**UNITED STATESSECURITIES 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 September 30, 2006**                                                                                                                                                                                                                                                                |
| ** **                                                                                                                                                                                                                                                                                                            |
| **OR**                                                                                                                                                                                                                                                                                                                |
| ** **                                                                                                                                                                                                                                                                                                            |
| **o**                                                                                                                                                                                                                                                                                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                                                                            | ** ** | ** **                                                                                              |
| **For the  transition period from                          to                     ** |
| ** **                                                                                                                                                                                                                                                                                                            | ** ** | ** **                                                                                              |
| **Commission  file number: 0-17189**                                                                                                                                                                                                                                                                                  |

 

**CALIFORNIA COASTAL COMMUNITIES,INC.**

**(Exactname of registrant as specified in its charter)**

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

 

Registrant’s telephonenumber, including area code:**(949) 250-7700**

Securities registeredpursuant to Section 12(b) of the Act: **NONE**

Securities registeredpursuant to Section 12(g) of the Act:

**Common Stock, par value $.05 pershare**

(Titleof Class)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES x  NO o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):
|  | **Large accelerated filer ****o** | **Accelerated filer ****x** | **Non-accelerated filer ****o** |
|--|----------------------------------------|----------------------------------|--------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act). YES o  NO x

The number of shares ofCommon Stock outstanding as of October 31, 2006 was 10,852,708.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2006

INDEX
| Cautionary Statement About  Forward-Looking Statements |                    |
|--------------------------------------------------------|-------------------------|
|                                                   |                    |   |
| Part I  -                                         | Financial  Information: |   |
|                                                   |                    |   |
|                                                   | Item 1 -                | Consolidated  Financial Statements |   |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated  Balance Sheets -  September 30, 2006 and December 31, 2005 (unaudited) |   |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated  Statements of Income -  Three and Nine Months Ended September 30, 2006 and 2005 (unaudited) |   |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated Statements of Cash Flows -  Nine Months Ended September 30, 2006 and 2005 (unaudited) |   |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated  Statement of Stockholders’ Equity -  Nine Months Ended September 30, 2006 (unaudited) |   |
|                                                   |                    |   |   |
|                                                   |                    | Notes  to Consolidated Financial Statements |   |
|                                                   |                    |   |   |
|                                                   | Item 2 -                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                                                   |                    |   |   |
|                                                   | Item 3 -                | Quantitative  and Qualitative Disclosures About Market Risk |   |
|                                                   |                    |   |   |
|                                                   | Item 4 -                | Evaluation of  Disclosure Controls and Procedures |   |
|                                                   |                    |   |   |
| Part II -                                         | Other Information:      |   |
|                                                   |                    |   |
|                                                   | Item  1 -               | Legal  Proceedings |   |
|                                                   |                    |   |   |
|                                                   | Item 1A -               | Risk Factors  That May Affect Results of Operations and Financial Condition |   |
|                                                   |                    |   |   |
|                                                   | Item 6  -               | Exhibits |   |
|                                                   |                    |   |   |
| SIGNATURE                                              |                    |   |

 

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CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS

This quarterlyreport on Form 10-Q contains forward-looking statements within the meaning ofSection 27A of the Securities Exchange Act of 1933 and Section 21E of theSecurities Exchange Act of 1934 that relate to future events or our futurefinancial performance. In addition, other statements we may make from time totime, such as press releases, oral statements made by our officials and otherreports that we file with the Securities and Exchange Commission may alsocontain such forward-looking statements. Undue reliance should not be placed onthese statements which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements. In some cases, you canidentify forward-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.

Theseforward-looking statements include, but are 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 takeadvantage of 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

·                  stock marketvaluations.

Any or all of theforward-looking statements included in this report and in any other reports orpublic statements made by us may turn out to be inaccurate. This can occur as aresult of incorrect assumptions or as a consequence of known or unknown risksand uncertainties. These risks and uncertainties include the competitive environmentin which we operate, local, regional and national economic conditions, thedemand for homes fluctuations in interest rates, changes in home prices, theavailability and cost of land for future growth, the availability of capital,uncertainties and fluctuations in capital and securities markets, changes intax laws and their interpretation, legal proceedings, the ability of customersto finance the purchase of homes, the availability and cost of labor andmaterials, our significant amount of debt and the impact of restrictivecovenants in our loan agreements, weather conditions, domestic andinternational political events, uncertainties created by terrorist attacks, theeffects of governmental regulation, and other risks discussed in our filingswith the Securities and Exchange Commission, including in our most recentAnnual Report on Form 10-K. Many factors mentioned in this report or in otherreports or public statements made by us, such as government regulation and thecompetitive environment, will be important in determining our futureperformance. Consequently, actual results may differ materially from those thatmight be anticipated from our forward-looking statements. You should not placeundue reliance on any of these forward-looking statements because they arebased on current expectations or beliefs regarding future events orcircumstances, which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by these forward-looking statements.

3

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Although webelieve that our strategies, plans, objectives, goals, expectations andintentions reflected in, or suggested by these forward-looking statements arereasonable given current information available to us, we can give no assurancethat any of them will be achieved.

Theseforward-looking statements should be considered in light of the informationincluded in this report and our other filings with the Securities and ExchangeCommission, including, without limitation, the “Risk Factors”, as well as thedescription of trends and other factors in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations”, set forth in ourForm 10-K for the year ended December 31, 2005. You should also read thefollowing “Management’s Discussion and Analysis of Financial Condition andResults of Operations” in conjunction with the unaudited condensed consolidatedfinancial statements and the related notes that appear elsewhere in thisreport.

We assume no, andhereby disclaim any, obligation to update any of the foregoing or any otherforward-looking statements. We nonetheless reserve the right to make suchupdates from time to time by press release, periodic report or other method ofpublic disclosure without the need for specific reference to this Form 10-Q orany other report filed by us.  No suchupdate shall be deemed to indicate that other statements not addressed by suchupdate remain correct or create an obligation to provide any other updates.

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**PART I.  FINANCIAL INFORMATION**

**ITEM 1 – FINANCIAL STATEMENTS**

CALIFORNIA COASTALCOMMUNITIES, INC.

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in millions)
| ** **                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                              | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                              |       |                   |       |                  |       |
| ** **                                                                                                                              |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                              |       | $                      | 12.2       |                  | $          | 7.7 |   |
| Short-term  investments                                                                                                                 |       | 1.3                    |       | 30.3                  |       |
| Restricted cash                                                                                                                         |       | 14.4                   |       | 2.3                   |       |
| Real estate  inventories                                                                                                                |       | 270.4                  |       | 253.6                 |       |
| Deferred tax  assets                                                                                                                    |       | 35.9                   |       | 35.4                  |       |
| Other assets,  net                                                                                                                      |       | 5.1                    |       | 1.1                   |       |
|                                                                                                                                    |       |                   |       |                  |       |
|                                                                                                                                    |       | $                      | 339.3      |                  | $          | 330.4 |   |
|                                                                                                                                    |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                          |       |                   |       |                  |       |
| ** **                                                                                                                              |       |                   |       |                  |       |
| Liabilities:                                                                                                                            |       |                   |       |                  |       |
| Accounts payable  and accrued liabilities                                                                                               |       | $                      | 17.9       |                  | $          | 17.4 |   |
| Senior secured  project revolver                                                                                                        |       | 9.0                    |       | —                |       |
| Senior secured  term loan                                                                                                               |       | 125.0                  |       | —                |       |
| Other project  debt                                                                                                                     |       | 57.1                   |       | 57.9                  |       |
| Other  liabilities                                                                                                                      |       | 7.9                    |       | 7.9                   |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Total  liabilities                                                                                                                      |       | 216.9                  |       | 83.2                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Minority  interest                                                                                                                      |       | —                 |       | .3                    |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Commitments and  contingencies                                                                                                          |       |                   |       |                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Stockholders’  equity:                                                                                                             |       |                   |       |                  |       |
| Common Stock—$.05  par value; 13,500,000 shares authorized; 10,852,708 and 10,160,212 shares  issued and outstanding, respectively |       | .5                     |       | .5                    |       |
| Excess Stock—$.05  par value; 13,500,000 shares authorized; no shares outstanding                                                  |       | —                 |       | —                |       |
| Additional  paid-in capital                                                                                                             |       | 62.7                   |       | 191.6                 |       |
| Retained  earnings                                                                                                                      |       | 61.0                   |       | 56.6                  |       |
| Accumulated other  comprehensive loss                                                                                                   |       | (1.8                   | )          | (1.8                  | )          |
| Total  stockholders’ equity                                                                                                        |       | 122.4                  |       | 246.9                 |       |
|                                                                                                                                    |       |                   |       |                  |       |
|                                                                                                                                    |       | $                      | 339.3      |                  | $          | 330.4 |   |

 

See the accompanying notes to consolidated financialstatements.

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CALIFORNIA COASTALCOMMUNITIES, INC.

