**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                                                                                                                                                                                                | ** **                                                                                                    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                                                                                                                                         | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **For the quarterly period ended March 31,  2008**                                                                                                                                                                                                                                                                       |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **o**                                                                                                                                                                                                                                                                                                                         | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                                                                                    |
| **For the transition period  from                         to                         ** |

 

**Commissionfile number: 0-17189**

 

**CALIFORNIA COASTALCOMMUNITIES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **02-0426634**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | ** ** | (I.R.S. Employer Identification No.) |
|                                                            | ** ** | ** **                           |
| **6 Executive Circle, Suite 250  Irvine, California**      |       | **92614**                            |
| (Address of principal executive offices)                        |       | (Zip Code)                           |

 

Registrant’stelephone number, including area code: **(949) 250-7700**

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

| **Title of Each Class**                | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------------------|------------|-----------------------------------------------|
| Common Stock, par value $.05 per share |       | NASDAQ Global Market                          |

 

Securitiesregistered pursuant to Section 12(g) of the Act:

**None**

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.YES o  NO x

 

Indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. YES o  NO x

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. YES x  NO o

 

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

 

| Large  accelerated filer o                     |   | Accelerated  filer x         |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                       |   | Smaller  reporting company o |
| (Do  not check if a smaller reporting company) |   |                              |

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act). YES oNO x

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate. 

 

As of April 30, 2008 there were 10,871,780shares of Common Stock, par value $.05 outstanding.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED MARCH 31, 2008

 

INDEX

 
| Cautionary  Statement About Forward-Looking Statements | 3                       |
|--------------------------------------------------------|-------------------------|
|                                                   |                    |   |   |
| Part I -                                          | Financial  Information: | 5 |
|                                                   |                    |   |   |
|                                                   | Item 1 -                | Consolidated  Financial Statements | 5 |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated Balance Sheets - March 31, 2008  (unaudited) and December 31, 2007 | 5 |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated Statements of Operations - Three Months  Ended March 31, 2008 and 2007 (unaudited) | 6 |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated Statements of Cash Flows -Three Months  Ended March 31, 2008 and 2007 (unaudited) | 7 |
|                                                   |                    |   |   |
|                                                   |                    | Notes to Consolidated Financial Statements | 8 |
|                                                   |                    |   |   |
|                                                   | Item 2 -                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 20 |
|                                                   |                    |   |   |
|                                                   | Item 3 -                | Quantitative  and Qualitative Disclosures About Market Risk | 33 |
|                                                   |                    |   |   |
|                                                   | Item 4 -                | Evaluation  of Disclosure Controls and Procedures | 33 |
|                                                   |                    |   |   |
| Part II -                                         | Other Information:      | 34 |
|                                                   |                    |   |   |
|                                                   | Item 1 -                | Legal Proceedings | 34 |
|                                                   |                    |   |   |
|                                                   | Item 1A -               | Risk  Factors That May Affect Results of Operations and Financial Condition | 34 |
|                                                   |                    |   |   |
|                                                   | Item 6 -                | Exhibits | 34 |
|                                                   |                    |   |   |
| SIGNATURE                                              | 35                      |

 

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CAUTIONARY STATEMENT ABOUTFORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of theSecurities Exchange Act of 1933 and Section 21E of the Securities ExchangeAct of 1934 that relate to future events or our future financial performance.In addition, other statements we may make from time to time, such as pressreleases, oral statements made by our officials and other reports that we filewith the Securities and Exchange Commission may also contain such forward-lookingstatements. Undue reliance should not be placed on these statements whichinvolve known and unknown risks, uncertainties and other factors which maycause our actual results, performance or achievements to be materiallydifferent from any future results, performances or achievements expressed orimplied by the forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,” “expects,”“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,”or the negative of such terms or other comparable terminology.

 

These forward-looking statements include, butare not limited to:

 

·      statementsabout our strategies, plans, objectives, goals, expectations and intentions;

 

·      informationrelating to anticipated operating results, financial resources, changes inrevenues, changes in profitability, interest expense, growth and expansion,anticipated income to be realized from our investments in unconsolidatedentities;

 

·      theimpact of demographic trends and supply constraints on the demand for andsupply of housing;

 

·      housingmarket conditions in the geographic markets in which we operate;

 

·      thenumber and types of homes and number of acres of land that we may develop andsell;

 

·      theability to deliver homes from backlog;

 

·      thetiming and outcomes of regulatory approval processes or administrativeproceedings, which may result in delays in the land entitlement, development,construction, or the opening of new communities (including, but not limited toongoing administrative proceedings related to our joint venture near Oxnard,California);

 

·      theability to secure materials and subcontractors;

 

·      theability to produce the liquidity and capital necessary to expand and take advantageof opportunities in the future;

 

·      ourability to realize the value of our net operating loss carry forwards;

 

·      ourability to continue relationships with current or future partners;

 

·      theeffectiveness and adequacy of our disclosure and internal controls;

 

·      theimpact of recent accounting pronouncements; and

 

·      stockmarket valuations.

 

Any or all of the forward-looking statementsincluded in this report and in any other reports or public statements made byus may turn out to be inaccurate. This can occur as a result of incorrectassumptions or as a consequence of known or unknown risks and uncertainties.These risks and uncertainties include the competitive environment in which weoperate; local, regional and national economic conditions; the effects of inflationor a recession; the demand for homes; fluctuations in interest rates and theavailability of mortgage financing; changes in home prices; the availabilityand cost of land for future growth; the availability of capital; uncertaintiesand fluctuations in capital and securities markets; changes in tax laws andtheir interpretation; legal proceedings; the ability of customers to financethe purchase of homes or sell existing homes; the availability and cost oflabor and materials; the amount of our debt and the impact of restrictivecovenants in our loan agreements; adverse weather conditions; domestic andinternational political events; uncertainties created by terrorist attacks; 

 

3

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the effects of governmental regulation, including regulationsconcerning development of land, the home building industry, sales and customerfinancing processes, and the environment; and other risks discussed in ourfilings with the Securities and Exchange Commission. Many factors mentioned inthis report or in other reports or public statements made by us, such asgovernment regulation and the competitive environment, will be important indetermining our future performance. Consequently, actual results may differ materiallyfrom those that might be anticipated from our forward-looking statements. Youshould not place undue reliance on any of these forward-looking statementsbecause they are based on current expectations or beliefs regarding futureevents or circumstances, which involve known and unknown risks, uncertaintiesand other factors which may cause our actual results, performance orachievements to be materially different from any future results, performancesor achievements expressed or implied by these forward-looking statements.

 

Although we believe that our strategies, plans,objectives, goals, expectations and intentions reflected in, or suggested bythese forward-looking statements are reasonable given current informationavailable to us, we can give no assurance that any of them will be achieved.Forward-looking statements speak only as of the date they are made. Weundertake no obligation to publicly update any forward-looking statements,whether as a result of new information, future events or otherwise. However,any further disclosures made on related subjects in our subsequent reports onForms 10-K, 10-Q and 8-K should be consulted.

 

These forward-looking statements should beconsidered in light of the information included in this report and our other filingswith the Securities and Exchange Commission, including, without limitation, the“Risk Factors” set forth below, as well as the description of trends and otherfactors in “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” set forth in our Form 10-K for the year ended December 31,2007. You should also read the following “Management’s Discussion and Analysisof Financial Condition and Results of Operations” in conjunction with theunaudited consolidated financial statements and the related notes that appearelsewhere in this report.

 

We assume no, and hereby disclaim any, obligation toupdate any of the foregoing or any other forward-looking statements. Wenonetheless reserve the right to make such updates from time to time by pressrelease, periodic report or other method of public disclosure without the needfor specific reference to this Form 10-Q or any other report filed by us.No such update shall be deemed to indicate that other statements not addressedby such update remain correct or create an obligation to provide any otherupdates.

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1 –FINANCIAL STATEMENTS**

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                                  | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                   |       | $                        | 1.2        |                        | $          | 24.3 |   |
| Restricted cash                                                                                                                             |       | 5.9                      |       | 6.0                         |       |
| Real estate inventories                                                                                                                     |       | 295.2                    |       | 286.4                       |       |
| Deferred tax assets                                                                                                                         |       | 44.8                     |       | 44.4                        |       |
| Other assets, net                                                                                                                           |       | 6.4                      |       | 6.5                         |       |
|                                                                                                                                        |       |                     |       |                        |       |
|                                                                                                                                        |       | $                        | 353.5      |                        | $          | 367.6 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Liabilities:                                                                                                                                |       |                     |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                    |       | $                        | 10.2       |                        | $          | 12.5 |   |
| Senior secured project revolver                                                                                                             |       | 67.0                     |       | 76.0                        |       |
| Senior secured term loan                                                                                                                    |       | 121.0                    |       | 121.8                       |       |
| Other project debt                                                                                                                          |       | 47.3                     |       | 48.8                        |       |
| Other liabilities                                                                                                                           |       | 7.1                      |       | 7.0                         |       |
|                                                                                                                                        |       |                     |       |                        |       |
| Total liabilities                                                                                                                           |       | 252.6                    |       | 266.1                       |       |
|                                                                                                                                        |       |                     |       |                        |       |
| Commitments and contingencies                                                                                                               |       |                     |       |                        |       |
|                                                                                                                                        |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                                  |       |                     |       |                        |       |
| Common Stock—$.05 par value; 13,500,000 shares authorized; 10,855,963  and 10,852,708 shares issued and outstanding, respectively |       | .5                       |       | .5                          |       |
| Excess Stock—$.05 par value; 13,500,000 shares authorized; no shares  outstanding                                                      |       | —                   |       | —                      |       |
| Additional paid-in capital                                                                                                                  |       | 59.4                     |       | 59.3                        |       |
| Retained earnings                                                                                                                           |       | 42.4                     |       | 43.1                        |       |
| Accumulated other comprehensive loss                                                                                                        |       | (1.4                     | )          | (1.4                        | )          |
| Total stockholders’ equity                                                                                                             |       | 100.9                    |       | 101.5                       |       |
|                                                                                                                                        |       |                     |       |                        |       |
|                                                                                                                                        |       | $                        | 353.5      |                        | $          | 367.6 |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
| ** **                                    | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                             |       |   |   |
| Homebuilding                                  |       | $                                                | 5.0        |   | $ | 12.2 |   |
|                                          |       |                                             |       |   |   |
| Costs of sales:                               |       |                                             |       |   |   |
| Homebuilding                                  |       | 3.9                                              |       | 11.4 |   |
|                                          |       |                                             |       |   |   |
| Loss on impairment of real estate inventories |       | —                                           |       | 4.0 |   |
|                                          |       | 3.9                                              |       | 15.4 |   |
|                                          |       |                                             |       |   |   |
| Gross operating profit (loss)                 |       | 1.1                                              |       | (3.2 | ) |
|                                          |       |                                             |       |   |   |
| Selling, general and administrative expenses  |       | 1.6                                              |       | 1.7 |   |
| Other expense, net                            |       | .6                                               |       | .1 |   |
|                                          |       |                                             |       |   |   |
| Loss before income taxes                      |       | (1.1                                             | )          | (5.0 | ) |
|                                          |       |                                             |       |   |   |
| Benefit from income taxes                     |       | (.4                                              | )          | (2.0 | ) |
|                                          |       |                                             |       |   |   |
| Net loss                                      |       | $                                                | (.7        | ) | $ | (3.0 | ) |
|                                          |       |                                             |       |   |   |
| Net loss per common share:                    |       |                                             |       |   |   |
|                                          |       |                                             |       |   |   |
| Basic                                         |       | $                                                | (.06       | ) | $ | (.28 | ) |
| Diluted                                       |       | $                                                | (.06       | ) | $ | (.28 | ) |
|                                          |       |                                             |       |   |   |
| Common equivalent shares:                     |       |                                             |       |   |   |
|                                          |       |                                             |       |   |   |
| Basic                                         |       | 10.9                                             |       | 10.9 |   |
| Diluted                                       |       | 10.9                                             |       | 10.9 |   |

 

See theaccompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                                                             |       |                                             |       |   |   |
| Cash flows from operating activities:                                            |       |                                             |       |   |   |
| Net loss                                                                         |       | $                                                | (.7        | ) | $ | (3.0 | ) |
| Adjustments to reconcile net loss to cash used in operating  activities:         |       |                                             |       |   |   |
| Stock-based compensation expense                                                 |       | .1                                               |       | — |   |
| Distributions from unconsolidated joint ventures                                 |       | .1                                               |       | — |   |
| Equity in earnings of unconsolidated joint ventures                              |       | (.1                                              | )          | — |   |
| Loss on change in fair value of derivative instrument                            |       | .5                                               |       | — |   |
| Deferred taxes                                                                   |       | (.4                                              | )          | (2.0 | ) |
| Gains on sales of real estate inventories                                        |       | (1.1                                             | )          | (.8 | ) |
| Loss on impairment of real estate inventories                                    |       | —                                           |       | 4.0 |   |
| Proceeds from sale of real estate inventories, net                               |       | 4.9                                              |       | 11.7 |   |
| Investments in real estate inventories                                           |       | (12.3                                            | )          | (18.1 | ) |
| Changes in assets and liabilities:                                               |       |                                             |       |   |   |
| Decrease in other assets                                                         |       | .1                                               |       | 1.5 |   |
| Decrease in accounts payable, accrued and other liabilities                      |       | (2.7                                             | )          | (2.9 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash used in operating activities                                                |       | (11.6                                            | )          | (9.6 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash flows from investing activities:                                            |       |                                             |       |   |   |
| Sales of short-term investments                                                  |       | —                                           |       | .5 |   |
| Investments in unconsolidated joint ventures                                     |       | (.1                                              | )          | (.1 | ) |
| Change in restricted cash                                                        |       | .1                                               |       | 1.0 |   |
|                                                                             |       |                                             |       |   |   |
| Cash provided by investing activities:                                           |       | —                                           |       | 1.4 |   |
|                                                                             |       |                                             |       |   |   |
| Cash flows from financing activities:                                            |       |                                             |       |   |   |
| Borrowings of senior secured project revolver                                    |       | 10.5                                             |       | 9.4 |   |
| Repayments of senior secured project revolver                                    |       | (19.5                                            | )          | — |   |
| Repayments of senior secured term loan                                           |       | (.8                                              | )          | — |   |
| Borrowings of other project debt                                                 |       | .7                                               |       | 5.3 |   |
| Repayments of other project debt                                                 |       | (2.2                                             | )          | (8.4 | ) |
| Deferred financing costs                                                         |       | (.2                                              | )          | — |   |
|                                                                             |       |                                             |       |   |   |
| Cash (used in) provided by financing activities                                  |       | (11.5                                            | )          | 6.3 |   |
|                                                                             |       |                                             |       |   |   |
| Net decrease in cash and cash equivalents                                        |       | (23.1                                            | )          | (1.9 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash and cash equivalents - beginning of period                                  |       | 24.3                                             |       | 10.6 |   |
|                                                                             |       |                                             |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                                | 1.2        |   | $ | 8.7 |   |
|                                                                             |       |                                             |       |   |   |
| Supplemental disclosures of cash flow information:                               |       |                                             |       |   |   |
| Cash paid during the period for income taxes, net of refunds received            |       | $                                                | —     |   | $ | .2 |   |
| Supplemental disclosures of non-cash investing and financing  activities:        |       |                                             |       |   |   |
| Amortization of deferred financing costs capitalized in real estate  inventories |       | $                                                | .3         |   | $ | — |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 - Basis of Presentation**

 

The accompanying financial statements have beenprepared by California Coastal Communities, Inc. and its consolidatedsubsidiaries (the “Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. The Company believes thatthese unaudited consolidated financial statements reflect all materialadjustments (consisting only of normal recurring adjustments) and disclosuresnecessary for the fair presentation of the results of operations and statementsof financial position when read in conjunction with the Consolidated FinancialStatements and Notes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2007. Intercompany accounts andtransactions have been eliminated.

