31, 2010.  CM Capital did not make the principal or interest payment on December 31, 2010, and, as of the date of this report, continues to be in default on its obligation to us.  As a result of this nonpayment, management assessed CM Capital’s current financial position and determined that it is unlikely CM Capital will be able to repay this note.   Based on this information, at December 31, 2010, we placed the note receivable on non performing status and recorded an additional impairment of $10.0 million, resulting in a full valuation allowance for the outstanding principal balance on the note.   The impairment does not reflect a change in the repayment terms of the note receivable or a reduction in the amount owed under the note receivable, and our Board of Directors is continuing to work with CM Capital on a resolution.  In March 2011, CM Capital surrendered its mortgage license to the State of Nevada and has indicated that it is winding down its operations.  At March 31, 2011 and December 31, 2010, the carrying value of the note receivable was zero, net of impairments.





We lease office space to CM Group and its affiliates under operating leases generally cancelable by either party on thirty days written notice.  Rental income received from related parties for the three months ended March 31, 2011 and March 31 2010 was $104,000 and $145,000, respectively.  At March 31, 2011, certain of our related party tenants were delinquent on rental payments totaling $74,000. Due to the financial condition of these affiliates, the receivable has been fully reserved at March 31, 2011.





In October 2010, we received a subpoena from the Securities and Exchange Commission requesting certain information pertaining to payments and transactions with our related party, CM Capital.  We have cooperated with the SEC with respect to the subpoena.





Note 11 - Fair Value of Financial Instruments


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





The following table summarizes the carrying values and the estimated fair values of financial instruments as of March 31, 2011 and December 31, 2010 (dollars in thousands):





March 31, 2011


December 31, 2010Carrying Value


Estimated Fair Value


Carrying Value


Estimated Fair ValueFinancial assets:Cash and cash equivalents

$
1,038


$
1,038


$
1,733


$
1,733Interest receivable


27



27



25



25Mortgage investments - net


5,538



5,320



5,379



5,201Financial liabilities:Notes payable


7,572



7,519



7,462



7,360Contingent liability on guarantee


4,731



4,731



4,731



4,731Mortgage payable


5,867



5,465



5,934



5,512Junior subordinated notes


30,928



-



30,928



5,379





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





●

Cash, cash equivalents: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.●

Mortgage investments-net:  At March 31, 2011 and December 31, 2010 the fair value of fixed rate loans currently classified as performing, was computed based on the probability of collection of the cash flow, a risk free rate of return on all estimated cash flows, the estimated realization of collateral based on recent history and the fixed interest rate of the loans.  Fair value inputs on performing and non-performing loans are considered Level 3.●

Contingent liability on guarantee: For March 31, 2011 and December 31, 2010 we based the fair value on the collateral value of the property underlying the guarantee, less carrying and settlement costs, factors that are considered Level 3 inputs.●

Mortgage payable and notes payable: For March 31, 2011 and December 31, 2010 our credit standing was taken into consideration, as well as the assigned collateral which was considered more than adequate, the estimated risk to the lender of the collateral to the loan balance and rates reflective of the current market environment, all of which were factors in the computation of fair value and were considered Level 3 inputs.●

Junior subordinated notes:  Our junior subordinated notes do not trade in an active market and, therefore observable price quotations are not available.  In the absence of observable price quotations, at December 31, 2010, fair value was determined based on the fair value of the assets that might be available to settle the debt, which is a Level 3 input. At March 31, 2011, fair value was reevaluated with the knowledge that, on April 29, 2011, certain of our creditors, including the holders of the trust preferred securities, filed a petition for involuntary Chapter 11 bankruptcy against us, and, based on this, we determined that, as of the date of this filing, we do not have sufficient information to determine the amount, if any, the holder of the junior subordinated notes would receive.





We do not have any assets or liabilities that are measured at fair value on a recurring basis.  The following table presents our assets and liabilities that are measured at fair value on a nonrecurring basis at March 31, 2011 and December 31, 2010.  Level 1 and Level 2 data were not used in the fair value measure.





Investments in


Real estate


Contingent liabilityreal estate


owned


on guarantee


TotalBalance, December 31, 2010

$
4,310


$
3,318


$
(4,731)


$
2,897Sales


(586)



-



-



(586)Impairments and equity losses


(299)



-



-



(299)Balance, March 31, 2011

$
3,425


$
3,318


$
(4,731)


$
2,012
  Note 12 – Commitments and Contingencies


We previously invested $11.9 million in a subordinated mortgage loan, together with a group private investors.  Our investment represented approximately 37.6% of the total subordinated loan amount.  In May 2007, the borrower defaulted on both the first lien mortgage loan and our subordinated mortgage loan, and in July 2007, we formed a limited liability company, Warm Jones, LLC, to take title to the property through a deed-in-lieu of foreclosure.  Pursuant to the deed-in-lieu of foreclosure, our $11.9 million investment was converted from an interest in a subordinated loan to a 37.6% equity interest in Warm Jones, LLC, the new owner of the property.  To protect its interest in the property, in September 2007, Warm Jones, LLC borrowed approximately $13.7 million to refinance the first lien mortgage loan on the property for 12 months.  We agreed to guarantee the loan to protect our interest in the property.  Warm Jones borrowed an additional $2.6 million pursuant to a second lien mortgage loan, the proceeds of which were used to pay 12 months of interest on the first and second lien loans and the carrying costs associated with the ownership of the property.  The first lien loan matured in October 2008 and was subsequently modified to extend the maturity date to February 2010.  The second lien loan matured in October 2009.  Warm Jones failed to pay the second lien upon maturity and in January 2010 the second lien holders began foreclosure proceedings on the property, which caused us to lose our 37.6% equity interest in the property in November 2010.  The first lien loan also matured and is now fully due and payable.  To potentially limit our liability on the guarantee, we paid $137,000 of interest during the three months ended March 31, 2010 to the first lien lenders to keep the interest payments on the note current through February 2010.    In July 2010, we entered into a forbearance agreement with the first lienholders.  Pursuant to the forbearance agreement, the first lien lenders agreed to forbear from enforcing payment under the guarantee until June 2011 and agreed to waive all accrued and unpaid interest and all interest that accrues during the forbearance period, provided that the loan is repaid in full on or before June 2011.  Upon our execution of the forbearance agreement, we paid outstanding property taxes of $200,000 and are required to continue to pay the property taxes during the forbearance period.  We have paid an additional $102,000 in property taxes since our execution of the forbearance agreement.





