Table of
Contents




UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549


_______________





FORM
10-Q


(Mark
One)


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





For the
Quarterly Period Ended March 31, 2009





OR





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





For the
Transition Period From ___ to ___


____________________





Commission
File Number 0-51344












DESERT
CAPITAL REIT, INC.


(Exact
Name of Registrant as specified in its charter)


Maryland
            20-0495883(State
      or other jurisdiction of incorporation or organization)
            ( I.R.S
      Employer Identification No.)1291
      W. Galleria Drive, Suite 200, Henderson, NV 89014(Address
      of principal executive office)(Zip
      Code)Registrant's
      telephone number, including area code:(800) 419-2855Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period that the
      registrant was required to file such reports), and (2) has been subject to
      such filing requirements for the past 90 days.
              Yes
      [ X ] No [  ]
              
              Indicate
      by check mark whether the registrant has submitted electronically and
      posted on its corporate Web site, if any, every Interactive Data File
      required to be submitted and posted pursuant to Rule 405 of Regulation S-T
      (§232.405
      of this chapter)during the preceding 12 months (or such shorter
      period that the registrant was required to submit and post such
      files).
              Yes
      [  ] No [  ]
              
              Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting
      company. See the definition of “large accelerated filer,” “accelerated
      filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
      (check one):
              
              Large
      accelerated filer [
      ]                                                                      Accelerated
      filer [ ]
              
              Non-accelerated
      filer [
      ]                                                                        Smaller
      reporting company [X]
              (Do
      not check if a smaller reporting company)
              
              Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Act).
              Yes
      [ ] No [X]
              
              The
      number of shares of the registrant’s common stock, par value $0.01 per
      share, outstanding as of May 13, 2009 was 16,835,867.
















INDEXPagePart I. Financial
    Information
            1Item 1. ConsolidatedFinancial
      Statements
            1a) Consolidated
      Balance Sheets as of March 31, 2009 (unaudited) and December
      31,
      2008
            1b) Consolidated Statements of Operations (unaudited) for the
      three months ended March
      31,
      2009and 2008
            2c) Consolidated Statements of Cash Flows (unaudited) for
      the threemonths endedMarch
      31, 2009and 2008
            3d)CondensedNotes
      to Consolidated Financial Statements
    (unaudited)
            4Item 2. Management's Discussion and Analysis of
      Financial Condition and Results of Operations
            16Item 3. Quantitative and Qualitative Disclosures About
      Market Risk
            24Item 4T. Controls and Procedures
            24Part II. Other Information
            25Item 1. Legal Proceedings
            25Item 1A. Risk Factors
            25Item 2. Unregistered Sales of Equity Securities and Use of
      Proceeds
            25Item 3. Defaults Upon Senior Securities
            25Item 4. Submission of Matters to a Vote of Security
      Holders
            25Item 5. Other Information
            25Item 6. Exhibits
            25Signatures
            26Certification of CEO Pursuant to Section
    302Certification of CFO Pursuant to Section
    302Certification of CEO and CFO Pursuant to Section
      906






Table of
Contents







PART I. Financial Information




ITEM 1.  Consolidated Financial
Statements


DESERT
      CAPITAL REIT, INC.ConsolidatedBalance Sheets(in
      thousands, except share amounts)March
      31,
              
              
              December
      31,2009
              
              
              2008(unaudited)ASSETSMortgage
      investments - net of allowance for loan losses of $15,152 at March 31,
      2009 and $20,805 at December 31, 2008
              
              $
              58,783
              
              
              $
              69,538Real
      estate owned
              
              
              28,471
              
              
              
              19,979Investments
      in real estate
              
              
              7,419
              
              
              
              7,167Notes
      receivable from related party - net of allowance for loan losses of $1,933
      at March 31, 2009 and $2,125 at December 31, 2008
              
              
              12,792
              
              
              
              12,600Building
      and equipment - net
              
              
              6,725
              
              
              
              6,815Land
              
              
              1,820
              
              
              
              1,820Cash
      and cash equivalents
              
              
              186
              
              
              
              351Restricted
      cash
              
              
              1,882
              
              
              
              1,278Interest
      receivable - includes related party interest of $145 at March 31, 2009 and
      $452 at December 31, 2008
              
              
              219
              
              
              
              531Deferred
      financing costs
              
              
              1,022
              
              
              
              941Other
      investments
              
              
              928
              
              
              
              928Other
      assets
              
              
              898
              
              
              
              681Total
      assets
              
              $
              121,145
              
              
              $
              122,629LIABILITIES
      AND STOCKHOLDERS' EQUITYNotes
      payable
              
              $
              2,556
              
              
              $
              1,360Mortgages
      payable
              
              
              7,801
              
              
              
              7,893Junior
      subordinated notes payable
              
              
              30,928
              
              
              
              30,928Dividends
      payable
              
              
              8
              
              
              
              8Management
      and servicing fees payable, related party
              
              
              1,698
              
              
              
              1,003Accounts
      payable and accrued expenses
              
              
              1,683
              
              
              
              1,550Shares
      subject to redemption
              
              
              1,137
              
              
              
              -Total
      liabilities
              
              
              45,811
              
              
              
              42,742Commitments
      and Contingencies - Note 13Preferred
      stock, $0.01 par value: 15,000,000 shares authorized, none
      outstanding
              
              
              -
              
              
              
              -Common
      stock, $0.01 par value: 100,000,000 shares authorized; 16,835,867
      shares  issued and outstanding on March 31, 2009 and December
      31, 2008
              
              
              168
              
              
              
              168Additional
      paid-in capital
              
              
              164,586
              
              
              
              165,723Accumulated
      deficit
              
              
              (90,235
              )
              
              
              (86,004
              )Equity
      available to common stockholders
              
              
              74,519
              
              
              
              79,887Noncontrolling
      interest
              
              
              815
              
              
              
              -Total
      stockholders' equity
              
              
              75,334
              
              
              
              79,887Total
      liabilities and stockholders' equity
              
              $
              121,145
              
              
              $
              122,629The
      accompanying notes are an integral part of these consolidated financial
      statements.
  1
 Table of
Contents


DESERT
      CAPITAL REIT, INC.ConsolidatedStatements of Operations(in
      thousands, except share amounts)(unaudited)Three
      Months Ended March 31,2009
              
              
              2008INTEREST
      INCOMEMortgage
      investments
              
              $
              220
              
              
              $
              2,216Other
      interest
              
              
              227
              
              
              
              548Total
      interest income
              
              
              447
              
              
              
              2,764Interest
      expense
              
              
              619
              
              
              
              834Net
      interest income
              
              
              (172
              )
              
              
              1,930Provision
      for loan losses
              
              
              1,014
              
              
              
              311Net
      interest income (loss) after provision for loan losses
              
              
              (1,186
              )
              
              
              1,619NON-INTEREST
      INCOMELoss
      on sale of real estate owned
              
              
              (3
              )
              
              
              -Rental
      income
              
              
              189
              
              
              
              224Other
              
              
              74
              
              
              
              152Total
      non-interest income
              
              
              260
              
              
              
              376NON-INTEREST
      EXPENSEImpairments
      of real estate owned
              
              
              1,087
              
              
              
              1Management
      and servicing fees
              
              
              1,041
              
              
              
              422Professional
      fees
              
              
              258
              
              
              
              288Insurance
              
              
              160
              
              
              
              113Depreciation
              
              
              122
              
              
              
              120Other
              
              
              658
              
              
              
              288Total
      non-interest expense
              
              
              3,326
              
              
              
              1,232Income
      (loss) before taxes
              
              
              (4,252
              )
              
              
              763Income
      tax benefit
              
              
              8
              
              
              
              43Consolidated
      net income (loss)
              
              $
              (4,244
              )
              
              $
              806Less:  Net
      loss attributable to noncontrolling interest
              
              
              13
              
              
              
              -Net
      income (loss) available to common stockholders
              
              $
              (4,231
              )
              
              $
              806Earnings
      (loss) per share - basic and diluted
              
              $
              (0.25
              )
              
              $
              0.05Weighted
      average outstanding shares - basic and diluted
              
              
              16,835,867
              
              
              
              16,782,728The
      accompanying notes are an integral part of these consolidated financial
      statements.
  2
 Table of
Contents


DESERT
      CAPITAL REIT, INC.ConsolidatedStatements of Cash Flows(in
      thousands)(unaudited)Three
      Months Ended March 31,2009
              
              
              2008OPERATING
      ACTIVITIESNet
      income (loss)
              $
              (4,244
              )
              
              $
              806Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Loss
      on sales of real estate
              
              3
              
              
              
              -Depreciation
      and amortization
              
              122
              
              
              
              128Provision
      for loan loss
              
              1,014
              
              
              
              311Impairment
      of real estate owned
              
              1,087
              
              
              
              1Provision
      for deferred taxes
              
              -
              
              
              
              (15
              )Mortgage
      loans originated for sale
              
              -
              
              
              
              (6,332
              )Mortgage
      loan sales
              
              -
              
              
              
              3,764Net
      change in:Interest
      receivable
              
              312
              
              
              
              47Other
      assets
              
              49
              
              
              
              (21
              )Accrued
      and Other Liabilities
              
              861
              
              
              
              (154
              )Net
      cash used by operating activities
              
              (796
              )
              
              
              (1,465
              )INVESTING
      ACTIVITIESInvestment
      in real estate mortgages
              
              -
              
              
              
              (7,594
              )Proceeds
      from repayments of real estate mortgages
              
              -
              
              
              
              6,941Proceeds
      from sales of real estate mortgages
              
              151
              
              
              
              2,700Proceeds
      received on equity investments in real estate
              
              61
              
              
              
              -Proceeds
      from sale of real estate owned
              
              32
              
              
              
              -Acquisition
      of building and equipment
              
              (32
              )
              
              
              (65
              )Net
      cash provided by investing activities
              
              212
              
              
              
              1,982FINANCING
      ACTIVITIESNet
      (repayments) borrowings on bank note
              
              (250
              )
              
              
              2,568Restricted
      Cash
              
              (604
              )
              
              
              -Principal
      repayments of mortgage loan
              
              (92
              )
              
              
              (38
              )Increase
      in notes payable
              
              1,446
              
              
              
              -Issuance
      of common stock
              
              -
              
              
              
              383Deferred
      financing costs
              
              (81
              )
              
              
              -Dividends
      on common stock
              
              -
              
              
              
              (2,896
              )Offering
      costs paid
              
              -
              
              
              
              (41
              )Net
      cash provided (used) by financing activities
              
              419
              
              
              
              (24
              )Net
      increase (decrease) in cash and cash equivalents
              
              (165
              )
              
              
              493Cash
      and cash equivalents at beginning of period
              
              351
              
              
              
              163Cash
      and cash equivalents at end of period
              $
              186
              
              
              $
              656Supplemental
      disclosure of cash flow information:Cash
      paid for interest
              $
              779
              
              
              $
              987Cash
      paid for taxes
              
              45
              
              
              
              -Common
      stock issued for dividend reinvestment program
              
              -
              
              
              
              867Common
      stock dividends declared but not paid
              
              -
              
              
              
              428Foreclosed
      assets acquired in exchange for loans, net of impairments
              
              9,390
              
              
              
              13,864Accrued
      property taxes and professional fees associated with
      foreclosure
              
              -
              
              
              
              411Adjustments
      to foreclosure costs
              
              195
              
              
              
              -Real
      estate assets owned contributed to equity investments in real
      estate
              
              -
              
              
              
              2,463Real
      estate assets owned contributed to investments in real
    estate
              
              417
              
              
              
              -Noncontrolling
      interest
              
              828
              
              
              
              -Equity
      investements sold in exchange for a receivable
              
              104
              
              
              
              -Offering
      costs incurred but not paid
              
              -
              
              
              
              29The
      accompanying notes are an integral part of these consolidated financial
      statements.
  3
 Table of
Contents


Desert Capital REIT, INC.