 

The results for interim periods are not necessarilyindicative of the results to be expected for the full year. This reportcontains forward-looking statements. Readers are cautioned that any suchforward-looking statements are not guarantees of future performance and involverisks and uncertainties that actual events or results may differ materiallyfrom those described herein as a result of various factors, including withoutlimitation, the factors discussed generally in this report.

 

**Note 2 - Significant Accounting Policies**

 

*Basis of Consolidation*

 

Certain of the Company’s wholly-owned subsidiariesare members in joint ventures involved in the development and sale ofresidential projects and residential loan production. The Company’sconsolidated financial statements include the Company’s accounts and all of itsmajority-owned and controlled subsidiaries and joint ventures. The financialstatements of joint ventures in which the Company has a controlling or majorityeconomic interest (and thus are controlled by the Company) are consolidatedwith the Company’s financial statements. The Company’s investments inunconsolidated joint ventures are accounted for using the equity method whenthe Company does not have voting or economic control of the venture operations,as further discussed in Note 4 to the consolidated financial statementsincluded in the Company’s Annual Report on Form 10-K for the year ended December 31,2007.

 

*Market Risks*

 

Current housing and credit market conditions presentuncertainty as to the ability of the Company to meet its projected homeclosings or secure new financings, if needed. The Company’s management istaking certain steps such as initiating discussion with the Company’s financialinstitutions regarding its current debt obligations and evaluating alternativesfor raising additional financing, if necessary. See Notes 4 and 5 for furtherdiscussion.

 

*Real Estate*

 

Real estate inventories primarily consist of homesunder construction and lots under development and are carried at the lower ofcost or fair value less costs to sell. The estimation process involved in thedetermination of fair value is inherently uncertain since it requires estimatesas to future events and market conditions. Such estimation process assumes theCompany’s ability to complete development and dispose of its real estateproperties in the ordinary course of business based on management’s presentplans and intentions. Economic, market, and environmental conditions may affectmanagement’s development and marketing plans. In addition, the implementationof such development and marketing plans could be affected by the availabilityof future financing for development and construction activities. Accordingly,the ultimate values of the Company’s real estate properties depend upon futureeconomic and market conditions, and the availability of financing.

 

The cost of sales of multi-unit projects isgenerally computed using the relative sales value method. Interest and othercarrying costs are capitalized to real estate projects during their developmentand construction period.

 

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*Impairment of Long-Lived Assets*

 

The Company assesses the impairment of realestate inventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets”*, (“SFAS 144”) which requires that long-livedassets be reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Asprovided by SFAS 144, impairment is evaluated by comparing an asset’scarrying value to the undiscounted estimated cash flows expected from the asset’soperations and eventual disposition. If the sum of the undiscounted estimatedfuture cash flows is less than the carrying value of the asset, an impairmentloss is recognized based on the fair value of the asset. If impairment occurs,the fair value of an asset for purposes of SFAS 144 is deemed to be theamount a willing buyer would pay a willing seller for such asset in a currenttransaction. Additionally, as appropriate, the Company identifies alternativecourses of action to recover the carrying value of its long-lived assets andevaluates all likely alternatives under a probability-weighted approach asdescribed in SFAS 144.

 

In accordance with SFAS 144, indeveloping estimated future cash flows for impairment testing for its realestate inventories, the Company has incorporated its own market assumptionsincluding those regarding home prices, sales pace, sales and marketing costs,infrastructure and home-building costs and financing costs regarding realestate inventories. The Company’s assumptions are based, in part, on generaleconomic conditions, the current state of the homebuilding industry,expectations about the short- and long-term outlook for the housing market, andcompetition from other homebuilders in the areas in which the Company buildsand sells homes. These assumptions can significantly affect the Company’sestimates of future cash flows. For those communities deemed to be impaired,the Company determined fair value based on discounted estimated future cashflows using estimated absorption rates for each community.

 

The Company recorded no additional impairmentcharges during the three months ended March 31, 2008, compared with $4.0million recorded related to the Beaumont project during the three months ended March 31,2007. The impairment charge recorded during the first quarter of 2007 reflectedthe continuing slowdown in the housing market and our expectations about thepace of sales and sales prices. To date, the Company has recorded impairmentcharges for five of its six active projects. The impairment charges werecalculated based on current market conditions and current assumptions made bymanagement, which may differ materially from actual results if marketconditions change. As required by SFAS 144, should market conditionsdeteriorate in the future or other events occur that indicate the carryingamount of the Company’s real estate inventories may not be recoverable, theCompany will reevaluate the expected cash flows from each project to determinewhether any additional impairment exists at any point in time.

 

The Company believes that the accounting forthe impairment of long-lived assets is a critical accounting policy because thevaluation analysis involves a number of assumptions that may differ from actualresults and the impact of recognizing impairment losses has been material tothe Company’s consolidated financial statements. The critical assumptions inthe Company’s evaluation of real estate inventories impairment includedprojected sales prices, anticipated sales pace within each community, andapplicable discount rates, any of which could change materially as economicconditions change.

 

*Earnings Per Common Share*

 

Earnings per common share is accounted for inaccordance with SFAS No. 128, *“Earnings Per Share”*.Basic earnings per common share is computed using the weighted-average numberof common shares outstanding for the period. Diluted earnings per common shareis computed using the weighted-average number of common shares outstanding andthe dilutive effect of potential common shares outstanding.

 

*Recent Accounting Pronouncements*

 

In September 2006, the FASB issued SFAS No. 157,*“Fair Value Measurements”* (“SFAS 157”),which defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosures about fairvalue measurements. The Company adopted SFAS 157 on January 1, 2008. Theadoption of SFAS 157 did not have a material effect on the Company’sconsolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159,*“The Fair Value Option for Financial Assets andFinancial Liabilities”* (“SFAS 159”), which expands the standardsunder SFAS 157 and provides entities a one-time election to measure financialinstruments and certain other items at fair value. The Company adoptedSFAS 159 on January 1, 2008. The adoption of SFAS 159 did not have amaterial effect on the Company’s consolidated financial statements.

 

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In December 2007, the FASB issued SFAS No. 160,*“Noncontrolling Interests in ConsolidatedFinancial Statements—an amendment of ARB No. 51”* (“SFAS 160”),which clarifies and expands the accounting and reporting standards for thenoncontrolling interest in a subsidiary. SFAS 160 requires that net incomeattributable to the parent and the noncontrolling interest be reported on theface of the consolidated statement of income and that a noncontrolling interestbe presented in the consolidated statement of financial position within equity.SFAS 160 is effective for financial statements issued for fiscal periodsbeginning after December 15, 2008 (the Company’s fiscal year beginning January 1,2009). The Company is currently evaluating the impact of adopting SFAS 160on its consolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161,*“Disclosures About Derivative Instrumentsand Hedging Activities — an amendment of FASB Statement No. 133”*(“SFAS 161”), which expands the disclosure requirements for derivativeinstruments and hedging activities required by Statement No. 133.SFAS 161 is effective for financial statements issued for fiscal periodsbeginning after November 15, 2008 (the Company’s fiscal year beginning January 1,2009). The Company is currently evaluating the impact of adopting SFAS 161on its consolidated financial statements.

 

**Note 3 – Real Estate Inventories**

 

Real estate inventories primarily consist ofhomes under construction and lots under development at Brightwater and fouradditional communities in four Southern California counties. At March 31,2008, real estate inventories aggregated 712 lots and homes, including 38 homescompleted and unsold, four homes completed and in escrow, and eight homes underconstruction and in escrow. Real estate inventories at March 31, 2008included $230.0 million recorded for the Brightwater community which islocated on a 105-acre parcel on a mesa north of the Bolsa Chica wetlands (“UpperMesa”). Brightwater is under development for 356 homes as discussed below. Inaddition, real estate inventories include approximately 51 acres nearby whichhave been offered for dedication to the County of Orange for inclusion in theHarriet M. Weider Linear Park in conjunction with the development of Brightwater,and 51 additional acres which are subject to a conservation easement. Thecarrying value of these two properties is zero. The Company capitalizescarrying costs including interest and property taxes, as well as directconstruction costs, to real estate inventories during the development andconstruction period.

 

The Brightwater planned community offers abroad mix of home choices, averaging 2,860 square feet and ranging in size from1,710 square feet to 4,339 square feet. The community also has 37 acres of openspace and conservation area. With 349 homes permitted on 68 acres of the UpperMesa, the resulting low-density plan equates to approximately five homes peracre, consistent and compatible with the neighboring Huntington Beachcommunities. In addition, the Company owns land adjacent to the Brightwaterdevelopment, on which it intends to process permits to build seven additionalhomes which will be included in the Brightwater community.

 

The Company began selling homes at The Trailsand The Sands in August 2007 and began delivering homes for these productsduring December 2007. Construction of models for the larger two products,The Cliffs and The Breakers, was completed in January 2008. In February 2008,the Company began selling homes to homebuyers who had previously registered onthe Brightwater priority list. The Company held a grand opening for theseproducts on March 15, 2008 and currently expects to begin delivering thesehomes during the third quarter of 2008.

 

The estimation process involved in thedetermination of value is inherently uncertain since it requires estimates asto future events and market conditions. Such estimation process assumes theCompany’s ability to complete development and disposition of its real estateproperties in the ordinary course of business based on management’s presentplans and intentions. Economic and market conditions may affect management’sdevelopment and marketing plans. In addition, the implementation of suchdevelopment and marketing plans could be affected by the availability of futurefinancing for development and construction activities. Accordingly, the amountultimately realized from such project may differ materially from currentestimates and the project’s carrying value.

 

Capitalized interest is allocated to real estateinventories when incurred and charged to cost of sales when the relatedproperty is delivered. Changes in capitalized interest follow (in millions):

 
| ** **                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
| Capitalized interest, beginning of period |       | $                                                | 26.2       |   | $ | 10.2 |   |
| Interest incurred and capitalized         |       | 4.0                                              |       | 4.1 |   |
| Charged to cost of sales                  |       | (.6                                              | )          | (.6 | ) |
| Capitalized interest, end of period       |       | $                                                | 29.6       |   | $ | 13.7 |   |

 

10

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**Note 4 – Senior Secured Project Revolver**

 

On September 15, 2006, the Companyentered into a three-year, $100 Million Senior Secured Revolving CreditAgreement with KeyBank National Association, as a lender and agent for severalother lenders (the “Revolving Loan”). The Revolving Loan is secured by a firsttrust deed on the Brightwater project, and stock pledges of the Company’smaterial subsidiaries. The Revolving Loan will fund the first $100 millionof development and construction costs for the project.

 

As of March 31, 2008 and December 31,2007, $67.0 million and $76.0 million, respectively, was outstandingunder the Revolving Loan at weighted average rates of 5.10% and 6.90%,respectively, based upon the Company’s elected rates. Outstanding advances bearinterest at the Company’s option at either (i) the Alternate Base rate (“Prime”)minus 25 basis points or (ii) LIBOR plus 200 basis points. As of March 31,2008, the undrawn availability was $30.4 million. Interest on the facilityis calculated on the average, outstanding daily balance and is paid monthly.Interest incurred on the Revolving Loan for the three months ended March 31,2008 and 2007 was $900,000 and $500,000, respectively, at weighted-averageinterest rates of 5.64% and 7.32%, respectively. As of May 5, 2008, the RevolvingLoan weighted average interest rate is 5.10%.

 

Beginning December 31, 2008 and at theend of each subsequent quarter, the commitment amount is scheduled to decreaseby $25.0 million until the commitment under the Revolving Loan is reducedto zero by the final maturity date on September 15, 2009. The RevolvingLoan is also subject to mandatory repayments and commitment reductions based on40% of the $600,000 release price on the first 50 units closed at theBrightwater project, and 40% of the $1 million release price per unitthereafter. These mandatory repayments are applicable to the commitmentreductions set forth above. During the three months ended March 31, 2008,the Company delivered two homes at Brightwater and made mandatory repayments of$480,000. As of March 31, 2008, the Company has delivered 11 homes atBrightwater and made cumulative mandatory repayments of $240,000 per home, or$2.6 million.

 

The Company’s credit facilities currentlyrequire the Company to make $33.4 million in aggregate principalamortization payments by December 31, 2008, including $22.4 millionfor the Revolving Loan (assuming the Company draws the remaining $30.4 millionwhich is available as of March 31, 2008) and $11.0 million for theTerm Loan discussed in Note 5 below. In order to make these payments outof cash flow from operations, the Company would need to deliver approximately50 homes at Brightwater during 2008, which appears unlikely based on salesorders to date, the number of homes currently under construction and theapproximately eight months it takes to build the larger homes (The Cliffs andThe Breakers). Therefore, the Company has initiated discussions with itslenders regarding potential amendments to the Revolving Loan that would defer aportion of its currently scheduled payments to future periods and modifycertain covenants to accommodate the slower projected pace of sales. Amendmentsto the payment schedule will require the unanimous consent of the RevolvingLoan bank syndicate. The Company is also evaluating alternatives for raisingadditional capital, if necessary. There can be no assurance that the Companywill be successful in these endeavors, or that requested amendments to theRevolving Loan will be agreed to by the Company’s lenders. Current creditmarket conditions present uncertainty as to the ability of the Company tosecure additional financing, if needed, and the terms of such financing if itis available, or as to the ability of the Company to achieve positive cash flowfrom operations to satisfy its obligations.