On April 6, 2011, we received notice from the first lienholders asserting that an event of default had occurred under the forbearance agreement and deed of trust securing the loan as a result of a trustee’s sale of the collateral conducted pursuant to $2.6 million second position lien. The notice further stated that as a result of such sale, the first lienholder exercised its option to call the entire amount of the loan immediately due.   We have estimated our potential liability under the guarantee to be $4.7 million at March 31, 2011 and December 31, 2010, which is presented as a contingent liability on guarantee in our consolidated balance sheets.   The estimated liability was based on our estimated value of the shortfall between the outstanding balance due under the first lien loan, including accrued interest, and the estimated value of the property collateralizing the loan.  On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the first lienholders. Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.




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Desert Capital REIT and Desert Capital TRS are both currently under audit by the Internal Revenue Service for the years 2006, 2007 and 2009; these audits had not concluded as of March 31, 2011.   The Internal Revenue Service issued a notice of proposed adjustment (NOPA) which stipulates adjustments and assessments with respect to the audits related to certain deductions for compensation and directors fees for which deductions taken by us in those periods are being denied.   In addition, the proposed adjustments and assessments disallow other uncertain tax positions, including management fees paid to our Advisor during 2005, 2006 and 2007 of $5.2 million.  As a result, we recorded a tax liability, including penalties and interest, of $3.4 million at December 31, 2010, which remains unchanged at March 31, 2011.  We have filed our formal response with the IRS defending our position on the disallowed deductions but have not received a response.





Note 13 – Going Concern


The accompanying financial statements have been prepared in conformity with principles of accounting applicable to a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business.  We have experienced substantial losses and the current liquidity issues we face have had a materially adverse impact on our financial condition and cause us to conclude that there is substantial doubt as to our ability to continue as a going concern.





Our performing portfolio currently consists of three loans, and our real estate portfolio is now almost exclusively comprised of non-income producing real estate, the carrying costs of which we must bear.  These costs include servicing and property management fees payable to CM Capital, property taxes, legal fees, maintenance costs and resolutions costs.  In addition, CM Capital has put us on notice that it does not have the ability to make payments on its debt to us, which is a loss of approximately $226,000 per quarter in interest income and approximately $388,000 per quarter in principal payments.  Because of our limited amount of revenue, our recurring cash flow is not sufficient to cover our general operating costs, including real estate carrying costs.  Our future viability is dependent on our ability to execute portfolio resolution strategies that will offer operating liquidity, including our ability to sell assets in the current distressed real estate market. On February 18, 2011 we received notice that the holders of $25.0 million of the trust preferred securities filed a lawsuit against us for collection of their debt.  On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the holders of the trust preferred securities and the first lienholders on the Warm Jones debt.  Under the involuntary petition, a Trustee has not been requested or appointed.  Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.  We are continuing discussions with the holders of the trust preferred securities and the Warm Jones lienholders, as well as other creditors, as we prepare our response to the bankruptcy petition.  It is likely that we will not have adequate liquidity to fund our operations and will not be able to continue as a going concern.





Note 14 - Subsequent Events





On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by holders of the trust preferred securities and the first lienholders on the Warm Jones debt.  The filing did not include any of our other subsidiaries or affiliates.  Under the involuntary petition, a Trustee has not been requested or appointed. Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.





In April and May 2011, the borrower on one of our performing loans did not pay its interest payment, causing an event of default to occur under such mortgage loan, resulting in a loss of interest income to us over these two months of approximately $13,000.





Item 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.





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





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


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●

the involuntary Chapter 11 bankruptcy proceeding that has been filed against us;●

our ability to continue as a going concern;●

our inability to restructure our obligations under our junior subordinated notes;●

economic conditions impacting the real estate market and credit markets;●

our potential liability for federal income taxes;●

continued distress in real estate markets;●

our real estate assets are non-income producing but have significant costs of ownership;●

nature of our real estate assets may result in further impairments;●

reduction in revenue due to CM Capital note default;●

our ability to sell assets;●

our continued inability to obtain liquidity;●

additional impairments on our assets;●

our contingent liability related to two financial guarantees; and●

although we believe our proposed method of operations will be in conformity with the requirements for qualification as a REIT, we cannot assure you that we will qualify as a REIT or, if so qualified, will continue to qualify as a REIT. Our failure to qualify or remain qualified as a REIT could have material adverse effect on our performance and your investment.





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





For a more detailed description of the risks affecting our financial condition and results of operations, see “Risk Factors” in Item 1A of our Form 10-K filed on March 18, 2011.





Overview




We continue to operate in an uncertain economy and a struggling residential and commercial market.  Our first quarter results are a direct reflection of these challenges.  For the quarter ended March 31, 2011, we reported a net loss of $1.9 million, or $.12 per share. The vast majority of our first quarter net loss was due to professional fees, costs associated with holding property and interest expense.





The greater Las Vegas market has seen little to no price appreciation within the commercial real estate and raw land sectors, and these sectors are likely to remain depressed for the foreseeable future.  Given that most of our remaining assets are commercial real estate and raw land, we believe that we will continue to be forced to sell assets at distressed prices in order to raise cash for operating expenses for the foreseeable future.  It was during the third quarter 2010 that our approach to valuing our real estate changed from an expectation of holding the assets for market recovery to an acknowledgement that we will likely be required to sell the assets as opportunities arise or as the need for cash dictates.  We continued this approach through the first quarter 2011.