Condensed
Notes to Unaudited Consolidated Financial Statements


March
31, 2009




Note
1 - Organization




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




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




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




All of
our loan origination and loan servicing activities were conducted through CM
Capital, which was our wholly-owned subsidiary from October 2005 through
November 2007 at which time it was sold to CM Group, a related
party.  CM Capital will continue to originate and service loans for
us.  We have a right of first refusal for the purchase of all new
loans originated by CM Capital.




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




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




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




Basis
of Presentation


The
accompanying unaudited consolidated interim financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements. The
accompanying unaudited consolidated interim financial statements should be read
in conjunction with the financial statements and the related management's
discussion and analysis of financial condition and results of operations filed
on Form 10-K for the fiscal year ended December 31, 2008.  In our
opinion, all adjustments (consisting only of normal recurring accruals)
considered necessary for a fair presentation have been included.  The
results of operations for the three months ended March 31, 2009 are not
necessarily indicative of results that may be expected for the entire year
ending December 31, 2009.




4
 Table of
Contents


Note
2 - Summary of Significant Accounting Policies




Principles
of Consolidation


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




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




As of
March 31, 2009, we consolidated one investment in real estate that is less
than wholly-owned, but which we control. Net operating results of the 8.8% non
controlling interest are reflected in net loss attributable to noncontrolling
interests.




Reclassifications


Certain
reclassifications have been made in the investing activities section of the
consolidated statement of cash flow for the three months ended March 31, 2008.
Specifically, within the captions “Investment in real estate mortgages” and
“Proceeds from repayment/sale of real estate mortgages,” changes have been made
to reflect gross receipts and gross payments of mortgage
investments.     In addition, certain reclassifications
have been made in the presentation of the quarter ended March 31, 2008 and year
ended December 31, 2008 consolidated financial statements, specifically within
the consolidated statements of operations within the caption “management and
servicing fees,” and within the consolidated balance sheets within the caption
“management and servicing fees payable, related party.” These reclassifications
were made to reflect such items consistent with our 2009 presentation and had no
impact on our cash flow from investing activities, net income, or balance sheets
as previously reported.




Use
of Estimates


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




Revenue
Recognition


Interest
income on our mortgage investments is recognized over the contractual term of
the investment and recorded on the accrual basis. Income recognition is
suspended for mortgage investments at the earlier of the date at which payments
become 90 days past due or when, in the opinion of management, a full recovery
of interest and principal becomes doubtful. Interest accrued but not collected
is reversed at the time a loan is classified as
non-performing.  Income recognition is resumed when the mortgage
investment becomes contractually current and performance is demonstrated to be
resumed.   In situations where we do not receive adequate
compensation, the restructuring is considered a troubled debt restructuring and
is evaluated accordingly for impairment based upon the expected present value of
the cash flows of the loan as restructured compared to the present value of cash
flows as required under the original terms of the loan.




Restricted
Cash


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





Mortgage
Investments


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




5
 Table of
Contents


Real
Estate Owned


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




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




Investments
in Real Estate


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




We
evaluate our investments in partially owned entities in accordance with
FIN 46R, to determine whether an entity is a variable interest entity
(VIE), and if so, whether we are the primary beneficiary of the
VIE.   We have evaluated (1) the sufficiency of the fair
value of the entities’ equity investments at risk to absorb losses,
(2) that as a group the holders of the equity investments at risk have
(a) the direct or indirect ability through voting rights to make decisions
about the entities’ significant activities, (b) the obligation to absorb
the expected losses of the entity and their obligations are not protected
directly or indirectly, (c) the right to receive the expected residual
return of the entity and their rights are not capped, and (3) substantially
all of the entities’ activities do not involve or are not conducted on behalf of
an investor that has disproportionately fewer voting rights in terms of its
obligation to absorb the expected losses or its right to receive expected
residual returns of the entity, or both.




We assess
whether events have occurred that would require us to reevaluate consolidation
criteria under APB Opinion No. 18, The
Equity Method of Accounting for Investments in Common Stock,
(APB 18).  As a part of this evaluation, we consider our
ownership percentages in the LLCs in which we are a member.




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






We also
assess our ownership interest in LLCs and assess the events occurring within the
LLC to determine if they qualify as triggering events for reclassification from
real estate owned to cost method investments.  If we determine that
the entity is not a VIE, we own less than 20%, and we do not exercise
significant influence, we account for these investments on the cost
method.




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




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




6
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Noncontrolling
Interests


Effective
January 1, 2009, we adopted the provisions of FAS 160, which requiresthat noncontrolling (i.e. minority) ownership interests in subsidiaries
held by parties other than the parent, and the amount of consolidated net
income, be clearly identified, labeled, and presented in the consolidated
financial statements within equity, but separate from the parent’s equity. It
also requires that once a subsidiary is deconsolidated, any retained
non-controlling equity investment in the former subsidiary be initially measured
at fair value. Sufficient disclosures are required to clearly identify and
distinguish between the interests of the parent and the interests of the
non-controlling owners.  In addition to the amendments to ARB 51, this
Statement amends SFAS 128, Earnings
per Share, so that earnings-per-share will continue to be calculated in
the same manner as it was calculated before FAS 160 was issued. Further,
as a result of the adoption of FAS 160, net income attributable to
noncontrolling interests is now excluded from the determination of consolidated
net income.   The adoption of FAS 160 didnot have a
material impact on our financial condition and results of
operations.  However, it did impact the presentation and disclosure of
noncontrolling interests in our consolidated financial statements. We did not
previously have any noncontrolling interests, thus the presentation and
disclosure requirements of retrospectively applying the effects to the financial
statements was not applicable to us.




Allowance
for Loan Losses


The
allowance for loan losses represents management’s estimate of probable losses
inherent in our portfolio of loans. The allowance for loan losses is reflected
in our financial statements based upon individual review of the loans, the
specific borrowers credit quality based upon an evaluation of known and inherent
risks affecting our portfolio of mortgage investments including, but not limited
to, economic conditions, delinquency status, value of collateral underlying the
loan, credit losses to date on underlying mortgages and any remaining credit
protection. Management monitors the delinquencies and defaults on mortgage
investments and, if an impairment of the related loan is noted, the carrying
value of the related loan will be reduced to fair value through the estimate of
the allowance for loan losses.  We consider mortgages to be delinquent
when principal or interest is contractually past due or the loan is past its
maturity date.   Individual valuations of non-performing loans
are performed in accordance with SFAS No. 114, Accounting
by Creditors for Impairment of a Loan, (FAS 114).  In
accordance with FAS 114, specific allowances for losses may be established for
non-performing and potentially impaired loans based on a comparison of the
recorded carrying value of the loan to either the present value of the loan’s
expected cash flow, the loan’s estimated market price or the estimated fair
value of the underlying collateral. The allowance is increased by charges to
operations and decreased by charge-offs (net of recoveries). Loan loss estimates
are reviewed periodically and adjustments are reported in earnings when they
become known.  Because any decision regarding the allowance for loan
losses reflects a judgment about the probability of future events, there is an
inherent risk that such judgments will prove incorrect.  In such
event, actual losses may exceed (or be less than) the amount of any
allowance.  To the extent that we experience losses greater than the
amount of our allowances, we may incur a charge to our earnings that will
adversely affect our operating results and the amount of any distributions
payable to our stockholders.





Fair
Value


We
measure or monitor many of our assets and liabilities on a fair value basis.
Fair value is used on a recurring basis for assets and liabilities in which fair
value is the primary basis of accounting. We do not have any assets for which
fair value is used on a recurring basis. Additionally, fair value is used on a
non-recurring basis to evaluate assets for impairment or for disclosure
purposes. Examples of these non-recurring uses of fair value include our
mortgage loan portfolio, real estate owned and investments in real estate
ventures, our debts, certain loans held for sale accounted for on a lower of
cost or market basis, and long-lived assets. Fair value is defined as the price
that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date. We have
not elected for any of our assets or liabilities to be accounted for under SFAS
No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities, (FAS
159).  Depending on the nature of the asset or liability, we
use various valuation techniques and assumptions when estimating fair value,
which are in accordance with SFAS No. 157, Fair
Value Measurements,(FAS 157), and FSP FAS 157-3, Determining
the Fair Value of a Financial Asset When the Market for that Asset is Not
Active, when applicable.




In
accordance with FAS No. 157, we applied the following fair value
hierarchy:




Level 1 –
Assets or liabilities for which the identical item is traded on an active
exchange, such as publicly-traded instruments or futures contracts.




Level 2 –
Assets and liabilities valued based on observable market data for similar
instruments.




Level 3 –
Assets or liabilities for which significant valuation assumptions are not
readily observable in the market; instruments valued based on the best available
data, some of which is internally developed, and considers risk premiums that a
market participant would require.




When
determining the fair value measurement for assets and liabilities required or
permitted to be recorded at fair value, we consider the principal or most
advantageous market in which it would transact and considers assumptions that
market participants would use when pricing the asset or
liability.





7
 Table of
Contents


Recent
Accounting Developments


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




On
January 1, 2008, we adopted the Securities and Exchange Commission’s (SEC)
Staff Accounting Bulletin (SAB) No. 109, Written
Loan Commitments Recorded at Fair Value Through Earnings, (SAB 109) for
loan commitments measured at fair value through earnings which were issued or
modified since adoption on a prospective basis. SAB 109 requires that the
expected net future cash flows related to servicing of a loan be included in the
measurement of all written loan commitments that are accounted for at fair value
through earnings. We purchase loans that are originated and serviced by others
and do not generally enter into loan commitments, therefore the adoption of this
SAB had no impact on our financial statements.




Note
3 - Mortgage Investments


Mortgage
investments represent first and second lien positions on acquisition and
development, construction and commercial property loans. As of March 31, 2009,
all of our loans had fixed interest rates and provided for payment of interest
only with a “balloon” payment of principal payable in full at the end of the
loan term.




