**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

**ý****                                ****QUARTERLY****REPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2005**

 

**o****                                ****TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                       to                       **

 

**Commission file number:  01-32386**

 

**SPIRITFINANCE CORPORATION**

(Exactname of registrant as specified in its charter)

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.     Yes  ý    No  o

 

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

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes o   No  ý

 

As of October 31, 2005, 67,663,071****sharesof the registrant’s Common Stock, par value $0.01 per share, were outstanding.

 

 

----

 

**PART I – FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

**SpiritFinance Corporation**

**CONSOLIDATEDBALANCE SHEETS**

(dollars in thousands, except per share data)

 
| ** **                                                                                                                                                                 | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| **Assets**                                                                                                                                                                 |       |                    |       |                   |       |
| Investments, at cost:                                                                                                                                                      |       |                    |       |                   |       |
| Real estate investments:                                                                                                                                                   |       |                    |       |                   |       |
| Land and improvements                                                                                                                                                      |       | $                       | 434,115    |                   | $          | 257,233 |   |
| Buildings and improvements                                                                                                                                                 |       | 734,832                 |       | 358,811                |       |
| Total real estate investments                                                                                                                                              |       | 1,168,947               |       | 616,044                |       |
| Less: Accumulated depreciation                                                                                                                                             |       | (16,088                 | )          | (4,303                 | )          |
|                                                                                                                                                                       |       | 1,152,859               |       | 611,741                |       |
| Mortgage and equipment loans receivable                                                                                                                                    |       | 59,155                  |       | 40,855                 |       |
| Net investments                                                                                                                                                            |       | 1,212,014               |       | 652,596                |       |
| Cash and cash equivalents                                                                                                                                                  |       | 47,906                  |       | 113,225                |       |
| Lease intangibles, net                                                                                                                                                     |       | 20,123                  |       | 10,742                 |       |
| Deferred costs and other assets, net                                                                                                                                       |       | 15,792                  |       | 5,664                  |       |
| Total assets                                                                                                                                                               |       | $                       | 1,295,835  |                   | $          | 782,227 |   |
|                                                                                                                                                                       |       |                    |       |                   |       |
| **Liabilities and stockholders’ equity**                                                                                                                              |       |                    |       |                   |       |
| Liabilities:                                                                                                                                                               |       |                    |       |                   |       |
| Mortgages and notes payable                                                                                                                                                |       | $                       | 637,412    |                   | $          | 178,854 |   |
| Secured credit facility                                                                                                                                                    |       | 36,477                  |       | —                 |       |
| Dividends payable                                                                                                                                                          |       | 12,858                  |       | 7,110                  |       |
| Accounts payable, accrued expenses and  other liabilities                                                                                                                  |       | 8,835                   |       | 8,560                  |       |
| Total liabilities                                                                                                                                                          |       | 695,582                 |       | 194,524                |       |
| Commitments and contingencies (Note 13)                                                                                                                                    |       |                    |       |                   |       |
| Stockholders’ equity:                                                                                                                                                 |       |                    |       |                   |       |
| Preferred stock, $0.01 par value per share,  125,000,000 shares authorized, no shares issued and outstanding                                                               |       | —                  |       | —                 |       |
| Common stock, $0.01 par value per share,  375,000,000 shares authorized, 67,673,071 (September 30, 2005) and 63,506,819  (December 31, 2004) shares issued and outstanding |       | 677                     |       | 635                    |       |
| Capital in excess of par value                                                                                                                                             |       | 640,044                 |       | 599,300                |       |
| Accumulated distributions in excess of net  income                                                                                                                         |       | (26,268                 | )          | (8,650                 | )          |
| Accumulated other comprehensive loss                                                                                                                                       |       | (14,200                 | )          | (3,582                 | )          |
| Total stockholders’ equity                                                                                                                                            |       | 600,253                 |       | 587,703                |       |
| Total liabilities and stockholders’ equity                                                                                                                            |       | $                       | 1,295,835  |                   | $          | 782,227 |   |

 

*Seeaccompanying notes.*

 

2

----

 

**SpiritFinance Corporation**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Unaudited)

(dollars in thousands, except per share data)

 
| ** **                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Rentals                                                     |       | $                                     | 21,232     |                                 | $          | 6,346 |   | $ | 50,736 |   | $ | 9,066 |   |
| Interest income on mortgage and equipment  loans receivable |       | 1,028                                 |       | 950                                  |       | 2,916 |   | 2,822 |   |
| Other interest income                                       |       | 1,163                                 |       | 378                                  |       | 1,792 |   | 1,646 |   |
| Total revenues                                              |       | 23,423                                |       | 7,674                                |       | 55,444 |   | 13,534 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Expenses:                                                   |       |                                  |       |                                 |       |   |   |   |   |
| General and administrative                                  |       | 3,176                                 |       | 1,816                                |       | 9,004 |   | 4,866 |   |
| Depreciation and amortization                               |       | 5,656                                 |       | 1,376                                |       | 12,858 |   | 2,028 |   |
| Interest                                                    |       | 8,402                                 |       | 1,491                                |       | 14,335 |   | 1,574 |   |
| Total expenses                                              |       | 17,234                                |       | 4,683                                |       | 36,197 |   | 8,468 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Income from continuing operations                           |       | 6,189                                 |       | 2,991                                |       | 19,247 |   | 5,066 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Discontinued operations:                                    |       |                                  |       |                                 |       |   |   |   |   |
| Income from discontinued operations                         |       | 21                                    |       | 236                                  |       | 1,033 |   | 255 |   |
| Net gains (losses) on sales of real estate                  |       | 442                                   |       | (6                                   | )          | 669 |   | (6 | ) |
| Total discontinued operations                               |       | 463                                   |       | 230                                  |       | 1,702 |   | 249 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Net income                                                  |       | $                                     | 6,652      |                                 | $          | 3,221 |   | $ | 20,949 |   | $ | 5,315 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Income per common share:                                    |       |                                  |       |                                 |       |   |   |   |   |
| Basic:                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                       |       | $                                     | 0.09       |                                 | $          | 0.08 |   | $ | 0.29 |   | $ | 0.14 |   |
| Discontinued operations                                     |       | 0.01                                  |       | 0.01                                 |       | 0.02 |   | — |   |
| Net income                                                  |       | $                                     | 0.10       |                                 | $          | 0.09 |   | $ | 0.31 |   | $ | 0.14 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Diluted:                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                       |       | $                                     | 0.09       |                                 | $          | 0.08 |   | $ | 0.29 |   | $ | 0.14 |   |
| Discontinued operations                                     |       | 0.01                                  |       | 0.01                                 |       | 0.02 |   | — |   |
| Net income                                                  |       | $                                     | 0.10       |                                 | $          | 0.09 |   | $ | 0.31 |   | $ | 0.14 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average outstanding common shares:                 |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                       |       | 67,310,586                            |       | 37,252,612                           |       | 67,216,680 |   | 36,661,371 |   |
| Diluted                                                     |       | 67,543,650                            |       | 37,409,753                           |       | 67,429,591 |   | 36,808,195 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Cash dividends declared per common share                    |       | $                                     | 0.19       |                                 | $          | 0.06 |   | $ | 0.57 |   | $ | 0.06 |   |

 

*Seeaccompanying notes.*

 

3

----

 

**SpiritFinance Corporation**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)

(dollars in thousands)

 
| ** **                                                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities**                            |       |                                |       |   |   |
| Net income                                                           |       | $                                   | 20,949     |   | $ | 5,315 |   |
| Adjustments  to net income:                                          |       |                                |       |   |   |
| Depreciation and amortization                                        |       | 13,289                              |       | 2,102 |   |
| Stock-based compensation                                             |       | 666                                 |       | 694 |   |
| Amortization of deferred financing costs                             |       | 1,782                               |       | 195 |   |
| Net (gains) losses on sales of real estate                           |       | (669                                | )          | 6 |   |
| Other noncash items                                                  |       | 182                                 |       | (75 | ) |
| Changes in operating assets and  liabilities:                        |       |                                |       |   |   |
| Deferred costs and other assets                                      |       | (1,398                              | )          | (1,237 | ) |
| Accounts payable, accrued expenses and  other liabilities            |       | 3,827                               |       | 1,627 |   |
| Net cash  provided by operating activities                           |       | 38,628                              |       | 8,627 |   |
|                                                                 |       |                                |       |   |   |
| **Cash  flows from investing activities**                            |       |                                |       |   |   |
| Acquisitions  of real estate investments                             |       | (567,282                            | )          | (226,198 | ) |
| Investment  in mortgage and equipment loans receivable               |       | (18,645                             | )          | (450 | ) |
| Proceeds  from sales of real estate investments                      |       | 54,148                              |       | 743 |   |
| Collections  of principal on mortgage and equipment loans receivable |       | 298                                 |       | 209 |   |
| Net cash  used by investing activities                               |       | (531,481                            | )          | (225,696 | ) |
|                                                                 |       |                                |       |   |   |
| **Cash  flows from financing activities**                            |       |                                |       |   |   |
| Borrowings  under secured credit facilities                          |       | 386,383                             |       | 23,243 |   |
| Repayments  under secured credit facilities                          |       | (349,906                            | )          | — |   |
| Borrowings  under mortgage notes payable                             |       | 551,300                             |       | — |   |
| Repayments  of mortgages and notes payable                           |       | (142,191                            | )          | (93 | ) |
| Deferred  financing costs paid                                       |       | (10,396                             | )          | (2,537 | ) |
| Payments  made on interest rate swaps                                |       | (14,758                             | )          | — |   |
| Proceeds  from initial public offering, net                          |       | 40,067                              |       | — |   |
| Proceeds  from private offering, net                                 |       | —                              |       | 55,700 |   |
| Proceeds  from exercise of stock options                             |       | 50                                  |       | — |   |
| Dividends  paid on common stock                                      |       | (32,819                             | )          | (2,244 | ) |
| Transfers to  restricted cash and escrow deposits                    |       | (196                                | )          | (1,215 | ) |
| Net cash  provided by financing activities                           |       | 427,534                             |       | 72,854 |   |
|                                                                 |       |                                |       |   |   |
| Net decrease  in cash and cash equivalents                           |       | (65,319                             | )          | (144,215 | ) |
|                                                                 |       |                                |       |   |   |
| Cash and  cash equivalents, beginning of period                      |       | 113,225                             |       | 199,089 |   |
| Cash and  cash equivalents, end of period                            |       | $                                   | 47,906     |   | $ | 54,874 |   |