During the third quarter 2010, our related party and asset manager, CM Capital Services, stopped making interest payments on its note to us and indicated its inability to make principal payments, which were scheduled to resume on December 31, 2010.  This note was originally entered into in November 2007, and was modified in November 2008, to defer principal payments to December 2010 and reduce the interest rate from 9.0% to 6.0% for the duration of the 10-year term.  While the terms of the promissory note have not been further modified, CM Capital has put us on notice that it does not have the ability to make payments on its debt to us and we have therefore fully impaired the note.  We have not recorded interest income on the note since June 30, 2010.  Any future interest payments will be applied to the principal balance of the promissory note, as dictated by generally accepted accounting principles.  In March 2011, CM Capital surrendered its mortgage license and is no longer operating as a loan originator.  Our Board of Directors continues to work with CM Capital for a resolution to the promissory note.





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Our lenders on our junior subordinated notes notified us that they accelerated the repayment of the debt under the junior subordinated notes. On March 3, 2011, we were formally served with notice that the lenders also filed suit against us to collect this debt.  We do not have the ability to refinance or the liquidity to repay this debt.   Moreover, because our portfolio of performing loans is only $6.2 million, our recurring cash flow is not sufficient to cover our general operating costs, including real estate carrying costs.  Our ability to continue as a going concern will be dependent upon our ability to restructure our debt and execute portfolio resolution strategies that will offer operating liquidity. No assurance can be given that we will be successful in achieving any of these steps or restructuring these arrangements on acceptable terms. On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the holders of the trust preferred securities. Under the involuntary petition, a Trustee has not been requested or appointed.  Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.  Therefore, we may not be able to realize our assets and settle our liabilities in the ordinary course of business, adversely impacting amounts actually realized relative to our financial statements. If we liquidate under Chapter 7 of the United States Bankruptcy Code or otherwise, it is expected that our common stockholders would not recover any value and holders of the junior subordinated notes would receive little, if any, value in relation to the outstanding principal amounts of the junior subordinated notes. Our consolidated financial statements included in this Quarterly Report on Form 10-Q do not reflect any adjustments that might specifically result from the outcome of this uncertainty.





In connection with our 37.6% equity investment in Warm Jones, LLC (Warm Jones) we guaranteed a $13.7 million first lien mortgage loan that was borrowed by Warm Jones.   Warm Jones borrowed an additional $2.6 million, the proceeds of which were used to pay 12 months of interest on the first and second lien loans, and carrying costs associated with property.  Both loans have since matured and both loans are in default.   In November 2010, our equity investment in Warm Jones was foreclosed upon, which eliminated our ownership position; however, we continue to have a liability for the guaranty on the first lien debt, which we have valued at $4.7 million at March 31, 2011.  On April 6, 2011, we received notice from the first lienholders of Warm Jones that an event of default occurred under the forbearance agreement and deed of trust securing the loan as a result of a trustee’s sale of the collateral conducted pursuant to the $2.6 million second position lien. The notice further stated that as a result of such sale, the first lienholders exercised their right to call the entire amount of the loan immediately due.





Our financial statements do not include adjustments that would be necessary if we were to determine that we could not continue as a going concern for the next twelve months, including adjustments relating to the recoverability and classification of recorded assets or to amounts and classification of liabilities.





In summary, we continue to suffer from the combination of a depressed real estate market and the lack of liquidity for making new investments.  Without the ability to invest in revenue generating assets, our only source of cash for operating purposes is through the continued sale of our remaining assets. We expect that the current state of the real estate and credit markets will continue to have an adverse effect on our operations for the foreseeable future.





Our Investments





Mortgage Investments, Real Estate Owned and Investments in Real Estate


We were established as a mortgage REIT; however, as our borrowers began defaulting on their obligations to us, our Advisor determined that, in many instances, the best course of action was to foreclose on the underlying collateral and take title to the property. Real estate owned and investments in real estate consist primarily of property acquired through foreclosure on mortgage loans. We did not foreclose on any loans during the first quarter 2011.





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





We account for our investments as real estate owned, investments in real estate, including cost method, equity method joint ventures and other equity method, and fully consolidated investments and mortgage loans.





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The following table provides a detailed listing of our remaining investment assets, and the debt associated with each asset as of March 31, 2011 (dollars in thousands). It excludes assets that were impaired to a zero carrying value as of March 31, 2011.




Description
Location

DCR % Ownership


Carrying Value


Related Debt Balance


Value Net of Secured DebtMortgage on undeveloped land
Kingman, AZ


100
%

$
4,212


$
-


$
4,212Mortgage on undeveloped land
Golden Valley, AZ


100
%


1,257



-



1,2578.5 acres undeveloped land
Sandy, UT


4
%


69



-



69Mortgage investments






$
5,538


$
-


$
5,53816 acres of undeveloped land
Houston, TX


100
%

$
700


$
-


$
70052 custom home lots
Springfield, MO


100
%


1,193



-



1,193946 acres of undeveloped land
Roach, MO


100
%


1,425



-



1,425Real Estate Owned






$
3,318


$
-


$
3,318Partially developed homes
Las Vegas, NV


86
%

$
391


$
369


$
2214 acres of undeveloped land
Indian Springs, NV


100
%


230



-



2305.0 acres of undeveloped land
Las Vegas, NV


100
%


298



250



485.0 acres of undeveloped land
Las Vegas, NV


100
%


282



226



562.5 acres of undeveloped land
Las Vegas, NV


100
%


163



126



3734.7 acres of undeveloped land
Pahrump, NV


64
%


322



321



13.0 acres of undeveloped land
Las Vegas, NV


76
%


806



722



84Fully Consolidated Investments in Real Estate





$
2,492


$
2,014


$
478640 acres of undeveloped land
Bullhead City, AZ


12
%

$
53


$
-


$
53Industrial building on 2.34 acres of land
Las Vegas, NV


10
%


84



-



8420,180 square foot office building
Las Vegas, NV


13
%


22



-



22JV with 9 remaining residential lots
Las Vegas, NV


30
%


720



-



720JV with 1 remaining residential home
Las Vegas, NV


12
%


54



-



54Cost and Equity Method Investments in Real Estate





$
933


$
-


$
933Total Investments in Real Estate and Mortgage Investments


$
12,281


$
2,014


$
10,267DCR office land and building
Henderson, NV


100
%

$
4,696


$
5,867


$
(1,171)
(1)Gentleman's club land and building
Las Vegas, NV


100
%


6,278



6,000



278Total Land and Building






$
10,974


$
11,867


$
(893)$
23,255


$
13,881


$
9,374(1) Under the terms of the general guaranty of the mortgage note payable, if the building were to be sold for an amount less than the outstanding debt balance, we would be liable for the deficiency.