The
following tables present our mortgage investments (dollars in
thousands):


March
      31, 2009Loan
      Type
            
            Number
      of Loans
            
            
            Balance
            
            
            Allowance
      for Loan Losses
            
            
            Net
      Balance
            
            
            Weighted
      Average Interest Rate (1)
            
            
            Portfolio
      PercentageAcquisition
      and development loans
            
            
            24
            
            
            $
            56,250
            
            
            $
            12,231
            
            
            $
            44,019
            
            
            
            12.3
            %
            
            
            76.1
            %Construction
      loans
            
            
            6
            
            
            
            3,277
            
            
            
            637
            
            
            
            2,640
            
            
            
            9.6
            %
            
            
            4.4
            %Commercial
      property loans
            
            
            2
            
            
            
            14,408
            
            
            
            2,284
            
            
            
            12,124
            
            
            
            14.0
            %
            
            
            19.5
            %Total
      mortgage investments
            
            
            32
            
            
            $
            73,935
            
            
            $
            15,152
            
            
            $
            58,783
            
            
            
            12.5
            %
            
            
            100.0
            %




December
      31, 2008Loan
      Type
            
            Number
      of Loans
            
            
            Balance
            
            
            Allowance
      for Loan Losses
            
            
            Net
      Balance
            
            
            Weighted
      Average Interest Rate (1)
            
            
            Portfolio
      PercentageAcquisition
      and development loans
            
            
            28
            
            
            $
            72,507
            
            
            $
            17,885
            
            
            $
            54,622
            
            
            
            12.3
            %
            
            
            80.3
            %Construction
      loans
            
            
            7
            
            
            
            3,428
            
            
            
            636
            
            
            
            2,792
            
            
            
            9.7
            %
            
            
            3.8
            %Commercial
      property loans
            
            
            2
            
            
            
            14,408
            
            
            
            2,284
            
            
            
            12,124
            
            
            
            14.0
            %
            
            
            15.9
            %Total
      mortgage investments
            
            
            37
            
            
            $
            90,343
            
            
            $
            20,805
            
            
            $
            69,538
            
            
            
            12.5
            %
            
            
            100.0
            %




(1)
Represents the stated rate of the loan.






The
following table presents our mortgage investments by geographic location
(dollars in thousands):


March
      31, 2009
              
              
              December
      31, 2008Location
              
              Balance
              
              
              Portfolio
      Percentage
              
              
              Balance
              
              
              Portfolio
      PercentageNevada
              
              $
              35,129
              
              
              
              47.5
              %
              
              $
              51,532
              
              
              
              57.1
              %California
              
              
              13,274
              
              
              
              18.0
              
              
              
              13,274
              
              
              
              14.7Texas
              
              
              10,425
              
              
              
              14.1
              
              
              
              10,425
              
              
              
              11.5Arizona
              
              
              7,711
              
              
              
              10.4
              
              
              
              7,711
              
              
              
              8.5Missouri
              
              
              7,396
              
              
              
              10.0
              
              
              
              7,401
              
              
              
              8.2Utah
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
              
              $
              73,935
              
              
              
              100.0
              %
              
              $
              90,343
              
              
              
              100.0
              %
 8
 Table of
Contents
 The
following tables present details on non-performing and impaired loans and
related allowance for loan losses as of March 31, 2009 and December 31, 2008 are
as follows (dollars in thousands):


March
      31, 2009
              
              
              December
      31, 2008Number
      of Loans
              
              
              Balance
              
              
              Number
      of Loans
              
              
              BalanceNon-performing
      loans with a specific valuation allowance
              
              
              20
              
              
              $
              49,646
              
              
              
              24
              
              
              $
              65,903Non-performing
      loans without a specific valuation allowance
              
              
              9
              
              
              
              18,142
              
              
              
              5
              
              
              
              17,822Related
      allowance for loan losses on non-performing loans
              
              
              -
              
              
              
              (13,946
              )
              
              
              -
              
              
              
              (20,805
              )Total
      non-performing loans
              
              
              29
              
              
              $
              53,842
              
              
              
              29
              
              
              $
              62,920Performing
      loans - no related allowance
              
              
              1
              
              
              $
              7
              
              
              
              8
              
              
              $
              6,618Performing
      loans - related allowance
              
              
              2
              
              
              
              6,140
              
              
              
              -
              
              
              
              -Related
      allowance for loan losses on performing loans
              
              
              -
              
              
              
              (1,206
              )
              
              
              -
              
              
              
              -Total
      performing loans
              
              
              3
              
              
              $
              4,941
              
              
              
              8
              
              
              $
              6,618Total
              
              
              32
              
              
              $
              58,783
              
              
              
              37
              
              
              $
              69,538




Interest
income recognized on impaired loans for the three months ended March 31, 2009
and 2008 was $4,000 and $824,000, respectively.




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




Three
      Months Ended
              
              
              Year
      EndedMarch 31,
              
              
              December
      31,2009
              
              
              2008
              
              
              2008Balance,
      beginning
              
              $
              20,805
              
              
              $
              25,444
              
              
              $
              25,444Provision
      for loan loss
              
              
              1,206
              
              
              
              311
              
              
              
              21,491Amounts
      charged off
              
              
              -
              
              
              
              (300
              )
              
              
              (5,600
              )Transfers
      to real estate owned
              
              
              (6,859
              )
              
              
              (601
              )
              
              
              (20,530
              )Balance,
      ending
              
              $
              15,152
              
              
              $
              24,854
              
              
              $
              20,805
  Note
4 – Real Estate Owned


At March
31, 2009, we held real estate through 18 limited liability companies, and our
ownership percentage ranged from 10% to 100%.




During
the three months ended March 31, 2009, we foreclosed on properties with a fair
value of $9.4 million which is comprised of loans with an aggregate
original balance of $16.3 million.  In addition, we disposed of
approximately $35,000 of real estate owned for cash proceeds of $32,000,
resulting in a $3,000 loss on the sale.  We did not dispose of any
real estate owned through sale during the three month period ending March 31,
2008.




We
reclassified property valued at $417,000 from real estate owned to investments
in real estate during the three months ended March 31, 2009. During 2008 we
contributed property valued at a total of $6.7 million to three joint ventures,
in each of which we have between a 13% and a 50% non-controlling ownership
interest.  See also Note 5 - Investments in Real Estate.




The
following summary provides an analysis of the changes in real estate owned
during three months ended March 31, 2009 (dollars in
thousands):


Balance
      December 31, 2008
              
              $
              19,979Foreclosures
              
              
              9,390Real
      estate consolidated as noncontrolling interest
              
              
              828Impairments
              
              
              (1,087
              )Sales
      of real estate owned
              
              
              (35
              )Adjustments
      to foreclosure costs
              
              
              (187
              )Real
      estate reclassified to investment in real estate
              
              
              (417
              )Balance
      March 31, 2009
              
              $
              28,471




9
 Table of
Contents


The
following is a summary of real estate owned as of March 31, 2009 and December
31, 2008 (dollars in thousands):




Description
              Location
              
              March
      31, 2009
              
              
              December
      31, 2008Undeveloped
      land
              NV,
      AZ, CA
              
              $
              16,423
              
              
              $
              13,947Single
      family residential lots
              NV,
      AZ
              
              
              1,707
              
              
              
              1,707Office
      building
              NV,
      TX
              
              
              2,000
              
              
              
              2,613Other
              NV
              
              
              8,341
              
              
              
              1,712Total
              
              
              $
              28,471
              
              
              $
              19,979
  Note
5 – Investments in Real Estate


During
the year ended December 31, 2008, we entered into three joint venture agreements
with a third-party homebuilder for the construction of single family homes in
Las Vegas, Nevada.  We contributed property to the joint ventures, which we
had previously acquired through foreclosure and classified as real estate
owned.  These ventures are accounted for under the equity method of
accounting because we have between a 13% and a 50% non-controlling ownership
interest.  Our venture partner manages the operations of the joint
ventures.  All major decisions require the approval of both joint venture
partners, and voting rights and the sharing of profits and losses are in
proportion to the ownership percentages of each joint venture partner.  We
recorded our initial investment in the three ventures in an aggregate amount of
$6.7 million, the carrying value of the lots which approximated fair value at
the time of the formation of the joint venture.  We have no responsibility
to provide additional funding to the ventures.  Additional funding for the
construction of homes and sales of such will be provided by our venture
partner.  Our share of losses, if any, would be limited to the value of
lots contributed.  During the first three months of 2009, three homes were
constructed and sold to homeowners, resulting in a return of $165,000 of our
equity investments.  We received cash proceeds of $61,000 during the
first three months of 2009 from this sale, with the remaining $104,000 received
after the quarter end.




As of
March 31, 2009 and December 31, 2008 we had $1.4 million and $1.0 million,
respectively, in real estate investments that we accounted for under the cost
method, including our investment of $1.0 million in a 1.5% equity and profits
interest in the development of a resort community near Lincoln City,
Oregon.  In addition, we are a 13% member of an LLC that was created
to foreclose on a mortgage asset. Prior to foreclosure, this asset was carried
on our balance sheet as a mortgage investment and upon foreclosure was
classified as real estate owned.  During the three months ended March
31, 2009, the LLC incurred debt in the form of a note payable and is now
considered an operating entity.  We have reclassified this property at
its carrying value of $417,000 to investments in real
estate.   We have evaluated the carrying value of our cost method
investments for impairment.  There were no impairments in value that would
be considered other than temporary at March 31, 2009.




The
following summary provides an analysis of the changes in investments in
real estate during the three months ended March 31, 2009 (dollars in
thousands):




Equity
      MethodJoint
      Ventures
              
              
              Cost
      Method
              
              
              TotalBalance
      December 31, 2008
              
              $
              6,167
              
              
              $
              1,000
              
              
              $
              7,167Assets
      reclassified from real estate owned
              
              
              -
              
              
              
              417
              
              
              
              417Distribution
      from sales of joint venture property
              
              
              (165
              )
              
              
              -
              
              
              
              (165
              )Balance
      March 31, 2009
              
              $
              6,002
              
              
              $
              1,417
              
              
              $
              7,419
  Note
6 - Stock Based Compensation


The Board
of Directors adopted the 2004 Stock Incentive Plan of Desert Capital REIT, Inc.
(the “Plan”), and we have reserved 1,000,000 shares of common stock for issuance
under the Plan. As of March 31, 2009 we have granted awards for 108,000
restricted shares in aggregate to our Board of Directors and certain executive
officers under the Plan. The shares were granted in annual grants to our
directors.




There was
no restricted stock expense for the three months ended March 31, 2009 and
2008.




Note
7 - Building and Equipment


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


March
      31, 2009
              
              
              December
      31, 2008Building
              
              $
              7,818
              
              
              $
              7,811Equipment
              
              
              100
              
              
              
              100Furniture
      and fixtures
              
              
              411
              
              
              
              411Construction
      in progress
              
              
              25
              
              
              
              -8,354
              
              
              
              8,322Less
      accumulated depreciation
              
              
              (1,629
              )
              
              
              (1,507
              )Building
      and equipment, net
              
              $
              6,725
              
              
              $
              6,815
 Note
8 – Earnings (loss) per Share


Earnings
(loss) per share is computed in accordance with SFAS 128. Basic earnings (loss)
per share is calculated by dividing net income (loss) by the weighted average
number of shares of common stock outstanding during each period. Diluted
earnings (loss) per share is calculated by dividing net income (loss) by the
weighted average number of shares outstanding plus the additional dilutive
effect of unvested restricted stock during each period.  As of March
31, 2009 and 2008, there were no unvested shares outstanding under our stock
incentive plan.