 

Under the Revolving Loan, the Company isrequired to comply with a number of covenants, including the followingfinancial covenants which the Company considers to be the most restrictive ofall of the debt covenants:

 

·                  a leverage covenant that prohibitsthe Company’s ratio of consolidated total liabilities to consolidated tangiblenet worth from exceeding the following:

 
| **Reporting Period**                            | ** ** | **Maximum  Leverage Ratio** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| March 31, 2008 through June 30,  2008 |       | 2.50 to 1.0                      |       |
| September 30, 2008 and thereafter          |       | 2.25 to 1.0                      |       |

 

·                  a minimum consolidated tangible networth covenant of $80 million.

 

As of March 31, 2008, the Company’sconsolidated total liabilities are $252.6 million, tangible net worth is$100.9 million and leverage ratio is 2.50. The Company is in compliancewith the covenants of the Revolving Loan as of March 31, 2008.

 

As a result of the sustained downturn in thehomebuilding industry and the $28.0 million of impairment charges the Companyrecorded during the third quarter of 2007, the Revolving Loan was amended,effective as of September 30, 2007, to reduce the tangible net worthcovenant from $100 million to $80 million. In connection with theamendment, which was approved by 95% of the lenders, the Company paid a fee of$142,500 (.15%) and there was no change to the Company’s borrowing rate.

 

11

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Availability under the $100 millionRevolving Loan is subject to the applicable borrowing base limitations. Theborrowing base limits lender advances to 50% of asset value. The borrowing basevalue is the appraised value of the Brightwater project, increased for costsincurred subsequent to the most recent lender appraisal and reduced by 72% ofthe sales value of homes delivered. As of March 31, 2008 and December 31,2007, the borrowing base was $191.2 million and $186.1 million,respectively. Certain subsidiaries of the Company provided full unconditionalguarantees.

 

As of March 31, 2008 and December 31,2007, approximately $500,000 and $600,000, respectively, of deferred loan feesand closing costs related to the Revolving Loan are included in other assetsand amortized over the life of the loan. Amortization of these costs isincluded in the capitalization of interest allocated to real estate inventorieswhen incurred, and charged to cost of sales when the related homes aredelivered.

 

**Note 5 – Senior Secured Term Loan**

 

On September 15, 2006, the Companyentered into a five-year, $125 Million Senior Secured Term Loan Agreementwith KeyBank National Association, as a lender and agent for several otherlenders (the “Term Loan”), and on September 15, 2006, the Company borrowedthe maximum loan amount of $125 million. The proceeds were used to fund a “specialdividend” of $12.50 per share, totaling $135.7 million, to commonstockholders paid on September 28, 2006.

 

As of March 31, 2008 and December 31,2007, $121.0 million and $121.8 million, respectively, wasoutstanding under the Term Loan at rates of 5.81% and 7.5%, respectively, basedupon the Company’s elected rates. The outstanding balance bears interest at theCompany’s option at either (i) the prime interest rate plus 25 basispoints, or (ii) LIBOR plus 275 basis points. Interest on the Term Loan iscalculated on the average, outstanding daily balance and is paid monthly.Interest incurred on the Term Loan for the three months ended March 31,2008 and 2007 was $2.0 million and $2.6 million, respectively, atweighted-average interest rates of 6.46% and 8.07%, respectively. As of May 5,2008, the Term Loan interest rate is 5.5%.

 

On December 31, 2008, September 30,2009 and September 30, 2010, the commitment amount will decrease by$15 million, $25 million, and $35 million, respectively.Thereafter, at the end of each subsequent quarter, the Term Loan commitmentamount will decrease in four equal installments of $12.5 million, untilthe commitment under the agreement is reduced to zero by the final maturitydate on September 15, 2011. The Term Loan is also subject to mandatoryrepayments based on 60% of the $600,000 release price on the first 50 unitsclosed at the Brightwater project, and 60% of the $1 million release priceper unit thereafter. These mandatory repayments are applicable to thecommitment reductions set forth above. During the three months ended March 31,2008, the Company delivered two homes at Brightwater and made mandatoryrepayments of $720,000. As of March 31, 2008, the Company has delivered 11homes at Brightwater and made cumulative mandatory repayments of$4.0 million, or $360,000 per home.

 

Under the Term Loan, the Company is requiredto comply with a number of covenants, including the following financialcovenants which the Company considers to be the most restrictive of all of thedebt covenants:

 

·                  a leverage covenant that prohibitsthe Company’s ratio of consolidated total liabilities to consolidated tangiblenet worth from exceeding the following:

 
| **Reporting Period**                            | ** ** | **Maximum  Leverage Ratio** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| March 31, 2008 through June 30,  2008 |       | 2.50 to 1.0                      |       |
| September 30, 2008 and thereafter          |       | 2.25 to 1.0                      |       |

 

·                  an interest coverage covenant thatprohibits the Company’s ratio of EBITDA to interest incurred from being lessthan the following:

 
| **Period**                                              | ** ** | **Minimum  Coverage Ratio** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| September 30, 2008 through  December 30, 2008 |       | 1.0 to 1.0                       |       |
| December 31, 2008 through  June 29, 2009      |       | 2.0 to 1.0                       |       |
| June 30, 2009 and thereafter                       |       | 2.5 to 1.0                       |       |

 

·                  a minimum consolidated tangible networth covenant of $80 million (reduced from $100 million, effectiveas of September 30, 2007).

 

12

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As of March 31, 2008, the Company’sconsolidated total liabilities are $252.6 million, tangible net worth is$100.9 million and leverage ratio is 2.50. The Company is in compliancewith the covenants of the Term Loan as of March 31, 2008.

 

As a result of the sustained downturn in thehomebuilding industry and the $28.0 million of impairment charges the Companyrecorded during the third quarter of 2007, the Term Loan was amended, effectiveas of September 30, 2007, to reduce the tangible net worth covenant from$100 million to $80 million. The Term Loan was also amended to deferthe phase-in of the minimum ratio of EBITDA to interest covenant from the firstquarter of 2008 to the third quarter of 2008 to provide greater operatingflexibility and accommodate the Company’s currently anticipated operatingresults for 2008. In connection with the amendment, which was approved by 100%of the lenders, the Company paid a fee of $187,500, and there was no change tothe Company’s borrowing rate.

 

The Company has also initiated discussionswith its lenders to amend the Term Loan to modify certain covenants toaccommodate the slower projected pace of sales. There can be no assurance that requested amendments to the Term Loanwill be agreed to by the Company’s lenders. Current credit market conditionspresent uncertainty as to the ability of the Company to secure additionalfinancing, if needed, and the terms of such financing if it is available, or asto the ability of the Company to achieve positive cash flow from operations tosatisfy its obligations.

 

Availability under the Term Loan is subjectto the applicable borrowing base loan to value limitations. The loan to valuelimits total lender advances under the Term Loan and the Revolving Loan to 65%of asset value. The borrowing base value is the appraised value of theBrightwater project, increased for costs incurred subsequent to the most recentlender appraisal and reduced by 72% of the sales value of homes delivered. Asof March 31, 2008 and December 31, 2007, the borrowing base was$191.2 million and $186.1 million, respectively. The Term Loan issecured by a second trust deed on the Brightwater project, and a general pledgeand assignment of the Company’s ownership interests in all materialsubsidiaries. All existing material subsidiaries of the Company have providedfull unconditional guarantees. The Term Loan includes financial covenants whichmay limit the amount that may be outstanding.

 

As of March 31, 2008 and December 31,2007, approximately $1.9 million of deferred loan fees and closing costsrelated to the Term Loan are included in other assets and amortized over thelife of the loan. Amortization of these costs is included in the capitalizationof interest allocated to real estate inventories when incurred, and charged tocost of sales when the related homes are delivered.

 

Under the Term Loan agreement, the Companywas required to enter into a swap agreement to hedge against risks associatedwith fluctuating interest rates related to $62.5 million of floating ratedebt. On September 15, 2006 the Company entered into an interest rate swaptransaction to effectively fix the interest rate on $62.5 million infloating rate debt at 8.015% per annum. The swap transaction terminates September 15,2008. The swap did not qualify for hedge accounting under SFAS No. 133, *“Accounting for Derivative Instruments and HedgingActivities”*. The fair value of the interest rate swap agreementrepresents the spread between the interest rate the Company paid and theinterest rate the Company would receive over the remaining life of theagreement. As of March 31, 2008, the fair value of the swap agreement isapproximately $700,000. The non-cash change in fair value of the interest rateswap agreement during the three months ended March 31, 2008 wasapproximately $500,000 and was charged to other expense. In addition, theCompany recorded a $200,000 expense for cash payments made under the terms ofthe interest rate swap agreement during the first quarter of 2008 due todeclining interest rates during the quarter. The counterparties to the interestrate swap agreement are financial institutions.

 

**Note 6 – Other Project Debt**

 

In conjunction with the acquisition ofsingle-family residential lots, the Company’s homebuilding subsidiary,Hearthside Homes, Inc. and its subsidiaries, enter into construction loanagreements with commercial banks. These loan facilities finance a portion ofthe land acquisition and the majority of the construction of infrastructure andhomes. Each loan facility requires a guaranty of project completion and anenvironmental indemnity by Hearthside Homes, Inc. The loans are secured byfirst trust deeds and bear an interest rate of prime plus one-half or primeplus three-fourths percent (5.75% to 6.0% at March 31, 2008). TheLancaster and Hellman loan facilities have minimum interest rates of 7.5% and7.25%, respectively. During the three months ended March 31, 2008,Hearthside Homes, Inc. did not enter into any new loan facilities.

 

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The following amounts were available andoutstanding under these loan facilities as of March 31, 2008 and December 31,2007 ($ in millions):

 
| ** **     | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **         | ** ** | **Outstanding at**  | ** ** |
|----------------|------------|------------------------------|------------|--------------------------|------------|--------------------|------------|--------------------------|------------|
| ** **     | ** ** | **Amount  of Facility** | ** ** | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|           |       |                         |       |                     |       |               |       |                     |       |   |   |
| Beaumont       |       | $                            | 17.9       |                     | 76         |               | 6/17/08    |                     | $          | 9.5 |   | $ | 9.9 |   |
| Ontario        |       | 11.7                         |       | 6                        |       | 7/19/08            |       | 1.7                      |       | 2.6 |   |
| Lancaster      |       | 14.0                         |       | 61                       |       | 9/30/08            |       | 3.9                      |       | 4.2 |   |
| Corona-Hellman |       | 54.5                         |       | 147                      |       | 1/7/09             |       | 32.2                     |       | 32.1 |   |
|           |       |                         |       |                     |       |               |       |                     |       |   |   |
|           |       |                         |       |                     |       |               |       | $                        | 47.3       |   | $ | 48.8 |   |
|                |            |                              |            |                          |            |                    |            |                          |            |  |  |  |  |  |

 

During the first quarter of 2008, the Companyextended the Beaumont loan to June 17, 2008. The Company has oneadditional three-month extension available for the Beaumont loan, subject toachieving minimum sales of four homes for the three-month period beginning March 18,2008 or making the requisite cash payment of approximately $309,000 per unit ifsuch sales levels are not achieved.

 

During April 2008, the Company exerciseda three-month extension for the Ontario loan and extended the maturity to July 19,2008. The Company has no additional extensions available for the Ontario loan.

 

The Lancaster loan requires cumulativeminimum repayments of $3.0 million by July 1, 2008. As of March 31,2008, the Company has made cumulative repayments of $2.6 million, resulting inan additional $400,000 due by July 1, 2008.

 

**Note 7 - Other Liabilities**

 

Other liabilities were comprised of the following(in millions):

 
| ** **                                          | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Accrued pensions and benefits                       |       | $                        | 3.7        |                        | $          | 3.8 |   |
| Home warranty reserves                              |       | 2.1                      |       | 2.3                         |       |
| Contingent indemnity and environmental  obligations |       | 1.2                      |       | 1.3                         |       |
| Deferred revenue                                    |       | .5                       |       | —                      |       |
| Unamortized discount                                |       | (.4                      | )          | (.4                         | )          |
|                                                |       | $                        | 7.1        |                        | $          | 7.0 |   |

 

Contingent indemnity and environmental obligationspartially reflect reserves before related discount (recorded pursuant toFresh-Start Reporting in 1997) for contingent indemnity obligations forbusinesses disposed of by former affiliates and unrelated to the Company’scurrent operations. Deferred revenue represents earnest money deposits held bythe Company for home sales contracts in escrow.

 

14

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*Home Warranty Reserve*

 

The Company provides a home warranty reserve toreflect its contingent obligation for product liability. The Company generallyrecords a provision as homes are delivered, based upon historical and industryexperience, for the items listed in the homeowner warranty manual, which doesnot include items that are covered by manufacturers’ warranties or items thatare not installed by the Company’s employees or contractors. The home warrantyreserve activity is presented below (in millions):

 
| ** **                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
| Balance at beginning of period       |       | $                                                | 2.3        |   | $ | 2.4 |   |
| Provision                            |       | —                                           |       | .1 |   |
| Adjustment due to change in estimate |       | (.1                                              | )          | — |   |
| Payments                             |       | (.1                                              | )          | (.1 | ) |
| Balance at end of period             |       | $                                                | 2.1        |   | $ | 2.4 |   |

 

**Note 8 - Income Taxes**

 

The following is a summary of thetax benefit:

 
| ** **                | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------|------------|--------------------------------------------------|------------|
| ** **                | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
| Current taxes             |       | $                                                | —     |   | $ | — |   |
| Deferred taxes            |       | (.4                                              | )          | (2.0 | ) |
| Benefit from income taxes |       | $                                                | (.4        | ) | $ | (2.0 | ) |

 

The net deferred tax balance at March 31, 2008and December 31, 2007 is primarily composed of federal net operatinglosses (“NOLs”). The Company has concluded that it is “more likely than not”that the Company will be able to generate sufficient taxable income to realizesuch assets. Therefore, the Company has no valuation allowance related to thepotential utilization of its deferred tax assets due to uncertainties. Suchuncertainties include the availability of real estate for development ateconomically viable prices and economic factors affecting the Company’soperations. The Company monitors these, as well as other positive and negativefactors that may arise in the future, as it assesses the need for a valuationallowance against its deferred tax assets.

 

The federal NOLs available as of March 31, 2008were approximately $137 million. The amount of federal NOLs which expire if notutilized is $3 million for 2008 and $11 million, $49 million, $42 million,zero, and $32 million for 2009, 2010, 2011, 2012 and thereafter, respectively.

