**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

| **ý** | ** ** | **QUARTERLY****REPORT UNDER SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                          |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                                                                                                         |
|       |       | **For the quarterly period ended  June 30, 2005**                                                                                                                                                                                                                                                                                                                       |
|       |       |                                                                                                                                                                                                                                                                                                                                                                         |
| **o**      | ** ** | **TRANSITION REPORT UNDER SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                            |
|       |       |                                                                                                                                                                                                                                                                                                                                                                         |
|       |       | **For the transition period from                              to                            ** |

 

**Commission file number: 01-32386**

 

**SPIRIT FINANCE CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Maryland**                                                       | ** ** | **20-0175773**                        |
|--------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)    |       | (I.R.S. Employer  Identification No.) |
| ** **                                                         | ** ** | ** **                            |
| **14631 N. Scottsdale Road,  Suite 200  Scottsdale, Arizona** | ** ** | **85254**                             |
| (Address of principal executive  offices)                          |       | (Zip Code)                            |

 

Registrant’s telephone number, including areacode: **(480) 606-0820**

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.      Yes  ý    No  o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes  o    No  ý

 

As of July 31, 2005, 67,675,171****shares of the registrant’s Common Stock,par value $0.01 per share, were outstanding.

 

 

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**PART I – FINANCIAL INFORMATION**

 

### **Item 1. Financial Statements**

 

**Spirit Finance CorporationCONSOLIDATED BALANCE SHEETS**

(dollars in thousands, except per share data)

 
| ** **                                                                                                                                                                      | ** **   | **June 30, 2005** | ** **   | **December 31,  2004** | ** **   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|------------------------|--------------|-----------------------------|--------------|
| ** **                                                                                                                                                                      | ** **   | **(Unaudited)**        | ** **   | ** **                  | ** **   |
| **Assets**                                                                                                                                                                      |         |                   |         |                        |         |
| Investments, at cost:                                                                                                                                                           |         |                   |         |                        |         |
| Real estate investments:                                                                                                                                                        |         |                   |         |                        |         |
| Land and improvements                                                                                                                                                           |         | $                      | 350,944      |                        | $            | 257,233 |   |
| Buildings and improvements                                                                                                                                                      |         | 575,606                |         | 358,811                     |         |
| Total real estate investments                                                                                                                                                   |         | 926,550                |         | 616,044                     |         |
| Less: Accumulated depreciation                                                                                                                                                  |         | (10,999                | )            | (4,303                      | )            |
|                                                                                                                                                                            |         | 915,551                |         | 611,741                     |         |
| Mortgage and equipment loans receivable                                                                                                                                         |         | 43,631                 |         | 40,855                      |         |
| Net investments                                                                                                                                                                 |         | 959,182                |         | 652,596                     |         |
| Cash and cash equivalents                                                                                                                                                       |         | 38,181                 |         | 113,225                     |         |
| Intangible assets, net                                                                                                                                                          |         | 16,238                 |         | 10,742                      |         |
| Deferred costs and other assets, net                                                                                                                                            |         | 9,793                  |         | 5,664                       |         |
| Total assets                                                                                                                                                                    |         | $                      | 1,023,394    |                        | $            | 782,227 |   |
| ** **                                                                                                                                                                      | ** **   | ** **             | ** **   | ** **                  | ** **   |
| **Liabilities  and stockholders’ equity**                                                                                                                                  | *** *** | *** ***           | *** *** | *** ***                | *** *** |
| Liabilities:                                                                                                                                                                    |         |                   |         |                        |         |
| Mortgages and notes payable                                                                                                                                                     |         | $                      | 155,000      |                        | $            | 178,854 |   |
| Secured credit facilities                                                                                                                                                       |         | 228,276                |         | —                      |         |
| Dividends payable                                                                                                                                                               |         | 12,852                 |         | 7,110                       |         |
| Fair value of derivative instruments                                                                                                                                            |         | 22,744                 |         | 3,582                       |         |
| Accounts payable, accrued expenses and  other liabilities                                                                                                                       |         | 8,048                  |         | 4,978                       |         |
| Total liabilities                                                                                                                                                               |         | 426,920                |         | 194,524                     |         |
| Commitments and contingencies (Note 13)                                                                                                                                         |         |                   |         |                        |         |
| Stockholders’ equity:                                                                                                                                                      |         |                   |         |                        |         |
| Preferred stock, $0.01 par value per share,  125,000,000 shares authorized, no shares issued and outstanding                                                                    |         | —                 |         | —                      |         |
| Common stock, $0.01 par value per share,  375,000,000 shares authorized, 67,643,171 (June 30, 2005) and 63,506,819  (December 31, 2004) shares issued and outstanding |         | 676                    |         | 635                         |         |
| Capital in excess of par value                                                                                                                                                  |         | 639,818                |         | 599,300                     |         |
| Accumulated distributions in excess of net  income                                                                                                                              |         | (20,054                | )            | (8,650                      | )            |
| Accumulated other comprehensive loss                                                                                                                                            |         | (23,966                | )            | (3,582                      | )            |
| Total stockholders’ equity                                                                                                                                                 |         | 596,474                |         | 587,703                     |         |
| Total liabilities and stockholders’ equity                                                                                                                                 |         | $                      | 1,023,394    |                        | $            | 782,227 |   |

 

*See accompanying notes.*

 

2

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**Spirit Finance Corporation**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

(dollars in thousands, except per share data)

 
| ** **                                    | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                     |       |                                |       |                              |       |   |   |   |   |
| Rentals                                       |       | $                                   | 16,514     |                              | $          | 1,747 |   | $ | 30,064 |   | $ | 2,725 |   |
| Interest income on mortgage loans  receivable |       | 958                                 |       | 936                               |       | 1,888 |   | 1,872 |   |
| Other interest income                         |       | 274                                 |       | 629                               |       | 629 |   | 1,268 |   |
| Total revenues                                |       | 17,746                              |       | 3,312                             |       | 32,581 |   | 5,865 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Expenses:                                     |       |                                |       |                              |       |   |   |   |   |
| General and administrative                    |       | 3,243                               |       | 1,584                             |       | 5,832 |   | 3,051 |   |
| Depreciation and amortization                 |       | 4,131                               |       | 379                               |       | 7,353 |   | 653 |   |
| Interest                                      |       | 3,342                               |       | 85                                |       | 5,994 |   | 85 |   |
| Total expenses                                |       | 10,716                              |       | 2,048                             |       | 19,179 |   | 3,789 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Income from continuing operations             |       | 7,030                               |       | 1,264                             |       | 13,402 |   | 2,076 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Discontinued operations:                      |       |                                |       |                              |       |   |   |   |   |
| Income from discontinued operations           |       | 164                                 |       | 18                                |       | 668 |   | 18 |   |
| Net gain on sales of real estate              |       | 284                                 |       | —                            |       | 227 |   | — |   |
| Total discontinued operations                 |       | 448                                 |       | 18                                |       | 895 |   | 18 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Net income                                    |       | $                                   | 7,478      |                              | $          | 1,282 |   | $ | 14,297 |   | $ | 2,094 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Income per common share:                      |       |                                |       |                              |       |   |   |   |   |
| Basic:                                        |       |                                |       |                              |       |   |   |   |   |
| Continuing operations                         |       | $                                   | 0.10       |                              | $          | 0.03 |   | $ | 0.20 |   | $ | 0.06 |   |
| Discontinued operations                       |       | 0.01                                |       | —                            |       | 0.01 |   | — |   |
| Net income                                    |       | $                                   | 0.11       |                              | $          | 0.03 |   | $ | 0.21 |   | $ | 0.06 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Diluted:                                      |       |                                |       |                              |       |   |   |   |   |
| Continuing operations                         |       | $                                   | 0.10       |                              | $          | 0.03 |   | $ | 0.20 |   | $ | 0.06 |   |
| Discontinued operations                       |       | 0.01                                |       | —                            |       | 0.01 |   | — |   |
| Net income                                    |       | $                                   | 0.11       |                              | $          | 0.03 |   | $ | 0.21 |   | $ | 0.06 |   |
|                                          |       |                                |       |                              |       |   |   |   |   |
| Weighted  average outstanding common shares:  |       |                                |       |                              |       |   |   |   |   |
| Basic                                         |       | 67,305,458                          |       | 37,252,612                        |       | 67,168,949 |   | 36,362,502 |   |
| Diluted                                       |       | 67,461,430                          |       | 37,405,159                        |       | 67,371,783 |   | 36,504,111 |   |

 

*See accompanying notes.*

 

3

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**Spirit Finance Corporation**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