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Below is a summary of activity in our mortgage investments and investments in real estate for the three months ended March 31, 2011:


●
We invested $300,000 in mortgage investments, using cash received from the sale of foreclosed properties, and at March 31, 2011, all but $69,000 of our investment had been repaid to us with interest.  These investments are short-term.  We had three performing loans of which two were with one borrower, secured by property located in Arizona with an aggregate principal balance of $6.1 million and a carrying value of $5.5 million. The borrower was performing on the loans in accordance with the terms of the restructured agreements through March 31, 2011;


●
We are currently engaged in two joint venture agreements with a third-party homebuilder for the construction of single family homes in Las Vegas, Nevada.  The carrying value of these joint ventures was $774,000;


●
We held $159,000 in real estate investments accounted for under the cost method;


●
Our equity method investments had a carrying value of zero;


●
We held $2.5 million in fully consolidated real estate investments and the noncontrolling interests related to these investments had a carrying value of $365,000.  We sold fully consolidated investments for cash proceeds of $621,000 during the first three months in 2011.





Investments in Variable Interest Entities


We determined that Warm Jones was a VIE under applicable accounting standards.  Our equity investment in Warm Jones has been eliminated and we are not the primary beneficiary of the VIE.  While we have, as a result of the guarantee, the requirement to absorb losses that could be significant to the VIE, we do not have the power to direct the matters that most significantly impact the activities of the LLC, including the management and operations of the property owned by the LLC and disposal rights with respect to the property. Such rights and power are held by the first lien holder.





Results of Operations for the three months ended March 31, 2011 compared to the three months ended March 31, 2010





Revenues


Other interest income is the interest income on our related party note from CM Capital.  Other interest income decreased $222,000, or 100%, to zero for the three months ended March 31, 2011 from $222,000 for the three months ended March 31, 2010.  In October 2010, CM Capital notified us that it was unable to make further interest payments on the note.  We placed the note on non-performing status at that time, and also in accordance with our policy reversed all previously accrued but impaired interest and as a result, we have not recorded interest income since July 2010.





Non-interest income decreased by $65,000 or 20.6%, to $251,000 for the three months ended March 31, 2011 from $316,000 for the three months ended March 31, 2010.  Non-interest income consists of rental income and other miscellaneous income, specifically gain on sales of real estate investments.  Rental income decreased by $100,000, a result of a $96,000 decrease in our rental income earned from 3MO, LLC, whose operating facilities were leased to a third party beginning in the fourth quarter of 2009.  Offsetting this decrease was a $35,000 gain on sales of real estate investments recognized during the three months ended March 31, 2011 due to the sales of two real estate investments during the period.  We did not recognize any gains during the three months ended March 31, 2010.





Expenses


Interest expense consists of interest and origination fees on our notes payable, mortgage debt, and junior subordinated notes payable. Interest expense decreased $186,000 or 20.3% to $729,000 for the three months ended March 31, 2011 from $915,000 for the three months ended March 31, 2010.   During the three months ended March 31, 2010, we paid $137,000 in interest on the debt of Warm Jones.  There were no payments made during this same period in 2011.  In addition, there was a $72,000 decrease on the interest expense and origination fees associated with our fixed rate debt.  This decrease was a result of a decrease in our average fixed rate debt by $647,000 from the first quarter in 2010 to the first quarter in 2011 resulting in an approximate $20,000 decrease in interest expense, coupled with a decrease in origination fees from the first quarter 2010 to the first quarter 2011 of $46,000.





Non-interest expense, including provision for loan losses decreased by $1.6 million, or 50.8%, to $1.6 million for the three months ended March 31, 2011 from $3.2 million for the three months ended March 31, 2010. The decrease in non-interest expense was primarily due to a decrease of $1.1 million in impairments on all assets.  A decrease of $248,000 in management and servicing fees was a result of a decrease in management fees payable pursuant to the advisory agreement with CM Group as a result of the decrease in our gross average invested assets during the three months in 2011 compared to the three months in 2010.  Also included in the decrease in overall non-interest expense was a $257,000 decrease in professional fees, a result of a decrease from the first three months in 2010 to the first three months in 2011 in legal expenses incurred related to our junior subordinated notes.   As a result of sales of properties during 2010 and into 2011, property taxes decreased $116,000 from the three months ended March 31, 2010 to the three months ended March 31, 2011.





As of March 31, 2011, we reported noncontrolling interests in real estate ventures with a carrying value of $365,000 related to our consolidation of six entities.  Net loss attributable to noncontrolling interests was $28,000 for the three months ended March 31, 2011, a decrease in loss of $763,000 from $791,000 for the three months ended March 31, 2010, a result of a decrease in impairments on the properties underlying the investments.





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In accordance with the Statement of Policy Regarding Real Estate Investment Trusts adopted by the NASAA membership on May 7, 2007, if total operating expenses exceed 2% of average invested assets or 25% of net income, whichever is greater, disclosure of such fact shall be made to the stockholders.  Total operating expenses are defined as the aggregate expenses of every character paid or incurred by us as determined under GAAP, including advisor fees, but excluding: organization and operating expenses; interest payments; taxes; non-cash expenditures such as depreciation, amortization and bad debt reserves; incentive fees; and acquisition fees and expenses.  For the twelve months ended March 31, 2011, total operating expenses were 3.19% of average invested assets.  The independent members of our board of directors reviewed the expenses and determined that the expenses were reasonable and justified based on the nature of the expenses relative to the value of our average invested assets.