 

*Seeaccompanying notes.*

 

4

----

 

**Spirit Finance Corporation**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

NineMonths Ended September 30, 2005

(Unaudited)

(dollars in thousands, except per share data)

 
| ** **                                                         | ** ** | **Common  Shares** | ** ** | **Common  Stock  Par Value** | ** ** | **Capital  in  Excess of Par  Value** | ** ** | **Accumulated  Distributions in  Excess of Net  Income** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|--------------------------------------------------------------------|------------|--------------------|------------|------------------------------|------------|---------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------|------------|
|                                                               |       |               |       |                         |       |                                  |       |                                                     |       |                                        |       |                                  |       |
| Balances at  December 31, 2004                                     |       | 63,506,819         |       | $                            | 635        |                                  | $          | 599,300                                                  |       | $                                           | (8,650     | )                                     | $          | (3,582 | ) | $ | 587,703 |   |
| Net income                                                         |       |               |       |                         |       |                                  |       | 20,949                                                   |       |                                        |       | 20,949                                |       |
| Net unrealized  loss on cash flow hedges                           |       |               |       |                         |       |                                  |       |                                                     |       | (10,618                                     | )          | (10,618                               | )          |
| Underwriters’  over-allotment on initial public offering, net |       | 3,913,043          |       | 39                           |       | 40,028                                |       |                                                     |       |                                        |       | 40,067                                |       |
| Dividends  declared on common stock ($0.57 per share)              |       |               |       |                         |       |                                  |       | (38,567                                                  | )          |                                        |       | (38,567                               | )          |
| Exercise of stock  options                                         |       | 5,000              |       | —                       |       | 50                                    |       |                                                     |       |                                        |       | 50                                    |       |
| Restricted stock  grants, net                                      |       | 248,209            |       | 3                            |       |                                  |       |                                                     |       |                                        |       | 3                                     |       |
| Stock-based  compensation                                          |       |               |       |                         |       | 666                                   |       |                                                     |       |                                        |       | 666                                   |       |
| Balances at  September 30, 2005                                    |       | 67,673,071         |       | $                            | 677        |                                  | $          | 640,044                                                  |       | $                                           | (26,268    | )                                     | $          | (14,200 | ) | $ | 600,253 |   |

 

*Seeaccompanying notes.*

 

5

----

 

**SpiritFinance Corporation**

**Notesto Consolidated Financial Statements**

**(Unaudited)**

 

**1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Business**

 

Spirit Finance Corporation (“SpiritFinance” or the “Company”) is a Maryland corporation formed on August 14, 2003as a self-managed and self-advised real estate investment trust (“REIT”) underthe Internal Revenue Code.   The commonstock of Spirit Finance is listed on the New York Stock Exchange under thesymbol “SFC.”

 

**Basisof Accounting and Principles of Consolidation**

 

The accompanying unaudited consolidatedfinancial statements are prepared on the accrual basis of accounting inaccordance with U.S. generally accepted accounting principles for interimfinancial information.  Accordingly, theydo not include all of the information and footnotes required for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been recorded. Operatingresults for the three months and nine months ended September 30, 2005 are notnecessarily indicative of the results that may be expected for the year endingDecember 31, 2005.  The accompanyingfinancial statements and notes should be read in conjunction with the auditedfinancial statements included in the Company’s Annual Report on Form 10-K forthe year ended December 31, 2004.

 

Theconsolidated financial statements of Spirit Finance include the accounts of theCompany and its wholly owned subsidiaries, Spirit Management Company, SpiritFinance Acquisitions, LLC and numerous wholly-owned special purpose entities. Substantialamounts of the Company’s consolidated assets and related debt are held inwholly-owned special purpose entities.  The assets of the special purpose entitiesare not available to pay, or otherwise satisfy obligations to, the creditors ofany owner or affiliate of the special purpose entities.  Assets totaling $1.2 billion at September 30,2005 and $331.4 million at December 31, 2004 and liabilities totaling $640.3million at September 30, 2005 and $178.1 million at December 31, 2004 were heldby these special purpose entities and are included in the accompanyingConsolidated Balance Sheets. All intercompany account balances and transactionshave been eliminated in consolidation.

 

For a complete listing of the Company’ssignificant accounting policies, please refer to Note 2 in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004.

 

**Reclassifications**

 

Certain reclassifications have been made toprior period balances to conform to the current period presentation.

 

6

----

 

**Useof Estimates**

 

The preparation of financialstatements in conformity with U.S. generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Although management believes its estimates are reasonable, actual results coulddiffer from those estimates.

 

**NewAccounting Standard**

 

In December 2004, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”)No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”).  This standard requires companies to recognizecompensation expense using a fair–value based method for all equity-classifiedawards granted, modified or settled for periods beginning after June 15, 2005.  On April 14, 2005, the Securities and ExchangeCommission delayed the effective date of SFAS No. 123R to January 1, 2006 forcalendar-year public companies.  Adoptionof SFAS No. 123R in the first quarter of 2006 is not expected to have amaterial effect on the Company’s financial position or results of operations.

 

**2. INVESTMENTS**

 

As of September 30, 2005,Spirit Finance owned or financed 601 real estate properties, including 506 ownedreal estate properties with a gross acquisition cost of $1,190.1 million and 95properties financed through mortgage loans receivable with a carrying amount of$55.8 million.  At September 30, 2005,the Company also held four equipment loans with an outstanding balance of $3.4million secured by equipment used in the operation of certain real estate propertiesowned by the Company.  A majority of the Company’s real estateinvestments are pledged as collateral under debt obligations (see Note 4).  During the first nine months of 2005,the Company had the following property activity (dollars in thousands):

 
| ** **                                   | ** ** | **Number of  Properties  Owned  or Financed** | ** ** | **Dollar Amount of  Real Estate  Investments (a)** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------------|------------|
| Balance,  December 31, 2004                  |       | 374                                           |       | $                                                  | 667,927    |   |
| Acquisitions                                 |       | 266                                           |       | 635,780                                            |       |
| Sales (see  Note 8)                          |       | (39                                           | )          | (54,095                                            | )          |
| Principal  payments and premium amortization |       | —                                        |       | (346                                               | )          |
| Balance,  September 30, 2005                 |       | 601                                           |       | $                                                  | 1,249,266  |   |

 

----

(a)          The dollar amount of real estate investmentsincludes the gross cost of land, buildings and lease intangibles (see Note 3) relatedto properties owned and the carrying amount of the mortgage and equipment loansreceivable.

 

7

----

 

As of September 30, 2005, theCompany’s total real estate investments (including related lease intangibles) consistedof the following property types:

 
| **Property Type**                                 | ** ** | **Number of  Properties  Owned or  Financed** | ** ** | **Percentage of Dollar  Amount of Total  Real Estate  Investments** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Restaurants                                       |       | 406                                           |       | 32                                                                  | %          |
| Movie  theaters                                   |       | 19                                            |       | 13                                                                  |       |
| Specialty  retailer properties                    |       | 31                                            |       | 11                                                                  |       |
| Educational  facilities                           |       | 14                                            |       | 10                                                                  |       |
| Recreational  facilities                          |       | 7                                             |       | 8                                                                   |       |
| Automotive  dealers, parts and service facilities |       | 45                                            |       | 7                                                                   |       |
| Supermarkets                                      |       | 13                                            |       | 4                                                                   |       |
| Distribution  facilities                          |       | 44                                            |       | 4                                                                   |       |
| Interstate  travel plazas                         |       | 4                                             |       | 3                                                                   |       |
| Industrial  properties                            |       | 7                                             |       | 2                                                                   |       |
| Call centers                                      |       | 1                                             |       | 2                                                                   |       |
| Medical  offices                                  |       | 1                                             |       | 2                                                                   |       |
| Drugstores                                        |       | 9                                             |       | 2                                                                   |       |
| Total                                             |       | 601                                           |       | 100                                                                 | %          |

 

The Company’s real estateinvestments are geographically dispersed throughout 39 states.  Only one state, Texas (19%), accounts for 10%or more of the total gross investment of Spirit Finance’s real estate portfolioat September 30, 2005.

 

The Company’s real estateproperties are leased to customers under long-term operating leases thattypically include one or more renewal options. The weighted average remaining noncancelable lease term at September 30,2005 is approximately 14.3 years. The leases are generally triple-net, whichprovide that the lessee is responsible for the payment of all propertyoperating expenses, including insurance, real estate taxes and maintenance;therefore, Spirit Finance is generally not responsible for repairs or othercapital expenditures related to the properties.

 

**3.LEASE INTANGIBLES, NET**

 

Intangible assets represent thevalue of in-place leases associated with properties that the Company acquiredsubject to existing leases.  The acquisitionsmade during the first nine months of 2005 included $11.2 million allocated tothe value of related lease intangibles.  Totalintangible assets are shown in the accompanying Consolidated Balance Sheets netof accumulated amortization of $1.0 million at September 30, 2005 and $286,000at December 31, 2004.