The
following is a reconciliation of the basic and diluted earnings (loss) per share
(dollars and shares in thousands):


For
      the Three Months Ended March 31,2009
            
            
            2008Net
      income (loss) available to common stockholders
            
            $
            (4,231
            )
            
            $
            806Weighted
      average number of common shares outstanding - basic and
      diluted
            
            
            16,836
            
            
            
            16,783Basic
      and diluted income (loss) per common share
            
            $
            (0.25
            )
            
            $
            0.05






10
 Table of
Contents


Note
9 - Dividends and Redemptions


To
maintain our status as a REIT, we are required to make dividend distributions,
other than capital gain dividends, each year in an amount at least equal to 90%
of our taxable income.  All dividend distributions are made at the
discretion of our Board of Directors and depend on our earnings, both tax and
GAAP, financial condition, maintenance of REIT status and such other factors as
the Board of Directors deems relevant.  No dividends were paid during
the three months ended March 31, 2009.  The following table lists the
dividend declaration dates and per share amounts for the three months ended
2008:





Declaration
      Date
            Distribution
      Date
            
            2008January
      31
            February
      15
            
            $
            0.100February
      29
            March
      14
            
            
            0.025March
      31
            April
      15
            
            
            0.025Total
            
            
            $
            0.150




Upon the
death of a stockholder, at the option of the stockholder’s estate, the estate
has a limited right of redemption with respect to the common
stock.  This right of redemption has been accounted for under FAS 150,
“Accounting for Certain Financial Instruments
with Characteristics of both Liabilities and Equity,” and at March 31,
2009, we had received redemption requests of 106,000 shares of common stock
totaling $1.1 million.
  Note
10 – Debt


Notes
Payable


Bank
Note


We had a
$7.5 million secured bank note with a term of one year that matured in
February 2009.  The note, which was originally a credit facility, was
established for short-term funding needs. Amounts drawn under this note bear
interest at an interest rate equal to the prime rate plus 75 basis points, with
a floor of 7.0%, and must be repaid within 90 days.  The interest rate
at March 31, 2009 was 7.0%.  Amounts drawn under this note are
secured by the corresponding loan that is being funded by the advance. At March
31, 2009 and December 31, 2008, we had an outstanding balance of $1.1 million
and $1.4 million, respectively. Certain of our assets are collateral for this
note.  The carrying value of these assets was $14.2 million on March
31, 2009. Of the balance outstanding at March 31, 2009, $1.0 million was
borrowed in January 2008, and was not repaid within the 90-day time required by
terms of the bank note. The bank granted us an extension to February 22, 2009,
the maturity date of the note, to pay the $1.0 million defaulted principal
balance and waived default-rate interest through the date of the
extension.  Our bank note matured and we were unable to repay the
outstanding balance in accordance with the terms of the agreement. In March
2009, the bank agreed to reduce the maximum amount of the note to its balance at
the time of modification, or $1.2 million, extend the maturity of the note for
12 months and to modify certain of the covenants. In addition, we agreed to the
following minimum principal payments:  $100,000 by March 31, 2009, of
which all amounts due have been paid; $25,000 by June 30, 2009, $50,000 by
November 30, 2009, $100,000 by December 31, 2009, and any remaining balance due
on February 22, 2010.  All interest payments are due as originally
agreed upon.  Our covenants contain customary default provisions and
require us to maintain financial ratios at quarterly determination
dates.  Our ability to incur additional debt is also
limited.  At March 31, 2009 and as of the date of this filing, we are
not in compliance with certain of the covenants required under this note
agreement.




Other
Notes Payable


During
the first three months of 2009, we entered into two debt agreements totaling
$1.8 million. We set aside interest reserves in the amount of
$317,000.  We have reflected the interest reserve fundings as a
reduction in the note balance, resulting in a net note balance of $1.4
million.   The interest is paid on the principal amount of the
notes, or $1.8 million.  The interest rates on these notes range from
10% to 13%, and payments will be made monthly from the interest reserve account
with a balloon payment of the principal balance due at maturity.  The
debt is collateralized by certain of our real estate owned with a carrying value
of $13.4 million.  The proceeds from the notes of $1.8 million, less
closing costs, funding of the interest reserves and other fees were $1.2 million
which is classified as restricted cash on our balance sheet.  The cash
will be used for the payment of ownership costs such as property taxes and legal
fees and servicing fees paid to our related party loan servicer, CM
Capital.     During the three months ended March 31,
2009, we recorded $16,000 of interest expense related to this debt.




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




Interest
      Rate
              
              Maturity
      Date
              
              Original
      Note Balance
              
              
              Interest
      Reserves
              
              
              Carrying
      Balance10%
              
              2/23/2011
              
              $
              1,248
              
              
              $
              (250
              )
              
              $
              99813%
              
              3/13/2010
              
              
              515
              
              
              
              (67
              )
              
              
              448$
              1,763
              
              
              $
              (317
              )
              
              $
              1,446




Mortgage
Loans Payable


We have a
mortgage loan from a bank, with an outstanding principal balance of $6.2 million
and $6.3 million as of March 31, 2009 and December 31, 2008,
respectively.  This loan bears interest at a rate equal to the prime
rate, with a floor of 6.75% and a ceiling of 7.75%. Principal and interest are
payable monthly and the note matures in 2026, with no prepayment penalty. The
interest rate on March 31, 2009 and December 31, 2008 was 6.75%. The mortgage is
secured by our office building in Henderson, Nevada. We were in compliance
with all financial covenants related to this loan as of March 31,
2009.




We
assumed a first lien mortgage payable to a bank upon foreclosure of a 10,330
square foot office building in Houston, Texas in November 2007 to preserve our
interest in the property. The loan had an outstanding principal balance of $1.6
million at March 31, 2009 and December 31, 2008.  The note bears
interest equal to the prime rate minus 50 basis points (2.75% at March 31,
2009), and matures in April 2011, with no prepayment
penalty.  Principal and interest are payable
monthly.




Junior
Subordinated Notes Payable


In June
2006, we issued $30.0 million in unsecured trust preferred securities through a
newly formed Delaware statutory trust, Desert Capital TRS Statutory Trust
I, which is our wholly-owned subsidiary.  The securities bear interest at a
floating rate based on the three-month LIBOR plus 400 basis points, which reset
each calendar quarter, which was 5.17% and 7.47% on March 31, 2009 and December
31, 2008, respectively.




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




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




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




11
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Our
covenants contain customary default provisions and require us to maintain
financial ratios at quarterly determination dates, including a minimum tangible
net worth requirement.  Our ability to incur additional subordinated
debt is also limited.  In June 2008 we entered into an agreement with
the holders of the trust preferred securities to modify the tangible net worth
covenant contained in our indenture through December 31, 2008.  In
exchange for the modification we agreed to establish a cash reserve account into
which we would make monthly deposits of 25% of our net income until such time as
the balance of the reserve account is at least equal to $2.1 million. In
addition, in the event that the aggregate amount of the dividends that we pay
during any month exceeds the amount that we deposit into the reserve account
during such month, we must also deposit into the reserve account 25% of each
principal payment we receive in respect of any of our mortgage loans until the
amount of the short-fall has been deposited into the reserve
account.  We must replace the reserve account with a letter of credit
in the face amount of $2.1 million as security for the trust preferred
securities.  At March 31, 2009, the balance in such reserve account
was $711,000, which is reflected as restricted cash on our balance
sheet.     At March 31, 2009, interest payable on the
securities was $259,000 which was included in the payment made on April 29,
2009. Of the quarterly payment of $388,000 made on April 29, 2009, $288,000 was
drawn from the Reserve Account.  At March 31, 2009 and December 31,
2008, we were not in compliance with all covenants as modified.  We
received a notice from the Trustee that a default had occurred and was
continuing under the indenture governing the junior subordinated
notes.  As of May 3, 2009, such default matured into an event of
default, which gives the Trustee and the holders of the trust preferred
securities the right to accelerate the outstanding indebtedness.  We
are in discussions with the Trustee and the holders of the securities regarding
our covenant compliance and the existing event of default.




Note
11 - Commitments and Related Parties


CM Group
is our Advisor and oversees our day-to-day operations including asset,
liability and capital management. In lieu of paying salaries to officers, we
compensate our Advisor pursuant to an advisory agreement that entitles it to
first-tier management compensation, second-tier management compensation, and
reimbursement of expenses.  The officers and majority owners of our
Advisor are also our executive officers. The annual first-tier management
compensation is 1% of the first $200 million of gross average invested assets
plus 0.8% of the gross average invested assets in excess of $200 million, to be
paid quarterly.   The first-tier management compensation for the three
months ended March 31, 2009 and 2008 was $377,000 and $422,000, respectively. At
March 31, 2009, $1.1 million of first tier management compensation was included
in accounts payable and accrued expenses.




The
second-tier management compensation is a tiered percentage of the amount of our
taxable income excluding provision for loan loss and capital losses, before
deducting second-tier compensation less a threshold return, which is the net
income that would produce an annualized return on our average invested assets
equal to the 10-year U.S. Treasury rate plus 1.0%. The tiered percentage is
calculated on the weighted average of 20% of the first $200 million of
average invested assets and 10% of the excess over $200 million of average
invested assets. The second-tier management compensation is calculated quarterly
and any positive quarterly amount is paid by us, along with the first-tier
management compensation, within 15 days of receipt of the
computations.  Second-tier management compensation for the three
months ended March 31, 2009 and 2008 was zero.




During
2008, the composition of our investment portfolio changed dramatically from a
performing loan portfolio to a defaulted loan and foreclosed property portfolio.
Our Advisor, CM Group, receives a management fee for general management of the
day-to-day operations of the REIT. With the changing composition of our assets,
the functions being performed by our Advisor, and to a larger degree, CM
Capital, our loan originator and servicer, increased and changed significantly.
CM Capital’s function as loan servicer has historically been to collect interest
payments from the borrowers and to distribute interest payment to the
investors.  As compensation for this service, the borrower would pay
CM Capital a servicing fee. As the borrowers began defaulting on their loans, CM
Capital was no longer able to collect the servicing fees on defaulted loans. At
the same time, CM Capital began to perform more complex functions related to the
defaulted loans and ultimately the foreclosed property, such as soliciting
investor votes on the handling of defaulted loans, handling foreclosure
proceedings, processing and paying carrying costs, negotiating with borrowers
and builders, structuring joint venture agreements, selling property and
designing and executing other workout strategies on behalf of the investors. In
December 2008, CM Capital services determined that it could no
longer advance the carrying costs and workout/resolution costs related to
the properties on which it had foreclosed on behalf of the investors, and sent a
letter to the investors (owners) of the foreclosed properties giving the
investors the option to assume the responsibility for their own asset management
functions, or pay CM Capital to provide such services. DCR received such a
letter, and in March 2009, agreed to have CM Capital provide asset management
services on its behalf. In exchange for such services, we agreed to pay CM
Capital an annual fee equal to 2.5% of the original loan amount of the
foreclosed properties, calculated from the date of foreclosure. For the three
months ended March 31, 2009, this fee totaled $663,000, and is included in
management and servicing fees in the consolidated statement of operations. 
At March 31, 2009, $634,000 is payable and included in management and servicing
fees payable on the consolidated balance sheets.