CONSOLIDATEDSTATEMENTS OF INCOME AND COMPREHENSIVE INCOME 

(in millions,except per share amounts)

(unaudited)
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                 | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Revenues:                                                  |       |                             |       |                            |       |   |   |   |   |
| Homebuilding                                               |       | $                                | 24.8       |                            | $          | 24.4 |   | $ | 71.5 |   | $ | 34.0 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Costs of sales:                                            |       |                             |       |                            |       |   |   |   |   |
| Homebuilding                                               |       | 21.4                             |       | 19.5                            |       | 60.2 |   | 26.5 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Gross operating  profit                                    |       | 3.4                              |       | 4.9                             |       | 11.3 |   | 7.5 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Selling, general and  administrative expenses              |       | 1.6                              |       | 1.5                             |       | 4.7 |   | 3.4 |   |
| Interest expense                                           |       | —                           |       | .1                              |       | — |   | .1 |   |
| Income from unconsolidated  joint ventures                 |       | (.1                              | )          | (.1                             | )          | (.1 | ) | (.1 | ) |
| Other (income) expense,  net                               |       | (.3                              | )          | .2                              |       | (.8 | ) | .5 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Income before  income taxes                                |       | 2.2                              |       | 3.2                             |       | 7.5 |   | 3.6 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Provision (benefit) for  income taxes                      |       | .9                               |       | 1.4                             |       | 3.1 |   | (3.0 | ) |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Minority interest in  income of consolidated joint venture |       | —                           |       | .1                              |       | — |   | .2 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Net income                                                 |       | 1.3                              |       | 1.7                             |       | 4.4 |   | 6.4 |   |
| Other comprehensive  income, net of income taxes:          |       |                             |       |                            |       |   |   |   |   |
| Minimum pension  liability income tax benefit              |       | —                           |       | —                          |       | — |   | .9 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Comprehensive  income                                      |       | $                                | 1.3        |                            | $          | 1.7 |   | $ | 4.4 |   | $ | 7.3 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Net earnings per common  share:                            |       |                             |       |                            |       |   |   |   |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Basic                                                      |       | $                                | .12        |                            | $          | .17 |   | $ | .43 |   | $ | .63 |   |
| Diluted                                                    |       | $                                | .12        |                            | $          | .16 |   | $ | .42 |   | $ | .61 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Common equivalent  shares:                                 |       |                             |       |                            |       |   |   |   |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Basic                                                      |       | 10.5                             |       | 10.2                            |       | 10.3 |   | 10.2 |   |
| Diluted                                                    |       | 10.7                             |       | 10.5                            |       | 10.6 |   | 10.5 |   |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Dividends paid per common share outstanding                |       | $                                | 12.50      |                            | $          | — |   | $ | 12.50 |   | $ | — |   |

 

See theaccompanying notes to consolidated financial statements.

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CALIFORNIA COASTALCOMMUNITIES, INC.

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(in millions)

(unaudited)
| ** **                                                                 | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                 | ** ** | **September 30,**          | ** ** |
| ** **                                                                 | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                     |       |                            |       |   |   |
| Net income                                                                 |       | $                               | 4.4        |   | $ | 6.4 |   |
| Adjustments to  reconcile net income to cash used in operating activities: |       |                            |       |   |   |
| Stock-based  compensation expense                                          |       | .1                              |       | — |   |
| Non-cash  interest expense                                                 |       | —                          |       | .1 |   |
| Distributions  from unconsolidated joint ventures                          |       | .1                              |       | — |   |
| Non-cash benefit  from reversal of deferred tax asset allowance            |       | —                          |       | (4.7 | ) |
| Deferred taxes                                                             |       | 3.1                             |       | 1.5 |   |
| Excess tax  benefits from share-based payment arrangements                 |       | (3.6                            | )          | — |   |
| Gains on sales  of real estate inventories                                 |       | (11.3                           | )          | (7.6 | ) |
| Minority  interest in income of consolidated joint venture                 |       | —                          |       | .4 |   |
| Proceeds from  sale of real estate inventories, net                        |       | 71.0                            |       | 34.0 |   |
| Investments in  real estate inventories                                    |       | (76.5                           | )          | (92.5 | ) |
| Investments in  land held for future development or sale                   |       | —                          |       | (1.9 | ) |
| Changes in  assets and liabilities:                                        |       |                            |       |   |   |
| (Decrease)  increase in other assets, net                                  |       | (.4                             | )          | 4.4 |   |
| Increase  (decrease) in accounts payable, accrued and other liabilities    |       | .5                              |       | (2.5 | ) |
|                                                                       |       |                            |       |   |   |
| Cash used in  operating activities                                         |       | (12.6                           | )          | (62.4 | ) |
|                                                                       |       |                            |       |   |   |
| Cash flows from  investing activities:                                     |       |                            |       |   |   |
| Sales of  short-term investments                                           |       | 67.4                            |       | — |   |
| Purchases of  short-term investments                                       |       | (38.4                           | )          | — |   |
| Investments in  unconsolidated joint ventures                              |       | (.6                             | )          | — |   |
| Changes in  restricted cash                                                |       | (12.1                           | )          | .5 |   |
| Cash provided by  investing activities:                                    |       | 16.3                            |       | .5 |   |
|                                                                       |       |                            |       |   |   |
| Cash flows from  financing activities:                                     |       |                            |       |   |   |
| Special dividend  paid                                                     |       | (135.7                          | )          | — |   |
| Borrowings of  senior secured project revolver                             |       | 9.0                             |       | — |   |
| Borrowings of  senior secured term loan                                    |       | 125.0                           |       | — |   |
| Borrowings of  other project debt                                          |       | 25.0                            |       | 82.4 |   |
| Repayments of  other project debt                                          |       | (25.8                           | )          | (23.6 | ) |
| Proceeds from  exercise of stock options                                   |       | 3.1                             |       | .3 |   |
| Excess tax  benefits from share-based payment arrangements                 |       | 3.6                             |       | — |   |
| Deferred  financing costs                                                  |       | (3.1                            | )          | — |   |
| Minority  interest distributions                                           |       | (.3                             | )          | (.4 | ) |
|                                                                       |       |                            |       |   |   |
| Cash provided by  financing activities                                     |       | .8                              |       | 58.7 |   |
|                                                                       |       |                            |       |   |   |
| Net increase (decrease)  in cash and cash equivalents                      |       | 4.5                             |       | (3.2 | ) |
|                                                                       |       |                            |       |   |   |
| Cash and cash  equivalents - beginning of period                           |       | 7.7                             |       | 9.0 |   |
|                                                                       |       |                            |       |   |   |
| Cash and cash  equivalents - end of period                                 |       | $                               | 12.2       |   | $ | 5.8 |   |
|                                                                       |       |                            |       |   |   |
| Supplemental  disclosures of cash flow information:                        |       |                            |       |   |   |
| Cash paid during the period for income taxes, net of refunds received      |       | $                               | 4.7        |   | $ | .9 |   |

 

See the accompanying notes to consolidated financialstatements.

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CALIFORNIA COASTALCOMMUNITIES, INC.

CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY 

Nine Months EndedSeptember 30, 2006

(in millions)

(unaudited)
| ** **                                                                              | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|-------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                              | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                                                                              | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Retained**   | ** ** | **Comprehensive** | ** ** | ** **      | ** ** |
| ** **                                                                              | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**      | ** ** | **(Loss)**      | ** ** | **Total**  | ** ** |
| ** **                                                                              | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | ** **      | ** ** | ** ** | ** ** |
| Balance—January 1, 2006                                                            |       | 10.2                  |       | $           | .5         |           | $          | 191.6             |       | $               | 56.6       |       | $          | (1.8 | ) | $ | 246.9 |   |
|                                                                                    |       |                  |       |        |       |           |       |              |       |            |       |       |       |
| Issuance of common  stock upon exercise of stock options and related income tax benefit |       | .7                    |       | —      |       | 6.7            |       | —            |       | —          |       | 6.7        |       |
|                                                                                    |       |                  |       |        |       |           |       |              |       |            |       |       |       |
| Stock-based  compensation expense                                                       |       | —                |       | —      |       | .1             |       | —            |       | —          |       | .1         |       |
|                                                                                    |       |                  |       |        |       |           |       |              |       |            |       |       |       |
| Cash dividends paid                                                                     |       | —                |       | —      |       | (135.7         | )          | —            |       | —          |       | (135.7     | )          |
|                                                                                    |       |                  |       |        |       |           |       |              |       |            |       |       |       |
| Net income                                                                              |       | —                |       | —      |       | —         |       | 4.4               |       | —          |       | 4.4        |       |
|                                                                                    |       |                  |       |        |       |           |       |              |       |            |       |       |       |
| Balance–September 30, 2006                                                         |       | 10.9                  |       | $           | .5         |           | $          | 62.7              |       | $               | 61.0       |       | $          | (1.8 | ) | $ | 122.4 |   |

 

See theaccompanying notes to consolidated financial statements.

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CALIFORNIA COASTAL COMMUNITIES, INC.

NOTES TO CONSOLIDATED FINANCIAL 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 that theseunaudited consolidated financial statements reflect all material adjustments(consisting only of normal recurring adjustments) and disclosures necessary forthe fair presentation of the results of operations and statements of financialposition when read in conjunction with the Financial Statements and Notesthereto included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2005 and the current year’s previously issued QuarterlyReports on Form 10-Q. Intercompany accounts and transactions have beeneliminated.  Certain prior year amountshave been reclassified to conform to the current year presentation.

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**

*Consolidation of VariableInterest Entities*

A VariableInterest Entity (“VIE”) is created when (i) the equity investment at risk isnot sufficient to permit the entity to finance its activities withoutadditional subordinated financial support from other parties or (ii) equityholders either (a) lack direct or indirect ability to make decisions about theentity, (b) are not obligated to absorb expected losses of the entity or (c) donot have the right to receive expected residual returns of the entity if theyoccur.  If an entity is deemed to be aVIE, pursuant to Financial Interpretation FIN No. 46, “Consolidation ofVariable Interest Entities – an interpretation of ARB No. 51” (“FIN 46”), anenterprise that has the majority of the variability in gains and losses of theVIE is considered to be the primary beneficiary and must consolidate theVIE.  FIN 46 was effective immediatelyfor VIEs created after January 31, 2003.

Based on theprovisions of FIN 46, the Company has concluded that whenever it options landor lots from an entity and pays a non-refundable deposit, a VIE may be createdunder condition (ii)(b) and (c) of the previous paragraph. The Company may bedeemed to have provided subordinated financial support, which refers tovariable interests that will absorb some or all of an entity’s expectedtheoretical losses if they occur.  Foreach VIE created with a significant nonrefundable option fee, the Company willcompute expected losses and residual returns based on the probability of futurecash flows as outlined in FIN 46.  If theCompany is deemed to be the primary beneficiary of the VIE, the VIE will beconsolidated on the Company’s balance sheet.