 

The Internal Revenue Code (the “Code”) generallylimits the availability of NOLs if an ownership change occurs within any three-yearperiod under Section 382. If the Company were to experience an ownershipchange of more than 50%, the use of all remaining NOLs would generally besubject to an annual limitation equal to the value of the Company’s equitybefore the ownership change, multiplied by the long-term tax-exempt rate (4.55%as of April 2008) plus (ii) recognized built-in-gains, defined asthose gains recognized within five years of the ownership change subject to anoverall limitation of the net unrealized built-in gains existing as of theownership change date. The Company believes it has net unrealized built-ingains sufficient to allow utilization of the entire net operating loss,assuming that the Company is able to recognize these gains within the five-yeartime limitation. The Company estimates that after giving effect to varioustransactions by stockholders who hold a 5% or greater interest in the Company,it has experienced a three-year cumulative ownership shift of approximately 42%as of May 5, 2008, as computed in accordance with Section 382.

 

On September 18, 2006, the Company’s Board ofDirectors suspended enforcement of the Company’s charter documents thatrestrict stockholders from acquiring more than 5% of the outstanding shares ofCommon Stock. The Board determined that such restrictions were not currentlyrequired to preserve the tax benefits of the Company’s $137 million of NOLs.While the Company remains subject to Code section 382, which limits theavailability of NOLs in the event of an ownership change, the Company wouldhave five years from the date of any such ownership change to recognize itsbuilt in gains and utilize its NOLs. With the commencement of home deliveriesat Brightwater in December 2007, and the related built-in-gain of theproject, the Company believes it will fully utilize its NOLs within five yearsfollowing an ownership change, should one occur. However, the Board mayreinstitute the 5% ownership limitation if required by currently unanticipatedevents.

 

Pursuant to SFAS 123(R), the Company has elected torecognize stock option deductions on the tax law ordering method, whichmaximizes the realization of the stock option deductions in the current year.While the Company realized the majority of its 2006 stock option deductions,approximately $400,000 of unrealized tax benefits related to stock optiondeductions are not reflected in the consolidated financial statements. Uponrealization of the tax benefits, the Company will increase its additionalpaid-in capital.

 

15

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*Uncertain Tax Positions*

 

The Company adopted the provisions of FASBInterpretation No. 48, *“Accounting forUncertainty in Income Taxes”* (“FIN 48”), on January 1,2007. As a result of the implementation of FIN 48, during the first quarter of2007, the Company recorded a $5.1 million decrease in deferred tax assetsfor unrecognized tax benefits, which was offset by an increase in deferred taxassets of $1.8 million for assets re-evaluated as recognizable. The net changein deferred tax assets of $3.3 million was recorded as a cumulative effect of achange in accounting principle and resulted in a decrease to the January 1,2007 retained earnings balance of $200,000 and a decrease to the additionalpaid in capital balance of $3.1 million related to fresh-start accountingpursuant to a 1997 pre-packaged bankruptcy. There have been no changes to thisamount during the three months ended March 31, 2008. Of the Company’sunrecognized tax benefits of $5.1 million at March 31, 2008, $200,000would decrease the Company’s effective tax rate if recognized. The Company doesnot expect that its unrecognized tax benefits will significantly fluctuate orchange within twelve months of the reporting date.

 

The Company recognizes interest expense andpenalties related to uncertain tax positions as interest or other expense. Asof March 31, 2008, the Company has not recorded any interest or penaltiesrelated to unrecognized tax benefits, due to the substantial NOLs available.

 

Certain tax year filings remain open toFederal and California examination, which are the Company’s primary taxjurisdictions. The years 2004 through 2007 and the years 2003 through 2007remain open for Federal and California purposes, respectively. The Company hasutilized NOLs generated between 1990 and 1993 to offset taxable income in thoseyears and expects to utilize Federal NOLs generated between 1994 and 1997 andin 1999, 2006 and 2007 in future years. In addition, the Company expects toutilize California NOL generated in 2007 in future years.

 

**Note 9 - Commitments and Contingencies**

 

*Real Estate Matters*

 

The Company is subject to the usualobligations associated with entering into contracts for the purchase of landand improved home sites. The purchase of properties under these contracts isgenerally contingent upon satisfaction of certain requirements by the sellers,including obtaining applicable property entitlements. The Company also utilizesoption contracts with third-party land sellers and financial entities as a methodof acquiring land in staged takedowns and minimizing the use of funds fromother corporate financing sources. These option contracts also help to managethe financial and market risk associated with land holdings. Option contractsgenerally require the payment of a non-refundable cash deposit of 5% to 15% ofthe purchase price for the right to acquire lots over a specified period oftime (usually one to two years) at predetermined prices. The Company has theright at its discretion to terminate its obligations under these land purchaseand option agreements by forfeiting the cash deposit with no further financialresponsibility. As of March 31, 2008, the Company has no consolidated landoption deposits.

 

The Company has outstanding performance andsurety bonds, for the benefit of city and county jurisdictions, relatedprincipally to its obligations for site improvements at various projects at March 31,2008. The Company does not believe that draws upon these bonds, if any, willhave a material effect on the Company’s financial position, results ofoperations or cash flows.

 

*Oxnard Land Development Joint Venture*

 

In February 2003, the Company enteredinto two option contracts to acquire land adjacent to the City of Oxnard inVentura County, California aggregating approximately 168 acres. The Company isdeveloping a land plan for the area, which also includes an additional 149acres owned by other landowners, with the intention of entitling the propertyfor residential development and annexing it into Oxnard. During October 2003,the Company entered into a limited liability company joint venture agreementwith a major financial partner to pursue the Oxnard development opportunity.The Company assigned the land purchase option contracts to the Oxnard LLC.Hearthside Homes, Inc., the Company’s homebuilding subsidiary, which isthe managing member of the Oxnard LLC.

 

As of March 31, 2008, the Company’saggregate capital contributions were $2.3 million and its total investmentin the Oxnard LLC was $2.8 million. In addition, as of March 31,2008, the Company has incurred capitalized overhead costs of approximately$600,000 for the project which are unreimbursed by the venture, bringing theCompany’s total investment in the project to $3.4 million. As of March 31,2008, the non-managing member’s aggregate capital contributions to the 

 

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Oxnard LLC were $6.3 million. The members are currentlyfunding capital requirements on a 50/50 basis. The Company expects to make additionalaggregate capital contributions of approximately $400,000 to theOxnard LLC during the remaining nine months of 2008, bringing the Company’stotal expected investment to $3.2 million and the Company’s totalinvestment in the project to $3.8 million.

 

In addition to the land purchase options forthe project property, the Oxnard LLC held a land purchase option whichcontrolled property which was expected to provide fill dirt for the projectproperty. On April 16, 2007, the Oxnard LLC sold the non-project landpurchase option for $1.8 million since the venture has contracted for analternate source for the fill dirt. The Oxnard LLC received net proceedsof approximately $1.6 million for the land and utilized the proceeds tofund ongoing entitlement and development costs.

 

While the Company exerts a large degree ofinfluence over the joint venture, the Company’s partner does have varioussubstantive participating rights such as approval rights with regard to themajority of business decisions, including approval of project budgets.

 

*Legal Proceedings*

 

There are various lawsuits and claims pending againstthe Company and certain subsidiaries. In the opinion of the Company’smanagement, ultimate liability, if any, will not have a material adverse effecton the Company’s financial condition or results of operations.

 

*California Department of Toxic Substances Control*

 

In October 2006, the CaliforniaDepartment of Toxic Substances Control (“DTSC”) filed a civil complaint againstthe Company’s Hearthside Residential Corp. subsidiary (“HRC”) in the FederalDistrict Court for the Southern Division of the Central District of California.A trial on this matter is currently scheduled to begin on October 7, 2008and discovery in the case is underway. The DTSC’s complaint requests that HRCpay for approximately $1.0 million of costs incurred by the DTSC, togetherwith interest on that amount, primarily in connection with the oversight andremediation of PCB contamination found on residential properties adjacent to a43-acre site where HRC completed the removal of PCB contaminated soil during September 2005.HRC’s remediation process was approved by the DTSC in December 2005 whenit issued a final acceptance of the remediation work. The complaint also seeksan order for HRC to pay any future costs which may be incurred in connectionwith further remediation, together with court costs and attorney’s fees.

 

Since May 2004, HRC has receivedinvoices from DTSC seeking reimbursement for these costs; however, HRCcontends, based upon advice of counsel, that it is not responsible for suchcosts because neither HRC nor any affiliate ever developed or built theneighboring residential properties, neither HRC nor any affiliate generated thecontamination, and the contamination did not emanate from the 43-acre site thatHRC remediated. Furthermore, HRC has also disputed such charges due to the factthat DTSC improperly submitted its bill. The Company’s subsidiary is vigorouslydefending itself in this matter. Therefore, the Company has not accrued for anyof DTSC’s approximately $1.0 million of claims related to theseresidential properties.

 

See Note 7 for a discussion of other contingencies.

 

*Corporate Indemnification Matters*

 

The Company and its former affiliates have, through avariety of transactions effected since 1986, disposed of several assets andbusinesses, many of which are unrelated to the Company’s current operations. Byoperation of law or contractual indemnity provisions, the Company may haveretained liabilities relating to certain of these assets and businesses. Thereis generally no maximum obligation or amount of indemnity provided for suchliabilities. A portion of such liabilities is supported by insurance or byindemnities from certain of the Company’s previously affiliated companies. TheCompany believes its consolidated balance sheet reflects adequate reserves forthese matters.

 

**Note 10 – Stock Plan**

 

*1993 Stock Option/Stock Issuance Plan*

 

The 1993 Stock Option/Stock Issuance Plan (“1993Plan”) was approved at the 1994 Annual Meeting of Stockholders, reserving7.5 million shares each of Series A Preferred Stock and Class ACommon Stock for issuance to officers, key employees and consultants of theCompany and its subsidiaries and the non-employee members of the Board of 

 

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Directors (the “Board”). On April 28, 1997, in connection with theRecapitalization, a new class of Common Stock replaced the Series APreferred Stock and Class A Common Stock, and the Compensation Committeeof the Board authorized the grant of stock options for 759,984 shares,equivalent at that time to 6% of the Company’s fully diluted equity, forcertain directors and officers. At the May 2004 and June 2006stockholder meetings, the stockholders of the Company authorized an additional150,000 and 250,000 stock options, respectively, for the 1993 Plan, resultingin total authorized grants of 1,159,984.

 

In January 2008, the Company issued atotal of 15,817 shares of its common stock to four independent directors underthe Director Fee Program, which is a component of the 1993 Plan. These sharesvest at the rate of 25% per quarter during 2008.

 

The Company did not grant any options duringthe three months ended March 31, 2008 and 2007. Pursuant to SFAS 123(R),the Company recorded $28,000 and $38,000 of compensation expense during thethree months ended March 31, 2008 and 2007, respectively, which isreflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993plan for the three months ended March 31, 2008 follows:

 
| ** **                                     | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |       |   |
| Granted                                        |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                      |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, March 31                     |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 7.85 years |   |
|                                           |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at  March 31 |       | 13,750                      |       | $                                     | 21.79      | (a)                                   | 7.71 years |   |
| Available for future grants at  March 31  |       | 345,916                     |       |                                  |       |                                  |       |

 

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(a)           Adjusted for specialdividend of $12.50

 

As of March 31, 2008, there were 17,500options outstanding with a weighted-average exercise price of $21.58 (rangingfrom $13.35 to $25.99) and a weighted-average remaining life of7.85 years. All outstanding unvested stock options are expected to vest.The aggregate intrinsic value of all outstanding, fully-vested and exercisablestock options at March 31, 2008 was zero.

 

The Company adopted SFAS 123(R) inthe first quarter of 2006 using the modified prospective method. Similar toSFAS 123, which the Company adopted in 2003, SFAS 123(R) requiresthe cost of all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalues measured at the grant date, or the date of later modification, over therequisite service period. For tax purposes, the Company expects to be entitledto a tax deduction, subject to certain limitations, based on the fair value ofcertain equity awards when stock options are exercised. SFAS 123(R) requiresthat compensation cost be recognized in the financial statements based on thefair value measured at the grant date, or the date of later modification, overthe requisite service period. The cumulative compensation cost recognized forequity awards pursuant to SFAS 123(R) and amounts that ultimatelywill be deductible for tax purposes are temporary differences as prescribed bySFAS 109, ***“****Accounting for Income Taxes”*. The taxeffect of compensation deductions for tax purposes in excess of compensationcost recognized in the financial statements, if any, will be recorded as anincrease to additional paid-in capital when realized. A deferred tax assetrecorded for compensation cost recognized in the financial statements thatexceeds the amount that is ultimately realized on the tax return, if any, willbe charged to income tax expense when the restrictions lapse or stock optionsare exercised or expire unless the Company has an available additional paid-incapital pool (“APIC Pool”), as defined pursuant to SFAS 123(R). TheCompany is required to assess whether there is an available APIC Pool when thestock options are exercised or expire.

 

SFAS 123(R) also amendsSFAS 95, *“Statement of Cash Flows”*,to require companies to change the classification in the statement of cashflows of any tax benefits realized upon the exercise of stock options orissuance of nonvested share unit awards in excess of that which is associatedwith the expense recognized for financial reporting purposes. These amounts arerequired to be reported as a financing cash inflow rather than as a reductionof income taxes paid in operating cash flows.

 

In addition, SFAS 123(R) requires acalculation to establish the beginning pool of excess tax benefits, or theadditional paid-in capital pool (“APIC pool”), available to absorb any taxdeficiencies recognized after the adoption of SFAS 123(R). The Company haselected the alternative transition method, which includes a simplifiedcalculation method, set forth in FASB Staff Position No. FAS 123(R)-3,*“Transition Election Related to Accountingfor the Tax Effects of Share-Based Payment Awards”* to calculate itsbeginning APIC pool.

 

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The Company estimates the fair value of itsstock options using the Black-Scholes option pricing model (the “Option Model”).The Option Model requires the use of subjective and complex assumptions,including the option’s expected term and the estimated future price volatilityof the underlying stock, which determine the fair value of the share-basedawards. The Company’s estimate of expected term is determined based on theweighted-average period of time that options granted are expected to beoutstanding considering current vesting schedules and the historical exercisepatterns of the existing option plan. The expected volatility assumption usedin the Option Model is based on historical volatility on traded options on theCompany’s stock in accordance with guidance provided in SFAS 123(R) andSAB 107. The risk-free interest rate used in the Option Model is based onthe yield of U.S. Treasuries with a maturity closest to the expected term ofthe Company’s stock options.

 

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MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**Overview of California Coastal Communities, Inc.**

 

We are a residential land development andhomebuilding company with properties owned or controlled primarily in OrangeCounty, California, and also in four other Southern California counties (LosAngeles, Riverside, San Bernardino and Ventura). Our principal activitiesinclude:

 

·      obtaining zoning and other entitlements for land we own or controlthrough purchase options or joint ventures;

 

·      improving the land for residential development; and

 

·      designing, constructing and selling single-family homes in SouthernCalifornia.