(dollars in thousands)

 
| ** **                                                | ** ** | **Six Months Ended June 30** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| **Cash flows from operating activities**                  |       |                              |       |   |   |
| Net income                                                |       | $                                 | 14,297     |   | $ | 2,094 |   |
| Adjustments to net income:                                |       |                              |       |   |   |
| Depreciation and amortization                             |       | 7,594                             |       | 653 |   |
| Stock-based compensation                                  |       | 440                               |       | 455 |   |
| Amortization of deferred financing costs                  |       | 1,247                             |       | — |   |
| Net gain on sales of real estate                          |       | (227                              | )          | — |   |
| Other noncash items                                       |       | 105                               |       | 39 |   |
| Changes in operating assets and  liabilities:             |       |                              |       |   |   |
| Deferred costs and other assets                           |       | (1,968                            | )          | (748 | ) |
| Accounts payable, accrued expenses and  other liabilities |       | 2,637                             |       | 936 |   |
| Net cash provided by operating activities                 |       | 24,125                            |       | 3,429 |   |
|                                                      |       |                              |       |   |   |
| **Cash flows from investing activities**                  |       |                              |       |   |   |
| Acquisitions of real estate investments                   |       | (310,268                          | )          | (133,441 | ) |
| Proceeds from sales of real estate  investments           |       | 40,532                            |       | — |   |
| Collections of principal on mortgage loans  receivable    |       | 193                               |       | 137 |   |
| Net cash used by investing activities                     |       | (269,543                          | )          | (133,304 | ) |
|                                                      |       |                              |       |   |   |
| **Cash flows from financing activities**                  |       |                              |       |   |   |
| Borrowings under secured credit facilities                |       | 329,776                           |       | — |   |
| Repayments under secured credit facilities                |       | (101,500                          | )          | — |   |
| Borrowings under mortgage notes payable                   |       | 67,000                            |       | — |   |
| Repayments of mortgages and notes payable                 |       | (140,441                          | )          | — |   |
| Deferred financing costs paid                             |       | (3,666                            | )          | (404 | ) |
| Payments made on interest rate swaps                      |       | (810                              | )          | — |   |
| Proceeds from initial public offering, net                |       | 40,067                            |       | — |   |
| Proceeds from private offering, net                       |       | —                            |       | 55,700 |   |
| Proceeds from exercise of stock options                   |       | 50                                |       | — |   |
| Dividends paid on common stock                            |       | (19,959                           | )          | — |   |
| Transfers to restricted cash and escrow  deposits         |       | (143                              | )          | (862 | ) |
| Net cash provided by financing activities                 |       | 170,374                           |       | 54,434 |   |
|                                                      |       |                              |       |   |   |
| Net decrease in cash and cash equivalents                 |       | (75,044                           | )          | (75,441 | ) |
|                                                      |       |                              |       |   |   |
| Cash and cash equivalents, beginning of  period           |       | 113,225                           |       | 199,089 |   |
| Cash and cash equivalents, end of period                  |       | $                                 | 38,181     |   | $ | 123,648 |   |

 

*See accompanying notes.*

 

4

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**Spirit Finance Corporation**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

SixMonths Ended June 30, 2005

(Unaudited)

(dollars in thousands, except per share data)

 
| ** **                                                         | ** ** | **Common  Shares** | ** ** | **Common  Stock  Par Value** | ** ** | **Capital in  Excess of Par  Value** | ** ** | **Accumulated  Distributions in  Excess of Net  Income** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|--------------------------------------------------------------------|------------|--------------------|------------|------------------------------|------------|--------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------|------------|
|                                                               |       |               |       |                         |       |                                 |       |                                                     |       |                                        |       |                                  |       |
| Balances at December 31, 2004                                 |       | 63,506,819         |       | $                            | 635        |                                 | $          | 599,300                                                  |       | $                                           | (8,650     | )                                     | $          | (3,582 | ) | $ | 587,703 |   |
| Net income                                                         |       |               |       |                         |       |                                 |       | 14,297                                                   |       |                                        |       | 14,297                                |       |
| Net unrealized loss on cash flow hedges                            |       |               |       |                         |       |                                 |       |                                                     |       | (20,384                                     | )          | (20,384                               | )          |
| Underwriters’ over-allotment on initial  public offering, net |       | 3,913,043          |       | 39                           |       | 40,028                               |       |                                                     |       |                                        |       | 40,067                                |       |
| Dividends declared on common stock ($0.38  per share)              |       |               |       |                         |       |                                 |       | (25,701                                                  | )          |                                        |       | (25,701                               | )          |
| Exercise of stock options                                          |       | 5,000              |       |                         |       | 50                                   |       |                                                     |       |                                        |       | 50                                    |       |
| Restricted stock grants, net                                       |       | 218,309            |       | 2                            |       |                                 |       |                                                     |       |                                        |       | 2                                     |       |
| Stock-based compensation                                           |       |               |       |                         |       | 440                                  |       |                                                     |       |                                        |       | 440                                   |       |
| Balances at June 30, 2005                                     |       | 67,643,171         |       | $                            | 676        |                                 | $          | 639,818                                                  |       | $                                           | (20,054    | )                                     | $          | (23,966 | ) | $ | 596,474 |   |

 

*See accompanying notes.*

 

5

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**Spirit Finance Corporation**

**Notes to Consolidated Financial Statements**

**(Unaudited)**

 

**1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Business**

 

Spirit Finance Corporation (“Spirit Finance” or the “Company”) is aMaryland corporation formed on August 14, 2003 as a self-managed andself-advised real estate investment trust (“REIT”) under the Internal RevenueCode.   The common stock of SpiritFinance is listed on the New York Stock Exchange under the symbol “SFC.”

 

**Basis of Accounting and Principles ofConsolidation**

 

The accompanying unaudited consolidated financial statements areprepared on the accrual basis of accounting in accordance with U.S. generallyaccepted accounting principles for interim financial information.  Accordingly, they do not include all of theinformation and footnotes required for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been recorded. Operating results for the three months and six months ended June 30,2005 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2005.  Theaccompanying financial statements and notes should be read in conjunction withthe audited financial statements included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

The consolidated financial statements ofSpirit Finance include the accounts of the Company and its wholly ownedsubsidiaries, Spirit Management Company, Spirit Finance Acquisitions, LLC andnumerous wholly owned special purpose entities. The assets of the specialpurpose entities are not available to pay, or otherwise satisfy obligations to,the creditors of any owner or affiliate of the special purpose entities.  Assets totaling $621,334,000 at June 30,2005 and $331,447,000 at December 31, 2004 and liabilities totaling$264,240,000 at June 30, 2005 and $178,064,000 at December 31, 2004were held by special purpose entities and are included in the accompanyingConsolidated Balance Sheets. All intercompany account balances and transactionshave been eliminated in consolidation.

 

For a complete listing of the Company’s significant accountingpolicies, please refer to Note 2 in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

**Reclassifications**

 

Certain reclassifications have been made to prior period balances toconform to the current period presentation.

 

6

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**Use of Estimates**

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities atthe date of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Although management believes itsestimates are reasonable, actual results could differ from those estimates.

 

**New Accounting Standard**

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards (“SFAS”) No. 123 (revised2004), “Share-Based Payment” (“SFAS No. 123R”).  This standard requires companies to recognizecompensation expense using a fair–value based method for all equity-classifiedawards granted, modified or settled for periods beginning after June 15,2005.  On April 14, 2005, theSecurities and Exchange Commission delayed the effective date of SFAS No. 123Rto January 1, 2006 for calendar-year public companies.  Adoption of SFAS No. 123R in the firstquarter of 2006 is not expected to have a material effect on the Company’sfinancial position or results of operations.

 

**2.INVESTMENTS**

 

As of June 30, 2005, Spirit Finance owned 419 real estateproperties with a gross acquisition cost of $943,509,000, financed 67properties through mortgage loans receivable with a carrying amount of$40,210,000 and held four equipment loans with an outstanding balance of$3,421,000 secured by equipment used in the operation of 35 real estateproperties owned by the Company.  A majority of the Company’s real estateinvestments are pledged as collateral under debt obligations (see Note 4).  During the first six months of 2005,the Company had the following property activity (dollars in thousands):

 
| ** **                                  | ** ** | **Number of  Properties  Owned or  Financed** | ** ** | **Dollar Amount of  Total Real Estate  Investments (a)** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------|------------|
| Balance, December 31, 2004             |       | 374                                           |       | $                                                        | 667,927    |   |
| Acquisitions                                |       | 135                                           |       | 360,121                                                  |       |
| Sales (see Note 8)                          |       | (23                                           | )          | (40,684                                                  | )          |
| Principal payments and premium amortization |       | —                                        |       | (224                                                     | )          |
| Balance, June 30, 2005                 |       | 486                                           |       | $                                                        | 987,140    |   |

 

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(a)          The dollar amount of realestate investments includes the gross cost of land, buildings and leaseintangibles related to properties owned and the carrying amount of the mortgageand equipment loans receivable.

 

7

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As of June 30, 2005, the Company’s total real estate investments(including related lease intangibles) consisted of the following propertytypes:

 
| **Property Type**             | ** ** | **Number of  Properties  Owned or  Financed** | ** ** | **Percentage of  Dollar Amount of  Total Real Estate  Investments** | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Restaurants                   |       | 316                                           |       | 33                                                                  | %          |
| Specialty retailer properties |       | 26                                            |       | 13                                                                  | %          |
| Movie theaters                |       | 11                                            |       | 12                                                                  | %          |
| Educational facilities        |       | 10                                            |       | 10                                                                  | %          |
| Automotive                    |       | 39                                            |       | 8                                                                   | %          |
| Distribution facilities       |       | 50                                            |       | 5                                                                   | %          |
| Recreational facilities       |       | 1                                             |       | 5                                                                   | %          |
| Supermarkets                  |       | 12                                            |       | 5                                                                   | %          |
| Interstate travel plazas      |       | 4                                             |       | 4                                                                   | %          |
| Industrial properties         |       | 7                                             |       | 3                                                                   | %          |
| Drugstores                    |       | 10                                            |       | 2                                                                   | %          |
| Total                         |       | 486                                           |       | 100                                                                 | %          |

 

The Company’s real estate investments are geographically dispersedthroughout 38 states.  Only two states,Texas (14.6%) and Arizona (11.6%), accounted for 10% or more of the total grossinvestment of Spirit Finance’s real estate portfolio at June 30, 2005.

 

The Company’s real estate properties are leased to customers underlong-term operating leases that typically include one or more renewaloptions.  The weighted average remainingnoncancelable lease term at June 30, 2005 is approximately 14.25 years.The leases are generally triple-net, which provide that the lessee isresponsible for the payment of all property operating expenses, includinginsurance, real estate taxes and maintenance; therefore, Spirit Finance isgenerally not responsible for repairs or other capital expenditures related tothe properties.