The Company’sexposure to loss as the result of a purchase contract with a VIE is limited tothe amount of the non-refundable option deposit, which is generally 5% to 15%of the purchase price, not total assets on the balance sheet of the VIE.  Therefore, the Company believes thatconsolidating the VIE does not reflect the economic realities or risks ofowning and developing land.  The Companyhas no material third party guarantees related to these contracts.  Creditors of these VIEs, if any, have norecourse against the Company.

As of September 30, 2006, the Company has no depositswith VIEs. See Note 7 – Real Estate Matters.

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*RealEstate*

Real estate inventories primarily consists of homes under construction andlots under development and are carried at the lower of cost or fair value lesscosts to sell. The estimation process involved in the determination of fairvalue is inherently uncertain since it requires estimates as to future eventsand market conditions. Such estimation process assumes the Company’s ability tocomplete development and dispose of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions.Economic, market, and environmental 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, theultimate values of the Company’s real estate properties are dependent uponfuture economic and market conditions, and the availability of financing.

The cost of salesof multi-unit projects is generally computed using the relative salesvalue method. Interest and other carrying costs are capitalized to real estateprojects during their development and construction period.

*Impairment of Long-Lived Assets*

The Companyassesses the impairment of real estate inventories and other long-lived assetsin accordance with Statement of Financial Accounting Standards (“SFAS”)No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets”, which requires that an impaired asset, for which costs cannot berecovered from estimated undiscounted future cash flows, be written down tofair value. Long-lived assets are reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. As provided by SFAS No. 144, impairment is evaluated bycomparing an asset’s carrying value to the undiscounted estimated cash flowsexpected from the asset’s operations and eventual disposition. If the sum ofthe undiscounted estimated future cash flows is less than the carrying value ofthe asset, an impairment loss is recognized based on the fair value of theasset. If impairment occurs, the fair value of an asset for purposes ofSFAS No. 144 is deemed to be the amount a willing buyer would pay awilling seller for such asset in a current transaction.

In accordance withSFAS No. 144, in developing estimated future cash flows for impairment testing,the Company has incorporated its own market assumptions including thoseregarding home prices, infrastructure, home-building costs and financing costsregarding real estate inventories. Additionally, as appropriate, the Company identifies alternative coursesof action to recover the carrying value of its long-lived assets and evaluatesall likely alternatives under a probability-weighted approach as described inSFAS No. 144.

*EarningsPer Common Share*

Earnings per common share is accounted for inaccordance with SFAS No. 128, “Earnings Per Share”. Basic earnings per commonshare is computed using the weighted-average number of common sharesoutstanding for the period. Diluted earnings per common share is computed usingthe weighted-average number of common shares outstanding and the dilutiveeffect of potential common shares outstanding. For the three and nine monthsended September 30, 2006 and 2005, the average market price of the Company’scommon stock exceeded the exercise price of outstanding stock options.  Therefore, diluted earnings per shareincludes the dilutive effect of the weighted average number of common sharesfrom the exercise of 12,500 options during the second quarter of 2006, anadditional 679,996 options which were exercised during the third quarter of2006 and the potential exercise of an additional 15,000 options which remainoutstanding.

The table below sets forththe reconciliation of the denominator of the earnings per share calculation (inmillions):
|                                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                 | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                       |       |                             |       |                            |       |   |   |   |   |
| Shares used in  computing basic earnings per common share  |       | 10.5                             |       | 10.2                            |       | 10.3 |   | 10.2 |   |
| Dilutive effect of  stock options                          |       | .2                               |       | .3                              |       | .3 |   | .3 |   |
| Shares used in computing diluted earnings per common share |       | 10.7                             |       | 10.5                            |       | 10.6 |   | 10.5 |   |

 

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*RecentAccounting Pronouncements*

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”).  This Statement replaces SFAS 123, “Accountingfor Stock-Based Compensation” and supersedes Accounting Principles Board (“APB”)Opinion No. 25. “Accounting for Stock Issued to Employees.”  SFAS 123(R) addresses the accounting forshare-based payment transactions in which an enterprise receives employeeservices in exchange for (a) equity instruments of the enterprise or (b) liabilitiesthat are based on the fair value of the enterprise’s equity instruments or thatmay be settled by the issuance of such equity instruments.  SFAS 123(R) eliminates the ability to accountfor share-based compensation transactions using the intrinsic value methodunder APB No. 25, and generally would require instead that such transactions beaccounted for using a fair-value-based method. The Company adopted SFAS 123(R) in the first quarter of 2006 using themodified prospective method, which requires that compensation is recognized onor after the required effective date for the portion of outstanding awards forwhich the requisite service has not yet been rendered, based on the grant-datefair value of those awards calculated under SFAS 123 for either recognition orpro forma disclosures. The Company previously adopted the fair valuerecognition provisions of SFAS 123 in 2003. The adoption of SFAS 123(R) did nothave a material impact on the Company’s consolidated financial position,results of operations, or cash flows.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections” (“SFAS 154”). This statement replaces APBOpinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting AccountingChanges in Interim Financial Statements,” and changes the requirements for theaccounting for and reporting of a change in accounting principle. SFAS 154requires retrospective application of changes in accounting principle to priorperiods’ financial statements unless it is impracticable to determine theperiod-specific effects or the cumulative effect of the change. This statementwas effective beginning in the Company’s first quarter of 2006. The adoption ofSFAS 154 did not have a material impact on the Company’s consolidated financialposition, results of operations, or cash flows.

In June 2005, the Emerging Issues Task Force (“EITF”)reached a final consensus on Issue No. 04-5, “Determining Whether a GeneralPartner, or the General Partners as a Group, Controls a Limited Partnership orSimilar Entity When the Limited Partners Have Certain Rights” (“EITF 04-5”).EITF 04-5 affects the consolidation of entities in which a general partner ormanaging member is presumed to control a partnership or limited liabilitycompany. EITF 04-5 was effective for the Company beginning in the first quarterof 2006. The adoption of EITF 04-5 did not have a material impact on theCompany’s consolidated financial position, results of operations, or cash flowsupon initial adoption. EITF 04-5 may materially impact the Company’sconsolidated financial position, results of operations, or cash flows in futureperiods should the Company form new limited partnerships or modify existinglimited partnerships such that the Company is deemed to control the limited partnership.Under those circumstances, the Company may be required by EITF 04-5 toconsolidate the limited partnership.

In July 2006,the FASB issued FASB Interpretation No. 48  (“FIN 48”),*Accounting for Uncertainty in Income Taxes*,which prescribes a recognition threshold and measurement process for recordingin the financial statements uncertain tax positions taken or expected to betaken in a tax return. Additionally, FIN 48 provides guidance on derecognition,classification, interest and penalties, accounting in interim periods anddisclosure requirements for uncertain tax positions. The accounting provisionsof FIN 48 are effective for reporting periods beginning after December 15,2006.  The Company is currently assessing the impact of the adoption of FIN48 and its impact on the Company’s consolidated financial statements.

In September 2006,the FASB issued SFAS No. 157, “*Fair ValueMeasurements*” (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. SFAS 157 is effectivefor financial statements issued for fiscal periods beginning after November 15,2007 (the Company’s fiscal year beginning January 1, 2008), and interim periodswithin those fiscal years. The company is currently evaluating the impact ofadopting SFAS No. 157 on the consolidated financial statements.

InSeptember 2006, the FASB issued SFAS No. 158, “Employer’s Accountingfor Defined Benefit Pension and Other Postretirement Plans – an amendment ofFASB Statements No. 87, 88, 106 and 132(R).” SFAS No.158 requires anemployer to recognize the overfunded or underfunded status of defined benefitand retiree medical plans as an asset or liability in its statement offinancial position and to recognize through comprehensive income changes in thefunded status in the year in which they occur. SFAS No. 158 is effective forfinancial statements issued for fiscal periods ending after December 15, 2006.The Company is evaluating the adoption of SFAS No. 158 to determine itsmateriality on the consolidated financial statements.

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InSeptember 2006, the Securities and Exchange Commission (“SEC”) issuedStaff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB No. 108”). SAB No. 108 provides guidance on theconsideration of effects of the prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment. SABNo. 108 is effective for the first annual period ending afterNovember 15, 2006. The Company is currently evaluating the impact ofadopting SAB No. 108 on the consolidated financial statements.

**Note 3 –Real Estate Inventories**

Real estateinventories primarily consist of homes under construction and lots underdevelopment at Brightwater and eight additional communities in five SouthernCalifornia counties.  At September 30,2006, real estate inventories aggregated 831 lots and homes, including 17 homescompleted and unsold, and 6 homes completed and in escrow.  $148.2 million of real estate inventories atSeptember 30, 2006 reflects the Brightwater community which is located on a 105-acreparcel on a mesa north of the Bolsa Chica wetlands (“Upper Mesa”) Brightwateris planned for 356 homes as discussed below. In addition, real estateinventories includes approximately 51 acres nearby which have been offered fordedication to the County of Orange for inclusion in the Harriet M. WeiderLinear Park in conjunction with the development of Brightwater, and 51additional acres which are subject to a conservation easement. The Companycapitalizes direct carrying costs including interest and property taxes, aswell as direct construction costs, to real estate inventories.

The Brightwater planned community will offer a broad mix of home choices,averaging 2,860 square feet and ranging in size from 1,720 square feet to 4,170square feet.  The plan also includes 37acres of open space and conservation area. With 349 homes permitted on 68 acres of the Upper Mesa, the resultinglow-density plan equates to approximately five homes per acre, consistent andcompatible with the neighboring Huntington Beach communities.  In addition, the Company owns land adjacentto the planned Brightwater development, on which it intends to process permitsto build seven additional homes which will be included in the Brightwatercommunity. The Company completed grading during October 2006, is preparing to constructinfrastructure (sewer, water, storm drain, streets, utilities, etc.) andexpects to (i) begin building model homes in November of 2006, (ii) startselling homes during mid-2007, and (iii) begin delivering homes by the end of2007.  However, there can be no assurancein that regard, or as to the absence of further development or constructiondelay, particularly if Southern California experiences a rainy winter and ElNino conditions as some weather forecasters are predicting.