 

8

----

 

**4.DEBT**

 

TheCompany’s debt outstanding as of September 30, 2005 and December 31, 2004 issummarized below (dollars in thousands): 

 
| ** **                                                                                    | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| MORTGAGES  AND NOTES PAYABLE:                                                                 |       |                    |       |                   |       |
| Net-lease  mortgage notes payable, Series 2005-1:                                             |       |                    |       |                   |       |
| Class A-1 amortizing mortgage note, 5.05%,  due 2020                                          |       | $                       | 181,717    |                   | $          | — |   |
| Class A-2 interest-only mortgage note,  5.37%, due 2020                                       |       | 258,300                 |       | —                 |       |
| Secured  fixed-rate mortgage notes payable:                                                   |       |                    |       |                   |       |
| 8.44% Note, effective interest rate 6.62%,  balloon due 2010                                  |       | 16,661                  |       | 16,783                 |       |
| 8.60% Note, effective interest rate 6.20%,  balloon due 2010                                  |       | 6,884                   |       | 6,971                  |       |
| 9.02% Note, effective interest rate 6.19%,  balloon due 2010                                  |       | 6,447                   |       | 6,522                  |       |
| 9.02% Note, effective interest rate 6.25%,  balloon due 2010                                  |       | 2,789                   |       | 2,821                  |       |
| 6.50% Note, balloon due 2012                                                                  |       | 14,298                  |       | —                 |       |
| 5.40% Notes, balloons due 2014                                                                |       | 35,321                  |       | —                 |       |
| 5.30% Note, balloon due 2015                                                                  |       | 39,122                  |       | —                 |       |
| 5.62% Note, balloon due 2015                                                                  |       | 35,700                  |       | —                 |       |
| 5.26% Note, balloon due 2015                                                                  |       | 30,210                  |       | —                 |       |
| 5.40% Note, balloon due 2015                                                                  |       | 4,800                   |       | —                 |       |
| Secured variable-rate promissory notes,  interest only, 1-month LIBOR + 3.0%, paid March 2005 |       | —                  |       | 140,135                |       |
| Unsecured  fixed-rate promissory note, 7.00%, due 2021                                        |       | 2,275                   |       | 2,330                  |       |
|                                                                                          |       | 634,524                 |       | 175,562                |       |
| Unamortized  debt premium                                                                     |       | 2,888                   |       | 3,292                  |       |
| Total  mortgages and notes payable                                                            |       | $                       | 637,412    |                   | $          | 178,854 |   |
|                                                                                          |       |                    |       |                   |       |
| SECURED  CREDIT FACILITY:                                                                     |       |                    |       |                   |       |
| $200 million secured credit facility,  1-month LIBOR + 1.50%, matures September 2006          |       | $                       | 36,477     |                   | $          | — |   |

 

On July 26, 2005, a specialpurpose, bankruptcy-remote subsidiary of Spirit Finance issued $441.3 millionaggregate principal amount of net-lease mortgage notes segregated in twoclasses as noted in the table above.  Thepayment of scheduled interest and ultimate payment of principal on the notesare guaranteed under an insurance policy issued by Ambac AssuranceCorporation.  The collateral pool securingthe notes is comprised of 408 single tenant commercial real estate properties.The notes may be prepaid at any time, subject to a yield maintenance prepaymentpremium, and the notes permit substitution of real estate investments from timeto time subject to certain conditions. In addition, the note structure allows for the addition of collateral tothe pool and the issuance of additional series of notes secured by the increasedcollateral pool of properties.

 

AtSeptember 30, 2005, the fixed-rate mortgages and notes payable weresecured by underlying real estate with an aggregate investment value of $927.1million.  In addition, at September 30,2005,

 

9

----

 

assets with an aggregate investmentvalue of $61.4 million were pledged as collateral for borrowings under thesecured credit facility described below.

 

In September 2005, SpritFinance established a $200 million revolving secured credit facility with CitigroupGlobal Markets Realty Corp.  The facilitymatures in September 2006, with the ability to extend the facility with theconsent of the bank.  Borrowings underthe facility require monthly payments of interest indexed to one-month LIBORplus 1.50%. In addition, on November 7, 2005, the Company established a one-year$200 million revolving secured credit facility with Credit Suisse, New YorkBranch.  Borrowings under this facilitywill require monthly payments of interest indexed to one-month LIBOR plus 1.25%and a non-use fee may be incurred under certain circumstances. These short-termcredit facilities are used to purchase real estate pending the issuance oflong-term, fixed-rate financing. The Company’s $125 million secured creditfacility with Citigroup Global Markets Realty Corporation and its $250 millionsecured facility with Bank of America Mortgage Capital Corp. expired in July 2005and September 2005, respectively.

 

The Company’s mortgage notespayable contain various covenants customarily found in mortgage notes,including a limitation on Spirit Finance’s ability to incur additionalindebtedness on the underlying real estate collateral.  The Company is also subject to variousfinancial and nonfinancial covenants under the secured credit facilities,including maintaining a minimum specified tangible net worth, a maximum total debtto tangible net worth ratio and a minimum liquidity requirement of $15 million.  As of September 30, 2005, Spirit Finance wasin compliance with these covenants.

 

Unamortized financing costsrelated to establishing the Company’s debt, totaling $11.1 million at September30, 2005 and $2.5 million at December 31, 2004, are included in the caption, “Deferredcosts and other assets, net” and are amortized to interest expense over theinitial term of the related debt.

 

**5.DERIVATIVE FINANCIAL INSTRUMENTS**

 

As of September 30, 2005,Spirit Finance had one outstanding forward-starting interest rate swapagreement with a total notional amount of $50 million.  This derivative instrument was designated tohedge the variability of cash flows related to forecasted interest paymentsover 15 years on long-term debt expected to be issued in 2006.  As the hedging relationship is expected to behighly effective at achieving offsetting changes in future cash flows, thisinterest rate swap is accounted for as a cash flow hedge.

 

On October 6, 2005, the Companyentered into a forward-starting interest rate swap agreement with a notionalamount of $80 million to hedge the variability of cash flows related toforecasted interest payments over 15 years on additional long-term debtexpected to be issued in 2006.  As thehedging relationship is expected to be highly effective at achieving offsettingchanges in future cash flows, this interest rate swap will also be accountedfor as a cash flow hedge.

 

Changes in the fair value of thederivatives are recorded in “Accumulated other comprehensive loss.” Hedgeeffectiveness is assessed using the hypothetical derivative method.  No hedge ineffectiveness was

 

10

----

 

recognized during 2005 or 2004.The fair value of the interest rate swap in place at September 30, 2005 was anasset of approximately $558,000 and is included in “Deferred costs and otherassets, net” on the Consolidated Balance Sheet.

 

In conjunction with theissuance of the net-lease mortgage notes in July 2005 (see Note 4), the Companysettled two forward-starting interest rate swap agreements for a net cashpayment of $13.7 million to the swap counterparty.  The total change in the fair value of the interestrate swaps from inception of the hedges, totaling $15.0 million, is beingamortized to earnings as an increase to interest expense over a period of 25years.  During the three and nine-monthperiods ended September 30, 2005, this amortization totaled $226,000.  The unamortized balance of the settledinterest rate swaps at September 30, 2005 was $14.8 million.

 

**6.STOCKHOLDERS’ EQUITY**

 

On January 7, 2005, the Companyissued 3,913,043 shares of common stock for proceeds of $40.1 million, net ofunderwriters’ discount and offering expenses, as a result of the exercise ofthe underwriters’ over-allotment option related to the Company’s December 2004 initialpublic offering.  During the first ninemonths of 2005, the Company granted 248,209 shares (net of forfeitures) ofrestricted stock to officers, directors and employees. Options to purchase5,000 shares of common stock were exercised in June 2005.

 

**7. STOCK-BASED COMPENSATION**

 

Prior to January 1, 2005, theCompany used the intrinsic-value method prescribed by Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,”and related interpretations in accounting for its stock-based compensation.Under this method, no compensation expense was recorded with respect to stockoptions as the options were granted at an exercise price equal to the estimatedfair value of the underlying common shares on the date of grant.  For pro forma disclosures under SFAS No. 123,“Accounting for Stock-Based Compensation,” the fair value of the options wasestimated on the grant dates using the minimum-value method because the Companywas not a public entity on the respective grant dates.  As required by APB Opinion No. 25,compensation expense related to restricted stock awards was recognized on agraded schedule over the respective vesting periods for time-based awards basedon the fair value of the underlying common stock at the date of grant. Forperformance-based awards, compensation was recognized on a graded schedule overthe respective performance periods based on the market value of the restrictedstock at each reporting period and giving consideration to the probability ofachieving the performance objectives.

 

To enhance comparability of2005 interim and annual financial statements with those to be reported infuture years after adoption of SFAS No. 123R, Spirit Finance elected to adoptthe fair-value based method of SFAS No. 123 effective January 1, 2005. Underthe modified prospective transition method described by SFAS No. 148, “Accountingfor Stock-Based Compensation – Transition and Disclosure,” Spirit Finance hasrecognized stock-based employee compensation cost in 2005 as if the fair-valuebased method had been used for all unvested stock-based awards outstanding atJanuary 1, 2005 and for all new grants made in 2005.  The Company has not restated prior periodfinancial statements.

 

11

----

 

For stock options granted in2005, the estimated grant date fair value was calculated using the Black-Scholes-Mertonformula.  In accordance with SFAS No.123, this estimated fair value will be expensed over the stock option vestingperiod on a straight-line basis.  Forrestricted stock awards with time-based service conditions granted in 2005,compensation expense will be recognized over their vesting period on astraight-line basis based on the fair value of the underlying common stock onthe date of grant.  For restricted stockawards with performance-related conditions granted in 2005, compensation expensewill be recognized on a straight-line basis over the respective performance periodsbased on the fair value of the underlying common stock on the date of grant,giving consideration to the probability of achieving the performanceobjectives.  For both stock options andrestricted stock awards granted in 2005, forfeitures were estimated on thegrant date and will be reevaluated at each reporting period, with compensationcost recognized only for those awards expected to vest.