 

**3. INTANGIBLE ASSETS**

 

Intangible assets represent the value of in-place leases associatedwith properties acquired subject to existing leases.  The acquisitions made during the first sixmonths of 2005 included $6,783,000 allocated to the value of related leaseintangibles.  Total intangible assets areshown in the accompanying Consolidated Balance Sheets net of accumulatedamortization of $720,000 at June 30, 2005 and $286,000 at December 31,2004.

 

8

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**4. DEBT**

 

The Company’s debt outstanding as of June 30,2005 and December 31, 2004 is summarized below (dollars in thousands):

 
| ** **                                                                                         | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| MORTGAGES AND NOTES PAYABLE:                                                                       |       |                    |       |                        |       |
| Secured variable-rate promissory notes,  interest only, 1-month LIBOR + 3.0%, paid March 2005 |       | $                       | —     |                        | $          | 140,135 |   |
| Secured fixed-rate mortgage notes payable:                                                         |       |                    |       |                        |       |
| Promissory note, 5.3%, balloon due 2015                                                            |       | 39,200                  |       | —                      |       |
| Promissory notes, 5.4%, balloons due 2014                                                          |       | 35,433                  |       | —                      |       |
| Promissory note, 5.25%, balloon due 2015                                                           |       | 27,800                  |       | —                      |       |
| Promissory note, 6.5%, balloon due 2012                                                            |       | 14,363                  |       | —                      |       |
| Promissory note, 8.4%, effective interest  rate 6.62%, balloon due 2010                            |       | 16,700                  |       | 16,783                      |       |
| Promissory note, 8.6%, effective interest  rate 6.20%, balloon due 2010                            |       | 6,913                   |       | 6,971                       |       |
| Promissory note, 9.0%, effective interest  rate 6.19%, balloon due 2010                            |       | 6,472                   |       | 6,522                       |       |
| Promissory note, 9.0%, effective interest  rate 6.25%, balloon due 2010                            |       | 2,799                   |       | 2,821                       |       |
| Unsecured fixed-rate promissory note, 7.0%,  due 2021                                              |       | 2,294                   |       | 2,330                       |       |
|                                                                                               |       | 151,974                 |       | 175,562                     |       |
| Unamortized debt premium                                                                           |       | 3,026                   |       | 3,292                       |       |
| Total mortgages and notes payable                                                                  |       | $                       | 155,000    |                        | $          | 178,854 |   |
|                                                                                               |       |                    |       |                        |       |
| SECURED CREDIT FACILITIES:                                                                         |       |                    |       |                        |       |
| $250 million  secured credit facility, LIBOR + 1.75%, matures September 2005                  |       | $                       | 107,493    |                        | $          | — |   |
| $125 million  secured credit facility, LIBOR + 1.75%, matures July 2005                       |       | 120,783                 |       | —                      |       |
| Total secured credit facilities                                                                    |       | $                       | 228,276    |                        | $          | — |   |

 

At June 30, 2005, thefixed-rate mortgages and notes payable were collateralized by underlying realestate with an aggregate investment value of $222,545,000.  Assets with an aggregate investment value of$467,028,000 (including all of the Company’s mortgage notes receivable) werepledged as collateral for borrowings under the secured credit facilities at June 30,2005.

 

9

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The Company’s mortgage notes payable contain various covenantscustomarily found in mortgage notes, including a limitation on Spirit Finance’sability to incur additional indebtedness on the underlying real estatecollateral.  The Company is also subjectto various financial and nonfinancial covenants under its secured creditfacilities, including debt service coverage andtotal-debt-to-total-gross-assets ratios, and a minimum liquidity requirement of$25,000,000.  As of June 30, 2005,Spirit Finance was in compliance with these covenants.

 

Unamortized financing costs related to establishing the Company’s debt,totaling $4,907,000 at June 30, 2005 and $2,488,000 at December 31,2004, are included in the caption, “Deferred costs and other assets” and areamortized to interest expense over the initial term of the related debt.

 

On July 26, 2005, a special purpose, bankruptcy-remote subsidiaryof Spirit Finance issued $441,300,000 aggregate principal amount of net-leasemortgage notes consisting of $183,000,000 of Class A-1 fully amortizingnotes bearing interest at an annual rate of 5.05% due in 2020 and $258,300,000of Class A-2 interest-only notes bearing interest at an annual rate of5.37% due in 2020.  The timely payment ofscheduled interest and ultimate payment of principal on the notes areguaranteed under an insurance policy issued by Ambac AssuranceCorporation.  The collateral poolsecuring the notes is comprised of 408 single tenant commercial real estateproperties with a gross acquisition cost of $640,278,000.  The notes may be prepaid at any time, subjectto a yield maintenance prepayment premium. In addition, the notes permit substitution of real estate investmentsfrom time to time subject to certain conditions as well as the issuance ofadditional series of notes secured by the same collateral pool.  Spirit Finance used the net proceeds from theissuance of the notes to repay the existing secured credit facilities, Theremaining proceeds will be used to provide funds for future real estateacquisitions.  The $125,000,000 securedcredit facility expired on July 26, 2005 in connection with the issuanceof the net-lease mortgage notes.  The$250,000,000 secured credit facility matures on September 14, 2005, withthe ability to extend the facility for an additional year with the consent ofthe bank.

 

**5. DERIVATIVE FINANCIAL INSTRUMENTS**

 

As of June 30, 2005, Spirit Finance had two forward-startinginterest rate swap agreements with a total notional amount of$322,000,000.  The derivative instrumentswere designated to hedge the variability of cash flows related to forecastedinterest payments over 25 years on long-term debt expected to be issued in2005.  As the hedging relationships areexpected to be highly effective at achieving offsetting changes in future cashflows, these interest rate swaps are accounted for as cash flow hedges.  Changes in the fair value of the derivativesare recorded in “Accumulated other comprehensive loss.”  Hedge effectiveness is assessed using thehypothetical derivative method.  No hedgeineffectiveness was recognized during 2005 or 2004.

 

In July 2005, the anticipated long-term debt was issued (see Note4), and the interest rate swaps were settled for a net cash payment of$13,670,000 to the swap counterparty. The total change in the fair value of the interest rate swaps frominception of the hedges, totaling $14,984,000, will be amortized to earnings asan increase to interest expense over a 25-year amortization period, whichincludes any future replacement or refinancing of the debt.

 

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**6. STOCKHOLDERS’ EQUITY**

 

On January 7, 2005, the Company issued 3,913,043 shares of commonstock for proceeds of $40,067,000, net of underwriters’ discount and offeringexpenses, as a result of the exercise of the underwriters’ over-allotmentoption related to the Company’s December 2004 initial publicoffering.  During the first six months of2005, the Company granted 218,309 shares (net of forfeitures) of restrictedstock to officers, directors and employees, and options to purchase 5,000 sharesof common stock were exercised.

 

Dividends declared during 2005 are summarized below (dollars inthousands, except per share data).  Nodividends were declared during the first or second quarter of 2004, although adistribution of $0.06 per share was declared in July 2004 that related tothe second quarter operations.

 
| ** **           | ** ** | ** **          | ** ** | ** **          | ** ** | **Dividends Declared** | ** ** |
|----------------------|------------|---------------------|------------|---------------------|------------|------------------------|------------|
| **Declaration Date** | ** ** | **Record Date**     | ** ** | **Payment Date**    | ** ** | **Per Common  Share**  | ** ** | **Total** | ** ** |
| March 25, 2005  |       | April 15, 2005 |       | April 25, 2005 |       | $                      | 0.19       |   | $ | 12,849 |   |
| June 27, 2005   |       | July 15, 2005  |       | July 25, 2005  |       | 0.19                   |       | 12,852 |   |
|                 |       |                |       |                |       | $                      | 0.38       |   | $ | 25,701 |   |

 

**7.STOCK-BASED COMPENSATION**

 

Prior to January 1, 2005, the Company used the intrinsic-valuemethod prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations in accounting forits stock-based compensation. Under this method, no compensation expense wasrecorded with respect to stock options as the options were granted at anexercise price equal to the estimated fair value of the underlying commonshares on the date of grant.  For proforma disclosures under SFAS No. 123, “Accounting for Stock-BasedCompensation,” the fair value of the options was estimated on the grant datesusing the minimum-value method because the Company was a nonpublic entity onthe respective grant dates.  As requiredby APB Opinion No. 25, compensation expense related to restricted stockawards was recognized on a graded schedule over the respective vestingperiods for time-based awards based on the fair value of the underlying commonstock at the date of grant. For performance-based awards, compensation wasrecognized on a graded schedule over the respective performance periodsbased on the market value of the restricted stock at each reporting period andgiving consideration to the probability of achieving the performanceobjectives.

 

To enhance comparability of 2005 interim and annual financialstatements with those to be reported in future years after adoption of SFAS No. 123R,Spirit Finance elected to adopt the fair-value based method of SFAS No. 123effective January 1, 2005. Under the modified prospective transitionmethod described by SFAS No. 148, “Accounting for Stock-Based Compensation– Transition and Disclosure,” Spirit Finance has recognized stock-basedemployee compensation cost in 2005 as if the fair-value based method had beenused for all unvested stock-based awards outstanding at January 1, 2005and for all new grants made in 2005.  TheCompany has not restated prior period financial statements.