 The estimation process involved inthe determination of 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 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.

Capitalizedinterest is allocated to real estate inventories when incurred, and charged tocost of sales when the related property is delivered. Certain informationregarding interest follows (in millions):
|                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                 | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                       |       |                             |       |                            |       |   |   |   |   |
| Capitalized interest,  beginning of period |       | $                                | 6.5        |                            | $          | 3.7 |   | $ | 6.1 |   | $ | 1.3 |   |
| Interest incurred and  capitalized         |       | 1.6                              |       | 1.8                             |       | 3.9 |   | 4.4 |   |
| Charged to cost of  sales                  |       | (.9                              | )          | (.6                             | )          | (2.8 | ) | (.8 | ) |
| Capitalized interest, end of period        |       | $                                | 7.2        |                            | $          | 4.9 |   | $ | 7.2 |   | $ | 4.9 |   |

 

**Note 4 –Senior Secured Project Revolver**

On September 15,2006, the Company entered into a three-year, $100 Million Senior SecuredRevolving Credit Agreement with KeyBank National Association, as a lender andagent for several other lenders (the “Revolving Loan”).

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The Revolving Loan issecured by a first trust deed on the Brightwater project, and stock pledges ofthe Company’s material subsidiaries. The Revolving Loan will fund the first$100 million of construction costs for the project. At the end of the second yearof the term of this facility and each subsequent quarter, the commitment amountwill decrease by $25 million until the commitment under the Revolving Loan isreduced to zero by the final maturity date, September 15, 2009. The RevolvingLoan is also subject to earlier commitment reductions based on 40% of the$600,000 release price on the first 50 units closed at the Brightwater project,and 40% of the $1 million release price per unit thereafter.

Availability underthe $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 sold. The initial borrowing basevalue of the Brightwater project was determined by an independent appraisal ofthe project on an “as-is” basis, which was $302 million as of July 6, 2006.This appraisal reflects substantial value in excess of the book value of $142million as of June 30, 2006 and $148 million as of September 30, 2006. Certainsubsidiaries of the Company provided full unconditional guarantees. TheRevolving Loan includes financial covenants which may limit the amount that maybe borrowed. Outstanding advances bear interest at the Company’s option ateither (i) the Alternate Base rate (“Prime”) minus 25 basis points or (ii)LIBOR plus 200 basis points.

As of September30, 2006, $9.0 million was outstanding under the Revolving Loan. Theundrawn availability was $91.0 million, as limited by the borrowing baseformulas. Interest on the facility is calculated on the average, outstandingdaily balance and is paid monthly. Interest incurred on the Revolving Loan for the three and nine monthsended September 30, 2006 was $22,000, at a weighted-average interest rateof 7.4%.

Initial loan feesand closing costs of approximately $800,000 incurred for the Revolving Loan onSeptember 15, 2006 are included in other assets, and are being amortizedover the life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories when incurred,and charged to cost of sales when the related homes are delivered.

Under theRevolving Loan, the Company is required to comply with a number of covenants,including a leverage covenant and a minimum consolidated tangible net worthcovenant The Company is in compliance with these covenants as ofSeptember 30, 2006.

**Note 5 – Secured Senior Term Loan**

On September 15,2006, the Company entered into a five-year, $125 Million Senior Secured TermLoan Agreement with KeyBank National Association, as a lender and agent forseveral other lenders (the “Term Loan”), and on September 15, 2006, theCompany borrowed the maximum loan amount of $125 million. The proceeds wereused to fund a “special dividend” of $12.50 per share, totaling $135.7 million,to common stockholders paid on September 28, 2006. At the end of the second,third and fourth years of the term of this agreement, the commitment amountwill decrease by $15 million, $25 million, and $35 million, respectively.Thereafter, for each subsequent quarter, the Term Loan commitment amount willdecrease in four equal installments, until the commitment under the agreementis reduced to zero by the final maturity date, September 15, 2011. The TermLoan is also subject to mandatory repayments based on 60% of the $600,000release price on the first 50 units closed at the Brightwater project, and 60%of the $1 million release price per unit thereafter.

Availability underthe Term Loan is subject to the applicable borrowing base loan to valuelimitations. The loan to value limits total lender advances under the Term Loanand the Revolving Loan to 65% of asset value. This is based upon the initialappraised value of the Brightwater project, increased for costs incurredsubsequent to the most recent lender appraisal and reduced by 72% of the salesvalue of homes sold. The Term Loan is secured by a second trust deed on theBrightwater project, and a general pledge and assignment of the Company’sownership interests in all material subsidiaries.  All existing material subsidiaries of theCompany have provided full unconditional guarantees. The Term Loan includesfinancial covenants which may limit the amount that may be outstanding. Theoutstanding balance bears interest at the Company’s option at either (i) theprime interest rate plus 25 basis points, or (ii) LIBOR plus 275 basis points.

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As ofSeptember 30, 2006, $125 million was outstanding under the Term Loan.Interest on the Term Loan is calculated on the average, outstanding dailybalance and is paid monthly. Interest incurred on the Term Loan for the threeand nine months ended September 30, 2006 was $446,000, at aweighted-average interest rate of 8.1%.

Initial loan feesand closing costs of $2.2 million incurred for the Term Loan onSeptember 15, 2006 are included in other assets, and are being amortizedover the life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories when incurred,and charged to cost of sales when the related homes are delivered.

Under the TermLoan, the Company is required to comply with a number of covenants, includingcovenants related to leverage, a minimum ratio of EBITDA to interest, and aminimum consolidated tangible net worth. The Company is in compliance withthese covenants asof and for the period ending September 30, 2006.

Underthe Term Loan agreement, the Company was required to enter into a swapagreement to hedge against risks associated with fluctuating interests ratesrelated to $62.5 million of floating rate debt. On September 15, 2006 theCompany entered into an interest rate swap transaction to effectively fix theinterest rate on $62.5 million in floating rate debt at 8.015% per annum. Theswap transaction terminates in September 2008. Since the Company does not usederivative financial instruments for trading purposes, the swap did not qualifyfor hedge accounting under SFAS No. 133. The fair value of the interest rateswap agreement represents the spread between the interest rate the Company paidand the interest rate the Company would receive over the remaining life of theagreement, however, this was not considered material at September 30, 2006. Thechange in fair value of the interest rate swap agreement during the nine monthsended September 30, 2006 was not material to the Company. The counterparties tothe interest rate swap agreement are financial institutions.

**Note 6 – Other Project Debt**

In conjunction with the acquisition of single-familyresidential lots, the Company’s homebuilding subsidiary, Hearthside Homes, Inc.and its subsidiaries, enter into construction loan agreements with commercialbanks (the “Loan Facilities”).  TheseLoan Facilities finance a portion of the land acquisition and the majority ofthe construction of infrastructure and homes. Each Loan Facility requires a guaranty of project completion and anenvironmental indemnity. The loans secured by first trust deeds bear interestat a rate of prime plus three-fourths percent (9.0 % at September 30, 2006),except for one new loan facility created in September 2006 for the Rancho SantaFe project which bears interest at a rate of prime plus one-half percent (8.75%at September 30, 2006). Some of these Loan Facilities have a minimum interestrate ranging from 5.75% to 7.5%. Additional borrowings under these LoanFacilities totaled $25.0 million during the nine months ended September 30,2006, and consisted primarily of draws on the Rancho Santa Fe, Beaumont andLancaster Loan Facilities and interest on outstanding borrowings. The $25.8million of repayments during the nine months ended September 30, 2006 includedfull repayment of $10.6 million outstanding under the Rancho Santa Fe facilitywhich was due in March 2006, and $15.2 million upon deliveries of homes.  The following amounts were outstanding underthese loan facilities as of September 30, 2006 and December 31, 2005 ($ inmillions):
|                                 | ** ** | ** **           | ** ** | ** **       | ** ** | ** **   | ** ** | **Outstanding at**                                                 | ** ** |
|---------------------------------|------------|----------------------|------------|------------------|------------|--------------|------------|-------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **Amount**           | ** ** | **Number**       | ** ** | **Maturity** | ** ** | **September 30,**                                                  | ** ** | **December 31,** | ** ** |
| **First Trust Deeds** | ** ** | **of Facility** | ** ** | **of Lots** | ** ** | **Date**     | ** ** | **2006**                                                                | ** ** | **2005** | ** ** |
|                            |       |                 |       |             |       |         |       |                                                                    |       |   |   |
| Rancho Santa Fe                 |       | $                    | 15.4       |             | —     |         | —     |                                                                    | $          | — |   | $ | 8.5 |   |
| Lancaster                       |       | 9.5                  |       | —           |       | —       |       | —                                                                  |       | .2 |   |
| Lancaster                       |       | 1.0                  |       | 2                |       | 11/17/06     |       | .6                                                                      |       | 1.0 |   |
| Lancaster                       |       | 10.5                 |       | 7                |       | 11/17/06     |       | .3                                                                      |       | 3.6 |   |
| Rancho Santa Fe                 |       | 1.8                  |       | 1                |       | 12/13/06     |       | .8                                                                      |       | 1.7 |   |
| Corona-Hellman                  |       | 41.1                 |       | 151              |       | 1/7/07       |       | 20.1                                                                    |       | 18.8 |   |
| Rancho Santa Fe                 |       | 10.4                 |       | 11               |       | 2/13/07      |       | 7.9                                                                     |       | — |   |
| Beaumont                        |       | 20.7                 |       | 92               |       | 2/17/07      |       | 12.0                                                                    |       | 7.6 |   |
| Ontario                         |       | 11.7                 |       | 26               |       | 4/19/07      |       | 4.9                                                                     |       | 4.6 |   |
| Corona-Chandler                 |       | 14.8                 |       | 31               |       | 4/26/07      |       | 5.3                                                                     |       | 7.0 |   |
| Corona-Chandler                 |       | 1.9                  |       | 4                |       | 4/26/07      |       | 1.9                                                                     |       | 1.8 |   |
| Lancaster                       |       | 17.7                 |       | 77               |       | 7/1/07       |       | 3.3                                                                     |       | 3.1 |   |
|                            |       |                 |       |             |       |         |       |                                                                    |       |   |   |
|                            |       |                 |       |             |       |         |       | $           57.1 |       | $ | 57.9 |   |
|                                 |            |                      |            |                  |            |              |            |                                                                         |            |  |  |  |  |  |

 

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Discussions are underway with the current lender to extend the $41.1million Hellman Loan Facility which matures in January 2007. Loans on theRancho Santa Fe, Beaumont and Ontario projects which mature in February throughApril 2007 have automatic extensions available for six months. The Companyexpects to repay the Lancaster and Rancho Santa Fe loans which mature in thefourth quarter of 2006 with proceeds from home deliveries and/or cash on hand.