In order
to facilitate payment of certain carrying costs and servicing fees, during the
three months ended March 31, 2009, we incurred debt totaling $1.8 million. CM
Capital served as our debt placement agent and servicer, for which we paid
placement fees of $64,000.  In addition, we funded interest reserves
related to the notes payable of $317,000, which are being held in a trust
account by CM Capital.  The net proceeds, less closing costs, funding
of the interest reserves and other fees of $1.2  million is classified
as restricted cash on our balance sheet for the purpose of the payment of costs
associated with being a land owner and servicing fees payable to CM
Capital.  The cash is being held by CM Capital for our benefit in a
trust account.




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The
dealer-manager of our offering of common stock, CM Securities, directs and
oversees the sale of our equity securities. CM Securities receives a marketing
support fee and sales commissions based on the number of shares of common stock
it sells. CM Securities contracts with third party broker-dealers to have a
larger sales distribution of equity securities and compensates them out of the
sales commissions and marketing support fees it receives from us. Because CM
Securities is controlled by our Advisor, it is our affiliate. CM Group acquired
ownership of CM Securities on November 21, 2007 and prior to November 21, 2007,
CM Securities was owned by our CEO.  Due to the general collapse of
the real estate market beginning in late 2007, and the impact of declining real
estate values on our mortgage investments, our Board of Directors suspended the
sale of Desert Capital REIT shares as of February 22, 2008.  As a
result, CM Securities did not earn any sales commissions or marketing support
fees for the three months ended March 31, 2009.  CM Securities earned
gross sales commissions and marketing support fees for the three months ended
March 31, 2008 of $36,000.  CM Securities paid a substantial portion
of these fees to third party broker
dealers.




In
September 2005, a third-party borrower asked us to enter into a land banking
transaction, meaning that we would purchase a tract of land, and simultaneously
enter into an option contract with the borrower, pursuant to which the borrower
would purchase smaller parcels of the initial tract from us over time at a
specified price, until it had purchased the entire initial tract.  Due
to the rules with which we must comply to maintain our REIT status, actual title
to that land had to be owned by a separate entity and could not be held by the
Company.  As an accommodation to us and the third-party borrower, our
CEO, Todd Parriott formed a company, CM Land, LLC, for the specific purpose of
holding title to that land.  We funded $11.9 million of loans to CM
Land,  secured by the property. In May 2007, the borrower did not
exercise its option under the contract to purchase the remaining portion of the
land.  As a result, we foreclosed on the property, and our investment
in the loan was converted to membership units representing a 37.6% interest in
the limited liability company.  In September 2007, the limited
liability company borrowed $13.7 million from private trust deed investors to
repay the first position lien-holder, and we guaranteed this debt.  We
receive a fee for guaranteeing this debt and for the first three months of 2009,
we earned $68,000 in guarantee fees, of which $68,000 remains receivable at
March 31, 2009.   At March 31, 2009, we have recorded an
aggregate impairment of $5.9 million related to this property, leaving a balance
of $6.1 million, which is included in real estate owned.




CM
Equity, LLC (“CM Equity”) was formed in June 2007 for the purpose of investing
in, developing, co-developing, operating, owning and financing commercial and
residential real estate projects. Some of the executive officers of CM
Equity are the same as our executive officers, and our Advisor is also the
manager of CM Equity.  In November 2007, we sold a non-performing loan
with an outstanding balance of $1.96 million to CM Equity.   No
gain or loss was recognized on the sale as we provided 100% financing on the
sale.  The loan had a fixed interest rate of 8.25% and was scheduled
to mature in November 2009.   The loan became non-performing in the
fourth quarter of 2008.  In January 2009, CM Equity deeded the
property back to us, and currently the property is being held as real estate
owned in the amount of $1.2 million net of impairment charges of
$760,000.




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




●
            
            293,001
      shares of our common stock with a value of $4.4 million based on the last
      offering of its common stock at a per share price of $15 per
      share.  We subsequently retired the 293,001 shares of
      stock.●
            
            $105,000
      in cash.●
            
            A
      $15.5 million promissory note bearing interest at 9% per annum with
      principal and interest payments due quarterly beginning on March 31,
      2008.  The note matures in December 2017.  The note is
      secured by all of the outstanding membership units of CM
      Capital.










In
addition to the consideration received, we receive a contingent installment
payment from CM Capital on loans we fund. The $8.25 million contingent
payment (the “Installment Payment”) is payable  as follows: CM
Group will pay or cause CM Capital to pay to TRS, on the last day of each
calendar quarter, an amount equal to: (i) 1% of the principal amount of all
mortgage loans originated or brokered by CM Capital or any of its affiliates and
funded by us during such calendar quarter for the first $200 million of mortgage
loans funded during each calendar year; and (ii) 0.5% of the principal amount of
all mortgage loans originated or brokered by CM Capital and funded by us during
such calendar quarter in excess of $200 million during each calendar year,
commencing on December 31, 2007 and continuing on the last day of each calendar
quarter thereafter, until TRS has received $8.25 million.  TRS’ right
to receive the Installment Payment is secured by all of the outstanding
membership units of CM Capital.   For the three months ended
March 31, 2009 and 2008, we recognized income of zero and $132,000 related to
the contingent installment payment.




We also
entered into a loan origination agreement with CM Capital and CM Group, which
terminates one month after the last day of the month in which the Installment
Payment is paid in full.   During the term of the Loan
Origination Agreement we have the right to fund all mortgage loans identified by
CM Capital or any affiliate of CM Group or CM Capital that becomes engaged in
the business of originating or brokering commercial loans. During the three
months ended March 31, 2009, we did not fund any loans originated by CM
Capital.




13
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During
2008, CM Capital was not in compliance with certain financial covenants
contained in the loan agreement related to the original balance of $15.5 million
promissory note payable to TRS.  In August 2008, our Board of
Directors formed a special committee of independent directors to review the
financial covenants and approve a strategy to resolve the defaulted status of
the loan. We granted CM Capital a limited waiver, either to enter into an
amendment to the loan agreement to modify such financial covenants upon terms
and conditions and in form and substance satisfactory to TRS or demonstrate that
CM Capital is in compliance with the loan agreement and will be in compliance
with the loan agreement at December 31, 2008.  In October 2008, the
Special Committee and CM Capital agreed to modify the loan terms, and in
November 2008 we executed documents to evidence the
modification.  Under the terms of the modification, principal payments
on the note were deferred for two years, and the interest rate was reduced from
9% to 6% per annum effective as of July 1, 2008.  Additionally, the
working capital financial covenant was replaced with the requirement to maintain
a cash balance of $250,000 at the end of each quarter, and the first measurement
period for the fixed charge coverage ratio was moved from December 31, 2007 to
December 31, 2008.  Based on the modified terms of the promissory
note, we evaluated the promissory note in accordance with SFAS No. 114,
“Accounting by Creditors for Impairment of a Loan,” (FAS 114) and determined
that the modification resulted in an impairment based on the present value of
the expected future cash flows under the modified terms.  Accordingly,
and included in the $12.8 million note receivable balance, we have provided an
allowance for loan loss of $1.9 million to reflect this
impairment.  As of December 31, 2008 and March 31, 2009, CM Capital
was in compliance with the modified financial covenants set forth
above.   We earned interest of $221,000 and $353,000 during the three
months ended March 31, 2009 and 2008, respectively, of which $145,000 was
receivable at March 31, 2009.   Subsequent to March 31, 2009, we have
received all interest amounts due.




We lease
office space to CM Group, CM Securities, CM Capital, and Residential Capital
Mortgage (an entity owned by certain of our officers) under non-cancelable
operating leases which expire in July 2010.  Total rents received from
related parties for the three months ended March 31, 2009 and 2008 were
$129,000.




Note
12- Fair Value of Financial Instruments


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




The
following table summarizes the carrying values and the estimated fair values of
financial instruments as of March 31, 2009 and December 31, 2008 (dollars in
thousands):   March
      31, 2009
                
                
                December
      31, 2008Carrying
      Value
                
                
                Estimated
      Fair Value
                
                
                Carrying
      Value
                
                
                Estimated
      Fair ValueFinancial
      assets:Cash,
      cash equivalents and restricted cash
                
                $
                2,068
                
                
                $
                2,068
                
                
                $
                1,629
                
                
                $
                1,629Interest
      receivable
                
                
                219
                
                
                
                219
                
                
                
                531
                
                
                
                531Note
      receivable - related party
                
                
                12,792
                
                
                
                10,379
                
                
                
                12,600
                
                
                
                11,024Mortgage
      investments - net
                
                
                58,783
                
                
                
                60,519
                
                
                
                69,538
                
                
                
                68,773Financial
      liabilities:Bank
      note
                
                
                1,110
                
                
                
                1,014
                
                
                
                1,360
                
                
                
                1,274Notes
      payable
                
                
                1,446
                
                
                
                1,697
                
                
                
                -
                
                
                
                -Mortgages
      payable
                
                
                7,801
                
                
                
                7,194
                
                
                
                7,893
                
                
                
                7,264Junior
      subordinated notes
                
                
                30,928
                
                
                
                24,601
                
                
                
                30,928
                
                
                
                27,493






14
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We used
the following methods and assumptions in estimating the fair value of each class
of financial instrument:




●
            
            Cash, cash equivalents and
      restricted cash: The carrying values of cash and short-term
      instruments approximate fair values.●
            
            Interest
      receivable: Carrying values approximate fair values due to
      their short term nature.●
            
            Note receivable – related
      party:Fair value is estimated using discounted cash flow analyses
      based on a rate reflective of the current market environment for a similar
      period, the fixed amount of the note receivable and an estimated risk of
      default based on similar business operations and history of
      operations.  We considered these inputs as Level 3.●
            
            Mortage
      investments-net:  At March 31, 2009 and December 31, 2008
      the fair value of fixed rate loans currently classifed as performing, was
      computed based on the probability of collection of the cash flow, a risk
      free rate of return on all estimated cash flows, the estimated realization
      of collateral based on recent history and the fixed interest rate of the
      loans.  At March 31, 2009 and December 31, 2008, substantially all of
      our impaired loans were evaluated based on the fair value of their
      underlying collateral based upon the most recent appraisal available to
      management or recent transaction prices for similar collateral, and as
      such, the carrying values of these instruments, net of allowance for loan
      losses, approximates the fair value.  Fair value inputs on performing
      and non-performing loans are considered Level 3.●
            
            Bank
      note:  The value of our variable rate-term borrowing,
      classifed as Level 3, were estimated using a cash flow analysis, taking
      our credit standing into consideration, as well as the excess assigned
      collateral, and a rate reflective of the current market
      environment.●
            
            Mortgage
      loans payable and notes payable:  For March 31, 2009 and
      December 31, 2008 our credit standing was taken into consideration, as
      well as the assigned collateral which was considered more than adequate,
      the estimated risk to the lender of the collateral to the loan balance and
      rates reflective of the current market environment, all of which
      were factors in the computation of fair value and were considered Level 3
      inputs.●
            
            Junior subordinated
      notes:  Our junior subordinated notes do not trade in an active
      market and, therefore observable price quotations are not available. 
      In the absence of observable price quotations, fair value is determined
      based on discounted cash flow models which incorporate the effects of our
      own credit risk in the fair value of the liability.  The cash flow
      assumptions were based on the contractual cash flows based on our
      anticipation that we will pay the debt according to its contractual terms,
      and were considered Level
3 inputs.