Taxable Loss


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





Our taxable REIT subsidiary is subject to federal, state, and local taxes. Accordingly, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards.  Deferred tax assets are subject to management’s judgment based upon available evidence that future realization is more likely than not.  During 2008, we established a valuation allowance against the net deferred tax assets.  Based upon the projected sources of taxable income, including those known to be available in future periods, management concluded that it was more likely than not that such sources of income at our taxable REIT subsidiary would likely be insufficient to utilize net operating losses and realize a benefit of other deferred tax assets.  Accordingly, a valuation allowance was necessary.  Management continues to reflect a full valuation allowance against deferred tax assets as of March 31, 2011.





We and our TRS are both currently under audit by the Internal Revenue Service for the years 2006, 2007 and 2009; these audits had not concluded as of March 31, 2011.   The Internal Revenue Service has proposed adjustments and assessments with respect to the audits that would disallow certain deductions for compensation and directors fees taken by us in those periods.   In addition, the proposed adjustments and assessments disallow other uncertain tax positions, including management fees paid to our Advisor during 2005, 2006 and 2007 of $5.2 million.  We do not agree with the adjustments, and plan to either appeal the findings or negotiate a settlement with the IRS.  The likelihood of either approach is undetermined at this time.  We recorded a tax liability, including penalties and interest of $3.4 million at December 31, 2010, which remains unchanged at March 31, 2011. We have filed our formal response with the IRS defending our position on the disallowed deductions but have not received a response.





Liquidity and Capital Resources





Our primary sources of liquidity historically consisted of net interest income from mortgage loans, proceeds from repayment of mortgage loans and proceeds from the sale of our common stock. With the significant deterioration in the performance of our loan portfolio, and the substantial increase in real estate owned and real estate investments due to foreclosures, our sources of funds from normal portfolio operations have been virtually eliminated. In addition, due to the general collapse of the real estate market beginning in late 2007, and the impact of declining real estate values on our mortgage investments, we suspended the sale of our common stock in February 2008. Because of our lack of cash flow, we are closely monitoring and managing our cash position. Our primary source of liquidity consists of proceeds from the sale of real estate investments.





Net cash used in operating activities during three months ended March 31, 2011 was $1.1 million, which was primarily due to the deterioration of interest income related to the default by CM Capital on the payment of interest on our note receivable combined with the increase in interest expense related to the leverage we placed on our assets for operating liquidity, servicing and property management fees, carrying costs related to our foreclosed assets, and legal expenses.   At March 31, 2011, our mortgage investments were $5.5 million, investments in real estate had a carrying balance of $3.4 million, and real estate owned had a carrying balance of $3.3 million. Non-performing mortgage loans and real estate assets produce minimal, if any, current earnings and will not provide cash flow until they are sold or an alternative resolution becomes available. Additionally, we will continue to incur carrying, servicing and property management costs on our real estate investments until we have disposed of the assets. This will result in added costs related to property ownership. While the disposition of any of our assets cannot be predicted, our Advisor believes that over time our real estate assets will be resolved and that the proceeds generated from the resolution of these assets will provide capital for operating expenses and a reduction in outstanding debt.  It is unlikely that we will have funds available for reinvestment into performing assets.  As of March 31, 2011, we have reviewed the carrying value of our investments and have recorded a recovery for loan losses of $90,000 due to the passage of time and the accompanying accretion of the restructure discount, a $271,000 loss on equity of unconsolidated investments in real estate and $28,000 in impairments on other real estate investments. With the current uncertainty in the real estate market, especially in the greater Las Vegas area, the amount of further losses on any individual asset or on the portfolio as a whole may vary. These estimates are based upon a thorough evaluation by our Advisor based on prevailing economic conditions, historical experience, unique characteristics of the assets, industry trends and an estimated net realizable value of the assets.




Net cash provided by investing activities for the three months ended March 31, 2011, was $552,000. During the first three months in 2011, we sold assets for cash proceeds of $621,000.   We will continue to evaluate assets for resolution on a case-by-case situation, and anticipate selling additional assets to generate cash for working capital purposes.





For the three months ended March 31, 2011, net cash used in financing activities was $178,000, which was related to repayments on notes payable.





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In 2007, we entered into a guarantee for the payment of a first mortgage loan in the amount of $13.7 million owed by Warm Jones, of which we were 37.6% owner.   In February 2010, Warm Jones failed to pay the note upon maturity.  To potentially limit our liability on the guarantee, we paid $137,000 of interest to the lenders to keep the interest payments on the note current. In July 2010, we entered into a forbearance agreement with the lenders.  Pursuant to the forbearance agreement the lenders agreed to forbear from enforcing payment under the guarantee until June 2011, and agreed to waive all accrued and unpaid interest and all interest that accrues during the forbearance period provided that the loan is repaid in full on or before June 2011.  Upon our execution of the forbearance agreement, we paid outstanding property taxes on the real estate held by Warm Jones in the amount of approximately $200,000 and are required to continue to pay the property taxes during the forbearance period.  We have paid an additional $102,000 in property taxes since our execution of the forbearance agreement.  In November 2010, our 37.6% equity interest in Warm Jones was foreclosed upon and we no longer have an ownership interest in the property; however, we continue to have a liability for the guaranty, which we have valued at $4.7 million as of March 31, 2011, based upon the estimated shortfall between the outstanding balance due under the promissory note, including accrued interest, and the estimated value of the property collateralizing the loan.  We continue negotiations with the lender; however, should we have to fund this shortfall, it would have a material impact on our liquidity and we would have to sell assets to generate cash for the payment.  As of the date of this report, there were no offers to purchase the property.  On April 6, 2011, we received notice from the first lienholders of Warm Jones that an event of default occurred under the forbearance agreement and deed of trust securing the loan as a result of a trustee’s sale of the collateral conducted pursuant to the $2.6 million second position lien. The notice further stated that as a result of such sale, the first lienholders exercised their right to call the entire amount of the loan immediately due.   On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the first lienholders on the Warm Jones debt. Under the involuntary petition, a Trustee has not been requested or appointed.  Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.