**Note 7 –Other Liabilities**

Other liabilitieswere comprised of the following (in millions):
|                                                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Accrued pensions  and benefits                      |       | $                      | 4.6        |                  | $          | 4.8 |   |
| Home warranty  reserves                             |       | 2.4                    |       | 2.1                   |       |
| Contingent  indemnity and environmental obligations |       | 1.4                    |       | 1.5                   |       |
| Unamortized  discount                               |       | (.5                    | )          | (.5                   | )          |
|                                                |       | $                      | 7.9        |                  | $          | 7.9 |   |

 

Contingentindemnity and environmental obligations primarily reflect reserves beforerelated discount (recorded pursuant to Fresh-Start Reporting) for contingentindemnity obligations for businesses disposed of by former affiliates andunrelated to the Company’s current operations.

*Home Warranty Reserve*

TheCompany provides a home warranty reserve to reflect its contingent obligationfor product liability. The Company generally records a provision as homes aredelivered, based upon historical and industry experience, for the items listedin the homeowner warranty manual, which does not include items that are coveredby manufacturers’ warranties or items that are not installed by the Company’semployees or contractors. The home warranty reserve activity is presented below(in millions):
|                                 | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **September 30,**          | ** ** |
| ** **                      | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                      | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Balance at  beginning of period |       | $                               | 2.1        |   | $ | 1.6 |   |
| Provision                       |       | .5                              |       | .2 |   |
| Payments                        |       | (.2                             | )          | (.3 | ) |
| Balance at end of  period       |       | $                               | 2.4        |   | $ | 1.5 |   |

 

**Note 8 - Income Taxes**

The following is a summary of thetax provision (benefit):
|                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                              | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Current taxes                                           |       | $                      | (.7        | )                     | $          | (.1 | ) | $ | — |   | $ | — |   |
| Deferred taxes                                          |       | 1.6                    |       | 1.5                   |       | 3.1 |   | 1.7 |   |
| Reversal of valuation  allowance on deferred tax assets |       | —                 |       | —                |       | — |   | (4.7 | ) |
| Provision (benefit) for  income taxes                   |       | $                      | .9         |                  | $          | 1.4 |   | $ | 3.1 |   | $ | (3.0 | ) |

 

Deferred tax benefits resulting from reductions in thedeferred tax asset valuation allowance on NOLs are recorded when the Companyconcludes that it is more likely than not that it will utilize additional NOLsto offset future taxable income.  As aresult of the California Coastal Commission’s approval of the Company’sdevelopment plan for the Bolsa Chica Upper Mesa on April 14, 2005, the Companyconcluded that it is more likely than not that it will utilize all of itsdeferred tax assets.  Therefore, duringthe nine months ended September 30, 2005, the Company recorded a

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reversal of valuation allowance on post-reorganization NOLs and otherdeferred tax assets of approximately $4.7 million, which is reflected in thetax benefit.  Pursuant to Fresh StartReporting, also during the nine months ended September 30, 2005, a reversal ofvaluation allowance on federal Pre-reorganization NOLs of approximately $38.5million was reflected by increasing the Company’s additional paid-in capital.

The federal NOLs available as of September 30, 2006were approximately $129 million. The amount of federal NOLs which expire if notutilized is zero for 2006, 2007 and 2008 and $10 million, $49 million, and $70million for 2009, 2010 and thereafter, respectively.

The Internal Revenue Code (the “Code”) generallylimits the availability of NOLs if an ownership change occurs within anythree-year period under Section 382. If the Company were to experience anownership change of more than 50%, the use of all remaining NOLs wouldgenerally be subject to an annual limitation equal to the value of the Company’sequity before the ownership change, multiplied by the long-term tax-exemptrate. The Company estimates that after giving effect to various transactions bystockholders who hold a 5% or greater interest in the Company, it has experienceda three-year cumulative ownership shift of approximately 35% as of October 26,2006.

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 $129 million netoperating loss carryovers (“NOLs”). While the Company remains subject to theInternal Revenue Code’s section 382, which limits the availability of NOLs inthe event of an ownership change, the Company would have five years from thedate of any such ownership change to recognize its built in gains and utilizeits NOLs. With the recent commencement of construction at Brightwater, theCompany believes it will fully utilize its NOLs within the next five years ifan ownership change does occur; however, the Board may reinstitute the 5%ownership limitation if currently unanticipated events so require.

**Note 9 - Commitments and Contingencies**

*RealEstate Matters*

The Company issubject to the usual obligations associated with entering into contracts forthe purchase of land and improved home sites. The purchase of properties underthese contracts is generally contingent upon satisfaction of certainrequirements by the sellers, including obtaining applicable propertyentitlements. The Company also utilizes option contracts with third-party landsellers and financial entities as a method of acquiring land in stagedtakedowns and minimizing the use of funds from other corporate financingsources. These option contracts also help to manage the financial and marketrisk associated with land holdings. Option contracts generally require the paymentof a non-refundable cash deposit of 5% to 15% of the purchase price for theright to acquire lots over a specified period of time (usually one to twoyears) at predetermined prices. The Company has the right at its discretion toterminate its obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility.  As of December 31, 2005, the Company had noland option deposits. As of September 30, 2006, the Company had one $25,000land option deposit. In addition, our unconsolidated Oxnard joint venture hasland deposits (discussed below).

In February 2003,the Company entered into two option contracts to acquire land adjacent to theCity of Oxnard in Ventura County, California aggregating approximately 168acres. The Company is in the process of developing a land plan for the area,which also includes an additional 149 acres owned by other landowners, with theintention of entitling the property for residential development and annexing itinto Oxnard. During October 2003, the Company entered into a limited liabilitycompany joint venture agreement with a major financial partner to pursue theOxnard development opportunity. The Company assigned the land purchase optioncontracts to the Oxnard limited liability company. Hearthside Homes, Inc., theCompany’s homebuilding subsidiary, is the managing member of the Oxnard jointventure, and made an initial contribution of $500,000. The non-managing memberalso made an initial contribution of $500,000 to the joint venture and, as ofDecember 31, 2005, had made an aggregate of $4 million of first tier additionalcontributions. The members have agreed to provide a second tier of additionalcapital contributions of up to $2 million, as necessary, to complete thebusiness plan.  For contributions inexcess of $5 million, the first $500,000 is to be contributed equally by theCompany and the Company’s partner.  Atthe Company’s discretion, the Company could continue to contribute equally tothe next $500,000. Thereafter, the next $1 million is to be contributed equallybetween the members. During the fourth quarter of 2005 and the first ninemonths of 2006, the members each contributed approximately $160,000 and$600,000, respectively, of the additional $2 million.  The Company’s total investment in the

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venture as of September30, 2006 is $1.3 million. The Company expects to make additional aggregatecapital contributions of approximately $800,000 to the joint venture during thenext 12 months, bringing the Company’s total expected investment in the ventureto $2.1 million.

The Company has outstanding performance and suretybonds, for the benefit of city and county jurisdictions, related principally toits obligations for site improvements at various projects.  The Company does not believe that draws uponthese bonds, if any, will have a material effect on the Company’s financialposition, results of operations or cash flows.

*LegalProceedings*

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.

On October 13,2006, the California Department of Toxic Substances Control (“DTSC”) filed acivil complaint against our Hearthside Residential Corp. subsidiary (“HRC”) inthe Federal District Court for the Southern Division of the Central District ofCalifornia.  The DTSC’s complaintrequests that HRC pay for $1,004,000 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 duringSeptember 2005.  HRC’s remediation processwas approved by the DTSC in December 2005 when it issued a final acceptance ofthe remediation work.  The complaint alsoseeks an order for HRC to pay any future costs which may be incurred inconnection with further remediation, together with court costs and attorney’sfees.

Since May 2004, HRC has received invoices from DTSCseeking reimbursement for these costs; however, HRC contends, based upon adviceof counsel, that it is not responsible for such costs because neither HRC norany affiliate ever developed or built the neighboring residential properties,neither HRC nor any affiliate generated the contamination, and thecontamination did not emanate from the 43-acre site HRC remediated and,therefore, it should not be part of the same “site” as the contaminatedresidential properties. Furthermore, HRC has also disputed such charges due tothe fact that DTSC did not present its bill in accordance with the requirementsof the applicable law. The Company’s subsidiary intends to vigorously defenditself in this matter. Therefore, the Company has not accrued for any of DTSC’s$1,004,000 of claims related to these residential 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 – Stockholders’ Equity**

During the threeand nine months ended September 30, 2006, certain directors, officers andemployees exercised options to purchase 679,996 shares, and 689,996 shares,respectively, of the Company’s common stock at a price of $4.50 per share inaccordance with the Company’s 1993 Stock Option/Stock Issuance Plan (“1993 Plan”).In addition, during the nine months ended September 30, 2006, a directorexercised options to purchase 2,500 shares of the Company’s common stock at anaverage price of $27.57 per share in accordance with the Company’s 1993 Plan.These stock option exercises increased cash and additional paid-in capital by$3.1 million.