 

Unvested stock options andrestricted stock awards outstanding at January 1, 2005 were originally grantedin 2003 and 2004, when the Company’s common stock was not publicly traded.  Compensation expense for the unvested stockoptions will continue to be recognized using the minimum-value method.  Compensation expense for unvested restrictedstock will continue to be recognized on a graded schedule over the remainingvesting period based on the original fair value of the underlying common stockon the date of grant, taking into consideration the probability of achievingthe performance objectives for the restricted stock with performance-relatedconditions.

 

The adoption of SFAS No. 123did not have a material impact on the Company’s financial position or resultsof operations.  Had Spirit Financeadopted the fair-value based method at the beginning of 2004, Spirit Finance’snet income and diluted and basic net income per common share for the threemonths and nine months ended September 30, 2004 would not have changed from thereported amounts.  Stock-basedcompensation expense for the three and nine months ended September 30, 2005 and2004 is summarized in the table below (dollars in thousands).

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                            |       |                                  |       |                                 |       |   |   |   |   |
| Restricted  stock amortization  |       | $                                     | 225        |                                 | $          | 239 |   | $ | 662 |   | $ | 694 |   |
| Stock option  expense           |       | 1                                     |       | —                               |       | 4 |   | — |   |
| Total  stock-based compensation |       | $                                     | 226        |                                 | $          | 239 |   | $ | 666 |   | $ | 694 |   |

 

Stock-based compensation isincluded in “General and administrative” expenses in the ConsolidatedStatements of Operations.

 

12

----

 

**8.DISCONTINUED OPERATIONS**

 

Periodically, Spirit Finance maysell real estate properties that do not meet its long-term strategic investmentobjectives.  Such properties aretypically acquired in conjunction with the acquisition of a portfolio of realestate properties.  The Company considersthese occasional sales of real estate properties to be a part of its long-termoperating business strategy of acquiring and holding a diversified real estateinvestment portfolio; consequently, proceeds from the sales of real estateproperties are expected to be reinvested in additional real estate propertiessuch that cash flows from ongoing operations are not negatively affected bysales of individual properties.  SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” requiresthat gains and losses from any such dispositions of properties and alloperations from these properties be reclassified as “discontinued operations”in the Consolidated Statements of Operations. As a result of this reporting requirement, each time a property is sold,previously reported “income from continuing operations” will be restated toreclassify the operations of such property into discontinued operations.  This presentation has no impact on net incomeor cash flow.

 

During the second half of 2004,Spirit Finance sold four properties.  Duringthe first nine months of 2005, the Company sold 39 properties for $54.1 millionin net sales proceeds, resulting in an aggregate net gain of $669,000.  The operations and net gain realized fromthese real estate dispositions have been reported as discontinued operations.  At December 31, 2004, the 39 properties soldduring 2005 had balances of $53.0 million in gross real estate investments, $1.1million in gross intangible assets and $0.9 million in related debt.

 

The following table sets forththe components of discontinued operations related to the 43 properties soldsubsequent to January 1, 2004 (dollars in thousands).

 
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                  | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                        |       |                                  |       |                                 |       |   |   |   |   |
| Rental  revenues                            |       | $                                     | 90         |                                 | $          | 496 |   | $ | 1,770 |   | $ | 531 |   |
|                                        |       |                                  |       |                                 |       |   |   |   |   |
| Expenses:                                   |       |                                  |       |                                 |       |   |   |   |   |
| General and administrative                  |       | 1                                     |       | 2                                    |       | 13 |   | 5 |   |
| Depreciation and amortization               |       | 38                                    |       | 73                                   |       | 431 |   | 74 |   |
| Interest                                    |       | 30                                    |       | 185                                  |       | 293 |   | 197 |   |
| Total  expenses                             |       | 69                                    |       | 260                                  |       | 737 |   | 276 |   |
|                                        |       |                                  |       |                                 |       |   |   |   |   |
| Income from  discontinued operations        |       | 21                                    |       | 236                                  |       | 1,033 |   | 255 |   |
| Net gains  (losses) on sales of real estate |       | 442                                   |       | (6                                   | )          | 669 |   | (6 | ) |
| Total  discontinued operations              |       | $                                     | 463        |                                 | $          | 230 |   | $ | 1,702 |   | $ | 249 |   |

 

13

----

 

**9.INCOME PER COMMON SHARE**

 

Areconciliation of the numerators and denominators used in the computation ofbasic and diluted income per common share is as follows (dollars in thousands,except per share data):

 
| ** **                                                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| *Income available to common shareholders:*                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                                                                    |       | $                                     | 6,189      |                                 | $          | 2,991 |   | $ | 19,247 |   | $ | 5,066 |   |
| Discontinued operations                                                                                  |       | 463                                   |       | 230                                  |       | 1,702 |   | 249 |   |
| Net income                                                                                               |       | $                                     | 6,652      |                                 | $          | 3,221 |   | $ | 20,949 |   | $ | 5,315 |   |
|                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| *Weighted average shares:*                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average outstanding common shares  used in the calculation of basic income per common share (a) |       | 67,310,586                            |       | 37,252,612                           |       | 67,216,680 |   | 36,661,371 |   |
| Effect of unvested restricted stock                                                                      |       | 96,762                                |       | 157,141                              |       | 75,039 |   | 146,824 |   |
| Effect of stock options (b)                                                                              |       | 136,302                               |       | —                               |       | 137,872 |   | — |   |
| Weighted average outstanding common shares  used in the calculation of diluted income per common share   |       | 67,543,650                            |       | 37,409,753                           |       | 67,429,591 |   | 36,808,195 |   |
|                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| *Income per common share:*                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Basic:                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                                                                    |       | $                                     | 0.09       |                                 | $          | 0.08 |   | $ | 0.29 |   | $ | 0.14 |   |
| Discontinued operations                                                                                  |       | 0.01                                  |       | 0.01                                 |       | 0.02 |   | — |   |
| Net income                                                                                               |       | $                                     | 0.10       |                                 | $          | 0.09 |   | $ | 0.31 |   | $ | 0.14 |   |
|                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Diluted:                                                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                                                                                    |       | $                                     | 0.09       |                                 | $          | 0.08 |   | $ | 0.29 |   | $ | 0.14 |   |
| Discontinued operations                                                                                  |       | 0.01                                  |       | 0.01                                 |       | 0.02 |   | — |   |
| Net income                                                                                               |       | $                                     | 0.10       |                                 | $          | 0.09 |   | $ | 0.31 |   | $ | 0.14 |   |

 

----

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

(b)         Optionsto purchase 30,000 shares of common stock at September 30, 2005 wereoutstanding but were not included in the computation of diluted net income percommon share for the three and nine months ended September 30, 2005 because theeffect was not dilutive. Options to purchase 1,290,000 shares of common stockat September 30, 2004 were outstanding but were not included in the computationof diluted net income per common share for the three and nine months ended September30, 2004 because the effect was not dilutive.

 

14

----

 

**10.COMPREHENSIVE INCOME**

 

Comprehensive income iscomprised of net income, adjusted for changes in unrealized gains or losses onderivative financial instruments or securities classified asavailable-for-sale.  The reconciliationof net income to comprehensive income for the three and nine months ended September30, 2005 and 2004 is as follows (dollars in thousands):

 
| ** **                                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                |       |                                  |       |                                 |       |   |   |   |   |
| Net income as reported                                              |       | $                                     | 6,652      |                                 | $          | 3,221 |   | $ | 20,949 |   | $ | 5,315 |   |
| Change in net unrealized gains (losses) on  cash flow hedges        |       | 9,540                                 |       | —                               |       | (10,844 | ) | — |   |
| Cash flow hedge losses reclassified to  earnings                    |       | 226                                   |       | —                               |       | 226 |   | — |   |
| Reclassification of realized gain on  available-for-sale securities |       | —                                |       | —                               |       | — |   | (1 | ) |
| Comprehensive income                                                |       | $                                     | 16,418     |                                 | $          | 3,221 |   | $ | 10,331 |   | $ | 5,314 |   |

 

**11.SUPPLEMENTAL CASH FLOW INFORMATION**

 

In conjunction with theacquisition of certain real estate investments during the first nine months of2005, Spirit Finance assumed existing mortgage notes payable of $49.9 million.  During the first nine months of 2004, theCompany entered into seller financing of $130.6 million in mortgage notespayable and assumed existing mortgage notes payable (including debt premium) of$36.9 million on real estate investments acquired.

 

**12.RELATED PARTY TRANSACTIONS**

 

The Company’s Chairman of theBoard is a member of the board of directors of the lessee of four interstatetravel plazas owned by Spirit Finance. Rental revenues totaled approximately $2.7 million for the nine monthsended September 30, 2005 and 2004 under this lease.

 

**13.COMMITMENTS AND CONTINGENCIES**

 

Spirit Finance had contractualcommitments totaling $12.3 million at September 30, 2005 for futureimprovements on properties the Company currently owns. These improvementsinclude costs incurred on facilities during which the tenants’ businessescontinue to operate without interruption and advances for the construction ofnew facilities for which operations have not yet commenced.  In accordance with the underlying leaseagreements, these improvements, themajority of which are anticipated to be completed during the next six months,will result in increases in related contractual rent when placed into operation.

 

InAugust 2005, the Company amended its operating lease agreement to leaseadditional space at its current corporate office location.  The current monthly rent will increase $7,000to approximately

 

15

----

 

$26,000effective November 2005.  As of September30, 2005, the minimum future rental payments required under the amended leasetotal $70,000 for the remainder of 2005, $312,000 in 2006, $325,000 in 2007,$340,000 in 2008, $353,000 in 2009 and $571,000 thereafter.