We do not
have any assets or liabilities that are measured at fair value on a recurring
basis.  The following table presents our assets and liabilities that
are measured at fair value on a nonrecurring basis at March 31,
2009.  Level 1 and Level 2 data were not used in the fair value
measure.




Estimated
      Fair Value  Level 3Impaired
      mortgage investments
              
              
              53,842Investments
      in real estate
              
              
              7,419Real
      estate owned
              
              
              28,471




Note
13 – Commitments and Contingencies


We
guaranteed approximately $13.7 million of indebtedness of Warm Jones, LLC, a
limited liability company in which we own a 37.6% membership
interest.  Under the original terms of the indebtedness, the note was
due in October 2008 and subsequently modified, extending the maturity to
February 2010.  The beneficiaries under the guarantee have the right
to make demand on us under the guarantee to pay the entire $13.7 million if the
borrower defaults on the note.   We have determined that our
potential liability pursuant to FASB Interpretation No. 45 (FIN 45), “Guarantor's Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of Others,”
is approximately $101,000 as of March 31, 2009 and December 31, 2008, and is
included in accrued expenses in our consolidated balance sheets.




In
December 2008, we received a comment letter from the SEC relating to the
accounting for the sale of our former subsidiary and related party, CM Capital,
as reported in our Form 10-K for the year ended December 31, 2007.  As of
the filing of this Form 10-Q, we have responded to the staff's inquiries;
however, we have not received a response from the SEC regarding our
submission.  While we believe that the accounting and reporting was
appropriate based upon the facts and circumstances at the time of the sale, the
resolution of this issue could have a material impact on our financial
statements.




Note 14
- Subsequent events


In April
2009, we formed a subsidiary
of our TRS to foreclose on a non-performing loan which was collateralized by an
operating business, a gentlemen's club in Las Vegas, Nevada.  Included
in the assets acquired through foreclosure were land, building, furniture and
fixtures and liquor, beer and wine inventory.  The loan had an
original balance of $14.4 million and a carrying value of $12.1 million at the
time of foreclosure, which approximated the fair value of the real estate and
business.  We are actively marketing the real estate and the business
for sale.




In April
2009, we acquired a property through a deed in lieu of foreclosure, with an
original loan balance of $20,000 and no associated impairment, and classified it
as real estate owned.




15
 Table of
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Item 2.  Management’s Discussion and Analysis of
Financial Condition and Results of Operations




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




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




●
            
            economic conditions impacting
      the real estate market and credit
      markets;●
            
            changes in interest
      rates;●
            
            potential
      impacts of changes to our strategies without stockholder
      approval;●
            
            an increase
      in the number of our loans that become non-performing;●
            
            our ability
      to sell assets;●
            
            our Advisor’s
      motivation to recommend riskier investments in an effort to maximize its
      incentive compensation under the advisory agreement;
  and●
            
            although we
      believe our proposed method of operations will be in conformity with the
      requirements for qualification as a REIT, we cannot assure you that we
      will qualify as a REIT or, if so qualified, will continue to qualify as a
      REIT. Our failure to qualify or remain qualified as a REIT could have
      material adverse effect on our performance and your
      investment.




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




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




Overview




The first
quarter 2009 results reflect continued pressure from an
uncertain economy and the struggling housing market.  For the three
months ended March 31, 2009, we reported a net loss of $4.2 million, compared to
net income of $806,000 for the three months ended March 31,
2008.  Contributing to the first quarter 2009 net loss was a $1.0
million provision for loan losses and a $1.1 million impairment of real estate
owned, coupled with a reduction in total interest income of $2.3 million. The
original balance of performing loans declined from $67.7 million at March 31,
2008 to $6.1 million at March 31, 2009, resulting in a significant loss of
interest income for the current quarter.




While our
entire portfolio of real estate investments continues to be negatively impacted
by market forces, we continue to take important steps to address our portfolio
issues and manage our cash position. The highlights of our first quarter actions
are as follows:


●
            
            Foreclosed
      on the underlying real estate on loans with an original balance of $16.3
      million;●
            
            Placed
      $1.8 million of debt on specific assets to generate cash to be used for
      servicing fees and real estate carrying and resolution
    costs;●
            
            Sold
      real estate for cash proceeds of $151,000; and●
            
            Negotiated
      a modification of our bank note to extend the maturity date of the
      existing note.


As the
size of our real estate portfolio continues to increase due to continued
foreclosure activity, our costs related to real estate ownership also increase.
These costs include servicing fees payable to CM Capital, property taxes, legal
fees, maintenance costs and resolutions costs.  Because our portfolio
of performing loans has shrunk to $6.1 million, our recurring cash flow is not
sufficient to cover our general operating costs, including real estate carrying
costs.  As a result, we determined that is was in the best interest of
our company to leverage a small portion of our real estate assets in order to
raise necessary operating capital. During the quarter, we entered into $1.8
million of debt, which was placed by CM Capital with individual trust deed
investors. The cash proceeds from this debt were set aside to cover specific
costs related to carrying and resolving our real estate portfolio, as well as 12
to 24 months of interest payments on the debt. We continue to closely monitor
and manage our liquidity position, understanding that this is of critical
importance in the current economic environment. With the addition of this
debt, our ratio of debt to total assets increased to 34.1% at March 31, 2009, up
slightly from 32.8% at December 31, 2008, which continues to be well below the
financial leverage used by other mortgage REITs.




16
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Although
the real estate and credit market disruptions continue to challenge us, we will
continue to explore portfolio resolution strategies that will offer both
operating liquidity and longer term capital appreciation. We will also explore
additional investment and business opportunities as they arise and as cash
becomes available; however, due to the current credit market disruption, our
investment opportunities are limited primarily due to our lack of capital
available for investment.  Until we generate proceeds through the
resolution of our non-performing loans and sale of real estate, we will not have
cash available for new investments that will generate cash flows to us. We
expect that the current state of the real estate and credit markets will
continue to have an adverse effect on our operations throughout
2009.





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




In early
2009, certain of our related parties made changes to their legal names in
conjunction with a corporate branding initiative. Specifically, our Advisor,
Sandstone, became CM Group, LLC (“CM Group”) and Consolidated Mortgage became CM
Capital Services, LLC (“CM Capital”).  In addition, CM Securities, LLC
(“CM Securities”) acquired the business of CMC Financial Services,
Inc.  The ownership of these entities was not affected.




Our
Investments




Real
Estate Owned


We were established as a
mortgage REIT; however, as our borrowers began defaulting on their obligations
to us, our Advisor determined that, in many instances, the best course of action
was to foreclose on the underlying collateral and take title to the property.
Real estate owned consists of property acquired through foreclosure on mortgage
loans. During the first three months of 2009, we foreclosed on four loans with
an aggregate original loan amount of $16.3 million, and a carrying value of $9.4
million. Our interest in real estate owned may be held directly by us, or
through LLCs. If we are one of several investors in a larger mortgage loan, such
loans are foreclosed on using an LLC to facilitate foreclosing our lender
interest along with private investors who hold the remaining loan balance. In
these instances, our original investment in the loan is converted to
proportionate interests in the LLC. In cases where our ownership interest in an
LLC is greater than 50%, we analyze strategic alternatives to determine whether
the property should be sold, contributed to a joint venture for development
or held for future resolution.  We are also considering certain
other strategic initiatives, such as developing and/or operating the real
properties that we have acquired through foreclosure. In situations where our
ownership interest in an LLC is less than 50%, our ability to make strategic
decisions regarding the property is subject to the voting interests of a
majority of the members of the limited liability company, which may hinder our
ability to execute our desired strategy for the property.




The
following table presents our real estate owned assets, classified by original
loan type (dollars in thousands):




March
      31, 2009
              
              
              December
      31, 2008Original
      Loan Type
              
              Original
      Loan Positions
              
              
              Net
      Carrying Value
              
              
              Original
      Loan Positions
              
              
              Net
      Carrying ValueAcquisition
      and development loans
              
              
              39
              
              
              $
              24,381
              
              
              
              36
              
              
              $
              15,271Construction
      loans
              
              
              15
              
              
              
              4,090
              
              
              
              16
              
              
              
              4,708Commercial
      property loans
              
              
              -
              
              
              
              -
              
              
              
              1
              
              
              
              -Total
              
              
              54
              
              
              $
              28,471
              
              
              
              53
              
              
              $
              19,979
  Investments
in Real Estate


Joint
Ventures


When we
pursue our resolution strategy of contributing foreclosed property to a joint
venture, we account for our resulting ownership as equity investments in real
estate.  To date, we have entered into three different joint venture
arrangements with one joint venture partner, and have contributed land with a
carrying value of $6.7 million to the joint ventures. Our joint venture partner,
the developer, will construct homes on each of the three projects, and sell the
completed homes to homeowners. Under terms of the joint venture agreements, the
developer will fund the majority of the costs of construction, and we will
receive our proportionate share of the lot contribution price plus between 13%
and 50% of the profits on the sale of each home, depending on our ownership
interest. We anticipate that the construction and sale of all the homes in each
of the joint venture projects will take from 18 to 60 months.  During the
first three months of 2009, three homes were constructed and sold to homeowners,
resulting in a return of $165,000 of our equity
investment.




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Equity
Investments


Our interest in real
estate owned may be held directly by us, or through LLCs. If we are one of
several investors in a larger mortgage loan, such loans are foreclosed on using
an LLC to facilitate foreclosing our lender interest along with private
investors who hold the remaining loan balance. In these instances, our original
investment in the loan is converted to proportionate interests in the limited
liability company.  If our interest is such that we have determined we
hold a controlling interest after evaluation under FIN 46 or APB 18, we classify
and account for these investments under the equity method of
accounting.  During the quarter ended March 31, 2009, we determined
that an investment we hold as real estate owned within an LLC, and with a
membership interest of 91%, should be consolidated and classified as an equity
investment.  We currently have this asset classified as real estate
owned as it is fully consolidated on our balance sheet.