Stockholdersequity also reflects an income tax benefit of $3.6 million (which was creditedto additional paid-in capital) related to the issuance of common stock uponexercise of stock options during the nine months ended September 30, 2006.

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A special dividendof $12.50 per share, totaling $135.7 million, was paid to the holders of theCompany’s common stock on September 28, 2006. This special dividend reduced additionalpaid-in capital by $135.7 million and was funded primarily by borrowings underthe $125 million Senior Secured Term Loan described in Note 5.

**Note 11 - Stock Plan**

*1993 Stock Option/Stock IssuancePlan*

The 1993 StockOption/Stock Issuance Plan (“1993 Plan”) was approved at the 1994 AnnualMeeting of Stockholders, reserving 7.5 million shares each of Series APreferred Stock and Class A Common Stock for issuance to officers, keyemployees and consultants of the Company and its subsidiaries and the non-employeemembers of the Board of Directors (the “Board”). On April 28, 1997, in connection with the Recapitalization, theCompensation Committee of the Board authorized the grant of stock options for759,984 shares, equivalent at that time to 6% of the Company’s fully dilutedequity, for certain 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.

In 1998, options for 569,988 shares were terminated inconnection with the Company’s sale of its commercial development business andnew options for 295,000 shares were granted. During 1999 through 2004, options aggregating 290,000 shares were issuedto certain officers and directors of the Company and its subsidiaries.  These options have a term of 10 years andvested 50% after one year and the remaining 50% after two years.  During each of the nine months endedSeptember 30, 2006 and the nine months ended September 30, 2005, the Companygranted 7,500 options with a fair value of $70,000 that vest 50% after one yearand 50% after two years, and have a term of 10 years. Pursuant to SFAS123, the Company recorded $54,000 and $21,000 of compensation expense duringthe nine months ended September 30, 2006 and 2005, respectively, which isreflected in additional paid-in capital.

The Company adopted SFAS 123(R) in the first quarter of 2006 using themodified prospective method. Similar to SFAS 123 which the Company adopted in2003, SFAS 123R requires the cost of all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values measured at the grant date, or the date oflater modification, over the requisite service period. For tax purposes, theCompany expects to be entitled to a tax deduction, subject to certainlimitations, based on the fair value of certain equity awards when stockoptions are exercised. SFAS****123R 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 123R and amounts that ultimately will bedeductible for tax purposes are temporary differences as prescribed by SFAS109,*******Accounting for Income Taxes*. The tax effect of compensation deductions for taxpurposes in excess of compensation cost recognized in the financial statements,if any, will be recorded as an increase to additional paid-in capital whenrealized. A deferred tax asset recorded for compensation cost recognized in thefinancial statements that exceeds the amount that is ultimately realized on thetax return, if any, will be charged to income tax expense when the restrictionslapse or stock options are exercised or expire unless the Company has anavailable additional paid-in capital pool (“APIC Pool”), as defined pursuant toSFAS 123R. We are required to assess whether there is an available APIC Poolwhen the stock options are exercised or expire.

SFAS 123R also amends SFAS 95,*Statement of Cash Flows*, torequire companies to change the classification in the statement of cash flowsof any tax benefits realized upon the exercise of stock options or issuance ofnonvested share unit awards in excess of that which is associated with theexpense recognized for financial reporting purposes. These amounts are requiredto be reported as a financing cash inflow rather than as a reduction of incometaxes paid in operating cash flows.

The Company estimates thefair value of its stock option plan using the Black-Scholes option pricingmodel (the “Option Model”).  The Option Model requires the use ofsubjective and complex assumptions, including the option’s expected term andthe estimated future price volatility of the underlying stock, which determinethe fair value of the share-based awards.  The Company’s estimate ofexpected term in 2006 was determined based on the weighted average period oftime that options granted are expected to be outstanding considering currentvesting schedules and the historical exercise patterns of the existing optionplan.  The expected volatility assumption used in the Option Model isbased on historical volatility on traded options on the Company’s stock inaccordance with guidance provided in SFAS 123R and SAB 107.  The risk-freeinterest rate used in the Option Model is based on the yield of U.S. Treasurieswith a maturity closest to the expected term of the Company’s stock options.

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A summary of the status of the Company’s stock optionplan for the nine months ended September 30, 2006 follows:
| ** **                                          | ** ** | **Number of   Options** | ** ** | **Weighted-  Average   Exercise Price** | ** ** | **Weighted-  Average   Remaining   Life** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| Outstanding, January  1, 2006                       |       | 699,996                           |       | $                                                 | 4.89       |                                                |       |   |
| Granted                                             |       | 7,500                             |       | $                                                 | 35.39      |                                                |       |   |
| Exercised                                           |       | (692,496                          | )          | $                                                 | 4.58       |                                                |       |   |
| Outstanding,  September 30, 2006                    |       | 15,000                            |       | $                                                 | 21.88      | (a)                                                 | 9.2 years  |   |
|                                                |       |                              |       |                                              |       |                                                |       |
| Fully vested and  exercisable at September 30, 2006 |       | 1,250                             |       | $                                                 | 24.57      | (a)                                                 | 8.8 years  |   |
| Available for future  grants at September 30, 2006  |       | 367,488                           |       |                                              |       |                                                |       |

 

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(a) Optionsgranted prior to November 2006 adjusted for September 2006 special dividend of$12.50

As of September30, 2006, there were 15,000 options outstanding with a weighted-averageexercise price of $21.88 (ranging from $13.35 to $25.99) and a weighted-averageremaining life of 9.1 years.  In the ninemonths ended September 2006, options for 1,250 shares at $25.85 per share,options for 1,250 shares at $29.29 per share, and options for 689,996 shares at$4.50 per share were exercised for an intrinsic value of $16.8 million.

As ofSeptember 30, 2006, the outstanding stock options and fully vested andexercisable stock options had an aggregate intrinsic value that was notconsidered material to the Company.

Theweighted-average assumptions used for stock option grants in September 30, 2006and 2005 were as follows:
|                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Risk-free  interest rate  |       | 5.0      | %          | 4.1      | %          |
| Expected life  (in years) |       | 4        |       | 4        |       |
| Expected  volatility      |       | 23.0     | %          | 40.0     | %          |
| Expected dividends        |       | None     |       | None     |       |

 

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**ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Overviewof California Coastal Communities, Inc.**

We are aresidential land development and homebuilding company with properties owned orcontrolled in six Southern California counties (Los Angeles, Orange, Riverside,San Bernardino, San Diego and Ventura). Our principal activities include:

·                  obtaining zoningand other entitlements for land we own or control through purchase options orjoint ventures;

·                  improving theland for residential development; and

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

Once ourresidential land is entitled, we may build homes, sell unimproved land to otherdevelopers or homebuilders, sell improved land to homebuilders, or participatein joint ventures with other developers, investors or homebuilders to financeand construct infrastructure and homes. The majority of our homes are designed to appeal to move-up homebuyersand are generally offered for sale in advance of their construction. During thenext 12 months, we will focus our primary efforts to:

·                  completeinfrastructure construction, build model homes, and begin selling productionhomes at the Brightwater project located on the Bolsa Chica mesa in OrangeCounty, California.

·                  complete theentitlement process for a 168-acre joint venture project near Oxnard,California; and

·                  increasedeliveries, revenues and profitability of our homebuilding operationsthroughout Southern California.

However, we mayalso consider other strategic opportunities as discussed below; and there canbe no assurance that we will accomplish, in whole or in part, all or any ofthese strategic goals.

Our total revenuesfor the three months ended September 30, 2006 and 2005 were $24.8 million and$24.4 million, respectively, and $71.5 million and $34.0 million for the ninemonths ended September 30, 2006 and 2005, respectively. For the three monthsended September 30, 2006 and 2005, we delivered 36 and 45 homes, respectively,and for the nine months ended September 30, 2006 and 2005, we delivered 113 and59 homes, respectively. Our total assets as of September 30, 2006 and December31, 2005 were $339.3 million and $330.4 million, respectively. Our homebuildingsubsidiary, Hearthside Homes, Inc., has delivered 2,000 homes to familiesthroughout Southern California since its formation in 1994.

Prior to obtainingthe Coastal Development Permit for our Brightwater project in December 2005, wehistorically maintained a minimal amount of leverage. As a result, we were ableto obtain $225 million of debt financing in September 2006 as described inNotes 4 and 5 to the Consolidated Financial Statements, which provided $125million to fund the special dividend described in Note 10 to the ConsolidatedFinancial Statements. As of September 30, 2006, we had $191.1 million of debtagainst $122.4 million of book equity and a $223.1 million equity marketcapitalization.

We were formed in1988 and our executive offices are located at 6 Executive Circle, Suite 250,Irvine, California 92614. Our telephone number is (949) 250-7700.

**Strategic Alternatives**

Our Board ofDirectors and management have always been and continue to be committed toenhancing value for all stockholders. From time to time we have considered thevarious strategic alternatives available to us with respect to our businesses,assets, operations and available cash. We have engaged investment bankers andother advisors for this purpose, with a view towards assessing alternativeswhich would enhance the value of our current businesses, create additionalbusiness opportunities, or otherwise maximize the value of our company for ourstockholders. Included in this

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process has been anexploration of merger, acquisition and disposition possibilities; analysis ofequity and debt financings; open market and other repurchases of our stock; dividendsand other distributions to our stockholders; and combinations of thesealternatives.

As we continue todevelop Brightwater, we will also continue to evaluate any other availablestrategic alternatives that will maximize value to our stockholders.