 

TheCompany may be subject to claims or litigation in the ordinary course ofbusiness.  At September 30, 2005, therewere no outstanding claims against the Company that management believes wouldhave a material adverse effect on the Company’s financial position or resultsof operations.

 

16

----

 

**Item2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

Management’s discussion andanalysis of financial condition and results of operations are more clearlyunderstood when read in conjunction with the accompanying unauditedconsolidated financial statements and notes thereto as of September 30, 2005and our audited financial statements included in our Annual Report on Form 10-Kfor the year ended December 31, 2004. Undue reliance should not be placed uponhistorical financial statements since they are not indicative of expectedresults of operations or financial condition for any future periods.

 

**Overview**

 

Spirit Finance Corporation(NYSE: SFC) is a self-managed and self-advised REIT formed as a Marylandcorporation on August 14, 2003. We were formed to acquire single tenant,operationally essential real estate leased to retail, distribution andservice-oriented companies on a long-term basis. Operationally essential realestate includes land and buildings vital to the generation of our customers’sales and profits. In addition, we may selectively originate or acquirelong-term mortgage loans or equipment loans that are integral to our strategyof providing a complete financing solution to our customers. We may also make alimited amount of unsecured corporate loans to our customers. Our objective isto acquire or finance the real estate of companies that provide goods andservices to consumers through retail, distribution and service locationsthroughout the United States, such as restaurants, interstate travel plazas,movie theaters, automotive parts stores and services facilities, drugstores,educational facilities, specialty retailers and other similar businesses.

 

Since we began purchasing realestate assets in December 2003, we have completed over $1.3 billion insale/leaseback transactions and mortgage and equipment loans.  As of September 30, 2005, 95% of our $1.2 billionportfolio represented real estate we own (including the gross cost of land,buildings and related lease intangibles) and 5% represented mortgage andequipment loans receivable.  Ourportfolio of 601 owned or financed single tenant properties is geographicallydiversified across 39 states.  Only onestate, Texas (19%), accounts for 10% or more of the total dollar value of ourreal estate and mortgage loan portfolio. Our properties are leased or financed to 94 customers operating invarious industries.  Our three largestproperty types at September 30, 2005 as a percentage of gross real estate investmentswere restaurants (32%), movie theaters (13%) and specialty retailer properties(11%). Our top 10 customers as a percentage of our total portfolio as of September30, 2005 were: Carmike Cinemas, Inc. (NASDAQ: CKEC); CarMax, Inc. (NYSE: KMX); UnitedSupermarkets, Ltd.; Main Event Entertainment, LP; CBH2O, LP, the operator ofCamelback Ski and Water Park; University of Phoenix (NASDAQ: APOL); GanderMountain Company (NASDAQ: GMTN); AMC Entertainment, Inc.; Flying J Inc.; and HughesSupply, Inc. (NYSE: HUG). Together, our top 10 customers accounted for 39% ofour total portfolio of investments at September 30, 2005, with no individual creditexposure greater than 6.5% of the total portfolio.  In comparison, the top 10 customers as of December31, 2004 accounted for 55% of our total investment portfolio, with the largestcredit exposure also at 6.5% of the total portfolio. As of September 30, 2005,all of our properties were occupied, and the monthly lease and loan paymentswere current.

 

17

----

 

We expect to grow throughcontinuing our strategy of acquiring single tenant, operationally essentialreal estate principally through sale/leaseback transactions.  We intend to fund future real estateinvestments primarily with borrowings on our secured credit facilities and byraising funds through the issuance of debt and additional equity capital asdescribed below in the section entitled “Liquidity and Capital Resources.”  Our ability to generate positive cash flowwill depend heavily on the difference between the income earned on our assetsand the interest expense incurred on our borrowings.

 

Our ability to achievecontinued growth is dependent on achieving a substantial volume of acquisitionsat yields that can be effectively financed to meet our targeted returns.  The current environment for net lease realestate acquisitions continues to be highly competitive, and this competitiveenvironment could limit both the number of properties we acquire and the yieldon those acquisitions.  We may delay or declineopportunities if we feel the rewards do not warrant the capital risk.  In addition, the timing on completing acquisitionsmay vary significantly from quarter to quarter. In response to these challenges, we are committed to seeking numerouspotential investment opportunities through our sales force.  We continue to seek opportunities to combineour cost of capital and operational structure with efficient leveragestrategies to deliver competitively priced lease products.

 

**Liquidityand Capital Resources**

 

Our real estate investments areinitially acquired using a combination of cash and borrowings under our securedcredit facilities.  During the first ninemonths of 2005, we acquired or financed 266 single tenant commercial realestate properties through various transactions totaling $635.8 million, ofwhich $275.7 million were acquired during the third quarter of 2005.  In conjunction with the acquisition of 32 ofthese real estate properties, we assumed existing mortgage notes payable or obtainednew long-term financing totaling $159.9 million.  We also used proceeds from the sales of realestate investments, totaling $54.1 million, to acquire newproperties.  At September 30, 2005, wehad contractual commitments totaling $12.3 million for future improvementson properties we currently own.  Inaccordance with the underlying lease agreements, these improvements, themajority of which are anticipated to becompleted during the next six months, will result in increases in relatedcontractual rent.  In addition, asof October 31, 2005, we had identified for review potential investmentopportunities of more than $1.5 billion. We consider investments as under review when we have signed aconfidentiality agreement, we have exchanged financial information or we or ouradvisors are in current and active negotiations.  Investments under review are generallysubject to significant change and the timing of closing any such transactionsmay vary significantly from quarter to quarter. After further due diligence, we may decide not to pursue any or all ofthese transactions and there is no assurance that we will ultimately completeany of the real estate acquisitions.

 

In order to achieve significantgrowth in revenues and net income, we will need to make substantial real estateacquisitions, which will in turn require that we obtain significant additionaldebt or equity funding beyond our currently committed external sources ofliquidity.  Our initial public offeringof 26.1 million shares of our common stock at a price of $11 per share inDecember 2004 represented such an equity issuance.  The underwriters exercised theirover-allotment

 

18

----

 

option and we issued anadditional 3.9 million shares of common stock on January 7, 2005 for$40.1 million, net of underwriters’ discount and offering costs.

 

At December 31, 2004, our debtincluded variable-rate mortgage notes payable totaling $140.1 million andfixed-rate debt with a carrying amount of $38.7 million.  During the first quarter of 2005, we repaidthe $140.1 million variable-rate mortgage notes payable using cash andborrowings under then existing secured credit facilities.  Also, in 2004, we established a$250 million secured credit facility with Bank of America Mortgage CapitalCorporation, and, in March 2005, we added a $125 million secured creditfacility with Citigroup Global Markets Realty Corp. During the quarter endedSeptember 30, 2005, both of these facilities expired and outstanding balanceswere repaid in full.

 

In September 2005, weestablished a $200 million revolving secured credit facility with CitigroupGlobal Markets Realty Corp.  The facilitymatures in September 2006. Borrowings under the facility require monthlypayments of interest indexed to one-month LIBOR plus 1.50%. At September 30,2005, the one-month LIBOR rate was approximately 3.86%. In November 2005, weestablished a one-year $200 million revolving secured credit facility withCredit Suisse, New York Branch, bringing our total credit line capacity to $400million.  Borrowings under this facilityrequire monthly payment of interest indexed to one-month LIBOR plus 1.25% and anon-use fee may be incurred under certain circumstances.  The facilities are structured as master loanrepurchase arrangements, and our borrowings under the facilities are secured bymortgages on specific properties we own or acquire. In November 2005, we alsoreceived a commitment from Citigroup Global Markets Realty Corp. to provide anadditional $100 million secured credit facility.  We expect to finalize this facility in thefourth quarter of 2005. These short-term credit facilities are used to purchasereal estate pending the issuance of long-term, fixed-rate financing.

 

On July 26, 2005, our specialpurpose, bankruptcy-remote subsidiary, Spirit Master Funding, LLC, issued$441.3 million aggregate principal amount of net-lease mortgage notesrated Aaa/AAA by Standard & Poor’s Ratings Services and Moody’s InvestorsService, Inc., respectively.  The privateplacement consisted of $183 million of Class A-1 fully amortizing notesbearing interest at an annual rate of 5.05% due in 2020 and $258.3 millionof Class A-2 interest-only notes bearing interest at an annual rate of 5.37%due in 2020.  The timely payment ofscheduled interest and ultimate payment of principal on the notes areguaranteed under an insurance policy issued by Ambac AssuranceCorporation.  The collateral poolsecuring the notes is comprised of 408 single tenant commercial real estateproperties.  The notes may be prepaid atany time, subject to a yield maintenance prepayment premium, and the notespermit substitution of real estate collateral from time to time subject tocertain conditions. In addition, the note structure allows for the addition ofcollateral to the pool and the issuance of additional series of notes securedby the increased collateral pool of properties. We used the net proceeds from the sale of the notes to repay balancesoutstanding under then-existing secured credit facilities totaling$248.4 million.  The remainingproceeds were used to provide funds for real estate acquisitions.

 

During the first nine months of2005, we assumed existing mortgage notes payable or obtained new long-termfinancing totaling $159.9 million in conjunction with certain real estateacquisitions. At September 30, 2005, our balance outstanding under the securedcredit facility was

 

19

----

 

$36.5 million and thetotal carrying amount of our fixed-rate debt was $637.4 million. Assetswith an aggregate investment value of $61.4 million and$927.1 million were pledged as collateral for borrowings under the securedfacility and fixed-rate debt, respectively.

 

We are subject to variouscustomary operating and financial covenants under the mortgage notes payableand the secured credit facilities. The mortgage notes payable and securedcredit facilities include a limitation on our ability to incur additionalindebtedness on the underlying secured real estate. Our secured credit facilitiesalso include, among other requirements, a minimum liquidity requirement of$15 million.  As of September 30,2005, we were in compliance with our debt covenants and requirements.