 

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For stock options granted in 2005, the estimated grant date fair valuewas calculated using the Black-Scholes-Merton formula.  In accordance with SFAS No. 123, thisestimated fair value will be expensed over the vesting period on astraight-line basis.  Compensationexpense related to restricted stock awards with time-based service conditionsgranted in 2005 will be recognized over the vesting period on a straight-linebasis based on the fair value of the underlying common stock on the date ofgrant.  Compensation expense related torestricted stock awards with performance-related conditions granted in 2005will be recognized on a straight-line basis over the respective performanceperiods using the original fair value of the underlying common stock on thedate of grant, giving consideration to the probability of achieving theperformance objectives.  For both stockoptions and restricted stock awards granted in 2005, forfeitures were estimatedon the grant date and will be reevaluated at each reporting period, withcompensation cost recognized only for those awards expected to vest.

 

Unvested stock options and restricted stock awards outstanding at January 1,2005 were originally granted in 2003 and 2004, when the Company’s common stockwas not publicly traded.  Compensationexpense for the unvested stock options will continue to be recognized using theminimum-value method.  Compensationexpense for unvested restricted stock will continue to be recognized on agraded schedule over the remaining vesting period based on the originalfair value of the underlying common stock on the date of grant, taking intoconsideration the probability of achieving the performance objectives for therestricted stock with performance-related conditions.

 

The adoption of SFAS No. 123 did not have a material impact on theCompany’s financial position or results of operations.  Had Spirit Finance adopted the fair-valuebased method at the beginning of 2004, Spirit Finance’s net income and dilutedand basic net income per common share for the three months and six months endedJune 30, 2004 would not have changed from the reported amounts.  Stock-based compensation expense for thethree and six months ended June 30, 2005 and 2004 is summarized in thetable below (dollars in thousands).

 
| ** **                     | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                     | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|                           |       |                                |       |                              |       |   |   |   |   |
| Restricted stock amortization  |       | $                                   | 236        |                              | $          | 226 |   | $ | 437 |   | $ | 455 |   |
| Stock option expense           |       | 1                                   |       | —                            |       | 3 |   | — |   |
| Total stock-based compensation |       | $                                   | 237        |                              | $          | 226 |   | $ | 440 |   | $ | 455 |   |

 

Stock-based compensation is included in “General and administrative”expenses in the Consolidated Statements of Operations.

 

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**8. DISCONTINUED OPERATIONS**

 

Periodically, Spirit Finance may sell real estate properties that donot meet its long-term strategic investment objectives.  Such properties are typically acquired inconjunction with the acquisition of a group of real estate properties.  The Company considers these occasional salesof real estate properties to be a part of its long-term operating businessstrategy in acquiring a diversified real estate investment portfolio; consequently,proceeds from the sales of real estate properties are expected to be reinvestedin additional real estate properties such that cash flows from ongoingoperations are not negatively affected by sales of individual properties.  SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” requires that gains and lossesfrom any such dispositions of properties and all operations from theseproperties be reclassified as “discontinued operations” in the ConsolidatedStatements of Operations.  As a result ofthis reporting requirement, each time a property is sold, previously reported “incomefrom continuing operations” will be restated to reclassify the operations ofsuch property into discontinued operations. This presentation has no impact on net income or cash flow.

 

During the latter half of 2004, Spirit Finance sold fourproperties.  During the first six monthsof 2005, the Company sold 23 properties for $40,532,000 in net sales proceeds,resulting in a combined net gain of $227,000. The operations and net gain realized from these real estate dispositionshave been reported as discontinued operations. At December 31, 2004, the 23 properties sold during 2005 hadbalances of $39,831,000 in gross real estate investments, $853,000 in grossintangible assets and $892,000 in mortgages and notes payable.

 

The following table sets forth the components of discontinuedoperations related to the 27 properties sold subsequent to January 1, 2004(dollars in thousands).

 
| ** **                          | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                |       |                                |       |                              |       |   |   |   |   |
| Rental revenues                     |       | $                                   | 331        |                              | $          | 29 |   | $ | 1,121 |   | $ | 29 |   |
|                                |       |                                |       |                              |       |   |   |   |   |
| Expenses:                           |       |                                |       |                              |       |   |   |   |   |
| General and administrative          |       | 3                                   |       | 2                                 |       | 8 |   | 2 |   |
| Depreciation and amortization       |       | 75                                  |       | —                            |       | 242 |   | — |   |
| Interest                            |       | 89                                  |       | 9                                 |       | 203 |   | 9 |   |
| Total expenses                      |       | 167                                 |       | 11                                |       | 453 |   | 11 |   |
|                                |       |                                |       |                              |       |   |   |   |   |
| Income from discontinued operations |       | 164                                 |       | 18                                |       | 668 |   | 18 |   |
| Net gain on sales of real estate    |       | 284                                 |       | —                            |       | 227 |   | — |   |
| Total discontinued operations       |       | $                                   | 448        |                              | $          | 18 |   | $ | 895 |   | $ | 18 |   |

 

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**9. NET INCOME PER COMMON SHARE**

 

A reconciliation of the numerators anddenominators used in the computation of basic and diluted income per commonshare is as follows (dollars in thousands, except per share data):

 
| ** **                                                                                               | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                     |       |                                |       |                              |       |   |   |   |   |
| *Income available to common shareholders:*                                                               |       |                                |       |                              |       |   |   |   |   |
| Continuing operations                                                                                    |       | $                                   | 7,030      |                              | $          | 1,264 |   | $ | 13,402 |   | $ | 2,076 |   |
| Discontinued operations                                                                                  |       | 448                                 |       | 18                                |       | 895 |   | 18 |   |
| Net income                                                                                               |       | $                                   | 7,478      |                              | $          | 1,282 |   | $ | 14,297 |   | $ | 2,094 |   |
|                                                                                                     |       |                                |       |                              |       |   |   |   |   |
| *Weighted average shares:*                                                                               |       |                                |       |                              |       |   |   |   |   |
| Weighted average outstanding common shares  used in the calculation of basic income per common share (a) |       | 67,305,458                          |       | 37,252,612                        |       | 67,168,949 |   | 36,362,502 |   |
| Effect of unvested restricted stock                                                                      |       | 62,312                              |       | 152,547                           |       | 64,177 |   | 141,609 |   |
| Effect of stock options (b)                                                                              |       | 93,660                              |       | —                            |       | 138,657 |   | — |   |
| Weighted average outstanding common shares  used in the calculation of diluted income per common share   |       | 67,461,430                          |       | 37,405,159                        |       | 67,371,783 |   | 36,504,111 |   |
|                                                                                                     |       |                                |       |                              |       |   |   |   |   |
| *Income per common share:*                                                                               |       |                                |       |                              |       |   |   |   |   |
| Basic:                                                                                                   |       |                                |       |                              |       |   |   |   |   |
| Continuing operations                                                                                    |       | $                                   | 0.10       |                              | $          | 0.03 |   | $ | 0.20 |   | $ | 0.06 |   |
| Discontinued operations                                                                                  |       | 0.01                                |       | —                            |       | 0.01 |   | — |   |
| Net income                                                                                               |       | $                                   | 0.11       |                              | $          | 0.03 |   | $ | 0.21 |   | $ | 0.06 |   |
|                                                                                                     |       |                                |       |                              |       |   |   |   |   |
| Diluted:                                                                                                 |       |                                |       |                              |       |   |   |   |   |
| Continuing operations                                                                                    |       | $                                   | 0.10       |                              | $          | 0.03 |   | $ | 0.20 |   | $ | 0.06 |   |
| Discontinued operations                                                                                  |       | 0.01                                |       | —                            |       | 0.01 |   | — |   |
| Net income                                                                                               |       | $                                   | 0.11       |                              | $          | 0.03 |   | $ | 0.21 |   | $ | 0.06 |   |

 

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(a)          Theincrease in the number of weighted average shares outstanding between 2004 and2005 is primarily the result of the Company’s initial public offering of30,000,000 shares of common stock.

(b)         Optionsto purchase 30,000 shares of common stock at June 30, 2005 wereoutstanding but were not included in the computation of diluted net income percommon share for the three and six months ended June 30, 2005 because theeffect was not dilutive. Options to purchase 1,290,000 shares of common stockat June 30, 2004 were outstanding but were not included in the computationof diluted net income per common share for the three and six months ended June 30,2004 because the effect was not dilutive.

 

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**10. COMPREHENSIVE INCOME**

 

Comprehensive income is comprised of net income, adjusted for changesin unrealized gains or losses on derivative financial instruments or securitiesclassified as available-for-sale.  Thereconciliation of net income to comprehensive income (loss) for the three andsix months ended June 30, 2005 and 2004 is as follows (dollars inthousands):

 
| ** **                                            | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income as reported                                |       | $                                   | 7,478      |                              | $          | 1,282 |   | $ | 14,297 |   | $ | 2,094 |   |
| Net unrealized loss on cash flow hedges               |       | (22,220                             | )          | —                            |       | (20,384 | ) | — |   |
| Net unrealized loss on available-for-sale  securities |       | —                              |       | (2                                | )          | — |   | (1 | ) |
| Comprehensive income (loss)                           |       | $                                   | (14,742    | )                                 | $          | 1,280 |   | $ | (6,087 | ) | $ | 2,093 |   |

 

**11. SUPPLEMENTAL CASH FLOW INFORMATION**

 

In conjunction with the acquisition of certain real estate investmentsduring the first six months of 2005, Spirit Finance assumed existing mortgagenotes payable of $49,853,000.  TheCompany entered into seller financing of $70,969,000 in mortgage notes payableand assumed existing mortgage notes payable (including debt premium) of$36,860,000 on real estate investments acquired during the first six months of2004.