**Outlook**

The housing marketin Southern California has slowed considerably during the first nine months of2006.  For the third quarter of 2006, ournet new orders decreased 73% to 17 homes from 63 homes for the third quarter of2005. The decrease in net new orders reflects the industry-wide slowdown and iscomparable to the 62% decrease in the first nine months of 2006 (62 net neworders for the first nine months of 2006 compared with 164 net new orders forthe first nine months of 2005). At the same time, backlog as of quarter enddecreased 72% (31 homes as of September 30, 2006 compared with 112 homes as ofSeptember 30, 2005), while the value of homes in backlog decreased 58% to $22.0million from $51.8 million. Although the homebuilding business historically hasbeen cyclical, it has not undergone an economic down cycle in a number ofyears. Further declines in the prices for new homes could adversely affect bothour revenues and margins.

This slowdownreflects an overall softening of demand for new homes as well as an oversupplyof homes available for sale. We attribute the reduction in demand to reducedaffordability of new homes due to rapid price increases over the last six yearsand declines in consumer confidence related to concerns on the part of prospectivehome buyers about the future direction of home prices, and their ability tosell existing homes. In addition, speculators and investors are no longerhelping to fuel demand. We try to avoid selling homes to speculators and startfew homes without having a signed agreement of sale. However, as of September30, 2006 we had an inventory of 17 completed unsold homes compared to no suchinventory as of September 30, 2005.

In addition, basedon the high cancellation rates reported by other builders, and on the increasedcancellation rates we have experienced, non-speculative buyer cancellations arealso adding to the supply of homes in the marketplace. Our cancellationsincreased to 10 and 27 in the three and nine months, respectively, endedSeptember 30, 2006, compared with nine and 18 in the comparable periods of2005.

We have also beenimpacted by an overall increase in the supply of homes available for sale inour markets as certain large homebuilders continue to build product in excessof current demand and as speculators attempt to sell the homes they previouslypurchased or cancel contracts for homes under construction. At the same time,many of the large national homebuilders operating in our markets are attemptingto reduce their inventories by offering incentives and/or lowering prices,leading to lower gross margins on home sales. We will continue to assess ourowned land position to identify those assets that should be reduced orrepositioned. Additionally, our strategy is to adjust our cost structure totoday’s market conditions by rebidding subcontracts and materials in line withreduced demand, all in an effort to partially offset our declining margins.

Despite thisslowdown, we remain cautiously optimistic about the future growth of ourbusiness. The long-term outlook for homebuilding in Southern California remainsstrong due to the continuing regulation-induced constraints on lot supplies. Wehave traditionally employed a conservative approach to managing our real estateinventories and believe we are well-positioned to withstand the effects of themarket downturn as it unfolds.  We do notpresently expect that current weaknesses in the homebuilding market willsignificantly impact our Brightwater project given the site’s spectacularlocation, the extremely limited supply of new homes on the coast of SouthernCalifornia and the absence of significant competition from other homebuildersin the Huntington Beach market.

There can be noassurance regarding the duration of the current slowdown of the SouthernCalifornia residential real estate market. In particular, (i) the significant increases in home prices over thelast six years and the related decline in the affordability of new homes inSouthern California, (ii) the decline in consumer confidence with respect tothe housing market, (iii)  the state ofthe national economy, recent increases in interest rates by the Federal ReserveBoard and the possibility of a recession in the future, and (iv) the continuedthreat of inflation and potential for further increases in interest rates bythe Federal Reserve Board, collectively may exert recessionary pressures on theCalifornia economy and may have further negative impacts on the SouthernCalifornia housing market.

In response toslower sales, we are offering more incentives and some price reductions, and wehave determined that the construction start for the 73-unit Lancaster IIproject, which has no recorded loan, will be deferred until sales activityimproves.

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**OurHomebuilding Projects**

Wecurrently have on-going Southern California homebuilding projects in:

·                  Orange County inthe Huntington Beach area;

·                  Riverside Countynear the cities of Corona and North Corona, and in the City of Beaumont;

·                  San BernardinoCounty in the City of Ontario;

·                  Northern LosAngeles County in the City of Lancaster; and

·                  San Diego Countyin the Rancho Santa Fe area.

We completedgrading our Brightwater development project during October 2006 and plan toprocess permits for seven homes on adjacent parcels, which would bring thetotal number of homes to 356.  Thefollowing chart describes our current projects, their location and our lotinventories as of September 30, 2006:
| Projects             | ** ** | **Location**                    | ** ** | **Lot  Inventory** | ** ** |
|----------------------|------------|---------------------------------|------------|--------------------|------------|
| Orange County:       |       |                            |       |               |       |
| Brightwater          |       | Bolsa Chica                     |       | 356                |       |
|                 |       |                            |       |               |       |
| San Diego County:    |       |                            |       |               |       |
| Cancion              |       | Rancho Santa Fe                 |       | 12                 |       |
|                 |       |                            |       |               |       |
| Inland Empire:       |       |                            |       |               |       |
| Chandler Ranch       |       | North Corona                    |       | 35                 |       |
| Alisal at  Ontario   |       | Ontario                         |       | 26                 |       |
| Woodhaven            |       | Beaumont                        |       | 92                 |       |
| Hearthside Lane      |       | Corona                          |       | 151                |       |
|                 | * *   | *Subtotal – Inland Empire* |       | 304                |       |
|                 |       |                            |       |               |       |
| Lancaster:           |       |                            |       |               |       |
| Alisal at  Lancaster |       | Lancaster                       |       | 9                  |       |
| Lancaster II         |       | Lancaster                       |       | 73                 |       |
| Quartz Hill          |       | Lancaster                       |       | 77                 |       |
|                 | * *   | *Subtotal – Lancaster*     |       | 159                |       |
|                 |       |                            |       |               |       |
|                 | * *   | *Total – All Projects*     |       | 831                |       |

 

These homebuildingprojects are currently expected to generate cash flows and gross operatingmargins through mid-2010.  Up toapproximately 554 additional single-family lots would be available for homebuildingoperations if we obtain entitlements for our Oxnard project; however, the exactnumber of homes will depend on the final outcome of the entitlement process.

*Brightwater at Bolsa Chica*

The Bolsa Chicaupper mesa is the largest property in our portfolio, representing approximately43% of our total assets as of September 30, 2006. The Bolsa Chica upper mesa isone of the last large undeveloped coastal properties in Southern California,and is located in Orange County, approximately 35 miles south of downtown LosAngeles. Bolsa Chica is bordered on the north and east by residentialdevelopment in the City of Huntington Beach and Huntington Harbor, to the southby open space and the Bolsa Chica wetlands, and to the west by 120 acres ofpublicly-owned open

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space, Pacific CoastHighway, Bolsa Chica State Beach, and the Pacific Ocean. Our holdings include68 acres of developable land on the Bolsa Chica upper mesa planned for aresidential community known as Brightwater, 37 acres of open space andconservation area in the planned community, five acres in the City ofHuntington Beach which are currently zoned agricultural, and approximately 104non-developable acres on, or adjacent to, the Huntington Mesa. Approximately 51acres of land on the Huntington Mesa have been offered for dedication to theCounty of Orange for inclusion in the Harriet M. Weider Linear Park inconjunction with the development of Brightwater and an additional 51 acres aresubject to a conservation easement. We are analyzing development alternativesfor the 5-acre Huntington Beach parcel and expect to submit a proposed siteplan to the City of Huntington Beach during 2007.

On December 15,2005, we received a permit from the California Coastal Commission fordevelopment of the 349-home Brightwater residential community, which will offera broad mix of home choices averaging 2,860 square feet and ranging in sizefrom 1,720 square feet to 4,170 square feet. In addition, we own land adjacentto the planned Brightwater development in the City of Huntington Beach, forwhich we intend to process permits to build seven additional homes which wouldbe included in the Brightwater community. With 356 homes on 68 acres of theupper mesa, the resulting low-density plan equates to approximately five homes peracre, consistent and compatible with the neighboring Huntington Beachcommunities. Between June 27, 2006 and October 31, 2006, over 1,500people registered their interest in buying a home at Brightwater on ourwebsite. We completed grading the Brightwater development during October 2006and we currently expect to:

·                  begin buildingmodel homes during November of 2006, and

·                  start sellinghomes during mid-2007, and

·                  begin deliveringhomes by the end of 2007;

however, there can be noassurance in that regard, or as to the absence of any delays, particularly ifSouthern California experiences a rainy winter and El Niño conditions as someweather forecasters are predicting.

During the firstquarter of 2005, following the Coastal Commission’s approval of our permit todevelop Brightwater, we concluded that it is more likely than not that we willutilize all of our deferred tax assets, including net operating losses, tooffset future taxable income. As a result, we recorded a $4.7 million reversalof valuation allowance on post-reorganization net operating losses and otherdeferred tax assets and a $38.5 million reversal of valuation allowance onfederal pre-reorganization net operating losses. See Note 8 in our ConsolidatedFinancial Statements.

Weused the following facts and assumptions in evaluating the value that we expectto receive from the Brightwater development project:

·                  The Brightwatercoastal development permit provides for 349 homes aggregating approximately995,000 square feet.

·                  We own landadjacent to Brightwater in the City of Huntington Beach, for which we intend toprocess permits to build seven additional homes which would be included in theBrightwater community.

·                  Development atBrightwater is projected to take approximately four to six months forinfrastructure, approximately eight months to build 14 model homes, and two tothree years for home construction.

·                  We are currentlyplanning to: (i) begin building model homes during November of 2006, (ii) beginselling homes during mid-2007, and (iii) begin delivering homes by the end of2007.

·                  Most of theBrightwater homes are currently expected to be delivered in 2008 and 2009.

·                  As of January2006, new home prices approximated $650 per square foot, including view andother premiums, in the local residential market (coastal Huntington Beach).