 

Over the long term, we expectlease rates to rise commensurate with increases in long-term interest rates. Inthe near-term, we may experience a period where long-term interest rates onfuture borrowings rise more quickly than lease rates, which may reduce our cashflow. Therefore, in order to limit the effects of changes in interest rates onour operations, we match-fund our long-term, fixed-rate assets with long-term, fixed-rateliabilities. At September 30, 2005, nearly 75% of our investment portfolio ismatch-funded with long-term debt.

 

As described further in the Notesto Consolidated Financial Statements and Quantitative and QualitativeDisclosures About Market Risk, we use interest rate swaps to manage ourexposure to changes in interest rates until we can put into place our long-termdebt arrangements.  In conjunction withthe issuance of the net-lease mortgage notes, two forward-starting interestrate swap agreements were settled for a net cash payment to the swapcounterparty of $13.7 million, because long-term rates had decreased sincethe inception of the hedges. Accordingly, the total $15.0 million change in the fair value ofthe interest rate swaps from inception of the hedges is being amortized toearnings as an increase to interest expense over a 25-year period such that theeffective adjusted interest rate approximates the long-term rates in effectwhen the hedges were placed.

 

We generate our revenue andcash flow by leasing our real estate properties to our customers and frominterest income on our portfolio of mortgage and equipment loans receivable. Wegenerally offer long-term leases that provide for payments of base rent withscheduled increases, increases based on future changes in the Consumer PriceIndex and/or contingent rent based on a percentage of the lessee’s grosssales.  At September 30, 2005, our weightedaverage remaining initial lease term was approximately 14.3 years, and ourleases generally provide for one or more renewal options.  Less than 5% of our current lease portfoliowill expire prior to 2013.  Our leasesare generally triple-net, which provides that the lessee is responsible for thepayment of all property operating expenses, including insurance, real estatetaxes and repairs and maintenance.  Sinceour tenants generally pay the property operating and maintenance costs, we donot believe we will incur significant capital expenditures on our properties. Inaddition, as our leases are generally triple-net, we have not incurred anysignificant increases in operating costs due to recent increases in oil pricesor incurred any significant capital expenditures related to properties in theareas impacted by recent hurricanes.

 

Our operating costs includeinterest expense on our debt and the general and administrative costs ofacquiring and managing our real estate investment portfolio, such as thecompensation and

 

20

----

 

benefit costs of our employees,professional fees such as legal and portfolio servicing costs and officeexpenses such as rent and other office operating costs.  Noncash expenses include depreciation expenseon the buildings and improvements in our real estate portfolio, stock-basedcompensation (included in general and administrative expenses) and amortizationof deferred financing costs (included in interest expense).  After payment of expenses, our cash flow fromoperating activities totaled $38.6 million for the nine months ended September30, 2005 as compared to $8.6 million for the same period in 2004.

 

We intend to make regularquarterly distributions to our stockholders so that we distribute each year allor substantially all of our REIT taxable income to avoid paying corporate levelfederal income tax and excise tax on our earnings.  During the initial years of our operations,the distributions we pay may include a return of capital.  Cash for future distributions is expected tobe generated from operations, although we may also borrow funds to makedistributions.  Our ability to paydistributions will depend on, among other things, our actual results ofoperations, which are dependent primarily on our receipt of payments from ourleases and loans with respect to our real estate investments. During the ninemonths ended September 30, 2005, we declared dividends of $0.57 per share or$38.6 million, including $0.19 per share or $12.9 million declared in Septemberand paid on October 25, 2005. Dividends paid (including those dividends declaredin 2004 and paid in 2005) totaled $32.8 million during the nine months endedSeptember 30, 2005.

 

In the short-term, we believethat cash provided by operating activities and liquidity available on oursecured credit facilities will be sufficient to meet our liquidity needs forthe operating and financing obligations and commitments of our existing realestate investment portfolio.  On a long-termbasis, we intend to use a combination of debt and equity financing methods toaccomplish our goal of acquiring real estate while maintaining our borrowingsat a targeted leverage ratio, defined as the ratio of our total debt to totalassets, not to exceed 65%. At September 30, 2005, our leverage ratio was 52%. Weintend to pursue additional debt and equity financing through various sourcesin the form of publicly or privately placed transactions.

 

**Resultsof Operations**

 

***Net income***

Net income for the three monthsended September 30, 2005 was $6.7 million, or $0.10 per diluted share,based on 67.5 million weighted average shares of common stockoutstanding.  Net income for the threemonths ended September 30, 2004 was $3.2 million or $0.09 per dilutedshare, based on 37.4 million weighted average shares of common stockoutstanding.

 

Net income for the nine monthsended September 30, 2005 was $20.9 million, or $0.31 per diluted share,based on 67.4 million weighted average shares of common stock outstanding.  Net income for the nine months ended September30, 2004 was $5.3 million or $0.14 per diluted share, based on 36.8 millionweighted average shares of common stock outstanding.

 

The increase in the number ofweighted average shares outstanding between 2005 and 2004 is primarily theresult of our December 2004 initial public offering of 30.0 million commonshares.

 

21

----

 

We commenced operations onAugust 14, 2003 and, particularly during the past 15 months, have realizedsignificant growth in revenues and net income per share due to the substantialgrowth in our real estate investment portfolio.

 

***Income from continuingoperations***

Income from continuingoperations for the three months ended September 30, 2005 was $6.2 million,or $0.09 per diluted share.  Income fromcontinuing operations for the three months ended September 30, 2004 was$3.0 million, or $0.08 per diluted share.

 

Income from continuingoperations for the nine months ended September 30, 2005 was $19.2 million,or $0.29 per diluted share.  Income fromcontinuing operations for the nine months ended September 30, 2004 was $5.1 million,or $0.14 per diluted share.

 

***Discontinued operations***

Periodically, we may sell realestate properties that do not meet our long-term strategic investmentobjectives.  Such properties aretypically acquired in conjunction with the acquisition of a portfolio of realestate properties.  We consider theseoccasional sales of real estate properties to be an integral part of our long-termoperating business strategy in acquiring a diversified real estate investmentportfolio; consequently, proceeds from the sales of real estate properties areexpected to be reinvested in additional real estate properties such that cashflows from ongoing operations are not negatively affected by sales ofindividual properties.  Each time propertiesare sold, current accounting principles require that gains and losses from anysuch dispositions and all operations from the properties previously reported aspart of “income from continuing operations” be reclassified to “discontinuedoperations.”  This reclassification and presentationhas no impact on net income or cash flows.

 

We sold four properties during2004 and 39 properties during the first nine months of 2005, including 16properties in the third quarter.  For thethree and nine months ended September 30, 2005, income from discontinued operationstotaled $0.5 million and $1.7 million, respectively, including netgains on sales of real estate of $0.4 million and $0.7 million,respectively, or $0.01 and $0.02 per diluted share, respectively.  Income from discontinued operations totaled $0.2million for the three and nine months ended September 30, 2004, or $0.01 and zeroper diluted share, respectively, including a net loss on sales of real estateof $6,000.

 

Revenues and expenses,including those classified as discontinued operations, for the three and ninemonths ended September 30, 2005 and 2004 are presented in the table below(dollars in thousands).

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                             |       | $                                     | 23,513     |                                 | $          | 8,170 |   | $ | 57,214 |   | $ | 14,065 |   |
| General and  administrative expenses |       | 3,177                                 |       | 1,818                                |       | 9,017 |   | 4,871 |   |
| Depreciation  and amortization       |       | 5,694                                 |       | 1,449                                |       | 13,289 |   | 2,102 |   |
| Interest                             |       | 8,432                                 |       | 1,676                                |       | 14,628 |   | 1,771 |   |
|                                      |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

22

----

 

The following discussion forthe three and nine months ended September 30, 2005 as compared to the sameperiods in 2004, includes the results of discontinued operations.

 

***Revenues***

Total revenues increased to $23.5 millionfor the third quarter of 2005 from $8.2 million for the third quarter of2004.  Total revenues for the first ninemonths of 2005 increased to $57.2 million from $14.1 million for the sameperiod in 2004.  The increase in revenuesfor the three and nine months ended September 30, 2005 is the result of thegrowth in our real estate portfolio primarily due to property acquisitions madeover the past year.  Because theacquisitions of properties tend to occur later in a quarter, the full earningsimpact of acquisitions made in the third quarter of 2005 will not begin to berealized until the fourth quarter.

 

Over 90% of the total revenuesgenerated in the third quarter and first nine months of 2005 were rentalrevenues from real estate properties we own and lease to our customers. Ourlong-term leases generally provide for payments of base rents with scheduledincreases, increases based on future changes in the Consumer Price Index and/orcontingent rent based on a percentage of the lessee’s gross sales. For leaseswith scheduled rent increases, rental revenue is recognized on a straight-linebasis, net of a valuation allowance, to produce a constant periodic rent overthe term of the leases.  Rental revenueand the related weighted average real estate investments are presented in thetable below (dollars in thousands):

 
| ** **                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Rental revenues, excluding the adjustment  for straight-line rent |       | $                                     | 21,023     |                                 | $          | 6,840 |   | $ | 51,697 |   | $ | 9,449 |   |
| Straight-line rent, net                                           |       | 299                                   |       | 2                                    |       | 809 |   | 148 |   |
| Total rental revenues                                             |       | $                                     | 21,322     |                                 | $          | 6,842 |   | $ | 52,506 |   | $ | 9,597 |   |
|                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average real estate investments                          |       | $                                     | 982,129    |                                 | $          | 300,133 |   | $ | 796,701 |   | $ | 138,383 |   |

 

The weighted average yield onour real estate acquisitions was lower during 2005 than in 2004, reflectingmarket lease rate compression and increased investments in properties leased tocompanies having higher credit profiles. Investments in properties leased to companies with higher credit profileswere designed to meet our total rate of return requirements because we wereable to obtain efficient long-term borrowings at rates ranging from 5.26% to 5.62%.