 

**12. RELATED PARTY TRANSACTIONS**

 

The Company’s Chief Executive Officer is a member of the board ofdirectors of the lessee of four interstate travel plazas owned by SpiritFinance.  Rental revenues totaledapproximately $1,800,000 for the six months ended June 30, 2005 and 2004under this lease.

 

One of the Company’s independent directors is a member of the board ofdirectors of a customer operating the underlying properties that collateralizeapproximately half of the mortgage loans receivable held by SpiritFinance.  In addition, Spirit Financeowns four properties leased by this customer. Interest income on the mortgage loans receivable and rental revenue onthe lease aggregated $1,097,000 for the six months ended June 30, 2005 and$964,000 for the six months ended June 30, 2004.

 

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**13. COMMITMENTS AND CONTINGENCIES**

 

Spirit Finance had contractual commitments totaling $10,891,000 at June 30,2005 for future improvements on properties the Company currently owns. Theseimprovements include costs incurred on facilities during which the tenant’sbusiness continues to operate without interruption and advances for theconstruction of new facilities for which operations have not commenced.  In accordance with the underlying leaseagreements, most of these improvementsare anticipated to be completed during 2005 and will result in increases inrelated contractual rent.

 

The Company may be subject to claims orlitigation in the ordinary course of business. At June 30, 2005, there were no outstanding claims against theCompany that would have a material adverse effect on the Company’s financialposition or results of operations.

 

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### **Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

Management’s discussion and analysis of financial condition and resultsof operations are more clearly understood when read in conjunction with theaccompanying unaudited consolidated financial statements and notes thereto asof June 30, 2005 and our audited financial statements included in ourAnnual Report on Form 10-K for the year ended December 31, 2004.Undue reliance should not be placed upon historical financial statements sincethey are not indicative of expected results of operations or financialcondition for any future periods.

 

**Overview**

 

Spirit Finance Corporation (NYSE: SFC) is a self-managed andself-advised REIT formed as a Maryland corporation on August 14, 2003. Wewere formed to acquire single tenant, operationally essential real estateleased to retail, distribution and service-oriented companies on a long-termbasis. Operationally essential real estate includes land and buildings vital tothe generation of our customers’ sales and profits. In addition, we mayselectively originate and acquire long-term mortgage loans or equipment loansthat are integral to our strategy of providing a complete financing solution toour customers. We may also make a limited amount of unsecured corporate loansto our customers. Our objective is to acquire or finance the real estate ofcompanies that provide goods and services to consumers through retail,distribution and service locations throughout the United States, such asrestaurants, interstate travel plazas, movie theaters, automotive parts storesand services facilities, drugstores, educational facilities, specialtyretailers and other similar businesses.

 

Since we began purchasing real estate assets in December 2003, wecompleted over $1.0 billion in sale/leaseback transactions and mortgageloan acquisitions.  During that period,we also sold $40.7 million in properties that we believe did not meet ourlong-term investment objectives.  As of June 30,2005, 96% of our $987.1 million portfolio represented real estate we own(including the gross cost of land, buildings and related lease intangibles) and4% represented mortgage and equipment loans receivable.  Our portfolio of 486 owned or financed singletenant properties is geographically diversified across 38 states.  Only two states, Texas (14.6%) and Arizona(11.6%), accounted for 10% or more of the total dollar value of our real estateand mortgage loan portfolio.  Ourproperties are leased or financed to 68 customers operating in variousindustries.  Our three largest propertytypes at June 30, 2005 as a percentage of gross real estate investmentswere restaurants (33%), specialty retailer properties (13%) and movie theaters(12%).  Our top 10 customers as apercentage of our total portfolio at June 30, 2005 were: CarMax, Inc.(NYSE: KMX); CBH2O, LP, the operator of Camelback Ski and Water Park; UnitedSupermarkets, Ltd.; Carmike Cinemas, Inc. (NASDAQ: CKEC); Gander MountainCompany (NASDAQ: GMTN); University of Phoenix (NASDAQ: APOL); AMC Entertainment, Inc.;Hughes Supply, Inc. (NYSE: HUG); Flying J Inc.; and Fuddruckers, Inc.  Together, our top 10 customers accounted for43% of our total portfolio investments at June 30, 2005, with noindividual credit exposure greater than 5.7% of the total portfolio.  In comparison, the top 10 customers as of June 30,2004 accounted for 82% of our total investment portfolio, with the largestcredit exposure at 12.2% of the total portfolio. As of June 30, 2005, allof our properties were occupied, and rental and mortgage payments were current.

 

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We expect to grow through continuing our strategy of acquiring singletenant, operationally essential real estate principally through sale/leasebacktransactions.  We intend to fund futurereal estate investments primarily with borrowings on our secured creditfacilities and by raising funds through the issuance of debt and additionalequity capital as described below in the section entitled “Liquidity andCapital Resources.”  Our ability togenerate positive cash flow will depend heavily on the difference between theincome earned on our assets and the interest expense incurred on ourborrowings.

 

Our ability to achieve continued growth is dependent on achieving asubstantial volume of acquisitions at yields that can be effectively financedto meet our targeted returns.  Thecurrent environment for net lease real estate acquisitions continues to behighly competitive, and this competitive environment could limit both thenumber of properties we acquire and the yield on those acquisitions.  We may delay or decline opportunities if wefeel the rewards do not warrant the capital risk.  In addition, the timing on completingacquisitions may vary significantly from quarter to quarter.  In response to these challenges, we arecommitted to seeking numerous potential investment opportunities through oursales force.  We continue to seekopportunities to combine our cost of capital and operational structure withefficient leverage strategies to deliver competitively priced lease products.

 

**Liquidity and Capital Resources**

 

Our real estate investments are initially acquired using a combinationof cash and borrowings under our secured credit facilities.  During the first six months of 2005, weacquired 135 single tenant commercial real estate properties through varioustransactions totaling $360.1 million, of which all but $38.0 millionwere acquired during the second quarter of 2005.  In conjunction with the acquisition of 24 ofthese real estate properties, we assumed existing mortgage notes payable orobtained new long-term financing totaling $116.9 million.  We also used proceeds from the sales of realestate investments, totaling $40.5 million, to acquire newproperties.  At June 30, 2005, wehad contractual commitments totaling $10.9 million for future improvementson properties we currently own.  Inaccordance with the underlying lease agreements, most of these improvements are anticipated to becompleted during 2005 and will result in increases in related contractualrent.  In addition, as of August 1,2005, we had identified for review potential investment opportunities of morethan $2 billion.  We considerinvestments as under review when we have signed a confidentiality agreement, wehave exchanged financial information or we or our advisors are in current andactive negotiations. Investments under review are generally subject tosignificant change and the timing of closing any such transactions may varysignificantly from quarter to quarter. After further due diligence, we may decide not to pursue any or all ofthese transactions and there is no assurance that we will ultimately completeany of the real estate acquisitions.

 

In order to achieve significant growth in revenues and net income, wewill need to make substantial real estate acquisitions, which will in turnrequire that we obtain significant additional debt or equity funding beyond ourcurrently committed external sources of liquidity.  Our initial public offering of26.1 million shares of our common stock at a price of $11 per share in December 2004,represented such an equity issuance.  Theunderwriters exercised their over-

 

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allotment option and we issued an additional 3.9 million shares ofcommon stock on January 7, 2005 for $40.1 million, net ofunderwriters’ discount and offering costs.

 

At December 31, 2004, our debt included variable-rate mortgagenotes payable totaling $140.1 million and fixed-rate debt with a carryingamount of $38.7 million.  In 2004,we established a $250 million secured credit facility with Bank of AmericaMortgage Capital Corporation, and in March 2005, we added a$125 million secured credit facility with Citigroup Global Markets RealtyCorporation.  Short-term creditfacilities such as these are used to purchase real estate pending the issuanceof long-term financing.  During the firstquarter of 2005, we repaid the $140.1 million variable-rate mortgage notespayable using cash and borrowings under our secured credit facilities.  During the second quarter of 2005, we assumedexisting mortgage notes payable or obtained new long-term financing totaling$116.9 million in conjunction with certain real estate acquisitions.  At June 30, 2005, our balanceoutstanding under the secured credit facilities was $228.3 million and thecarrying amount of our fixed-rate debt was $155.0 million.

 

On July 26, 2005, our $125 million secured credit facilitymatured.  Our $250 million securedcredit facility will mature on September 14, 2005 but may be extended foran additional year with the consent of the lender.  We intend to obtain short-term secured and/orunsecured financing through various sources including banks, institutionalinvestors and other lenders. This financing may include lines of credit, bridgeloans, warehouse facilities and other debt arrangements.  We are currently negotiating short-term financingthat we expect to complete during the third quarter.

 

On July 26, 2005, our special purpose, bankruptcy-remotesubsidiary, Spirit Master Funding, LLC, issued $441.3 million aggregateprincipal amount of net-lease mortgage notes rated Aaa/AAA by Standard &Poor’s Ratings Services and Moody’s Investors Service, Inc.,respectively.  The private placementconsisted of $183 million of Class A-1 fully amortizing notes bearinginterest at an annual rate of 5.05% due in 2020 and $258.3 million of Class A-2interest-only notes bearing interest at an annual rate of 5.37% due in2020.  The timely payment of scheduledinterest and ultimate payment of principal on the notes are guaranteed under aninsurance policy issued by Ambac Assurance Corporation.  The collateral pool securing the notes iscomprised of 408 single tenant commercial real estate properties with a grossacquisition cost of $640.3 million. The notes may be prepaid at any time, subject to a yield maintenanceprepayment premium.  In addition, thenotes permit substitution of real estate investments from time to time subjectto certain conditions as well as the issuance of additional series of notessecured by the same collateral pool.  Weused the net proceeds from the sale of the notes to repay balances outstandingunder the secured credit facilities with Bank of America and Citigroup totaling$248.4 million.  The remainingproceeds will be used to provide funds for future real estate acquisitions.