Investments
accounted for under the cost method


In situations where our
interest in an LLC represents less than 50% and we do have direct control over
the LLC, we account for the investment under the cost method of
accounting.  During the quarter ended March 31, 2009, we determined
that an investment we previously held as real estate owned within an LLC, and
with a membership interest of a 13%, should be classified as an investment in
real estate under the cost method of accounting.  We reclassified this
asset at its carrying value of $417,000.




Mortgage
Loans


At the time of our
inception, our stated business plan was the investment in a variety of types of
mortgage loans.  As of December 31, 2008, mortgage investments still
constitute a majority of our assets; however, because of our current lack of
access to capital, during 2009 we did not originate any new mortgage loans. We
will not have funds available to make new investments in mortgage loans until we
are able to resolve some of our non-performing loans, sell some of our real
estate assets, or have access to the capital markets which are currently closed
to us.  At the time of origination, our mortgage investments are
short-term (12 to 18 months), balloon loans with fixed interest rates. A
substantial portion of these loans consists of interest-carry loans, meaning we
provide the borrower with sufficient financing to enable it to make the interest
payments during the term of the loan. The interest-carry nature of our mortgage
loans means that we may not be able to determine that a loan is non-performing
until the balloon payment is due.  To date, all of the mortgage loans
which we have funded have been identified by CM Capital. We do not have a
contractual arrangement with any other mortgage originator. Our Board of
Directors has not established any limits upon the geographic concentration of
mortgage loans that we may acquire.  At March 31, 2009, 47.5% of our
portfolio of mortgage investments was located in Nevada.  In addition,
we have a significant concentration of credit risk with our largest
borrowers.  At March 31, 2009, the aggregate amount of loans to
our five largest borrowers was $53.4 million representing approximately
72.3% of our total investments in mortgage loans.  All but $6.1
million of this amount was classified as non-performing and $6.5 million was
reserved in the allowance for loan losses.




Historically, we have
primarily invested in mortgage loans that are secured by first or second-lien
mortgages on real property. These loans fall into the following categories:
acquisition and development, construction, and commercial property loans. No
single mortgage loan exceeds 20% of our debt and equity capital. Additionally,
mortgage loans in favor of any one borrower will not exceed 20% of our debt and
equity capital.  The majority of the mortgage loans in our portfolio
are either full recourse against all assets of individual borrowers, including
the real estate being financed, or if the mortgage loan is made to an entity
borrower, the mortgage loan is personally guaranteed, on a full recourse basis,
by each of the principals of that entity. Even though we have generally insisted
on obtaining these guarantees at the time of funding the mortgage loan, to date
we generally have not attempted to collect on any guarantees regarding our
non-performing or defaulted mortgage loans.




The development and/or
construction loans we fund or acquire are initially fully funded, with the
maximum borrowing capacity being established by an appraisal of the completed
value of the property. Once the amount of credit has been established, the funds
are placed into an account with a third party construction control company which
monitors the progress of the construction process and releases the funds as
certain thresholds are reached. The vendors, suppliers and subcontractors of the
borrower submit invoices for services rendered or goods provided to the
construction control company. Once the construction control company has
confirmed the delivery of the goods or the satisfactory completion of the
services, it receives a lien release from the billing party, and obtains
approval from CM Capital to pay the invoice. At no time does the borrower have
direct access to the committed funds.





Results
of Operations for the three months ended March 31, 2009 compared to the three
months ended March 31, 2008




Revenues:




Interest
income is generated on our mortgage investments and our related party note
receivable from CM Capital. Interest income decreased by $2.3 million, or 83.8%,
to $447,000 for the quarter ended March 31, 2009 from $2.8 million for the
quarter ended March 31, 2008. This decrease was due to a 92.0% decrease in the
average balance of the performing loans in our portfolio from $76.7 million for
the three months in 2008 to $6.2 million for the three months in
2009.  Our interest income was also negatively impacted by the
significant increase in non-performing loans. The increased balance of
non-performing loans lowered the average yield on the entire portfolio to 1.1%
for the three months in 2009 from 6.5% for the three months in
2008.




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Non-interest
income decreased $116,000, or 30.9% from the three months ended March 31, 2008,
primarily due to the decrease in the rate, as driven by LIBOR on our common
securities issued by Desert Capital TRS Statutory Trust I.    The
rate on these common securities decreased from 7.25% at March 31, 2008 to 5.17%
at March 31, 2009.  The decrease was also due to the decrease in rents
collected as a result of the departure of certain of our un-related party
tenants.





Expenses:




Interest
expense consists of interest on our mortgage debt, bank note, and junior
subordinated notes payable. Interest expense decreased 25.8%, to $619,000 for
the three months ended March 31, 2009 from $834,000 for the three months ended
March 31, 2008.   This decrease was a result of a decrease in the
average interest rate on our variable rate debt to 6.0% from 7.8% during the
three months ended March 31, 2008.





Non-interest
expense, including provision for loan losses increased $2.8 million or 181%, to
$4.3 million for the three months ended March 31, 2009 from $1.5 million for the
three months ended March 31, 2008. The primary increases in non-interest expense
were due to the increase in the provision for loan loss of $703,000, or 226%
from $311,000 for the three months ended March 31, 2008, the impairment of real
estate owned, representing an increase of $1.1 million, and the increase in
management and servicing fees of $619,000, or 147% from $422,000 for the three
months ended March 31, 2008.  The increase in the allowance for loan
loss and the impairment of real estate owned was due to a further decline in the
real estate and credit markets, causing the value of our real estate to
decline.    The increase of $619,000 in management and
servicing fees was a direct result of the accrual of a 2.5% annual servicing fee
paid to CM Capital, our related party servicer, pursuant to the agreement
entered into for the servicing of our foreclosed properties during the quarter
ended March 31, 2009.





Taxable
Income




Our
income (loss) calculated for tax purposes differs from income (loss) calculated
in accordance with GAAP primarily because of the provision for loan losses and
the impairment of real estate recorded for GAAP purposes, which differs from
items recorded for tax purposes.  In addition, the financial
statements of the REIT and its taxable REIT subsidiaries are consolidated for
GAAP purposes while they are not consolidated for tax purposes.  REIT
taxable income should be considered in addition to, and not as a substitute
for, our GAAP-based net income as a measure of our financial
performance.




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


Three
      Months Ended March 31,2009
              
              
              2008GAAP
      net income (loss)
              
              $
              (4,244
              )
              
              $
              806Adjustments
      to GAAP net income (loss):Noncontrolling
      interest
              
              
              13Provision
      for loan losses
              
              
              1,206
              
              
              
              311Impairment
      of real estate
              
              
              1,087
              
              
              
              1Actual
      losses on real estate and loans
              
              
              (3,802
              )
              
              
              (300
              )Net
      adjustment for TRS loss
              
              
              184
              
              
              
              60REIT
      taxable income (loss)
              
              $
              (5,556
              )
              
              $
              878




Liquidity and Capital
Resources




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





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Net cash
used by operating activities during 2009 was $796,000, which was primarily due
to the substantial loss of interest income due to the deterioration of our loan
portfolio and the increase in servicing fees and carrying costs related to our
foreclosed assets.  At March 31, 2009, the original loan balance of our
mortgage investments was $73.9 million, of which $6.1 million was performing,
and real estate owned had a carrying balance of $28.5 million. It is likely that
non-performing mortgage loans and real estate assets will produce minimal, if
any, current earnings until they are sold or an alternative resolution becomes
available. Additionally, we will continue to incur carrying and servicing costs
on our real estate owned portfolio until we have disposed of the assets. We
anticipate that we will continue to foreclose on the assets underlying our
non-performing portfolio throughout the remainder of 2009, which will result in
further increases in costs related to property ownership. While the disposition
of any of our assets cannot be predicted, our Advisor believes that over time
our non-performing mortgage loans and real estate assets will be resolved and
that the proceeds generated from the resolution of these assets will provide
capital for reinvestment into performing assets or reduction in outstanding debt
as deemed appropriate by our Advisor.  As of March 31, 2009, we have
reviewed our mortgage investments and real estate owned and have recorded a
provision for loan losses and an impairment of real estate owned as needed to
reflect the impaired value of our investments. However, with the current
uncertainty in the real estate market, the amount of further losses on any
individual asset or on the portfolio as a whole may vary. These estimates
are based upon a thorough evaluation by our Advisor based on prevailing
economic conditions, historical experience, unique characteristics of the loan,
borrowers’ financial condition, industry trends and an estimated net realizable
value of any underlying collateral in relation to the real estate loan
amount.





We have a
$1.2 million secured bank note that matures in February
2010.  The note, initially a $7.5 million credit facility, was
established for short-term funding requirements, not for working capital
purposes, and matured in February 2009. We were in default under terms of the
note during 2008 and at the maturity date in February 2009. Under terms of the
modification, repayment of the outstanding principal balance at the date of
modification was extended until February 2010.  Under terms of the
modification, we are required to make principal payments of $25,000 on June 30,
$50,000 on September 30 and $100,000 on December 31, 2009, with the remaining
balance, if any, due in February 2010. The outstanding balance bears interest at
an interest rate equal to the prime rate plus 75 basis points, with a floor of
7%. The interest rate on this note at March 31, 2009 was 7% and the outstanding
principal balance was $1.1 million. Under terms of the note, interest
payments are due monthly.  Currently we are restricted from further
borrowings under this note.  We are not in compliance with certain
covenants applicable to this note and are currently in negotiations with the
lender to modify such covenants.





With the
continued loss of recurring cash flow, combined with the increase in carrying
costs related to our growing non-performing real estate portfolio, our Advisor
made the determination that it was in the best interest of the Company to incur
additional debt. During the three months ended March 31, 2009, in an effort to
facilitate the payment of certain of our expenses as a property owner, we
entered into two note payable agreements with an aggregate principal amount of
$1.8 million for net cash proceeds of $1.2 million.  This cash is
classified as restricted on our balance sheet for the purpose of the payment of
our expenses as a land owner, including property taxes, legal expenses, and
servicing fees to our related party, CM Capital. In addition, we set aside cash
of $317,000 for the payment of interest during the term of the
debt.  The outstanding principal balance of these notes payable bear
interest at 10-13% per annum and is payable monthly. For the foreseeable future,
as we continue to incur servicing fees and other expenses related to the
ownership of non-income-producing real estate, we anticipate incurring
additional debt to fund such expenses.




In June
2006, we issued $30.0 million in unsecured trust preferred securities, which are
reflected on our balance sheet as junior subordinated notes payable. At March
31, 2009, we were not in compliance with certain covenants under the modified
terms of the indenture. On April 3, 2009, we received a notice of default and
were given 30 days to cure. Due to our inability to cure the default, it matured
into an event of default, which gives the Trustee and the holders of the trust
preferred securities the right to accelerate the outstanding indebtedness. We
are in ongoing discussions with the holders of the trust preferred
securities regarding our covenant defaults.


Upon the
death of a stockholder, the stockholder’s estate has a limited right of
redemption with respect to its common stock, and at March 31, 2009, we had
received redemption requests of 106,000 shares of common stock totaling $1.1
million.