 

Interest income on mortgage andequipment loans receivable totaled $1.0 million for the third quarter of2005 as compared to $0.9 million for the third quarter of 2004.  For the first nine months of 2005 and 2004,interest income on mortgage and equipment loans receivable totaled $2.9 millionand $2.8 million, respectively.  Approximately95% of the interest income is generated by mortgage loans to two borrowers.

 

Other interest income representsincome generated on temporary investment securities pending investment in realestate. Other interest income totaled $1.2 million for the third quarter of2005

 

23

----

 

compared to $0.4 million forthe third quarter of 2004. The increase in interest income in the third quarter2005 is the result of interest earned on the temporary investment of proceeds fromthe issuance of the net-lease mortgage notes prior to investment in real estateproperties later in the quarter. For the first nine months of 2005 and 2004,other interest income totaled $1.8 million and $1.6 million, respectively.

 

For the nine months ended September30, 2005, no single lessee represented more than 5.8% of total revenues.  At September 30, 2005, no single group ofrelated tenants or borrowers represented greater than 6.5% of the total dollaramount of the investment portfolio.

 

***Expenses***

General and administrativeexpenses include employee-related expenses, professional fees, portfolioservicing costs and office and other expenses. Included in employee-related expenses was noncash stock-basedcompensation of $0.2 million for the three months ended September 30, 2005and 2004 and $0.7 million for the nine months ended September 30, 2005 and2004.  Employee-related expenses increasedas a result of the increase in our number of employees from 23 at September 30,2004 to 36 at September 30, 2005. The increased number of properties in ourportfolio has resulted in increased portfolio servicing costs and higherinsurance costs and franchise taxes.

 

Depreciation and amortization expenserelates primarily to real estate properties and related lease intangibles.  Increases over prior periods are primarilythe result of the increased real estate investment portfolio.

 

Interest expense, including $1.1 millionassociated with the amortization of deferred financing costs, debt insurerpremiums and the amortization of interest rate swap settlement costs, totaled $8.4 millionfor the three months ended September 30, 2005 on weighted average outstandingdebt of approximately $545.4 million. For the nine months ended September 30, 2005, interest expense totaled$14.6 million, including $2.4 million associated with theamortization of related deferred financing costs, debt insurer premiums and theamortization of interest rate swap settlement costs, on weighted averageoutstanding debt of approximately $299.7 million. The increase in LIBORrates over the past year has contributed to the increase in interest expense onour short-term variable rate debt. Interest expense totaled $1.7 million and$1.8 million for the three and nine months ended September 30, 2004,respectively, on weighted average outstanding debt of approximately $115.0million and $113.0 million, respectively.

 

Due to the continued ramp up inoperations and real estate investment activity during 2004 and 2005, ourgeneral and administrative expenses are expected to continue to increase duringthe fourth quarter, although at a slower pace than acquisition growth.  Depreciation and amortization expense isexpected to increase in future periods with future real estate acquisition activity.  Interest expense is expected to increase infuture periods as we continue to make investments in real estate that arefunded with debt financing.

 

24

----

 

**Reconciliationof Non-GAAP Financial Measures**

 

We use certain measures ofhistorical or future financial performance that are different from measurescalculated and presented in accordance with U.S. generally accepted accountingprinciples (“GAAP”).  One such non-GAAPfinancial measure is funds from operations (“FFO”). We use FFO as a measure ofour performance as a REIT because we believe this measure provides investorswith an understanding of our operating performance, cash flows andprofitability.

 

We calculate FFO consistentwith the definition used by the National Association of Real Estate InvestmentTrusts (“NAREIT”), adopted to promote an industry-wide standard measure of REIToperating performance.  We use FFO as ameasure of performance to adjust for certain non-cash expenses such asdepreciation and amortization because accounting for real estate assets underGAAP implicitly assumes that the value of real estate assets diminishespredictably over time. We disclose FFO to facilitate comparisons between SpiritFinance and other REITs, although other REITs may not calculate FFO inaccordance with the NAREIT definition and, accordingly, our FFO may not bedirectly comparable to FFO reported by other REITs.

 

FFO should not be considered analternative to net income determined in accordance with GAAP as a measure ofprofitability, nor should it be considered an equivalent to cash flows providedby operating activities determined in accordance with GAAP as a measure ofliquidity. Spirit Finance’s statements of operations and cash flows includedisclosures of interest expense, capital expenditures and items excluded fromthe calculation of FFO, all of which should be considered when evaluating ourperformance.

 

Funds from operations totaled $11.9 millionfor the third quarter of 2005, including $0.3 million representing theadjustment between scheduled rents and rental revenue recognized on astraight-line basis, and $4.7 million for the third quarter of 2004.  FFO totaled $33.5 million for the ninemonths ended September 30, 2005 (including $0.8 million of straight-linerent) and $7.4 million for the nine months ended September 30, 2004(including $0.1 million of straight-line rent).

 

A reconciliation of net incomecalculated in accordance with GAAP to FFO for the three and nine months ended September30, 2005 and 2004 is presented in the following table (dollars in thousands):

 
| ** **                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income                                        |       | $                                     | 6,652      |                                 | $          | 3,221 |   | $ | 20,949 |   | $ | 5,315 |   |
| Portfolio  depreciation and amortization expense: |       |                                  |       |                                 |       |   |   |   |   |
| Continuing operations                             |       | 5,623                                 |       | 1,356                                |       | 12,764 |   | 1,993 |   |
| Discontinued operations                           |       | 38                                    |       | 73                                   |       | 431 |   | 74 |   |
| Net (gains)  losses on sales of real estate       |       | (442                                  | )          | 6                                    |       | (669 | ) | 6 |   |
| FFO                                               |       | $                                     | 11,871     |                                 | $          | 4,656 |   | $ | 33,475 |   | $ | 7,388 |   |

 

25

----

 

**SignificantAccounting Estimates and Critical Accounting Policies**

 

Our accounting policies aredetermined in accordance with U.S. generally accepted accountingprinciples.  The preparation of ourconsolidated financial statements requires us to make estimates and assumptionsthat are subjective in nature and consequently our actual results could differmaterially from our estimates.  Estimatesand assumptions include, among other things, subjective judgment with regard tothe fair values and useful lives of our properties for depreciation purposesand for classification of leases as either operating or capital leases,judgment regarding the collectibility of receivables and asset impairmentanalysis, assumptions used in estimating the fair value of our financialinstruments and judgment required to estimate the fair value and hedgeeffectiveness of our derivative financial instruments.  Listed below are the more critical accountingpolicies that require management judgment and estimates in the preparation ofour consolidated financial statements.

 

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

 

We recognize interest income onmortgage loans receivable using the effective-interest method applied on aloan-by-loan basis. Direct costs associated with originating loans are offsetagainst any related fees received and the balance, along with any premium or discount,is deferred and amortized as an adjustment to interest income over the terms ofthe related mortgage loans receivable using the effective-interest method. Aloan is placed on non-accrual status when the loan has become 60 days past due,or earlier, if in our opinion, full recovery of the contractual principal andinterest becomes doubtful. While on non-accrual status, interest income isrecognized only when received.

 

Real estate investments – Investments in realestate are recorded at cost, including acquisition and closing costs.  For real estate acquired subject to existinglease agreements, we must allocate a portion of the purchase price of our realestate investments between the tangible and intangible assets and liabilitiesacquired, which requires us to make subjective assessments regarding theirestimated fair values.  We primarily useappraisals to support our estimates of the fair value of our real estate.  We also make subjective assessments regardingthe useful lives of our investments in real estate for purposes of determiningthe amount of depreciation to record on an annual basis.

 

26

----

 

Depreciationis generally computed using the straight-line method over an estimated usefullife of 40 years for buildings and building improvements and 20 years for landimprovements.

 

Impairment ofreal estate investments – We make subjectiveassessments in our review of our real estate investments for impairmentwhenever events or changes in circumstances indicate that the carrying amountof these assets may not be recoverable. Management considers factors such asexpected future operating income, estimated residual value, market trends suchas the effects of leasing demand and competition and other factors in makingthis assessment.  In general, if thecarrying amount of an asset exceeds its estimated undiscounted future cashflows, an impairment charge is recognized in the amount by which the carryingamount of the asset exceeds the fair value of the asset. The carrying amount ofour real estate investments is the largest component of our consolidatedbalance sheets. If events should occur that require us to reduce the carryingamount of our real estate by recording provisions for impairment losses, itcould have a material impact on our results of operations and our financialcondition.

 

Loanimpairment – We periodically evaluate our mortgageloans receivable, including accrued interest, for collectibility by analyzingthe underlying property-level economics and trends, collateral value andquality and other relevant factors in determining the adequacy of our allowancefor loan losses. A loan is determined to be impaired when, in our judgmentbased on current information and events, it is probable that we will be unableto collect all amounts due according to the contractual terms of the loanagreement. Specific allowances for losses are provided for impaired loans on anindividual loan basis in the amount by which the carrying amount exceeds theestimated fair value of the underlying collateral less disposition costs.

 

**Forward-LookingStatements**

 

Someof the statements in this report constitute forward-looking statements.Forward-looking statements relate to expectations, beliefs, projections, futureplans and strategies, anticipated events or trends and similar expressionsconcerning matters that are not historical facts. In some cases,forward-looking statements can be identified by terms such as “anticipate,” “believe,”“could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will”and “would” or the negative of these terms or other similar terminology.