 

As described further in the Notes to Consolidated Financial Statementsand Quantitative and Qualitative Disclosures About Market Risk, we usedinterest rate swaps to manage our exposure to changes in interest rates untilwe could put into place our long-term debt strategy.  In conjunction with the issuance of thenet-lease mortgage notes, our interest rate swaps were settled for a net cashpayment to the swap counterparty of $13.7 million, because long-term rateshad decreased since the inception of the hedges.  Accordingly, the total $15.0 millionchange in the

 

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fair value of the interest rate swaps from inception of the hedges willbe amortized to earnings as an increase to interest expense over a 25-yearamortization period such that the effective adjusted interest rate approximatesthe long-term rates in effect when the hedges were placed.

 

We are subject to various customary operating and financial covenantsunder the mortgage notes payable and the secured credit facilities. Themortgage notes payable include a limitation on our ability to incur additionalindebtedness on the underlying secured real estate. Our secured credit facilityincludes a minimum liquidity requirement of $25 million.  As of June 30, 2005, we were incompliance with these covenants and requirements.

 

We generate our revenue and cash flow by leasing our real estateproperties to customers and from interest income on our portfolio of mortgageloans receivable. We generally offer long-term leases that provide for paymentsof base rent with scheduled increases, increases based on future changes in theConsumer Price Index and/or contingent rent based on a percentage of the lessee’sgross sales.  At June 30, 2005, ourweighted average remaining initial lease term was approximately 14.25 years,and our leases generally provide for one or more renewal options.  Less than 2% of our current lease portfoliowill expire prior to 2013.  Our leasesare generally triple-net, which provides that the lessee is responsible for thepayment of all property operating expenses, including insurance, real estatetaxes and repairs and maintenance.  Sinceour tenants generally pay the property operating and maintenance costs, webelieve that funds we require for maintenance and other capital expenditures onthe properties will not be significant. Substantially all of our real estateinvestments are pledged as collateral under our debt obligations.

 

Our operating costs include interest expense on our debt and certaingeneral and administrative costs of acquiring and managing our real estateinvestment portfolio, such as the compensation and benefit costs of ouremployees, professional fees such as legal and portfolio servicing costs andoffice expenses such as rent and other office operating costs.  Noncash expenses include depreciation expenseon the buildings and improvements in our real estate portfolio, stock-basedcompensation (included in general and administrative expenses) and amortizationof deferred financing costs (included in interest expense).  After payment of expenses, our cash flow fromoperating activities totaled $24.1 million for the six months ended June 30,2005.

 

During the second quarter of 2005, we declared dividends of $0.19 pershare, payable to shareholders of record as of July 15, 2005.  This distribution, totaling$12.9 million, was paid on July 25, 2005.  On April 25, 2005, a cash dividend of$0.19 per share, totaling $12.8 million, was paid.  On January 31, 2005, a cash distributionof $0.19 per share, totaling $7.1 million, was paid to stockholders ofrecord as of December 10, 2004 (prior to the initial publicoffering).  We intend to make regularquarterly distributions to our stockholders so that we distribute each year allor substantially all of our REIT taxable income to avoid paying corporate levelincome tax and excise tax on our earnings. During the initial years of our operations, the distributions we pay mayinclude a return of capital.  Cash forfuture distributions is expected to be generated from operations, although wemay also borrow funds to make distributions. Our ability to pay distributions will depend on, among other things, ouractual results of operations, which are dependent primarily on our receipt ofpayments from our leases and loans with respect to our real estate investments.

 

20

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In the short-term, we believe that cash provided by operatingactivities will be sufficient to meet our liquidity needs for the operating andfinancing obligations of our existing investment portfolio.  On a long-term basis, we intend to use acombination of debt and equity financing methods to accomplish our goal ofacquiring real estate while maintaining our borrowings at a targeted leverage rationot to exceed 65% of our total assets. We define our leverage ratio as theratio of our total debt to total assets. On a pro forma basis, giving effect tothe July 2005 private placement and subsequent repayment of the securedcredit facilities, approximately 87% of the gross investment value of our realestate and mortgage loan assets at June 30, 2005 was pledged ascollateral, resulting in a leverage ratio of approximately 48%.  We intend to pursue additional debt andequity financing through various sources in the form of publicly or privatelyplaced transactions.

 

**Results of Operations**

 

***Net income***

 

Net income for the three months ended June 30, 2005 was$7.5 million, or $0.11 per diluted share, based on 67.5 millionweighted average shares of common stock outstanding.  Net income for the three months ended June 30,2004 was $1.3 million or $0.03 per diluted share, based on37.4 million weighted average shares of common stock outstanding.

 

Net income for the six months ended June 30, 2005 was$14.3 million, or $0.21 per diluted share, based on 67.4 millionweighted average shares of common stock outstanding.  Net income for the six months ended June 30,2004 was $2.1 million or $0.06 per diluted share, based on36.5 million weighted average shares of common stock outstanding.  We commenced operations on August 14,2003, and the first quarter 2004 results of operations did not includesignificant operating data, as the majority of our current real estateportfolio was acquired after the first quarter of 2004.

 

The increase in net income per share is due to increased revenuescaused by the growth in our real estate portfolio due to acquisitions ofproperties throughout the past year.  Theincrease in the number of weighted average shares outstanding between 2005 and2004 is primarily the result of our December 2004 initial public offeringof 30.0 million common shares.

 

***Income from continuing operations***

 

Income from continuing operations for the three months ended June 30,2005 was $7.0 million, or $0.10 per diluted share.  Income from continuing operations for thethree months ended June 30, 2004 was $1.3 million, or $0.03 perdiluted share.

 

Income from continuing operations for the six months ended June 30,2005 was $13.4 million, or $0.20 per diluted share.  Income from continuing operations for the sixmonths ended June 30, 2004 was $2.1 million, or $0.06 per dilutedshare.

 

21

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***Discontinued operations***

 

Periodically, we may sell real estate properties that do not meet ourlong-term strategic investment objectives. Such properties are typically acquired in conjunction with theacquisition of a group of real estate properties.  We consider these occasional sales of real estateproperties to be an integral part of our long-term operating business strategyin acquiring a diversified real estate investment portfolio; consequently,proceeds from the sales of real estate properties are expected to be reinvestedin additional real estate properties such that cash flows from ongoingoperations are not negatively affected by sales of individual properties.  Statement of Financial Accounting Standards No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” requires thatgains and losses from any such dispositions of properties and all operationsfrom these properties be reclassified as “discontinued operations” in theConsolidated Statements of Operations. As a result of this reporting requirement, each time a property is sold,previously reported “income from continuing operations” will be restated toreclassify the operations of such property into discontinued operations.  This presentation has no impact on net incomeor funds from operations.

 

We sold four properties during 2004, six properties during the firstquarter of 2005 and 17 properties during the second quarter of 2005.  Discontinued operations for the three monthsended June 30, 2005 totaled $0.4 million, or $0.01 per diluted share,including net gains on sales of real estate of $0.3 million.  Discontinued operations for the six monthsended June 30, 2005 totaled $0.9 million, or $0.01 per diluted share,including net gains on sales of real estate of $0.2 million.  Discontinued operations totaled $18,000 forthe three and six months ended June 30, 2004.  Revenues and expenses, including thoseclassified as discontinued operations, for the three and six months ended June 30,2005 and 2004 are presented in the table below (dollars in thousands).

 
| ** **                          | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                            |       | $                                   | 18,077     |                              | $          | 3,341 |   | $ | 33,702 |   | $ | 5,894 |   |
| General and administrative expenses |       | 3,246                               |       | 1,586                             |       | 5,840 |   | 3,053 |   |
| Depreciation and amortization       |       | 4,206                               |       | 379                               |       | 7,595 |   | 653 |   |
| Interest                            |       | 3,431                               |       | 94                                |       | 6,197 |   | 94 |   |
|                                     |            |                                     |            |                                   |            |  |  |  |  |  |  |  |  |

 

The following discussion for the three and six months ended June 30,2005 as compared to the three and six months ended June 30, 2004, includesthe results of discontinued operations.

 

***Revenues***

 

Total revenues (including those recorded in discontinued operations)increased to $18.1 million for the second quarter of 2005 as compared to$3.3 million for the second quarter of 2004.  Total revenues for the first six months of2005 increased to $33.7 million as compared to total revenues of $5.9 millionfor the first six months of 2004.  Theincrease in revenues for the three and six months ended June 30, 2005 isthe result of the growth in our real estate portfolio due to propertyacquisitions made over the past 12 months. Because the acquisitions of properties are made throughout the quarter,the full impact of acquisitions made in the second quarter of 2005 will not berealized until the third quarter.

 

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Approximately 93% of the total revenues generated in the second quarterand first six months of 2005 were rental revenues from real estate propertieswe own and lease to our customers. Rental revenue and the related weighted average real estate investmentsare presented in the table below (dollars in thousands):

 
| ** **                                                        | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                        | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Rental revenues, excluding the adjustment  for straight-line rent |       | $                                   | 16,582     |                              | $          | 1,695 |   | $ | 30,674 |   | $ | 2,608 |   |
| Straight-line rent                                                |       | 263                                 |       | 81                                |       | 510 |   | 146 |   |
| Total rental revenues                                             |       | $                                   | 16,845     |                              | $          | 1,776 |   | $ | 31,184 |   | $ | 2,754 |   |
|                                                              |       |                                |       |                              |       |   |   |   |   |
| Weighted average real estate investments                          |       | $                                   | 761,368    |                              | $          | 73,662 |   | $ | 702,401 |   | $ | 56,167 |   |

 

The weighted average yield on our real estate acquisitions was lowerduring 2005 than in 2004, reflecting market lease rate compression andincreased investments in properties leased to companies having higher creditquality profiles.  Such investments weredesigned to meet our total rate of return requirements because we were able toobtain efficient long-term borrowings on those acquisitions at rates rangingfrom 5.25% to 5.4%.