In April 2009, we foreclosed on the operating business and real estate securing a defaulted loan with an original principal balance of $14.4 million.  From April 2009 to November 2009, we reflected the business as discontinued operations in our financial statements and were operating the business in order to retain value in the property as an operating business until sold or leased. In November 2009, we entered into a lease agreement with an operator of similar businesses, which provides for monthly rent of $40,000 plus 30% of net profits, if any, and contains an option to purchase the facility for $10.0 million at any time during the four-year term of the agreement.  On November 16, 2009, the effective date of the lease, the operator/lessee assumed operations of the business, including the responsibility to fund all operating costs of the business. To fund operating costs prior to the execution of the lease agreement with the tenant, we leveraged the property with $5.0 million of debt.  This debt matured in September 2010, at which time we extended the maturity date by one year, and increased the principal balance to $6.0 million.  Monthly interest payments are $60,000, and are payable from an interest reserve account established from the proceeds of the debt.  The balance of the interest reserves is $400,000 at March 31, 2011 and will be available to fund payments through September 2011.





On June 16, 2006, we issued trust preferred securities through our unconsolidated subsidiary, Desert Capital Statutory Trust I (the “Trust”), in a private transaction exempt from registration under the Securities Act of 1933, as amended, or the Securities Act. Concurrently, we issued $30.9 million in junior subordinated notes to the Trust and made a $928,000 common equity investment in the Trust. The junior subordinated notes had a 30-year term ending June 2036 and were redeemable at par on or after June 30, 2011. The assets of the Trust consist solely of the $30.9 million of junior subordinated notes concurrently issued by us, with terms that mirror the trust preferred securities. We were previously notified that we are in default of certain covenants with respect to our junior subordinated notes.  Pursuant to our indenture, the trustee or holders of not less than 25% aggregate principal amount of the junior subordinated notes have the right to accelerate our obligation to pay the principal amount and accrued interest on the junior subordinated notes. In July 2009, we were notified that repayment of the debt under the junior subordinated notes had been accelerated and was immediately due and payable.





In March 2010, we entered into a standstill agreement with the holders of the trust preferred securities pursuant to which such holders agreed to not exercise any rights or remedies against us to enforce or collect the debt in exchange for  continued payment of the quarterly interest payments due under the Junior Subordinated Notes in accordance with the terms of the junior subordinated indenture.  We failed to make our October 30, 2010 interest payment and the standstill agreement has been terminated.  We have been in discussions with the holders of the trust preferred securities; however, such discussions stalled in February 2011, and on March 3, 2011, we were formally served with notice that on February 18, 2011, the holders of $25.0 million of the trust preferred securities had filed a lawsuit against us to collect this debt.  On April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the holders of our trust preferred securities. Under the involuntary petition, a Trustee has not been requested or appointed.  Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business.





We have a mortgage note payable to a bank that is collateralized by the Henderson, Nevada office building, which serves as our corporate headquarters. Both Desert Capital REIT and Desert Capital TRS have guaranteed the debt in the event of nonpayment or in the event that the liquidated value of the building is not sufficient to cover the outstanding mortgage debt.  At December 31, 2010, we recorded a $3.3 million impairment on the land and office building, which resulted in a carrying value of $4.8 million.  At March 31, 2011, the carrying value of the building was $1.2 million less than the outstanding debt balance of $5.9 million.  Under terms of the debt agreement, we are required to maintain a stipulated loan-to-value ratio.  In the event that the debt balance exceeds the stipulated loan-to-value ratio, the bank could require us to make a principal prepayment on the debt in the amount that the debt exceeds the required collateral coverage.  In addition, under terms of the general guarantee of the mortgage note the bank has the ability to declare the entire principal balance of the note immediately due and payable. We are in discussions with the bank due to our default of certain financial covenants but have not received a formal notice of default.  The bank may hold us liable for the deficiency between the value of the collateral and the note balance if the building were to be liquidated for less than the principal balance outstanding on the debt.


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In June 2010, we entered into a forbearance agreement with CM Capital whereby we agreed to give CM Capital ninety days to address the covenant default on our $15.5 million note receivable.  Subsequent to June 30, 2010, the independent members of our Board of Directors agreed to extend the forbearance agreement for an additional 90 days, and to further evaluate the financial strength of CM Capital.  CM Capital notified us in October 2010 that it would be discontinuing interest payments on the note until it returns to profitability. Further, in December 2010, pursuant to the terms of the note, CM Capital was obligated to resume principal payments on the note. CM Capital has failed to make principal and interest payments on the note and the note continues to be in default.  The note is secured by a pledge of all of the ownership interests in CM Capital.  The independent members of our Board of Directors issued a notice of default to CM Capital, and are continuing discussions with management of CM Capital on a resolution to the note receivable.  The non-payment of principal and interest has had a material adverse effect on our financial condition.  Based on our concerns about the financial condition of CM Capital and its non-payment of principal and interest, we had substantial doubt as to the collectability of the note receivable and recorded an allowance for loan losses for the outstanding principal balance of $14.7 million at December 31, 2010.  The impairment does not reflect a change in the payment terms of the note or a reduction in the amount we are owed under the note.  In March 2011, CM Capital surrendered its mortgage license to the state of Nevada and has indicated it is winding down its operation.





Upon the death of a stockholder, the stockholder’s estate has a limited right of redemption with respect to its common stock, and at March 31, 2011, we had received redemption requests of 276,000 shares of common stock totaling $2.2 million, which is reflected as a liability on our balance sheet.





Desert Capital REIT and Desert Capital TRS are both currently under audit by the Internal Revenue Service for the years 2006, 2007 and 2009; these audits had not concluded as of March 31, 2011.   In February 2011, the Internal Revenue Service provided us with an economist's report which concluded that several of the deductions we had taken for tax purposes on our TRS tax return for the years 2006 and 2007 should be disallowed.  As a result, we recorded a liability for federal income tax, including penalties and interest, of $3.4 million at December 31, 2010 and our balance remains unchanged at March 31, 2011.   In March, 2011, we received formal notice of proposed adjustment (NOPA) from the IRS,which stipulates adjustments and assessments with respect to the audits related to certain deductions for compensation and directors fees for which deductions taken by us in those periods are being denied.   In addition, the proposed adjustments and assessments disallow other uncertain tax positions, including management fees paid to our Advisor during 2005, 2006 and 2007 of $5.2 million.  We do not agree with the economist’s conclusion or the NOPA, and plan to either appeal the findings or negotiate a settlement with the IRS.  The likelihood of success of either approach is undetermined at this time. The audit for the 2009 tax year began in January 2011; therefore, at this time, we do not have an indication of the outcome.