 

Theforward-looking statements are based on our beliefs, assumptions andexpectations of our future performance, taking into account all informationcurrently available to us. These beliefs, assumptions and expectations canchange as a result of many possible events or factors, not all of which areknown to us or are within our control. If a change occurs, our business,financial condition, liquidity and results of operations may vary materiallyfrom those expressed in our forward-looking statements. The following are someof the factors that could cause actual results to vary from our forward-lookingstatements:

 

•                  changes in our industry, interest rates orgeneral economic conditions;

•                  general volatility of the capital markets andthe market price of our common stock;

•                  changes in our business strategy ordevelopment plans;

•                  availability, terms and effective developmentof capital;

 

27

----

 

•                  availability of suitable properties toacquire and our ability to rent those properties at favorable rates;

•                  availability of qualified personnel and ourability to retain our key management personnel;

•                  changes in, or the failure or inability tocomply with, government regulation;

•                  the degree and nature of our competition; and

•                  other factors referenced in our annual reporton Form 10-K, including those set forth under the captions “Factors AffectingOur Operating Results” and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”

 

Theseforward-looking statements speak only as of the date of this report. Weexpressly disclaim any obligation or undertaking to disseminate any updates orrevisions to any forward-looking statement contained in this report to reflectany change in our expectations with regard to the statements or any change inevents, conditions or circumstances on which any such statement is based.

 

**Item3. Quantitative and Qualitative Disclosures About Market Risk**

 

We are exposed to variousfinancial market risks, especially interest rate risk.  Our interest rate risk management policyseeks to limit the effects of changes in interest rates on our operations.  One objective of our interest rate riskmanagement policy is to match fund fixed-rate assets with fixed-rateliabilities and variable-rate assets with variable-rate liabilities.  As part of this strategy, we have used andmay continue to use derivative contracts, such as interest rate swaps, tomanage our interest rate risk We do not enter into derivative contracts forspeculative or trading purposes.

 

At September 30, 2005, ourfixed-rate debt totaled $637.4 million as compared to $38.7 millionat December 31, 2004.  Using a discountedcash flow analysis based on estimates of the amount and timing of future cashflows, market rates and credit spreads, the estimated fair value of thefixed-rate debt was approximately $7.1 million below its carrying amount atSeptember 30, 2005.  Our mortgage loansreceivable are also fixed-rate instruments. At September 30, 2005, our mortgage loans receivable (excludingequipment loans) totaled $55.8 million as compared to $40.4 millionat December 31, 2004.  Using a discountedcash flow analysis, the estimated fair value of our fixed-rate mortgage loansreceivable exceeded the carrying amount by approximately $1.1 million at September30, 2005.  It is our intent to hold ourfixed-rate mortgage loans receivable and our fixed-rate mortgages and notespayable to maturity; accordingly, changes in market interest rates impact thefair value of these financial instruments but have no impact on interestrecognized or cash flows.

 

We use variable-rate debt tofund acquisitions on a short-term basis until our long-term debt strategies canbe implemented.  For the nine monthsended September 30, 2005, the weighted average outstanding balance of ourvariable-rate debt, which was based on one-month LIBOR, was $99.6 million.  Excluding amortization of deferred financingcosts, this variable rate indebtedness had a weighted average interest rate of5.2%. During the first nine months of 2005, one-month LIBOR has increasedapproximately 150 basis points. Had the weighted average interest rate been 100basis points higher (lower) during the first nine months of 2005, our netincome for the nine months ended September 30, 2005 would have been reduced(increased) by approximately $0.8 million. This amount was determined by considering the impact of a

 

28

----

 

hypothetical interest ratechange on our average variable-rate borrowings outstanding during the first ninemonths of 2005 and assumes no other changes in our capital structure.

 

On October 4, 2004, we enteredinto a forward-starting interest rate swap with a notional amount of$235 million, and on March 31, 2005, we entered into an additionalforward-starting interest rate swap agreement with a notional amount of$87 million.  In July 2005, the anticipatedlong-term debt was issued, and the interest rate swaps were settled for a net cashpayment of $13.7 million to the swap counterparty because long-term rateshad decreased since the inception of the hedges.  The total change in fair value of the interestrate swaps from inception of the hedges of $15.0 million is recorded in “Accumulatedother comprehensive loss” and will be amortized to earnings as an increase tointerest expense over a 25-year amortization period. The unamortized balance ofthe settled interest rate swaps at September 30, 2005 was $14.8 million.Because the anticipated interest payments are considered probable, the hedgescontinue to be effective.

 

On August 26, 2005, we enteredinto a forward-starting interest rate swap with a notional amount of $50million.  On October 6, 2005, we enteredinto an additional forward-starting interest rate swap with a notional amountof $80 million. Both of these derivative instruments are designated to hedgethe variability of cash flows related to forecasted interest payments over 15years on long-term debt expected to be issued in 2006.  The counterparty for each swap is a majorfinancial institution that has a credit rating of at least “A-” from anationally recognized rating agency.  Asthe hedging relationships are expected to be highly effective at achievingoffsetting changes in cash flows, these interest rate swaps are accounted foras cash flow hedges. The fair value of the interest rate swaps resulted in anunrealized gain of $0.6 million at September 30, 2005.  Hedge effectiveness is assessed using thehypothetical derivative method; no hedge ineffectiveness was recognized throughthe income statement for the three or nine months ended September 30, 2005.

 

29

----

 

**Item4.  Controls and Procedures**

 

Wehave adopted and maintain disclosure controls and procedures that are designedto ensure that information required to be disclosed in our reports under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported within thetime periods required under the Securities and Exchange Commission’s rules andforms and that the information is gathered and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

Asrequired by Rule 13a-15(b) of the Exchange Act, we carried out an evaluation,under the supervision and with the participation of management, including ourChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe design and operation of our disclosure controls and procedures as of theend of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective atthe reasonable assurance level.

 

Nochange in our internal control over financial reporting occurred during ourmost recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

30

----

 

**PART II – OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

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

 

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

 

NotApplicable.

 

**Item3.  Defaults Upon Senior Securities**

 

NotApplicable.

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

None.

 

**Item5.  Other Information**

 

None.

 

31

----

 

**Item6.  Exhibits**

 
| **Exhibit****No.** | ** ** | **Description**                                                                                                                                                                    |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                                                                                               |
| 4.1                |       | Master Indenture dated as of July 26, 2005, between Spirit  Master Funding, LLC and Citibank, N.A., as indenture trustee.(1)                                                  |
|               |       |                                                                                                                                                                               |
| 4.2                |       | Series 2005-1 Indenture Supplement dated as of July 26,  2005, between Spirit Master Funding, LLC and Citibank, N.A., as indenture  trustee.(1)                          |
|               |       |                                                                                                                                                                               |
| 10.1               |       | Property Management and Servicing Agreement dated as of July 26,  2005, among Spirit Master Funding, LLC, Spirit Finance Corporation and  Midland Loan Services, Inc.(1) |
|               |       |                                                                                                                                                                               |
| 10.2               |       | Master Repurchase Agreement between Spirit Finance Corporation and  Citigroup Global Markets Realty Corp. dated as of September 13, 2005.(2)                                  |
|               |       |                                                                                                                                                                               |
| 31.1               |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                          |
|               |       |                                                                                                                                                                               |
| 31.2               |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                          |
|               |       |                                                                                                                                                                               |
| 32.1               |       | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                          |
|               |       |                                                                                                                                                                               |
| 32.2               |       | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                          |

 

----

(1)  Incorporated by reference to the Registrant’s Current Reporton Form 8-K dated July 26, 2005, filed August 1, 2005.

(2)  Incorporated by reference to the Registrant’s Current Reporton Form 8-K dated September 13, 2005, filed September 19, 2005.

 

32

----

 

**SIGNATURES**

 

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

 
|                           | SPIRIT FINANCE CORPORATION |
|--------------------------------|----------------------------|
|                           |                       |
| Date:   November 14, 2005 | By:                        | /s/  Christopher H. Volk |   |
|                           |                       | Christopher H. Volk  Chief Executive Officer and President |
|                           |                       |
|                           | By:                        | /s/  Catherine Long |   |
|                           |                       | Catherine Long  Chief Financial Officer, Senior Vice  President and Treasurer |

 

33

 

----

 

**ExhibitIndex**

 
| **Exhibit****No.** | ** ** | **Description**                                                                                                                                                                    |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                                                                                               |
| 4.1                |       | Master Indenture dated as of July 26, 2005, between Spirit  Master Funding, LLC and Citibank, N.A., as indenture trustee.(1)                                                  |
|               |       |                                                                                                                                                                               |
| 4.2                |       | Series 2005-1 Indenture Supplement dated as of July 26,  2005, between Spirit Master Funding, LLC and Citibank, N.A., as indenture  trustee.(1)                          |
|               |       |                                                                                                                                                                               |
| 10.1               |       | Property Management and Servicing Agreement dated as of July 26,  2005, among Spirit Master Funding, LLC, Spirit Finance Corporation and  Midland Loan Services, Inc.(1) |
|               |       |                                                                                                                                                                               |
| 10.2               |       | Master Repurchase Agreement between Spirit Finance Corporation and  Citigroup Global Markets Realty Corp. dated as of September 13, 2005.(2)                                  |
|               |       |                                                                                                                                                                               |
| 31.1               |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                          |
|               |       |                                                                                                                                                                               |
| 31.2               |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                          |
|               |       |                                                                                                                                                                               |
| 32.1               |       | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                          |
|               |       |                                                                                                                                                                               |
| 32.2               |       | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                          |

 

----

(1)  Incorporated by reference to the Registrant’s Current Reporton Form 8-K dated July 26, 2005, filed August 1, 2005.

(2)  Incorporated by reference to the Registrant’s Current Reporton Form 8-K dated September 13, 2005, filed September 19, 2005.

 

34

----