 

Interest income on mortgage and equipment loans receivable totaled$1.0 million for the second quarter of 2005 as compared to$0.9 million for the second quarter of 2004.  For the first six months of both 2005 and 2004,interest income on mortgage and equipment loans receivable totaled$1.9 million.  Most of the interestincome is generated by the mortgage loans, with approximately half of theinterest income generated by each of two borrowers.  Other interest income represents incomegenerated on temporary investment securities pending investment in real estate.

 

For the six months ended June 30, 2005, no single lesseerepresented more than 6.1% of total revenues. At June 30, 2005, no single group of related tenants or borrowersrepresented greater than 5.7% of the total investment portfolio.

 

***Expenses***

 

General and administrative expenses include employee-related expenses,professional fees and outsourced services and office and other expenses.  Included in employee-related expenses wasnoncash stock-based compensation of $0.2 million for the three monthsended June 30, 2005 and 2004, $0.4 million for the six months ended June 30,2005 and $0.5 million for the six months ended June 30, 2004.  Employee-related expenses increased as aresult of increasing our number of employees from 17 at June 30, 2004 to32 at June 30, 2005.  Professionalfees and outsourced services increased as a result of public company costs andhigher real estate portfolio management and servicing fees due to increasedreal estate acquisitions.  Office andother expenses increased as a result of higher insurance costs and higherfranchise taxes due to increased real estate acquisitions.

 

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Depreciation and amortization expense relates primarily to real estateproperties and related lease intangibles. Increases over prior periods are primarily the result of increased realestate acquisitions.

 

Interest expense, including $0.7 million associated with theamortization of related deferred financing costs, totaled $3.4 million forthe three months ended June 30, 2005 on weighted average outstanding debtof approximately $199.9 million. For the six months ended June 30, 2005, interest expense totaled$6.2 million, including $1.3 million associated with the amortizationof related deferred financing costs, on weighted average outstanding debt ofapproximately $174.8 million. Interest expense totaled $0.1 million for the three and six monthsended June 30, 2004.

 

Due to the significant ramp up in operations and real estate investmentactivity during 2004 and 2005, our general and administrative expenses areexpected to continue to increase throughout the remainder of 2005, although ata slower pace than acquisition growth. Depreciation and amortization expense is expected to increase in futureperiods with future real estate acquisition activity.  Interest expense is expected to increase infuture periods as we continue to make investments in real estate that arefunded with debt financing.

 

**Reconciliation of Non-GAAP Financial Measures**

 

Funds from operations (“FFO”) totaled $11.4 million for the secondquarter of 2005 and $1.7 million for the second quarter of 2004, including$0.3 million and $0.1 million, respectively, representing theadjustment between scheduled rents and rental revenue recognized on astraight-line basis.  FFO totaled$21.6 million for the six months ended June 30, 2005 (including$0.5 million of straight-line rent) and $2.7 million for the sixmonths ended June 30, 2004 (including $0.1 million of straight-linerent). FFO is a non-GAAP financial measure. Non-GAAP financial measures present calculations of a company’shistorical or future financial performance that are different from thosecalculated and presented in accordance with U.S. generally accepted accountingprinciples (“GAAP”).  We use FFO as ameasure of our performance as a REIT because we believe this measure providesinvestors with an understanding of our operating performance, cash flows andprofitability.

 

We calculate FFO consistent with the definition used by the NationalAssociation of Real Estate Investment Trusts (“NAREIT”), adopted to promote anindustry-wide standard measure of REIT operating performance.  We use FFO as a measure of performance toadjust for certain non-cash expenses such as depreciation and amortizationbecause accounting for real estate assets under GAAP implicitly assumes thatthe value of real estate assets diminishes predictably over time. We discloseFFO to facilitate comparisons between Spirit Finance and other REITs, althoughother REITs may not calculate FFO in accordance with the NAREIT definition and,accordingly, our FFO may not be directly comparable to FFO reported by otherREITs.

 

FFO should not be considered an alternative to net income determined inaccordance with GAAP as a measure of profitability, nor should it be consideredan equivalent to cash flows provided by operating activities determined inaccordance with GAAP as a measure of liquidity. Spirit Finance’s statements ofoperations and cash flows include disclosures of interest expense, capital

 

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expenditures and items excluded from the calculation of FFO, all ofwhich should be considered when evaluating our performance.

 

A reconciliation of net income calculated in accordance with GAAP toFFO for the three and six months ended June 30, 2005 and 2004 is presentedin the following table (dollars in thousands):

 
| ** **                                               | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                               | ** ** | **2005**                            | ** ** | **2004**                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income                                               |       | $                                   | 7,478      |                              | $          | 1,282 |   | $ | 14,297 |   | $ | 2,094 |   |
| Portfolio depreciation and amortization  expense:        |       |                                |       |                              |       |   |   |   |   |
| Continuing operations                                    |       | 4,101                               |       | 370                               |       | 7,292 |   | 638 |   |
| Discontinued operations                                  |       | 75                                  |       | —                            |       | 242 |   | — |   |
| Net gains on sales of real estate  investment properties |       | (284                                | )          | —                            |       | (227 | ) | — |   |
| FFO                                                      |       | $                                   | 11,370     |                              | $          | 1,652 |   | $ | 21,604 |   | $ | 2,732 |   |

 

**Significant Accounting Estimates and CriticalAccounting Policies**

 

Our accounting policies are determined in accordance with U.S.generally accepted accounting principles. The preparation of our consolidated financial statements requires us tomake estimates and assumptions that are subjective in nature and consequentlyour actual results could differ materially from our estimates.  Estimates and assumptions include, amongother things, subjective judgment with regard to the fair values and usefullives of our properties for depreciation purposes and for classification of leasesas either operating or capital leases, judgment regarding the collectibility ofreceivables and asset impairment analysis, assumptions used in estimating thefair value of our financial instruments and judgment required to estimate thefair value and hedge effectiveness of our derivative financialinstruments.  Listed below are the morecritical accounting policies that require management judgment and estimates inthe preparation of our consolidated financial statements.

 

Revenue recognition – We lease real estate toothers under long-term net leases that are classified as operating leases.Throughout the lease term, the leases may include scheduled rent escalations aswell as contingent rentals based on a percentage of the lessee’s gross sales orbased on future increases in the Consumer Price Index. We recognize contingentrentals as revenue when the change in the factor on which the contingent leasepayment is based actually occurs. For operating leases with scheduled rentescalations, rental revenue is recognized on a straight-line basis so as toproduce a constant periodic rent over the term of the lease, net of a portfoliovaluation allowance based on management’s evaluation of the risks associatedwith these receivables, giving consideration to industry default rates forlong-term receivables. Accrued rental revenue, calculated as the aggregatedifference between the scheduled rents and rental revenue recognized on astraight-line basis, represents unbilled rent receivables that we will receiveonly if the tenant makes all rent payments required through the expiration ofthe initial term of the lease. In the event a lessee’s monthly lease paymentsbecome more than 60 days past due, we will suspend revenue recognition on thatlease until collectibility is reasonably assured.

 

25

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We recognize interest income on mortgage loans receivable using theeffective-interest method applied on a loan-by-loan basis. Direct costsassociated with originating loans are offset against any related fees receivedand the balance, along with any premium or discount, is deferred and amortizedas an adjustment to interest income over the terms of the related mortgageloans receivable using the effective-interest method. A loan is placed onnon-accrual status when the loan has become 60 days past due, or earlier, if inour opinion, full recovery of the contractual principal and interest becomesdoubtful. While on non-accrual status, interest income is recognized only whenreceived.

 

Real estate investments – Investments in realestate are recorded at cost, including acquisition and closing costs.  For real estate acquired subject to existinglease agreements, we must allocate a portion of the purchase price of our realestate investments between the tangible and intangible assets and liabilitiesacquired, which requires us to make subjective assessments regarding theirestimated fair values.  We primarily useappraisals to support our estimates of the fair value of our real estate.  We also make subjective assessments regardingthe useful lives of our investments in real estate for purposes of determiningthe amount of depreciation to record on an annual basis. Depreciation isgenerally computed using the straight-line method over an estimated useful lifeof 40 years for buildings and building improvements and 20 years for landimprovements.

 

Impairment of real estate investments – Wemake subjective assessments in our review of our real estate investments forimpairment whenever events or changes in circumstances indicate that thecarrying amount of these assets may not be recoverable. Management considersfactors such as expected future operating income, estimated residual value,market trends such as the effects of leasing demand and competition and otherfactors in making this assessment.  Ingeneral, if the carrying amount of an asset exceeds its estimated undiscountedfuture cash flows, an impairment charge is recognized in the amount by whichthe carrying amount of the asset exceeds the fair value of the asset. The carryingamount of our real estate investments is the largest component of ourconsolidated balance sheets. If events should occur that require us to reducethe carrying amount of our real estate by recording provisions for impairmentlosses, it could have a material impact on our results of operations and ourfinancial condition.