 

Once our residential land is entitled, we may buildhomes, sell unimproved land to other developers or homebuilders, sell improvedland to homebuilders, or participate in joint ventures with other developers,investors or homebuilders to finance and construct infrastructure and homes.The majority of our homes are designed to appeal to move-up homebuyers and aregenerally offered for sale in advance of their construction.

 

During the remaining nine months of 2008, ourprimary goals will be to:

 

·      begin delivering homes in The Cliffs and TheBreakers neighborhoods at our Brightwater project during the third quarter of2008;

 

·      continue selling and delivering homes in TheSands and The Trails neighborhoods at Brightwater;

 

·      complete the entitlement process with the City ofOxnard for a 168-acre joint venture project near Oxnard, California;

 

·      reduce standing inventories and thereforemaximize deliveries and revenues at our other homebuilding projects throughoutSouthern California; and

 

·      modify our existing credit agreements toaccommodate the ongoing downturn in the Southern California housing market.

 

There can be no assurance that we will accomplish,in whole or in part, all or any of these strategic goals or any other strategicgoals or opportunities that we may pursue.

 

Our total revenues for the three months ended March 31,2008 and 2007 were $5.0 million and $12.2 million, respectively. For the threemonths ended March 31, 2008 and 2007, we delivered eight and 15 homes,respectively. Our total assets as of March 31, 2008 and December 31,2007 were $353.5 million and $367.6 million, respectively, with Brightwaterconstituting $230.0 million (65% of total assets) and $219.9 million (60% oftotal assets), respectively. Our homebuilding subsidiary, Hearthside Homes, Inc.,has delivered over 2,100 homes to families throughout Southern California sinceits formation in 1994.

 

Prior to obtaining the Coastal Development Permitfor our Brightwater project in December 2005, we historically maintained aminimal amount of leverage. In September 2006, we obtained $225 million ofdebt financing as described in Notes 4 and 5 to the consolidated financialstatements in this Form 10-Q, which provided $100 million for Brightwaterconstruction and $125 million to fund the $12.50 special dividend to ourstockholders in September 2006, as described in Note 12 to the consolidatedfinancial statements in our Annual Report on Form 10-K for the year ended December 31,2007. As of March 31, 2008, we had $235.3 million of debt against $100.9million of book equity.

 

As a result of the sustained downturn in thehomebuilding industry and the $32.0 million of impairment charges we recordedduring 2007, we amended our credit facilities, effective as of September 30,2007, to reduce the tangible net worth covenant and to defer the phase-in ofthe minimum ratio of EBITDA to interest incurred covenant to accommodate ouranticipated operating results for 2008.

 

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In addition, our credit facilities require usto make $33.4 million in aggregate principal payments by December 31,2008, including $22.4 million for the revolving loan (assuming we draw theremaining $30.4 available as of March 31, 2008) and $11.0 million forthe term loan. In order to make these payments out of cash flow fromoperations, we would need to deliver approximately 50 homes at Brightwaterduring 2008, which appears unlikely based on sales orders to date, the numberof homes currently under construction and the approximately eight months ittakes to build the larger homes (The Cliffs and The Breakers). Therefore, we haveinitiated discussions with our lenders regarding potential amendments to theRevolving Loan that would defer a portion of our currently scheduled paymentsto future periods and modify certain covenants to accommodate the slowerprojected pace of sales. Amendments to the payment schedule will require theunanimous consent of the Revolving Loan bank syndicate. We are also evaluatingalternatives for raising additional capital, if necessary. There can be noassurance that we will be successful in these endeavors, or that requestedamendments to the Revolving Loan and the Term Loan will be agreed to by ourlenders.

 

We were formed in 1988 and our executive offices arelocated at 6 Executive Circle, Suite 250, Irvine, California 92614. Ourwebsite address is http://www.californiacoastalcommunities.com and ourtelephone number is (949) 250-7700. Through our website we make available ourannual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to these reports filed or furnishedpursuant to Section 13(d) or 15(d) of the Securities ExchangeAct of 1934 as soon as reasonably practicable after they are filed with, orfurnished to, the Securities and Exchange Commission. Copies of our annualreport on Form 10-K, quarterly reports on Form 10-Q, current reportson Form 8-K, and amendments to these reports are available free of chargeupon request. In addition, at our website we post current versions of our codeof ethics, audit committee charter and nominating committee charter.

 

**Outlook**

 

During the first quarter of 2008, we and theoverall homebuilding industry continued to experience challenging businessconditions created by eroding consumer confidence due in part to a generaldownturn in economic activity and job creation; an oversupply of new andexisting homes; increased foreclosures; intense competition for sales; ongoingturmoil in consumer mortgage lending and other credit markets; and reducedaffordability for potential homebuyers. 

 

These adverse conditions have clearlyimpacted our results for the first quarter of 2008. We believe the reduction indemand is due to concerns on the part of prospective homebuyers about thedirection of home prices, due in part to the constant media attention regardingthe potential for mortgage foreclosures and possible recession, and concerns byprospective homebuyers about being able to sell their existing homes. Webelieve the concern about the direction of home prices is due to an oversupplyof homes available for sale, and many other builders advertising pricereductions and increased sales incentives. In addition, we have been impactedby an overall increase in the supply of homes available for sale in manymarkets.

 

During the first quarter of 2008, our InlandEmpire and Lancaster markets saw continued price depreciation and an excesssupply of homes available for sale. These conditions resulted in both loweroverall sales compared to the comparable period of 2007 and prior years anddownward pressure on our selling prices and margins, as competition for salesincreased the need for sales incentives.

 

We do not expect the present businessenvironment in our inland markets or overall real estate market trends toimprove during 2008 and we expect that the real estate market downturn willcontinue into 2009. Therefore, we have reduced selected sales prices andoffered incentives for all of our homes in these inland markets in order toreduce our standing inventory and remain competitive during this continuingsignificant economic downturn in the housing market. The price reductions andadditional incentives have resulted in significantly reduced gross profits forInland Empire and Lancaster home sales.

 

In view of the continuing significanteconomic downturn in the housing market, we currently expect that during 2008and continuing into 2009 our new home construction will be limited primarily toour 356-home Brightwater project located on the Bolsa Chica mesa in HuntingtonBeach, California; and that our operations in other markets will focus on thesale of standing inventory, with limited construction starts of small phases(four to six homes) subject to adequate sales volume, and entitlement effortsfor our joint venture project near Oxnard.

 

As of March 31, 2008, we had standinginventory of 38 homes, including 11 homes at Brightwater and 27 homes at ourinland projects. During the first three months of 2008, net new ordersincreased to 16 homes compared with 13 homes during the comparable period of2007, primarily due to sales activity at our Brightwater community, whichgenerated 11 sales orders during the first quarter of 2008. Cancellations as apercentage of new orders were 27% during the first quarter of 2008, comparedwith approximately 32% during the comparable period of 2007. Backlog as of March 31,2008 decreased to 12 homes compared with 15 homes as of March 31, 2007primarily due to reduced sales activity in our Inland Empire and Lancastermarkets during 2007.

 

As the housing market downturn continues tounfold, we continue to adjust and reevaluate our operating strategy in aneffort to reduce standing inventories while monitoring our margins andliquidity. Our operating strategy includes:

 

·      adjusting our cost structure to today’s marketconditions by reducing our headcount and overhead and rebidding subcontractsand materials in line with reduced demand;

 

·      offering more incentives and price reductions atour inland projects to reduce standing inventories and achieve acceptablelevels of sales volume and cash flow;

 

·      limiting construction starts to better alignproduct available for sale with sales activity; and

 

·      seeking to balance our short-term goal ofselling homes in a tough market and our long-term goal of maximizing the valueof our communities.

 

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Despite the challenges of the currenthomebuilding market, we believe the potential for our Brightwater projectremains high. While Brightwater has not been immune to the effects of theunstable mortgage and housing markets, that impact appears less severe than theweakness in our inland markets and we remain optimistic about continuing sales.We believe that the reduced impact is a result of Brightwater’s superiorcoastal location, the extremely limited supply of new homes on the coast ofSouthern California and the absence of significant competition from otherhomebuilders in the Huntington Beach market due to the lack of available landfor new single family detached home development. We believe that Brightwater isin a location that is difficult to replace and in a market where approvals areincreasingly difficult to achieve. We also believe that Brightwater hassubstantial embedded value that will be realizable in the future and that thisvalue should not necessarily be sacrificed in the current soft market. Finally,we believe that Brightwater’s demographics remain strong due to the continuingregulation-induced constraints on lot supplies and the growing number ofaffluent households along the coast of Southern California.

 

We have generated net sales orders for 24homes at Brightwater from inception of sales in August 2007 through May 5,2008 (discussed below under “Our Current and Future Homesites—Brightwater atBolsa Chica”). As of May 5, 2008, we have four completed homes in escrowat Brightwater and eight completed homes available for sale.

 

**Our Current and Future Homesites**

 

We currently have on-going SouthernCalifornia homebuilding projects in:

 

·      Orange County in the Huntington Beach area;

 

·      Riverside County near the cities of Corona andNorth Corona, and in the City of Beaumont;

 

·      San Bernardino County in the City of Ontario; and

 

·      Northern Los Angeles County in the City ofLancaster.

 

We started selling homes at our Brightwatercommunity in Orange County during August 2007 and plan to process permitsfor seven homes on adjacent parcels in the City of Huntington Beach, whichwould bring the total unit count to 356. The following chart describes ourcurrent projects, their location and our lot and standing home inventories asof March 31, 2008:

 
| **Project**                             | ** ** | **Location**      | ** ** | **Models** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** | ** ** |
|-----------------------------------------|------------|-------------------|------------|------------|------------|-------------|------------|-------------------------|------------|---------------------|------------|-------------------------------|------------|
| Brightwater in Orange County:           |       |              |       |       |       |        |       |                    |       |                |       |                          |       |
| The Trails                              |       | Huntington  Beach |       | 4          |       | —      |       | 7                       |       | 45                  |       | 56                            |       |
| The Sands                               |       | Huntington  Beach |       | 4          |       | 1           |       | 4                       |       | 64                  |       | 73                            |       |
| The Cliffs                              |       | Huntington  Beach |       | 4          |       | 5           |       | —                  |       | 98                  |       | 107                           |       |
| The Breakers                            |       | Huntington  Beach |       | 5          |       | 3           |       | —                  |       | 101                 |       | 109                           |       |
|                                    |       |              |       |       |       |        |       |                    |       |                |       |                          |       |
| *Subtotal—Orange County*           |       |              |       | 17         |       | 9           |       | 11                      |       | 308                 |       | 345                           |       |
| * *                                |       |              |       |       |       |        |       |                    |       |                |       |                          |       |
| Inland Empire/Lancaster:                |       |              |       |       |       |        |       |                    |       |                |       |                          |       |
| Hearthside Lane                         |       | Corona            |       | 5          |       | —      |       | 8                       |       | 134                 |       | 147                           |       |
| Woodhaven                               |       | Beaumont          |       | 4          |       | 3           |       | 7                       |       | 62                  |       | 76                            |       |
| Quartz Hill                             |       | Lancaster         |       | 3          |       | —      |       | 4                       |       | 54                  |       | 61                            |       |
| Other developments                      |       | Various           |       | —     |       | —      |       | 8                       |       | 2                   |       | 10                            |       |
| Other unimproved lots                   |       | Lancaster         |       | —     |       | —      |       | —                  |       | 73                  |       | 73                            |       |
|                                    |       |              |       |       |       |        |       |                    |       |                |       |                          |       |
| *Subtotal—Inland Empire/Lancaster* |       |              |       | 12         |       | 3           |       | 27                      |       | 325                 |       | 367                           |       |
| * *                                |       |              |       |       |       |        |       |                    |       |                |       |                          |       |
| *Total—All Projects*               |       |              |       | 29         |       | 12          |       | 38                      |       | 633                 |       | 712                           |       |

 

These homebuilding projects are currentlyexpected to generate cash flows and gross operating margins through 2011 or2012. Up to approximately 554 additional single-family lots could be availablefor homebuilding operations if we obtain entitlements for our Oxnard project;however, the exact number of homes will depend on the final outcome of theentitlement process.

 

*Brightwater at Bolsa Chica*

 

Brightwater is our Orange County residentialcommunity, located on the 110-acre Bolsa Chica upper mesa adjacent to the Cityof Huntington Beach, approximately 35 miles south of downtown Los Angeles.Brightwater is being annexed into the City of Huntington Beach as developmentprogresses. Brightwater offers a broad mix of home choices averaging 2,860square feet and ranging in size from 1,710 square feet to 4,339 square feet.Located near Pacific Coast Highway and 

 

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overlooking the Pacific Ocean and the recently restored 1,200-acreBolsa Chica Wetlands, 62 of the 356 homes at Brightwater will have unobstructedocean and/or wetlands views. To date, over 3,600 people have registered on ourwebsite requesting information about purchasing a home at Brightwater; however,there can be no assurance that these people will ultimately purchase a home.

 

Brightwater is the largest property in ourportfolio, representing approximately 78% of our real estate inventories as of March 31,2008. This project is located on one of the last large undeveloped coastalproperties in Southern California. Brightwater is bordered on the north andeast by residential development in the City of Huntington Beach and HuntingtonHarbor, to the south by open space and the 1,200-acre Bolsa Chica wetlands, andto the west by 120 acres of publicly-owned conservation land and open space onthe lower bench of the Bolsa Chica mesa, Pacific Coast Highway, Bolsa ChicaState Beach, and the Pacific Ocean. Brightwater also has 37 acres of open spaceand conservation area, and we expect to submit a proposed site plan to the Cityof Huntington Beach during 2008 to extend the Brightwater development onto a5-acre parcel that is currently zoned agricultural.

 

In July 2007, we completed constructionof eight model homes at The Trails and The Sands neighborhoods and held a grandopening on August 11, 2007. We delivered two homes at The Trails and TheSands during the three months ended March 31, 2008 and generated$2.2 million in revenue for a 33.8% gross operating profit due, in part,to our low cost basis in Brightwater. Homes at The Trails and The Sands arepresently being offered at prices ranging from $950,000 to $1.2 million;however, home prices are inherently subject to change. As of May 5, 2008,we have four completed homes in escrow at Brightwater and eight completed homesavailable for sale.

 

During January 2008, we completedconstruction of nine additional model homes for The Cliffs and The Breakers andin February 2008 began selling homes to buyers who previously registeredon our priority list. We held a grand opening for these neighborhoods on March 15,2008. These homes are larger than The Trails and The Sands, ranging from 2,724to 4,339 square feet, and are currently offered for sale at prices ranging from$1.5 to $3.0 million. As of May 5, 2008, we have nine sales ordersfor The Cliffs and The Breakers at prices ranging from $1.5 to$3.1 million for 2,724 to 4,100 square foot homes. The first of thesehomes are currently expected to be completed during the third quarter of 2008.