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




To the
extent that recurring cash flow, coupled with loan payoffs and proceeds from
asset sales, is not sufficient to satisfy our operating costs, which primarily
include board fees, management fees, legal and professional expenses, property
owner expenses and principal and interest payments on our debt, we would be
required to liquidate investment assets to satisfy our obligations or incur
additional debt against our real estate owned assets. Given current market
conditions, we may not be able to liquidate assets at a price we believe to be
reasonable, or at all, or be able to incur debt on attractive
terms. Because we rely primarily on repayment of outstanding loans or the
sale of assets to provide capital, the significant level of defaults on our
outstanding loans has eliminated the funds we have available for investing in
new loans. For the foreseeable future, we do not anticipate having cash
available for investing in new loans.




Contractual
Obligations




The
following table sets forth information about certain of our contractual
obligations as of March 31, 2009 (dollars in thousands):


Payments
      due by PeriodTotal
                
                
                Less
      than 1 year
                
                
                1 -
      3 years
                
                
                3 -
      5 years
                
                
                More
      than 5 yearsLong-Term
      Debt ObligationsJunior
      subordinated notes
                
                $
                30,928
                
                
                
                30,928
                (1)
                
                
                -
                
                
                
                -
                
                
                
                -Mortgages
                
                $
                7,801
                
                
                
                310
                
                
                
                1,862
                
                
                
                479
                
                
                
                5,150Notes
      payable
                
                $
                998
                
                
                
                -
                
                
                
                998
                
                
                
                -
                
                
                
                -Short-Term
      Debt ObligationsBank
      note
                
                $
                1,110
                
                
                
                1,110
                
                
                
                -
                
                
                
                -
                
                
                
                -Notes
      payable
                
                $
                448
                
                
                
                448
                
                
                
                -
                
                
                
                -
                
                
                
                -Total
                
                $
                41,285
                
                
                $
                32,796
                
                
                $
                2,860
                
                
                $
                479
                
                
                $
                5,150(1) Junior
      subordinated note payable is in default and callable by the lender at
      March 31, 2009 and the date of this filing.







Critical
Accounting Policies and Management Estimates


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




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




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Revenue
Recognition


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




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




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




Allowance
for Loan Losses


The allowance for loan
losses represents management’s estimate of probable losses inherent in our
portfolio of loans. The allowance for loan losses is reflected in our financial
statements based upon individual review of the loans, the specific borrowers’
credit quality and mortgages based upon an evaluation of known and inherent
risks affecting our portfolio of mortgage investments including, but not limited
to, economic conditions, delinquency status, value of collateral underlying the
loan, credit losses to date on underlying mortgages and any remaining credit
protection. Management monitors the delinquencies and defaults on mortgage
investments and, if an impairment of the related loan is noted, the carrying
value of the related loan will be reduced to fair value through the estimate of
the allowance for loan losses.  We consider mortgages to be delinquent
when principal or interest is contractually past due or the loan is past its
maturity date.   Individual valuations on non-performing loans
are performed in accordance with FAS 114.  In accordance with FAS 114,
specific allowances for losses may be established for non-performing and
potentially impaired loans based on a comparison of the recorded carrying value
of the loan to either the present value of the loan’s expected cash flow, the
loan’s estimated market price or, if the loan is collateral dependent, the
estimated fair value of the underlying collateral. The allowance is increased by
charges to operations and decreased by charge-offs (net of recoveries). Loan
loss estimates are reviewed periodically and adjustments are reported in
earnings when they become known.  Because any decision regarding the
allowance for loan losses reflects a judgment about the estimated fair value of
real estate and the probability of future events, there is an inherent risk that
such judgments will prove incorrect.  In such event, actual losses may
exceed (or be less than) the amount of any allowance.  To the extent
that we experience losses greater than the amount of our allowances, we may
incur a charge to our earnings that will adversely affect our operating results
and the amount of any distributions payable to our
stockholders.




Real
Estate Owned


Real estate properties
acquired through, or in lieu of, loan foreclosure are initially recorded at the
lower of the recorded amount of our related mortgage loan being foreclosed (net
of any specific allowance for loan loss or loan impairment charge), or our
economic interest in the property’s estimated fair value less estimated costs to
sell. Any valuation adjustments required at the time of foreclosure are charged
to the allowance for loan losses. After foreclosure, the properties are carried
at the lower of carrying value or fair value less estimated costs to sell. Any
subsequent valuation adjustments, operating expenses or income, and gains and
losses on disposition of such properties are recognized in current operations.
The valuation allowance is established based on our assessment of whether there
are any indicators that the fair value is less than the carrying value as
adjusted for current market trends.  Because any decision regarding
the valuation of real estate owned reflects a judgment about the probability of
future events, there is an inherent risk that such judgments will prove
incorrect.  In such event, actual losses may exceed (or be less than)
the amounts recorded.  To the extent that we experience additional
deterioration in fair value of such properties, we may incur a charge to our
earnings that will adversely affect our operating results and the amount of any
distributions payable to our stockholders.




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Investments
in Real Estate


In December 2003, the FASB
issued FIN 46R, which requires a VIE to be consolidated by its primary
beneficiary (PB). The PB is the party that absorbs a majority of the VIE’s
anticipated losses and/or a majority of the expected
returns.




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




Entities that issue junior
subordinated notes are considered VIEs. However, it is not appropriate to
consolidate these entities under the provisions of FIN 46 as equity
interests are variable interests only to the extent that the investment is
considered to be at risk. Since our investments were funded by the entities that
issued the junior subordinated notes, they are not considered to be at
risk.




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




Investments in real estate
are carried at the lower of cost or fair value. Our decisions regarding the
impairment of our investments in real estate are subjective. Because any
decision regarding the impairment losses reflects a judgment about the estimated
fair value of real estate and the probability of future events, there is an
inherent risk that such judgments will prove incorrect.  In such
event, actual losses may exceed (or be less than) the amount of any impairments
taken.  To the extent that we experience losses greater than the
amount of our impairments, we may incur a charge to our earnings that will
adversely affect our operating results and the amount of any distributions
payable to our stockholders.




Income
Taxes


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




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




We adopted FASB
Interpretation 48, “Accounting
for Uncertainty in Income Taxes”, as of January 1, 2007. A tax
position is recognized as a benefit only if it is “more likely than not” that
the tax position would be sustained in a tax examination, with a tax examination
being presumed to occur. The amount recognized is the largest amount of tax
benefit that is greater than 50% likely of being realized on examination. For
tax positions not meeting the “more likely than not” test, no tax benefit is
recorded.   We have recorded a liability in the amount of
$55,000.  Changes in estimates and probabilities related to such
calculation may have an impact on our financial statements.




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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




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




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




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




Based on our loans and
liabilities as of March 31, 2009, and assuming the balances of these loans
and liabilities remain unchanged for the subsequent twelve months, a 1% increase
in interest rates would decrease our annual net income and cash flows by
approximately $343,000. This decrease is due to our fixed rate investments and
variable rate debt. Based on our loans and liabilities as of March 31,
2009, and assuming the balances of these loans and liabilities remain unchanged
for the subsequent twelve months, a 1% decrease in interest rates would increase
our annual net income and cash flows by approximately $343,000. This increase
again is due to our fixed rate investments and variable rate
debt.




In the event of a
significant rising interest rate environment and/or future economic downturn,
defaults could increase and result in credit losses to us, which could adversely
affect our liquidity and operating results. Further, such additional
delinquencies or defaults could have an adverse effect on the spreads between
interest-earning assets and interest-bearing liabilities.




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








ITEM 4T. CONTROLS AND PROCEDURES




As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of management, including our
principal executive officer and principal financial officer, of the
effectiveness of the design and operation of the Company’s disclosure controls
and procedures pursuant to Securities Exchange Act of 1934 Rule 13a-15 (Exchange
Act).  Disclosure controls and procedures are designed to ensure that
information required to be disclosed in reports filed or submitted under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC rules and forms and that such information is
accumulated and communicated to management, including the Chief Executive
Officer and Chief Financial Officer, to allow timely decisions regarding
required disclosures.   Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer have concluded that our disclosure
controls and procedures were ineffective as of March 31, 2009, as described
below.




We have
identified two material weaknesses relating to the entrance into related party
agreements as follows:




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




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




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Subsequent
to March 31, 2009, in an effort to remediate the identified material weaknesses
and other deficiencies and enhance our internal controls, we continue to foster
awareness and understanding of standards and principles for accounting and
financial reporting across our finance and non-finance functions. This includes
(1) an integrated approach to monitoring financial performance among our
finance and non-finance functions; (2) clarification of specific accounting
and corporate governance policies and procedures; and (3) continuous monitoring
of compliance with policies and procedures.  In addition, we will
continue to monitor the processes and controls to ensure sustainment of the
improvements made to our control environment.  We will continue to
implement process changes to address the material weaknesses
identified.




Notwithstanding
management’s assessment that our disclosure controls and procedures were
ineffective as of March 31, 2009 due to the material weakness described
above, we believe that the consolidated financial statements in this Quarterly
Report on Form 10-Q fairly present, in all material respects, our consolidated
financial condition as of March 31, 2009 and December 31, 2008 and
consolidated statements of operations and cash flows for the three-month periods
ended March 30, 2009 and 2008, in conformity with GAAP.




In
addition, there were no other changes in our internal control over financial
reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the
Exchange Act) that occurred during the quarter ended March 31, 2009 that has
materially affected, or is reasonable likely to materially affect, the
Corporation’s internal control over financial reporting.





Part II. Other Information




Item 1.
Legal Proceedings


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




Item
1A. Risk Factors


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




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


None.




Item 3.
Defaults Upon Senior Securities


None.




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


None.




Item
5.
Other Information


None.




Item
6. Exhibits




(a)
Exhibits




3.1
            
            Third
      Amended and Restated Articles of Incorporation (included as exhibit 3.1 to
      the Registrant’s Form 10-K filed on March 31, 2009 and incorporated herein
      by reference).3.2
            
            Bylaws
      of the Company (included as Exhibit 3.2 to Amendment No. 2 to the
      Registrant’s Registration Statement on Form S-11 (File No. 333-111643)
      (the “Registration Statement”) and incorporated herein by
      reference).21.1
            
            List
      of Subsidiaries31.1*
            
            Certification
      of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2*
            
            Certification
      of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1**
            
            Certification
      of Chief Executive Officer and Chief Financial Officer, Pursuant to 18
      U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.




*Filed
      herewith
            **Furnished
      herewith
            +Compensation
      Plan










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SIGNATURES






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








May 15,
      2009
            DESERT
      CAPITAL REIT, INC.
              By: /s/Todd B.
      Parriott
              Todd B. Parriott, Chief Executive Officer, President and
      Chief Investment Officer and Chairman of the Board (Principal Executive
      Officer)May 15,
      2009
            DESERT
      CAPITAL REIT, INC.
                By: /s/Stacy M.
      Riffe
                Stacy M. Riffe, Chief Financial
      Officer, (Accounting
Officer)




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