In order to continue to qualify as a REIT, we are required to distribute on an annual basis to our stockholders at least 90% of our REIT taxable income (excluding the dividends paid deduction and any net capital gain), 90% of our net income from foreclosure property less the tax imposed on such income, and any excess noncash income.  During 2010 we foreclosed upon certain properties and during 2010 and 2011 sold certain properties that secured loans we made to third parties.  Although these activities generated cash proceeds, they generally did not result in income for federal income tax purposes, and many produced losses.  Accordingly, the recent foreclosures and sales did not increase (and in many cases may have actually decreased) the amounts that we were required to distribute.  In October 2008, the Board of Directors suspended the dividend until the cash position of the Company improved, or until distributions were necessary to maintain our REIT status.  Due to our taxable loss, we were not required to make distributions to our stockholders during the three months ended March 31, 2011.





As indicated throughout this report, our ongoing operating costs and other obligations are significantly greater than our cash flow.  Our estimate of cash needs for the next twelve months is between $4.0 million and $5.0 million and includes the following:





●
principal and interest payments on our notes and mortgages payable;


●
property ownership expenses, including property taxes, servicing fees and asset management fees;


●
advisory fees;


●
legal and professional expenses;


●
board fees;


●
corporate insurance premium; and


●
other general operating expenses.





Not included in this estimate are any payments related to potential liability under the Warm Jones guaranty, any federal income tax assessment on the outcome of the IRS audit, other debt due within 12 months, and any deficiency payments related to the mortgage on our office building.





Due to our limited sources of operating revenue, recurring cash flow will not be sufficient to satisfy our operating costs and obligations. To fund our cash shortfall, we expect to sell assets.  Our options for incurring additional debt are limited by the carrying value of the underlying asset, and we do not believe this is a likely source of future cash flow.  Given current market conditions, we may not be able to liquidate assets at a price we believe to be reasonable, or at all, or be able to incur additional debt or repay our existing debt.  In addition, on April 29, 2011, a petition for involuntary Chapter 11 bankruptcy was filed against us by certain of our creditors, including the holders of our trust preferred securities and the first lienholders on the Warm Jones debt. Under the involuntary petition, a Trustee has not been requested or appointed.  Once we are served with a summons and citation for the involuntary petition, we will have twenty days to file an answer to the petition, during which time we will continue to operate our business. We and our board of directors are evaluating our options as we prepare to respond to the petition.





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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. There have been no changes in our critical accounting policies as filed in Form 10-K on March 18, 2011.








ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not required for smaller reporting companies.





ITEM 4. CONTROLS AND PROCEDURES





(a) Evaluation of Disclosure Controls and Procedures


Disclosure controls and procedures are designed to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information we are required to disclose in the reports we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.





Under the supervision and with participation of our Chief Executive Officer and Chief Financial Officer, management has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) and 15(d)-15(e)) as of the end of the period covered by this report (the “Evaluation Date”) and concluded that as of the Evaluation Date our disclosure controls and procedures were effective.





(b) Changes in Internal Controls





There were no significant changes in our control over financial reporting that occurred during the first quarter of 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.




Part II. Other Information





Item 1.  Legal Proceedings





Thomas vs. CM Securities, Todd Parriott, CM Capital, Desert Capital


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





Case No. A540232, Second James, Inc. et al. v. Todd Parriott, et al., in the District Court of Clark County, Nevada, Department XI


We are named in a lawsuit brought by a current shareholder and its affiliates arising from a transaction whereby Desert Capital TRS, Inc. acquired all of the units in CM Capital in exchange for cash and shares of our stock.  Named as defendants in the lawsuit, in addition to us, are the following: Todd Parriott, our Chief Executive Officer, Phillip Parriott, CM Securities, LLC, Burton, Desert Capital TRS, Inc., ARJ Management Inc., CM Land LLC, and CM Capital.  Plaintiffs allege, among other things, the existence of an oral agreement pursuant to which they are allegedly entitled to receive a portion of the management fee paid by us to Burton. Plaintiffs also allege, among other things, that CM Capital made certain overpayments to management before the formation of Desert Capital REIT and undisclosed payments in connection with the formation of Desert Capital REIT and various other entities.  Plaintiffs seek, among other things, damages, prejudgment interest, attorneys' fees, and punitive damages.  We believe that the claims asserted in the lawsuit are without merit.  We deny the existence of any oral agreement and believe that we have fully performed all of the obligations which were memorialized in the Unit Purchase Agreement concerning CM Capital.  We also deny all other allegations of wrongdoing.  We intend to vigorously defend the lawsuit.





SEC Subpoena in the Matter of CM Capital Services, LLC (LA-3825)


We received a subpoena from the United States Securities and Exchange Commission requesting various documents and information.  The subpoena was issued in an investigation entitled In the Matter of CM Capital Services, LLC(LA-3825).  CM Capital  is a subsidiary of our Advisor, CM Group, LLC.  CM Capital originated loans in which we invested funds.  We intend to cooperate with the SEC with respect to the subpoena.