 

We also own approximately 104 undevelopableacres on, or adjacent to, the Huntington Mesa. Approximately 51 acres of landon the Huntington Mesa have been offered for dedication to the County of Orangefor inclusion in the Harriet M. Weider Linear Park in conjunction with thedevelopment of Brightwater and an additional 51 acres are subject to aconservation easement.

 

Key facts and assumptions regarding theBrightwater development project include the following:

 

·      Brightwater will consist of 356 homes, including109 homes at The Breakers, 107 homes at The Cliffs, 78 homes at The Sands and62 homes at The Trails.

 

·      There are 62 homes at Brightwater which will haveunobstructed views of the Pacific Ocean and/or the Bolsa Chica wetlands,including 35 homes at The Breakers, 25 homes at The Cliffs and two homes at TheSands.

 

·      Build-out of production homes, which is subjectto market conditions, is currently expected to take approximately four to fiveyears and be completed in 2011 or 2012.

 

·      Costs to improve the lots from their rawcondition to finished lots, including County permits, City annexation fees andschool fees, approximate $200,000 per lot.

 

·      The direct costs (excluding indirect costs suchas supervision, overhead, sales and marketing, warranty, insurance, etc.) ofbuilding homes at Brightwater are currently expected to range fromapproximately $130 to $150 per square foot.

 

·      Indirect costs are expected to approximate 6% ofsales revenues.

 

·      Based on current sales price projections, thevarious Brightwater products are currently expected to generate gross marginsof approximately 30% to 40% due to our low carrying value in Brightwater. Grossmargins for the larger homes at The Cliffs and The Breakers are currentlyexpected to approximate 35% to 40%, while gross margins at The Trails and TheSands are currently expected to approximate 30% to 35%.

 

The estimation process involved in thedetermination of value is inherently uncertain because it requires estimates asto future events and market conditions. This estimation process assumes ourability to complete development and disposition of our real estate inventoriesin the ordinary course of business based on management’s present plans andintentions. 

 

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Economic, market, and environmental conditions may affect ourdevelopment and marketing plans. The development of Brightwater depends uponvarious factors. Accordingly, the amount ultimately realized from theBrightwater project may differ materially from our current estimates and theproject’s carrying value.

 

*Oxnard Land Development - UnconsolidatedJoint Venture*

 

In February 2003, we entered into twooption contracts to acquire approximately 168 acres of land adjacent to theCity of Oxnard in Ventura County, California. We are developing a land plan forthe area, which also includes an additional 149 acres owned by other landowners,with the intention of entitling the property for residential development andannexing it into Oxnard. During October 2003, we entered into a jointventure agreement with a major financial partner to pursue the Oxnarddevelopment opportunity. We assigned the land purchase option contracts to theOxnard joint venture. Hearthside Homes, Inc., our homebuilding subsidiary,is the manager of the Oxnard joint venture.

 

The option contracts allow the Oxnard jointventure to complete entitlement activities before purchasing the land. During March 2008,the land purchase option contracts were amended to extend the current escrowclosing date to February 2009 and provide additional extensions which, ifexercised, would extend the outside closing date to December 2011.

 

A draft environmental impact report (“EIR”)for the proposed Oxnard development was circulated for public comments duringthe summer of 2007. As a result of the public comments received, the City ofOxnard has decided that the EIR needs to be amended to address availability ofwater for the development and the impact of such development on global warming.The City plans to recirculate a revised EIR for additional public comments inthe second quarter of 2008. The Oxnard joint venture is attempting to obtainapproval of its development plan from the Oxnard City Council by the end of2008 and approval of annexation into the City of Oxnard from the Local AgencyFormation Commission during 2009; however, additional delays could beencountered. Infrastructure construction is expected to take approximately oneyear, and build out of homes is expected to occur over the course of five tosix years, based on current expectations and assumptions.

 

We currently expect the residentialdevelopment plan to include approximately 760 single-family detached lots andapproximately 630 attached residential units (townhomes, condominiums andapartments); however, these numbers are subject to change during the course ofthe entitlement process. Approximately 554 of the single-family lots andapproximately 347 of the attached units would be developed on the 168 acres ofoptioned land that we currently expect the Oxnard joint venture to purchase.The single-family detached product is currently expected to range from approximately1,700 square feet to 3,400 square feet and the attached units are currentlyexpected to range from approximately 1,050 square feet to 1,575 square feet.

 

As of March 31, 2008, our aggregatecapital contributions were $2.3 million and our total investment in theOxnard joint venture was $2.8 million. In addition, as of March 31,2008, we have incurred capitalized overhead costs of approximately $600,000 forthe project which are unreimbursed by the venture, bringing our totalinvestment in the project to $3.4 million. As of March 31, 2008, thenon-managing member’s aggregate capital contributions to the joint venture were$6.3 million. The members are currently funding capital requirements on a50/50 basis. We expect to make additional aggregate capital contributions ofapproximately $400,000 to the joint venture during the remaining nine months of2008, bringing our total expected investment in the venture to$3.2 million and our total investment in the project to $3.8 million.

 

After payment of a preferred return of thegreater of 10% or prime plus 5% on invested capital to us and the non-managingmember, the first $8 million of profits are allocated 75% to thenon-managing member and 25% to us, and profits over $8 million and lossesover $5 million are generally allocated on a 50/50 basis in accordancewith the operating agreement. The first $5 million of losses are generallyallocated 80% to the non-managing member and 20% to us. While we are themanaging member and exert a large degree of influence over the joint venture,the non-managing member does have various substantive participating rights suchas approval rights with regard to the majority of business decisions, includingapproval of project budgets.

 

In addition to the land purchase options for theproject property, the Oxnard joint venture previously held a land purchaseoption which controlled property which was expected to provide fill dirt forthe project property. On April 16, 2007, the Oxnard joint venture soldthis non-project land purchase option for $1.8 million because the jointventure contracted for an alternate source for the fill dirt. The Oxnard jointventure received net proceeds of approximately $1.6 million for the landand utilized the proceeds to fund ongoing entitlement and development costs.

 

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*Homebuilding*

 

Our homebuilding operations include activeprojects in the Huntington Beach, Inland Empire (Corona, Ontario and Beaumont),and Lancaster areas of Southern California. We delivered eight homes during thefirst quarter of 2008, compared with 15 deliveries during the comparable periodof 2007. We acquired no single-family residential lots during the three monthsended March 31, 2008 and 2007 and we have no contracts to acquire land orlots except through our Oxnard joint venture. During the first quarter of 2008,we saw continued price depreciation and an excess supply of homes available forsale in the Inland Empire and Lancaster markets. Therefore, we have reducedselected sales prices and offered incentives for all of our homes in thesemarkets in order to reduce our standing inventory and remain competitive duringthis continuing significant economic downturn in the housing market. The pricereductions and additional incentives have resulted in significantly reducedgross profits for Inland Empire and Lancaster home sales. We recorded no assetimpairment charges during the first quarter of 2008, compared with $4.0 millionof asset impairment charges recorded during the first quarter of 2007. Theimpairment charges reflect our expectations about home prices, sales pace,sales and marketing costs, infrastructure and homebuilding costs and financingcosts for our inland projects. The impairment charges were calculated based oncurrent market conditions and current assumptions made by management, which maydiffer materially from actual results if market conditions change. As requiredby Statement of Financial Accounting Standards No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets*,” (“SFAS 144”), we will reevaluate theexpected cash flows from our homebuilding projects to determine whether anyadditional impairment exists should events or circumstances change.

 

In view of the continuing downturn in thehousing market, we currently expect that, during the next 12 months, ournew home construction will primarily be at our 356-home Brightwater project inHuntington Beach; and that our operations in other markets will involve thesale of standing inventory, limited construction in small phases (four to sixhomes) subject to adequate sales volume, and entitlement efforts for our jointventure project near Oxnard.

 

Our homebuilding projects are describedbelow:

 
| ** **              | ** ** | ** **        | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **    | ** ** | **Deliveries**     | ** ** |
|-------------------------|------------|-------------------|------------|---------------------------------|------------|------------------|------------|---------------|------------|--------------------|------------|
| ** **              | ** ** | ** **        | ** ** | **Land**                        | ** ** | **Commenced**    | ** ** | **Commenced** | ** ** | **March 31,** | ** ** |
| ** **              | ** ** | **Location**      | ** ** | **Acquisition**                 | ** ** | **Construction** | ** ** | **Sales**     | ** ** | **2008**           | ** ** | **2007** | ** ** |
| ** **              | ** ** | ** **        | ** ** | ** **                      | ** ** | ** **       | ** ** | **n/a**       | ** ** | ** **         | ** ** | ** ** | ** ** |
| Brightwater             |       |              |       |                            |       |             |       |          |       |               |       |   |   |
| The Trails              |       | Huntington  Beach |       | 1970                            |       | 2006             |       | 2007          | (a)        | 1                  |       | — |   |
| The Sands               |       | Huntington  Beach |       | 1970                            |       | 2006             |       | 2007          | (a)        | 1                  |       | — |   |
| The Cliffs              |       | Huntington  Beach |       | 1970                            |       | 2006             |       | 2008          | (b)        | —             |       | — |   |
| The Breakers            |       | Huntington  Beach |       | 1970                            |       | 2006             |       | 2008          | (b)        | —             |       | — |   |
|                    |       |              |       |                            |       |             |       |          |       |               |       |   |   |
| * *                |       |              |       | *Total Brightwater*             |       | 2                |       | —        |       |
| * *                |       |              |       |                            |       |             |       |          |       |               |       |   |   |
| Inland Empire/Lancaster |       |              |       |                            |       |             |       |          |       |               |       |   |   |
| Completed Projects      |       | Various           |       | n/a                             |       | n/a              |       | n/a           |       | —             |       | 6 |   |
| Chandler Ranch          |       | North Corona      |       | 2004                            |       | 2005             |       | 2005          |       | 1                  |       | 3 |   |
| Alisal at Ontario       |       | Ontario           |       | 2005                            |       | 2005             |       | 2006          |       | 2                  |       | 2 |   |
| Woodhaven               |       | Beaumont          |       | 2005                            |       | 2005             |       | 2006          |       | 1                  |       | — |   |
| Hearthside Lane         |       | Corona            |       | 2005                            |       | 2005             |       | 2007          |       | 1                  |       | — |   |
| Alisal at Lancaster     |       | Lancaster         |       | 2004                            |       | 2004             |       | 2005          |       | —             |       | 2 |   |
| Quartz Hill             |       | Lancaster         |       | 2005                            |       | 2006             |       | 2006          |       | 1                  |       | 2 |   |
| Future Community        |       | Lancaster         |       | 2005                            |       | —           | (c)        | —        | (c)        | —             |       | — |   |
|                    |       |              |       |                            |       |             |       |          |       |               |       |   |   |
| * *                |       |              |       | *Total Inland Empire/Lancaster* |       | 6                |       | 15            |       |
| * *                |       |              |       |                            |       |             |       |          |       |               |       |   |   |
| * *                |       |              |       | *Total Deliveries*              |       | 8                |       | 15            |       |

 

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(a)           Commenced in August 2007.

 

(b)           Commenced in February 2008.

 

(c)           To be determinedsubject to market conditions.

 

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*Huntington Beach.*  We completed construction of the first eightmodel homes for The Trails and The Sands products which range from 1,710 to2,160 square feet during July 2007 and opened for sales in August 2007.We completed construction of nine model homes for The Cliffs and The Breakersin January 2008 and began selling homes to homebuyers who previouslyregistered on our priority list in February 2008. We held a grand openingfor The Cliffs and The Breakers on March 15, 2008. We delivered nine homesat an average price of $1.2 million, or $609 per square foot during 2007and two homes during the three months ended March 31, 2008, at an averageprice of $1.1 million, or approximately $594 per square foot. As of May 5,2008, 13 Brightwater homes are in escrow at an average price of$1.7 million, or approximately $599 per square foot.

 

*Corona.*  We acquired 83 lots in North Corona in May 2004.Following construction of infrastructure, during April 2005, we beganconstruction of homes averaging 3,160 square feet. We opened for sales duringthe third quarter of 2005 and delivered 58 homes during 2006 at an averageprice of $600,000. We delivered 21 homes during 2007 at an average price of$511,000 and one home during the three months ended March 31, 2008 at aprice of $455,000. As of May 5, 2008, one model home is completed and hasbeen released for sale and the final two homes are under construction.

 

During April 2005, we acquired 151additional lots in Corona. Following construction of infrastructure,construction of five model homes averaging 3,600 square feet on lots ofapproximately 7,200 square feet began during the fourth quarter of 2006. Thesemodels were completed during April 2007, and we opened for sales duringthe second quarter of 2007. We delivered three homes at an average price of$545,000 during 2007 and one home at a price of $527,000 during the firstquarter of 2008. As of May 5, 2008, three homes are completed and inescrow at an average price of $479,000 and five homes are completed andavailable for sale.

 

*Ontario.*  During April 2005, we acquired 26 lotsin the City of Ontario in Riverside County, California. This small community ofhomes, averaging 3,380 square feet, is an infill site. Construction of thefirst phase of 13 homes began during the fourth quarter of 2005, and we openedfor sales during March 2006. We delivered nine homes during 2006 at anaverage price of $675,000, nine homes during 2007 at an average price of$613,000 and two homes during the first quarter of 2008 at an average price of$565,000. As of May 5, 2008, six homes are completed and available forsale.

 

*Beaumont.*  We acquired 102 lots in the City of Beaumontduring the third quarter of 2005. Following construction of infrastructure,construction of homes averaging 2,500 square feet began during the firstquarter of 2006, and sales commenced during March 2006. We delivered 15homes during 2006 at an average price of $387,000, 10 homes during 2007 at anaverage price of $304,000 and one home during the first quarter of 2008 at aprice of $269,000.  As of May 5,2008, two homes are in escrow at an average price of $291,000 and eightadditional homes are completed and available for sale.

 

*Lancaster.*  We acquired 104 lots in the City of Lancasterin northern Los Angeles County during May 2004. We began construction ofmodel homes averaging approximately 2,860 square feet during the third quarterof 2004 and opened for home sales in January 2005. During 2005 and 2006,we delivered 55 homes and 41 homes, respectively, at average prices of $406,000and $448,000, respectively. We delivered seven homes during 2007 at an averageprice of $401,000. As of May 5, 2008, the final home is completed and isavailable for sale.

 

In April 2005, we acquired an additional73 unentitled lots in Lancaster. We have deferred the construction start forthe 73-unit project, which has no recorded loan, until sales activity in themarket has improved. The tentative map for this project is prepared, but wehave delayed filing for approval in order to defer the entitlement feesrequired to be paid at the time of filing.