 

Loan impairment – We periodically evaluate ourmortgage loans receivable, including accrued interest, for collectibility byanalyzing the underlying property-level economics and trends, collateral valueand quality and other relevant factors in determining the adequacy of ourallowance for loan losses. A loan is determined to be impaired when, in ourjudgment based on current information and events, it is probable that we willbe unable to collect all amounts due according to the contractual terms of theloan agreement. Specific allowances for losses are provided for impaired loanson an individual loan basis in the amount by which the carrying amount exceedsthe estimated fair value of the underlying collateral less disposition costs.

 

26

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**Item 3. Quantitative and QualitativeDisclosures About Market Risk**

 

We are exposed to various financial market risks, especially interestrate risk.  Our interest rate riskmanagement policy seeks to limit the effects of changes in interest rates onour operations.  One objective of ourinterest rate risk management policy is to match fund fixed-rate assets withfixed-rate liabilities and variable-rate assets with variable-rateliabilities.  As part of this strategy,we have used and may continue to use derivative contracts, such as interestrate swaps, to manage our interest rate risk We do not enter into derivative contracts for speculative or tradingpurposes.

 

At June 30, 2005, our fixed-rate debt totaled $155.0 millionas compared to $38.7 million at December 31, 2004.  Using a discounted cash flow analysis basedon estimates of the amount and timing of future cash flows, market rates andcredit spreads, the estimated fair value of the fixed-rate debt exceeded itscarrying amount by approximately $0.5 million at June 30, 2005.  Our mortgage loans receivable are alsofixed-rate instruments.  At June 30,2005, our mortgage loans receivable (excluding equipment loans) totaled$40.2 million as compared to $40.4 million at December 31,2004.  Using a discounted cash flowanalysis, the estimated fair value of our fixed-rate mortgage loans receivableexceeded the carrying amount by approximately $2.5 million at June 30,2005.  It is our intent to hold ourfixed-rate mortgage loans receivable and our fixed-rate mortgages and notespayable to maturity; accordingly, changes in market interest rates impact thefair value of these financial instruments but have no impact on interestrecognized or cash flows.

 

We use variable-rate debt to fund acquisitions on a short-term basisuntil our long-term debt strategies can be implemented.  For the six months ended June 30, 2005,the weighted average outstanding balance of our variable-rate debt, which wasbased on LIBOR, was $116.9 million. Excluding amortization of deferred financing costs, this variable rateindebtedness had a weighted average interest rate of 5.25%.  Had the weighted average interest rate been100 basis points higher (lower) during the first half of 2005, the Company’snet income for the six months ended June 30, 2005 would have been reduced(increased) by approximately $0.6 million. This amount was determined by considering the impact of a hypotheticalinterest rate change on our average variable-rate borrowings outstanding duringthe first six months of 2005 and assumes no other changes in our capitalstructure.

 

On October 4, 2004, we entered into a forward-starting interestrate swap with a notional amount of $235 million, and on March 31,2005, we entered into an additional forward-starting interest rate swapagreement with a notional amount of $87 million.  These derivative instruments were designatedto hedge the variability of cash flows related to forecasted interest paymentsover 25 years on long-term debt expected to be issued in 2005.  The counterparty is a major financialinstitution that has a credit rating of at least “A-” from a nationallyrecognized rating agency.  As the hedgingrelationships are expected to be highly effective at achieving offsettingchanges in cash flows, these interest rate swaps are accounted for as cash flowhedges.  The fair value of the interestrate swaps resulted in an unrealized loss of $22.7 million at June 30,2005 and $3.6 million at December 31, 2004.  Hedge effectiveness is assessed using thehypothetical derivative method; no hedge ineffectiveness was recognized throughthe income statement for the three or six months ended June 30, 2005.  In July 2005, the anticipated long-termdebt was issued,

 

27

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and the interest rate swaps were settled for a net cash payment of$13.7 million to the swap counterparty because long-term rates haddecreased since the inception of the hedges. The total change in fair value of the interest rate swaps from inceptionof the hedges is recorded in “Accumulated other comprehensive loss” and will beamortized to earnings as an increase to interest expense over a 25-yearamortization period, which includes any future replacement or refinancing ofthe debt.  Because the anticipatedinterest payments are considered probable, the hedges continue to be effective.

 

**Item 4. Controls and Procedures**

 

We have adopted and maintain disclosure controlsand procedures that are designed to ensure that information required to bedisclosed in our reports under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods required under theSecurities and Exchange Commission’s rules and forms and that theinformation is gathered and communicated to our management, including our ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow fortimely decisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, and managementis required to apply its judgment in evaluating the cost-benefit relationshipof possible controls and procedures.

 

As required by Rule 13a-15(b) ofthe Exchange Act, we carried out an evaluation, under the supervision and withthe participation of management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures as of the end of the period covered bythis report.  Based on the foregoing, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective at the reasonable assurancelevel.

 

No change in our internal control overfinancial reporting occurred during our most recent fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**PART II – OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

We are not a party to any material litigationor legal proceedings which, in the opinion of management, individually or inthe aggregate, would have a material adverse effect on our results ofoperations or financial condition.

 

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

 

Not Applicable.

 

**Item 3. Defaults Upon Senior Securities**

 

Not Applicable.

 

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

 

The Annual Meeting of Shareholders of SpiritFinance Corporation was held May 20, 2005. The following table sets forth each of the proposals that thestockholders were asked to vote upon and the results of the meeting:

 

1.     Aproposal to elect 10 directors to the board of directors.

 
| **Director**        | ** ** | **For**    | ** ** | **Withheld  Authority** | ** ** |
|---------------------|------------|------------|------------|-------------------------|------------|
| Morton H. Fleischer |       | 63,067,018 |       | 440,458                 |       |
| Christopher H. Volk |       | 63,428,270 |       | 79,206                  |       |
| Linda J. Blessing   |       | 63,427,970 |       | 79,506                  |       |
| Willie R. Barnes    |       | 63,423,620 |       | 83,856                  |       |
| Dennis E. Mitchem   |       | 63,429,220 |       | 83,256                  |       |
| Paul F. Oreffice    |       | 63,424,320 |       | 83,156                  |       |
| James R. Parish     |       | 63,428,170 |       | 79,306                  |       |
| Kenneth B. Roath    |       | 63,428,420 |       | 79,056                  |       |
| Casey J. Sylla      |       | 63,428,320 |       | 79,156                  |       |
| Shelby Yastrow      |       | 63,424,270 |       | 83,206                  |       |

 

2.               A proposal to amend the Company’s charter asrequired by the New York Stock Exchange, Inc.

 
| FOR     |   | 63,476,996 |   |
|---------|--------|------------|--------|
| AGAINST |   | 19,680     |   |
| ABSTAIN |   | 10,800     |   |

 

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3.               A proposal to amend and restate the Company’s2003 Stock Option and Incentive Plan to reserve an additional 2,000,000 sharesof common stock for issuance under the plan, to amend how fair market value ofthe Company’s common stock is determined under the plan and to amend the planto comply with current legislation.

 
| FOR     |   | 39,556,808 |   |
|---------|--------|------------|--------|
| AGAINST |   | 8,277,227  |   |
| ABSTAIN |   | 48,285     |   |

 

4.               A proposal to ratify the selection of Ernst &Young LLP as Spirit Finance’s independent registered public accounting firm forthe fiscal year ending December 31, 2005.

 
| FOR     |   | 63,421,696 |   |
|---------|--------|------------|--------|
| AGAINST |   | 76,130     |   |
| ABSTAIN |   | 9,650      |   |

 

**Item 5. Other Information**

 

None.

 

30

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**Item 6. Exhibits**

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                      |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Articles of Amendment and Restatement (filed as Exhibit 3.1 to  the Company’s Current Report on Form 8-K dated May 20, 2005 and  incorporated herein by reference).                                                                                                                                              |
|             |       |                                                                                                                                                                                                                                                                                                                                 |
| 4.1              |       | Master Indenture dated as of July 26, 2005, between Spirit  Master Funding, LLC and Citibank, N.A., as indenture trustee (filed as  Exhibit 4.1 to the Company’s Current Report on Form 8-K dated  August 1, 2005 and incorporated herein by reference).                                                    |
|             |       |                                                                                                                                                                                                                                                                                                                                 |
| 4.2              |       | Series 2005-1 Indenture Supplement dated as of July 26,  2005, between Spirit Master Funding, LLC and Citibank, N.A., as indenture  trustee (filed as Exhibit 4.2 to the Company’s Current Report on  Form 8-K dated August 1, 2005 and incorporated herein by  reference).                            |
|             |       |                                                                                                                                                                                                                                                                                                                                 |
| 10.1             |       | Spirit Finance Corporation Amended and Restated 2003 Stock Option and  Incentive Plan (filed as Exhibit 10.1 to the Company’s Current Report on  Form 8-K dated May 20, 2005 and incorporated herein by reference).                                                                                              |
|             |       |                                                                                                                                                                                                                                                                                                                                 |
| 10.2             |       | Property Management and Servicing Agreement dated as of July 26,  2005, among Spirit Master Funding, LLC, Spirit Finance Corporation and  Midland Loan Services, Inc. (filed as Exhibit 10.1 to the Company’s  Current Report on Form 8-K dated August 1, 2005 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 pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |
|             |       |                                                                                                                                                                                                                                                                                                                                 |
| 32.2             |       | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |

 

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**SIGNATURES**

 

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

 
|                       | SPIRIT FINANCE CORPORATION |
|----------------------------|----------------------------|
|                       |                       |
| Date: August 12, 2005 | By:                        | /s/ Morton H. Fleischer |   |
|                       |                       | Morton H. Fleischer  Chairman of the Board and Chief  Executive Officer |
|                       |                       |   |
|                       | By:                        | /s/ Catherine Long |   |
|                       |                       | Catherine Long  Chief Financial Officer, Senior Vice  President and Treasurer |

 

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