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Civil Action No. 11-CV-1159, Taberna Preferred Funding VI, Ltd. v. Desert Capital REIT, Inc., in the United States District Court for the Southern District of New York


We are named in a lawsuit brought by Taberna Preferred Funding VI. Ltd. ("Taberna") in the United States District Court for the Southern District of New York.  Taberna is the holder of certain trust preferred securities issued by our subsidiary, Desert Capital TRS Statutory Trust I.  Taberna holds a substantial amount of these securities.   Desert Capital TRS Statutory Trust I issued approximately $30 million of trust preferred securities and approximately $928,000 in common securities.  It used the proceeds of these securities to purchase $30.9 million of our junior subordinated notes issued pursuant to a Junior Subordinated Indenture.  The terms of the junior subordinated notes match the terms of the trust preferred securities.  Taberna alleges that a default has occurred under the Junior Subordinated Indenture and alleges that the Junior Subordinated Indenture permits Taberna to file a suit directly against the Company in the event of a default.  Taberna's lawsuit alleges a cause of action for breach of contract and seeks an award of damages of at least $25 million plus all accrued interest and its costs and disbursements incurred in the action including reasonable attorneys' fees.





Cause No. 2009 16312, Phase One Technologies, L.L.C. and Alpine Environmental Technologies Corporation v. Consolidated Mortgage, L.L.C., d/b/a CM Capital Services, L.L.C., CM Capital Services, L.L.C., Desert Capital REIT, Inc., Hayden Almeda, L.L.C., Todd B. Parriott, Paul Huygens et al.; In the District Court of the 133rd Judicial District of Harris County, Texas


Plaintiffs Phase One Technologies and Alpine Environmental Technologies Corporation allege that Defendants Consolidated Mortgage, L.L.C., d/b/a CM Capital Services, L.L.C., CM Capital Services, L.L.C., Desert Capital REIT, Inc., Todd B. Parriott, and Paul Huygens (collectively the “CM Defendants”) failed to pay for environmental remediation work performed by Plaintiffs.  Plaintiffs have stated causes of action for breach of contract/quantum meruit, foreclosure of Plaintiffs’ constitutional/statutory lien, sham contract, fraudulent conveyance, conspiracy, alter ego and piercing the corporate veil, fraud, negligent misrepresentation, promissory estoppel, equitable subrogation, and Texas Prompt Payment Act violations.  Plaintiffs are seeking an undefined amount of damages, exemplary damages, sale of the property on which the environmental remediation work was performed, attorneys’ fees and expenses, pre- and post-judgment interest, and costs.  The CM Defendants also face cross claims from co-defendant SRG Real Estate, LLC.  SRG Real Estate alleges that the CM Defendants failed to pay in accordance with alleged promises made to SRG Real Estate.  SRG Real Estate has stated causes of action for breach of oral contract, promissory estoppel, and seeks to hold all the CM Defendants responsible under various theories of vicarious liability.  SRG Real Estate seeks an undisclosed amount of damages, pre- and post-judgment interest, costs, attorneys’ fees, and additional recovery for indemnity and/or contribution.  CM Capital has alleged causes of action fraudulent conveyance, and wrongful foreclosure, and seeks to pierce the SRG Real Estate’s corporate veil to enforce a deficiency from a related arbitration award.  CM Capital seeks an undisclosed amount of damages, exemplary damages, costs, pre- and post- judgment interest, a declaration that the fraudulent transfers are void, the cancellation of improper deeds of trust, attorneys’ fees and expenses





Item 1A.Risk Factors


The Company has updated its risk factors as previously disclosed in its Form 10-K for the year ended December 31, 2010. The following risk factor should be read together with the risk factors included in Part I, Item 1A of our Form 10-K for the year ended December 31, 2010.  References in the risk factors to “we,” “our” and “us” or "Company" are to Desert Capital REIT, Inc. and its subsidiaries unless the context specifically otherwise requires.
 
 Certain of our creditors have filed an involuntary Chapter 11 bankruptcy petition against us, which raises substantial doubt about our ability to continue as a going concern.
 
 Our consolidated financial statements are presented in this report on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  Over the past three years we have experienced substantial losses including a net loss of $53.4 million, or $3.17 per share for 2010.  These financial results have had a materially adverse impact on our financial condition.   As previously disclosed, as a result of our limited sources of operating cash flow, and limited cash and other liquid assets, we do not have the ability to satisfy all of our obligations.  On April 29, 2011, certain of our creditors filed an involuntary Chapter 11 bankruptcy petition against us, which raises substantial doubt about our ability to continue as a going concern.
 
 As with any judicial proceeding, there are risks of unavoidable delay with a Chapter 11 proceeding and there are risks of objections from certain stakeholders, including objections from the holders of unsecured claims. Any material delay in the confirmation of a plan, or the threat of rejection of the plan by the Bankruptcy Court, would not only add substantial expense and uncertainty to the process, but also would adversely affect the value of our assets.
 
 Furthermore, so long as the Chapter 11 proceedings continue, we will be required to incur substantial costs for professional fees and other expenses associated with the administration of the Chapter 11 proceedings. A prolonged continuation of the Chapter 11 proceedings would cause our assets to become further devalued or worthless.  If the Company does not have sufficient liquidity to satisfy its needs during the bankruptcy proceeding, a liquidation of the Company pursuant to Chapter 7 of the Bankruptcy Code will occur.


Item2. Unregistered Sales of Equity Securities and Use of Proceeds


None





Item 3. DefaultsUpon Senior Securities


None





Item 4. Reserved


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Item 5. Other Information
 None





Item 6. Exhibits





3.1

Third Amended and Restated Articles of Incorporation (included as exhibit 3.1 to the Registrant’s Form 10-K filed on March 31, 2008 and incorporated herein by reference).3.2

Bylaws of the Company (included as Exhibit 3.2 to the Registrant’s Registration Statement on Form S-11 (File No. 333-111643) (the “Registration Statement”) and incorporated herein by reference).31.1

Certification of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*31.2

Certification of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*32.1

Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**





*Filed herewith

**Furnished herewith








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SIGNATURES








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








May 10, 2011
DESERT CAPITAL REIT, INC.

By: /s/Todd B. Parriott

Todd B. Parriott, Chief Executive Officer, President and Chief Investment Officer and Chairman of the Board (Principal Executive Officer)May 10, 2011
DESERT CAPITAL REIT, INC.

By: /s/Stacy M. Riffe

Stacy M. Riffe, Chief Financial Officer, (Principal Accounting Officer)





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