 

In December 2005, we acquired 77additional lots in an area known as Quartz Hill in the City of Lancaster. Thehomes in this community are on 10,000 square foot lots and will average 3,640square feet. Construction of models began in May 2006 and we opened forsales during July 2006. We delivered three homes at an average price of$537,000 during 2006 and 12 homes during 2007 at an average price of $427,000.During the first quarter of 2008, we delivered one home at a price of $383,000.As of May 5, 2008, four homes are completed and available for sale.

 

**Critical Accounting Policies**

 

In the preparation of the ConsolidatedFinancial Statements, we applied accounting principles generally accepted inthe United States of America. The application of generally accepted accountingprinciples may require management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying results.Listed below are those policies and estimates that we believe are critical andrequire the use of complex judgment in their application. In particular, ourcritical accounting policies and estimates include the evaluation of theimpairment of long-lived assets and the evaluation of the probability of beingable to realize the future benefits indicated by our significant federal taxnet operating losses, as discussed further in Note 8 to the consolidatedfinancial statements.

 

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*Basis of Consolidation*

 

Certain of our wholly-owned subsidiaries aremembers in joint ventures involved in the development and sale of residentialprojects and residential loan production. Our consolidated financial statementsinclude our accounts and all of our majority-owned and controlled subsidiariesand joint ventures. The financial statements of joint ventures in which wegenerally have a controlling or majority economic interest (and thus arecontrolled by us) are consolidated with our financial statements. Ourinvestments in unconsolidated joint ventures are accounted for using the equitymethod when we do not have voting or economic control of the ventureoperations, as further discussed in Note 9 to the consolidated financialstatements.

 

*Impairment of Long-Lived Assets*

 

We assess the impairment of real estateinventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” (“SFAS 144”) which requiresthat long-lived assets be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. As provided by SFAS 144, impairment is evaluated by comparingan asset’s carrying value to the undiscounted estimated cash flows expectedfrom the asset’s operations and eventual disposition. If the sum of theundiscounted estimated future cash flows is less than the carrying value of theasset, an impairment loss is recognized based on the fair value of the asset. Ifimpairment occurs, the fair value of an asset for purposes of SFAS 144 isdeemed to be the amount a willing buyer would pay a willing seller for suchasset in a current transaction. Additionally, as appropriate, we identifyalternative courses of action to recover the carrying value of our long-livedassets and evaluate all likely alternatives under a probability-weightedapproach as described in SFAS 144.

 

In accordance with SFAS No. 144, indeveloping estimated future cash flows for impairment testing for our realestate inventories, we incorporated our own market assumptions including thoseregarding home prices, sales pace, sales and marketing costs, infrastructure,home-building costs and financing costs regarding real estate inventories. Ourassumptions are based, in part, on general economic conditions, the currentstate of the homebuilding industry, expectations about the short- and long-termoutlook for the housing market, and competition from other homebuilders in theareas in which we build and sell homes. These assumptions can significantlyaffect our estimates of future cash flows. For those communities deemed to beimpaired, we determined fair value based on discounted estimated future cashflows using estimated absorption rates for each community.

 

We recorded no additional impairment chargesduring the three months ended March 31, 2008, compared with $4.0 millionrecorded related to the Beaumont project during the three months ended March 31,2007. The impairment charges recorded during the first quarter of 2007reflected the continuing slowdown in the housing market and our expectationsabout the pace of sales and sales prices. To date, we have recorded impairmentcharges aggregating $32.0 million for five of our active projects. The impairmentcharges were calculated based on current market conditions and currentassumptions made by management, which may differ materially from actual resultsif market conditions change. As required by SFAS 144, should marketconditions deteriorate further in the future or other events occur thatindicate the carrying amount of our real estate inventories may not berecoverable, we will reevaluate the expected cash flows from each project todetermine whether any additional impairment exists at any point in time.

 

We believe that the accounting for theimpairment of long-lived assets is a critical accounting policy because thevaluation analysis involves a number of assumptions that may differ from actualresults and the impact of recognizing impairment losses has been material toour consolidated financial statements. The critical assumptions in ourevaluation of real estate inventories impairment included projected salesprices, anticipated sales pace within each community, and applicable discountrates, any of which could change materially as economic conditions change.

 

*Income Taxe*s

 

We account for income taxes on the liabilitymethod. Deferred income taxes are determined based on the difference betweenthe financial statement and tax bases of assets and liabilities. The liabilitymethod requires an evaluation of the probability of being able to realize thefuture benefits indicated by deferred tax assets, such as tax net operatinglosses. A valuation allowance related to the deferred tax asset is recorded whenit is more likely than not that some portion or all of the deferred tax assetwill not be realized. Given the significance of our historical federal tax netoperating losses, as discussed in Note 9 to the Consolidated FinancialStatements, the application of our policy in evaluating the expected futurebenefit of net operating losses is critical. In applying those policies,estimates and judgments affect the amounts at which certain assets andliabilities are recorded. We apply our accounting policies on a consistentbasis. As circumstances change, they are considered in our estimates andjudgments, and future changes in circumstances could result in changes in theamounts at which assets and liabilities are recorded.

 

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We remain subject to the general rules ofSection 382 of the Internal Revenue Code, which limit the availability ofnet operating losses if an ownership change occurs. If we were to experienceanother ownership change, the amount of net operating losses available wouldgenerally be limited to an annual amount equal to (i) the value of ourequity immediately before the ownership change, multiplied by the long-termtax-exempt rate (4.55% as of April 2008) plus (ii) recognizedbuilt-in-gains, defined as those gains recognized within five years of theownership change subject to an overall limitation of the net unrealizedbuilt-in gains existing as of the ownership change date. We believe we have netunrealized built-in gains sufficient to allow utilization of the entire netoperating loss, assuming that we are able to recognize these gains within thefive-year time limitation. We estimate that as of May 5, 2008, we haveexperienced a three-year cumulative ownership shift of approximately 42%, ascomputed in accordance with Section 382.

 

*Homebuilding Revenues and Cost of Sales*

 

Our homebuilding operation generates revenuesfrom the sale of homes. The majority of these homes are designed to appeal tomove-up homebuyers and the homes are generally offered for sale in advance oftheir construction. Sales contracts are usually subject to certaincontingencies such as the buyer’s ability to qualify for financing. Revenuefrom the sale of homes is recognized at closing when title passes to the buyer,and the earnings process is complete. As a result, our revenue recognitionprocess does not involve significant judgments or estimates. However, we dorely on certain projections and estimates to determine the related constructioncosts and resulting gross margins associated with revenues recognized. The costof sales is recorded based upon total estimated costs within a subdivision andallocated using the relative sales value method. Our construction costs arecomprised of direct and allocated costs, including estimated costs for futurewarranties and indemnities. Our estimates are based on historical results,adjusted for current factors.

 

*Litigation Reserves*

 

We and certain of our subsidiaries have beennamed as defendants in various cases arising in the normal course of businessand regarding assets and businesses disposed of by us or our former affiliates.See Note 9 in our consolidated financial statements included in this quarterlyreport. We have reserved for costs expected to be incurred with respect tothese cases based upon information provided by our legal counsel. There can beno assurance that total litigation costs actually incurred will not exceed theamount of such reserve.

 

**Recent Accounting Pronouncements**

 

See discussion regarding Recent Accounting Pronouncementsin Note 2 to the consolidated financial statements.

 

**Results of Operations**

 

The following tables set forth key operating andfinancial data for our homebuilding operations for the three months ended March 31,2008 and 2007.

 

**Backlog as of March 31**

** **
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**                       | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 12                             |       | 15                                       |       | (20.0                                                           | )%         | $ | 17.4 |   | $ | 8.0 |   | 117.5 | % | $ | 1,447 |   | $ | 531 |   | 172.5 | % |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

**Homes Delivered****Three Months Ended March 31**

** **
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2008**                 | ** ** | **2007**                                 | ** ** | **Change**                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
| 8                        |       | 15                                       |       | (46.7                                                           | )%         | $ | 5.0 |   | $ | 12.2 |   | (59.0 | )% | $ | 625 |   | $ | 813 |   | (23.1 | )% |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Three Months Ended March 31, 2008 Compared withthe Three Months Ended March 31, 2007*

 

We reported revenues of $5.0 million andgross operating profit of $1.1 million for the first quarter of 2008,compared with $12.2 million in revenues and gross operating loss of$3.2 million for the first quarter of 2007. Revenues in the current periodreflect deliveries of eight homes, including two deliveries at Brightwaterwhich generated revenues of $2.2 million and gross operating profit of$700,000, and six homes at our inland projects which generated revenues of 

 

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$2.8 million and gross operating profit of $400,000. Thecomparable period of the prior year reflects deliveries of 15 homes, includingthe final six homes at the Rancho Santa Fe project, three homes at the ChandlerRanch project and two homes each at our Alisal project in Ontario, our LasColinas project in Quartz Hill, and our Alisal project in Lancaster.

 

Gross operating loss for the first quarter of2007 includes an impairment charge of $4.0 million related to theremaining homes at our Beaumont project. This impairment charge reflected ourexpectations at that time about selling prices, gross margins, and sales pacefor the project. As required by SFAS 144, should market conditions furtherdeteriorate in the future or other events occur that indicate the carryingamount of our real estate inventories may not be recoverable, we willreevaluate our expected cash flows from each project to determine whether anyadditional impairment exists at any point in time.

 

We generated $300,000 more in grossoperating profit before impairment charges from home sales during the firstquarter of 2008 compared with the first quarter of 2007 primarily as a resultof delivering two homes at Brightwater which generated a 33.8% gross profit of$700,000 and was partially offset by reduced margins at our inland projects dueto the prolonged real estate slowdown which has resulted in lower sellingprices and greater incentives in order to remain competitive and move standinginventories in this difficult market. Homebuilding gross margin for the firstquarter of 2008 increased to 22.0% compared with 6.6% before impairment chargesin the comparable period of 2007.

 

The $500,000 increase in other expense, netduring the first quarter of 2008 compared with the comparable period of 2007primarily reflects a $700,000 loss on our interest rate swap agreement whichincluded a $500,000 non-cash fair value adjustment and $200,000 of cashpayments made under the terms of the agreement.

 

*Payments Under Contractual Obligations*

 

We have entered into certain contractualobligations to make future payments for items such as loans, project debt, andlease agreements. A summary of the payments due under specified contractualobligations, aggregated by category of contractual obligation, for specifiedtime periods is presented below as of March 31, 2008 (in millions):

 
| ** **                                     | ** ** | **Payments due by period** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                     | ** ** | **Total**                                 | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More  than  5 years** | ** ** |
| Revolving loan(a)                              |       | $                                         | 71.4       |   | $ | 20.5 |   | $ | 50.9 |   | $ | — |   | $ | — |   |
| Term loan(a)                                   |       | 134.4                                     |       | 18.7 |   | 90.7 |   | 25.0 |   | — |   |
| Other project debt(a)                          |       | 49.7                                      |       | 49.7 |   | — |   | — |   | — |   |
| Defined benefit retirement plan  contributions |       | 1.5                                       |       | .2 |   | .4 |   | .4 |   | .5 |   |
| Operating leases                               |       | 1.3                                       |       | .3 |   | .7 |   | .3 |   | — |   |
| Total                                          |       | $                                         | 258.3      |   | $ | 89.4 |   | $ | 142.7 |   | $ | 25.7 |   | $ | .5 |   |

 

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(a)           Amounts includeestimated interest expense which is calculated based on forecasted debtbalances and the applicable interest rate at March 31, 2008.

 

Our purchase contracts which are made in thenormal course of our homebuilding business for land acquisition andconstruction subcontracts are generally cancelable at will. Other contractualobligations including our tax liabilities, accrued benefit liability for afrozen retirement plan and other accrued pensions, home warranty reserves andcontingent indemnity and environmental obligations are estimated based onvarious factors. Payments are not due as of a given date, but rather aredependent upon the incurrence of professional services, the lives of annuitantsand other factors. The estimation process involved in the determination ofcarrying values of these obligations is inherently uncertain since it requiresestimates as to future events and contingencies. We have provided additionaldisclosure below in Part II Item 1. “Legal Proceedings” and inNote 9 to our consolidated financial statements above.

 

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**Liquidity and Capital Resources**

 

Year-over-year changes in theprincipal components of our liquidity and capital resources are as follows (inmillions, except percentages):

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **March 31,**               | ** ** |
| ** **                                       | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Cash and cash equivalents                        |       | $                                | 1.2        |   | $ | 8.7 |   |
| Cash used in operating activities                |       | (11.6                            | )          | (9.6 | ) |
| Cash provided by investing activities            |       | —                           |       | 1.4 |   |
| Cash (used in) provided by financing  activities |       | (11.5                            | )          | 6.3 |   |
|                                                  |            |                                  |            |  |  |  |  |

 

The principal assets in our portfolio areresidential land which must be held over an extended period of time in order tobe developed to a condition that, in management’s opinion, will ultimatelymaximize our return. Consequently, we require significant capital to financeour real estate development and homebuilding operations. Historically, sourcesof capital have included loan facilities secured by specific projects, assetsales and available internal funds. Our unrestricted cash and cash equivalentsas of March 31, 2008 aggregated $1.2 million. At March 31, 2008,we had $22.9 million of immediately available borrowing capacity asfurther described below.  We utilizedavailable cash during the first quarter of 2008 to prepay outstanding balancesunder the Revolving Loan (described below) and accounts payable in order to bein compliance with the maximum leverage ratio of 2.50 described in Notes 4 and5 to the consolidated financial statements.

 

On September 15, 2006 we entered intothe $100 million Revolving Loan (the “Revolving Loan”) and the$125 million Term Loan (the “Term Loan”) with KeyBank NationalAssociation, as a lender and agent for several other lenders. These loans aredescribed in greater detail in Notes 4 and 5 to the consolidated financialstatements.

 

We obtained the Revolving Loan as aconstruction facility to finance infrastructure and homebuilding activities atBrightwater. This loan is funding a revolving $100 million of developmentand construction costs for the Brightwater project. Availability under the$100 million Revolving Loan is subject to the applicable borrowing baselimitations. The borrowing base limits lender advances to 50% of asset value.The borrowing base value is the appraised value of the Brightwater project,increased for costs incurred subsequent to the most recent lender appraisal andreduced by 72% of the sales value of homes delivered. As of March 31,2008, the borrowing base was $191.2 million, thereby causing no currentlimitation to the amount available to be borrowed. The Revolving Loan includesother financial covenants which may limit the amount that may be borrowed.

 

As of March 31, 2008, based onconstruction in place, the immediately available borrowing capacity on ourRevolving Loan is $22.9 million. As of March 31, 2008 and December 31,2007, $67.0 million and $76.0 million, respectively, was outstandingunder the Revolving Loan. On January 2, 2008, we repaid $18.0 millionon the Revolving Loan, which is available to be reborrowed, in order tominimize interest costs. In addition, during the first quarter of 2008, we mademandatory repayments of $480,000 and $720,000 on the Revolving and Term Loans,respectively, in connection with two home deliveries at Brightwater during thequarter. Outstanding advances on the Revolving Loan bear interest at our optionat either (i) the Alternate Base rate (“Prime”) minus 25 basis points or (ii) LIBORplus 200 basis points. Outstanding advances on the Term Loan bear interestat our option at either (i) the prime interest rate plus 25 basis points,or (ii) LIBOR plus 275 basis points.

 

As a result of the sustained downturn in thehomebuilding industry and the $28.0 million of impairment charges we recordedduring the third quarter of 2007, we amended the Term Loan and Revolving Loan,effective as of September 30, 2007, to reduce the tangible net worthcovenant from $100 million to $80 million. The Term Loan was alsoamended to defer the phase-in of the minimum ratio of EBITDA to interestincurred covenant from the first quarter of 2008 to the third quarter of 2008to accommodate our anticipated operating results for 2008.

 

In addition, our credit facilities require usto make $33.4 million in aggregate principal amortization payments by December 31,2008, including $22.4 million for the Revolving Loan (assuming we draw theremaining $30.4 million which is available as of March 31, 2008) and$11.0 million for the Term Loan. In order to make these payments out ofcash flow from operations, we would need to deliver approximately 50 homes atBrightwater during 2008, which appears unlikely based on sales orders to date,the number of homes currently under construction and the approximately eightmonths it takes to build the larger homes (The Cliffs and The Breakers).Therefore, we have initiated discussions with our lenders regarding potentialamendments to the Revolving Loan that would defer a portion of our currentlyscheduled payments to future periods and modify certain covenants toaccommodate the slower projected pace of sales. Amendments to the paymentschedule will 

 

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require the unanimous consent of the Revolving Loan banksyndicate.  We are also evaluatingalternatives for raising additional capital, if necessary. There can be noassurance that we will be successful in these endeavors, or that requestedamendments to the Term Loan and Revolving Loan will be agreed to by ourlenders. Current credit market conditions present uncertainty as to our abilityto secure additional financing, if needed, and the terms of such financing ifit is available, or as to our ability to achieve positive cash flow fromoperations to satisfy our obligations.

 

Our other project debt, which is secured byvarious inland projects, has been modified through loan extension agreements toinclude certain commitment curtailments. The curtailments are tied to thenumber of sales at the particular projects, or payment of commitment releaseamounts through deliveries or from other available cash. During April 2008,we exercised the remaining three-month extension for our Ontario loan andextended the maturity date to July 19, 2008. The maturity dates for ourBeaumont and Lancaster loans are June 17, 2008 and September 30,2008, respectively. We have one additional three-month extension available forthe Beaumont loan, subject to achieving minimum sales of four homes for thethree-month period beginning March 18, 2008 or making the requisite cashpayment of approximately $309,000 per unit if such sales levels are notachieved. The Lancaster loan requires cumulative minimum repayments of$3.0 million by July 1, 2008. As of March 31, 2008, we have madecumulative repayments of $2.6 million, resulting in an additional $400,000 dueby July 1, 2008.

 

We are utilizing internally generated cashand joint venture contributions to fund the Oxnard land development project.During the three months ended March 31, 2008, we made aggregate additionalcapital contributions of approximately $200,000 to the Oxnard joint venture,bringing our total investment in the venture to $2.8 million (seeNote 9 to the consolidated financial statements). In addition, as of March 31,2008, we have incurred capitalized overhead costs of approximately $600,000 forthe project which are unreimbursed by the venture, bringing our totalinvestment in the project to $3.4 million. During the remaining ninemonths of 2008, we expect to make additional aggregate capital contributions ofapproximately $400,000.

 

As discussed above, we are pursuing andevaluating various financing alternatives, including amending our RevolvingLoan and Term Loan, and raising additional capital. We believe that the resultsof these efforts, in addition to our cash and cash equivalents, future realestate sales proceeds, and funds available under our current credit agreementswill be sufficient to meet anticipated operating and capital investmentrequirements and project development costs for homebuilding projects, theOxnard land development project, and general and administrative expenses, forat least the next 12 months.

 

We are subject to the usual obligationsassociated with entering into contracts for the purchase of land and improvedhomesites. The purchase of properties under these contracts is generallycontingent upon satisfaction of certain requirements by the sellers, includingobtaining applicable property entitlements. We also utilize option contractswith third-party land sellers and financial entities as a method of acquiringland in staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Purchase and option contractsgenerally require the payment of a non-refundable cash deposit of 5% to 15% ofthe purchase price for the right to acquire lots over a specified period oftime (usually one to two years) at predetermined prices. We have the right atour discretion to terminate our obligations under these land purchase andoption agreements by forfeiting the cash deposit with no further financialresponsibility. As of March 31, 2008, we have no consolidated land optiondeposits. However, our unconsolidated Oxnard joint venture does have landdeposits of $2.5 million.

 

We may enter into land development andhomebuilding joint ventures from time to time as a means of expanding ourmarket opportunities, establishing strategic alliances, managing our riskprofile and leveraging our capital base. These joint ventures may obtainsecured acquisition, development and construction financing, which minimize theuse of funds from other corporate financing sources.

 

*March 31, 2008 Compared with December 31, 2007*

 

Cash used in operating activities of$11.6 million for the first quarter of 2008 primarily reflects investmentsin Brightwater of $11.3 million, which were partially offset by netproceeds of $2.2 million generated by two deliveries at Brightwater and$1.7 million of net cash flow generated by our inland projects($2.7 million generated from deliveries of six homes less$1.0 million of project investments).

 

Our primary uses of cash during the quarterinclude $11.3 million of investments in Brightwater, $9.0 million of netrepayments of our Revolving Loan and $1.5 million of net repayments ofother project debt.

 

The $400,000 increase in deferred tax assetsreflects a $400,000 tax benefit for additional net operating losses generatedduring the first quarter of 2008.

 

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The $2.3 million decrease in accounts payableand accrued liabilities primarily reflects reductions in accounts payablerelated to payments of project construction costs.

 

**Off Balance Sheet Financing**

 

In the ordinary course of business, we enterinto land option contracts in order to procure land for the construction ofhomes. The use of such option agreements allows us to reduce the risksassociated with land ownership and development; reduce our financialcommitments, including interest and other carrying costs; and minimize landinventories. Under such land option contracts, we will fund a specified optiondeposit or earnest money deposit in consideration for the right to purchaseland in the future, usually at a predetermined price. Our liability isgenerally limited to forfeiture of the nonrefundable deposits, letters ofcredit and other nonrefundable amounts incurred. As of March 31, 2008, wehave no consolidated land option deposits and no third party guarantees.

 

We also acquire land and conduct residentialconstruction activities through participation in joint ventures in which wehold less than a controlling interest. Through joint ventures, we reduce andshare our risk and also reduce the amount invested in land, while increasingour access to potential future home sites. The use of joint ventures also, insome instances, enables us to acquire land which we might not otherwise obtainor access on as favorable terms, without the participation of a strategicpartner. While we view the use of unconsolidated joint ventures as beneficialto our homebuilding activities, we do not view them as essential to thoseactivities.

 

Our investment in unconsolidated jointventures totaled $2.8 million and $2.7 million at March 31, 2008and December 31, 2007. These joint ventures had total assets of$8.9 million and $9.7 million as of March 31, 2008 and December 31,2007, respectively, which included land deposits of $2.5 million for bothperiods. In certain instances, we may provide varying levels of guarantees ondebt of unconsolidated joint ventures. As of March 31, 2008, we provide noguarantees on debt of unconsolidated joint ventures.

 

Under the requirements of FASB InterpretationNo. 46(R), “*Consolidation of VariableInterest Entities*” (“FIN 46(R)”), certain of our land optioncontracts may create a variable interest for us, with the land seller beingidentified as a VIE. In compliance with FIN 46(R), we analyze our landoption contracts and other contractual arrangements and consider whether weshould consolidate the fair value of certain VIEs from which we are purchasingland under option contracts. As of March 31, 2008, we had no consolidateddeposits with VIEs.

 

**Inflation**

 

The long-term impact of inflation may affectus through increased costs for land, land development, construction andoverhead, as well as in increased sales prices of our homes. Our landacquisition costs are generally fixed, therefore, increases or decreases in thesales prices of homes will affect our profits. The sales price of each of ourhomes is fixed at the time a buyer enters into a contract to acquire ahome.  Therefore, since we generallycontract to sell our homes before we begin construction, any inflation of costsin excess of those anticipated may result in lower gross margins. 

 

In general, housing demand is adverselyaffected by increases in interest rates and housing costs. Interest rates, thelength of time that land remains in inventory and the proportion of inventorythat is financed affect our interest costs. If we are unable to raise salesprices enough to compensate for higher costs, or if mortgage interest ratesincrease significantly, affecting prospective buyers’ ability to adequatelyfinance home purchases, our revenues, gross margins and net income would beadversely affected. Increases in sales prices, whether the result of inflationor demand, may affect the ability of prospective buyers to afford new homes.

 

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ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

We utilize variable rate debt financing foracquisition, development and construction of homes. The interest rates on ourdebt approximate the current rates available for secured real estate financingwith similar terms and maturities, and as a result, their carrying amountsapproximate fair value. While changes in interest rates generally do not impactthe fair market value of the debt instrument, they do affect our earnings andcash flows. Holding our variable rate debt balance constant as of March 31,2008, each one point percentage increase in interest rates would result in anincrease in variable rate interest incurred for the next 12 months ofapproximately $1.7 million.

 

We are exposed to market risks related tofluctuations in interest rates on our outstanding variable rate debt. Otherthan an interest rate swap used to manage our exposure to changes in interestrates on $62.5 million of our variable rate-based Term Loan, we did notutilize swaps, forward or option contracts on interest rates, or other types ofderivative financial instruments as of or during the year ended March 31,2008. We do not enter into or hold derivatives for trading or speculativepurposes.

 

Under the Term Loan agreement, we wererequired to enter into a swap agreement to hedge against risks associated withfluctuating interest rates related to $62.5 million of floating rate debt.On September 15, 2006 we entered into an interest rate swap transaction toeffectively fix the interest rate on $62.5 million in floating rate debtat 8.015% per annum for two years. The swap transaction terminates September 15,2008. The swap did not qualify for hedge accounting under SFAS No. 133.The fair value of the interest rate swap agreement represents the spreadbetween the interest rate we paid and the interest rate we would receive overthe remaining life of the agreement. As of March 31, 2008, the fair valueof the swap agreement is approximately $700,000. The non-cash change in fairvalue of the interest rate swap agreement during the three months ended March 31,2008 was approximately $500,000 and is included in other expense in ourconsolidated statement of operations and in accounts payable and accruedliabilities in our consolidated balance sheet. In addition, we recorded a$200,000 expense for cash payments made under the interest rate swap agreementduring the first quarter of 2008 due to declining interest rates during thequarter. The counterparties to the interest rate swap agreement are financialinstitutions.

 

You should be aware that many of thestatements contained in this section are forward looking and should be read inconjunction with our disclosures under the heading “Forward-Looking Statements.”

 

ITEM 4 - EVALUATION OF DISCLOSURE CONTROLS ANDPROCEDURES

 

*Conclusion Regarding the Effectiveness of Disclosure Controls andProcedures*

 

Our chief executive officer and chief financialofficer, with the assistance of management, evaluated the effectiveness of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) as of theend of the period covered by this report (the “Evaluation Date”). Based on thatevaluation, our chief executive officer and chief financial officer concludedthat, as of the Evaluation Date, our disclosure controls and procedures wereeffective to ensure that information required to be disclosed in our reportsunder the Exchange Act, is recorded, processed, summarized and reported withinthe time periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate to allow timelydecisions regarding required disclosure.

 

However, no matter how well a control system isconceived and operated, it can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. In addition, the design of acontrol system must reflect the fact that there are resource constraints andthe benefits of controls must be considered relative to costs. Therefore, nocost-effective control system and no evaluation of controls can provideabsolute assurance that all control issues and instances of misstatements dueto error or fraud, if any, within our company have been detected.

 

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*Changes in Internal Controls*

 

There have been no changes in our internal controlover financial reporting during the three months ended March 31, 2008 thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

PART II - OTHERINFORMATION

 

ITEM 1 -                LEGAL PROCEEDINGS

 

See Notes 7 and 9 to the consolidated financialstatements above, and “Item 1 - Business - Corporate Indemnification Matters”and “Item 3 - Legal Proceedings” in our Annual Report on Form 10-K for theyear ended December 31, 2007.

 

ITEM 1A -             RISKFACTORS THAT MAY AFFECT RESULTS OF OPERATIONS AND FINANCIAL CONDITION

 

 Set forth belowis a discussion of the material changes in our risk factors as previouslydisclosed in Item 1A of Part I of our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2007; however, the risks anduncertainties described in the Form 10-K are not the only ones facing us.Other events that we do not currently anticipate or that we currently deemimmaterial also may affect our results of operations and financial condition.

 

The information presented below updates, and shouldbe read in conjunction with, the risk factors and other information disclosedin our December 31, 2007 Form 10-K.

 

***We are subject to current credit marketrisks.***

 

Current credit market conditions presentuncertainty as to our ability to secure additional financing, if needed, andthe terms of such financing if it is available, or as to our ability to achievepositive cash flow from operations to satisfy our obligations.

 

ITEM 6 -                EXHIBITS

 
| 31.1 |   | Section 302  Certificate of Raymond J. Pacini, Chief Executive Officer of California  Coastal Communities, Inc.                                                  |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Section 302  Certificate of Sandra G. Sciutto, Chief Financial Officer of California  Coastal Communities, Inc.                                                  |
| 32.1 |   | Section 906  Certificate of Raymond J. Pacini, Chief Executive Officer and Sandra G.  Sciutto, Chief Financial Officer of California Coastal  Communities, Inc.* |

 

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*              These certifications are being furnishedsolely to accompany this report pursuant to 18 U.S.C. Section 1350, andare not being filed for purposes of Section 18 of the Securities ExchangeAct of 1934, as amended, and are not to be incorporated by reference into anyfiling of the Company, whether made before or after the date hereof, regardlessof any general incorporation language in such filing.

 

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**SIGNATURE**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| Date: May 8, 2008 | CALIFORNIA COASTAL  COMMUNITIES, INC. |
|------------------------|---------------------------------------|
|                   |                                  |   |
|                   |                                  |   |
|                   | By:                                   | */s/ Sandra G. Sciutto* |
|                   |                                  | SANDRA G. SCIUTTO |
|                   |                                  | Senior Vice President  and |
|                   |                                  | Chief Financial Officer |

 

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