·                  The finished lotcomponent of home prices ranges from 60% to 65%.

·                  Costs to improvethe lots from their raw condition to finished lots, including building permitsand city fees, approximate $140,000 per lot.

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·      Thedirect costs (excluding indirect costs such as supervision, overhead, sales andmarketing, warranty, insurance, etc) of building homes at Brightwater arecurrently expected to range from $110 to $155 per square foot.

·                  While the supplyof new housing in coastal Orange County is limited, the volume of home saleshas slowed during the first nine months of 2006 and pressure for continuedappreciation of home prices appears to have subsided.

The estimationprocess involved in the determination of value is inherently uncertain becauseit requires estimates as to future events and market conditions. Thisestimation process assumes our ability to complete development and dispositionof our real estate inventories in the ordinary course of business based onmanagement’s present plans and intentions. Economic, market, and environmentalconditions may affect our development and marketing plans. The development ofBrightwater is dependent upon various economic factors. Accordingly, the amountultimately realized from the Brightwater project may differ materially from ourcurrent estimates and the project’s carrying value.

*OxnardLand Development - Unconsolidated Joint Venture*

In February 2003,we entered into two option contracts to acquire land adjacent to the City ofOxnard in Ventura County, California aggregating approximately 168 acres. Weare in the process of developing a land plan for the area, which also includesan additional 149 acres owned by other landowners, with the intention ofentitling the property for residential development and annexing it into Oxnard.We currently expect the residential development plan to include approximately760 single-family detached lots and approximately 630 attached residentialunits (townhomes and condominiums); however, these numbers are subject tochange during the course of the entitlement process. Approximately 554 of thesingle-family lots and approximately 500 of the attached units would bedeveloped on the 168 acres of optioned land that we currently expect topurchase.  The single-family detachedproduct is currently expected to range from approximately 1,880 square feet to3,850 square feet and the attached units are currently expected to range fromapproximately 1,030 square feet to 1,850 square feet. An independent marketstudy as of August 2006, estimated average home prices for the project ofapproximately $665,800, or an average of $311 per square foot. The optioncontracts give us two years, plus up to three additional years through theexercise of extensions, to complete these entitlement activities beforepurchasing the land. We have the right to terminate these option agreements byforfeiting the cash deposits. We are striving to obtain approval of our planfrom the Oxnard City Council in the second quarter of 2007 and approval ofannexation into the City of Oxnard from the Local Agency Formation Commissionin the third quarter of 2007; however, delays could be encountered.  If we complete the entitlement process in thetime frame set forth above, and decide to build homes (rather than sell lots),most of the homes would be delivered between 2010 and 2012, based on currentexpectations and assumptions. We have exercised four six-month extensions, extendingthe current closing date for the option contracts to February 2007, and havetwo remaining six-month extensions through February 2008.

During October2003, we entered into a limited liability company joint venture agreement witha major financial partner to pursue the Oxnard development opportunity. Weassigned the land purchase option contracts to the Oxnard limited liabilitycompany. Hearthside Homes, Inc., our homebuilding subsidiary, is the managingmember of the Oxnard joint venture, and made an initial contribution of$500,000. The non-managing member also made an initial contribution of $500,000to the joint venture and, as of December 31, 2005, had made an aggregate of $4million of first tier additional contributions. The members have agreed toprovide a second tier of additional capital contributions of up to $2 million,as necessary, to complete the business plan. For contributions in excess of $5 million, the first $500,000 is to becontributed equally by us and our partner. At our discretion, we could continue to contribute equally to the next$500,000. Thereafter, the next $1 million is to be contributed equally betweenus. During the fourth quarter of 2005 and the first nine months of 2006, themembers each contributed approximately $160,000 and $600,000, respectively, ofthe additional $2 million.

Our totalinvestment in the venture as of September 30, 2006 is $1.3 million. We expectto make additional aggregate capital contributions of approximately $800,000 tothe joint venture during the next 12 months, bringing our total expectedinvestment in the venture to $2.1 million. After payment of a 10% preferred return on invested capital to us andour partner, the first $8 million of profits are generally allocated 75% to ourpartner and 25% to us, and profits over $8 million and losses over $5 millionare generally allocated on a 50/50 basis. The first $5 million of losses aregenerally allocated 80% to our partner and 20% to us.  While we exert a large degree of influenceover the joint venture, our partner does have various substantive participatingrights such as approval rights with regard to the majority of businessdecisions, including approval of project budgets.

*Homebuilding*

We acquired nosingle-family residential lots during the first nine months of 2006. After homeprices in Southern California increased dramatically over the last few years,we have seen price depreciation in our markets in the first nine

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months of 2006. We have reduced sales prices and offered incentives for anumber of our homes which are not yet in escrow in response to our competitionand to reflect current market pricing. We delivered 36 homes during the thirdquarter of 2006, compared to 45 deliveries during the comparable period in2005.

Our homebuilding projects are described below:

|                      | ** ** | ** **      | ** ** | ** **      | ** ** | ** **         | ** ** | ** **    | ** ** | **Deliveries**                                   | ** ** |
|----------------------|------------|-----------------|------------|-----------------|------------|--------------------|------------|---------------|------------|--------------------------------------------------|------------|
| ** **           | ** ** | ** **      | ** ** | **Land**        | ** ** | **Commenced**      | ** ** | **Commenced** | ** ** | **Quarter Ended   September 30,** | ** ** |
| ** **           | ** ** | **Location**    | ** ** | **Acquisition** | ** ** | **Construction**   | ** ** | **Sales**     | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                 |       |            |       |            |       |               |       |          |       |                                             |       |   |   |
| Completed  Projects  |       | Various         |       | n/a             |       | n/a                |       | n/a           |       | —                                           |       | 32 |   |
|                 |       |            |       |            |       |               |       |          |       |                                             |       |   |   |
| Active Projects      |       |            |       |            |       |               |       |          |       |                                             |       |   |   |
| Brightwater          |       | Bolsa Chica     |       | 1970            |       | 2006               |       | 2007          | (a)        | —                                           |       | — |   |
| Cancion              |       | Rancho Santa Fe |       | 2003-2005       |       | 2005               |       | 2005          |       | 8                                                |       | — |   |
| Chandler  Ranch      |       | North Corona    |       | 2004            |       | 2005               |       | 2005          |       | 4                                                |       | — |   |
| Alisal  at Ontario   |       | Ontario         |       | 2005            |       | 2005               |       | 2006          |       | —                                           |       | — |   |
| Woodhaven            |       | Beaumont        |       | 2005            |       | 2005               |       | 2006          |       | 10                                               |       | — |   |
| Hearthside  Lane     |       | Corona          |       | 2005            |       | 2005               |       | 2007          | (a)        | —                                           |       | — |   |
| Alisal  at Lancaster |       | Lancaster       |       | 2004            |       | 2004               |       | 2005          |       | 14                                               |       | 13 |   |
| Lancaster  II        |       | Lancaster       |       | 2005            |       | 2007               | (a)        | 2007          | (a)        | —                                           |       | — |   |
| Quartz  Hill         |       | Lancaster       |       | 2005            |       | 2006               |       | 2006          |       | —                                           |       | — |   |
|                 | * *   | * *        |       |            |       | *Total Deliveries* |       | 36            |       | 45                                               |       |

 

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(a) Pending

*Rancho Santa Fe.*  In October 2003, we entered into an agreementto acquire 32 lots in a luxury golf community known as Crosby Estates in theRancho Santa Fe area of San Diego County in California. We acquired the lotsduring the period from October 2003 to March 2005.  During 2005, two model homes averagingapproximately 3,370 square feet were completed and six homes were delivered atan average price of $1,223,000.  Wedelivered 14 homes during the first nine months of 2006 at an average price of$1,409,000. During October 2006, two additional homes were delivered at an averageprice of $1,427,000. As of October 31, 2006, five homes are in escrow at anaverage price of $1,411,000, and five additional homes are under constructionand held for sale.

*Lancaster.*   We acquired 104 lots in the City ofLancaster in northern Los Angeles County during May 2004. We began constructionof model homes averaging approximately 2,850 square feet during the thirdquarter of 2004 and opened for home sales in January 2005.  During 2005, we delivered 55 homes at anaverage price of $406,000. We delivered 40 homes during the first nine monthsof 2006 at an average price of $447,000, and, as of October 31, 2006, fivehomes are in escrow at an average price of $473,000, and four homes arecompleted models or are under construction and held for sale. In April 2005, weacquired an additional 73 unentitled lots in Lancaster. We are completing theentitlement process and plans for the project and expect to begin constructionduring 2007; however, we have determined that the construction start for the73-unit project, which has no recorded loan, will be deferred if sales activityin the market has not improved.

In December 2005, we acquired 77 additional lots in an area known asQuartz Hill in the City of Lancaster. The homes in this community will be on10,000 square foot lots and will average 3,640 square feet. Construction ofmodels began in May 2006 and we opened for sales during July 2006. As ofOctober 31, 2006, four model homes are completed and 13 production homes areunder construction. Of the 13 homes that have been released for sale, two homesare in escrow at an average price of $552,000.

*Corona.*  We acquired 83 lots in North Corona in May2004. 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 48 homes during the first nine monthsof 2006 at an average price of $607,000 and delivered four additional homes inOctober. As of October 31, 2006, six homes are in escrow at an average price of$597,000, and 14 homes are completed and held for sale.

During April 2005, we acquired 151 lots in Corona.  Following construction of infrastructure,construction of homes averaging 3,600 square feet on lots of approximately7,200 square feet is expected to begin during the first quarter of 2007.

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*Ontario.*  During April 2005, we acquired 26 lots in theCity of Ontario in Riverside County, California. This small community of homes,planned to average 3,380 square feet, is an infill site situated very close tothe projects we recently completed in the City of Chino. Construction beganduring the fourth quarter of 2005, and we opened for sales during March 2006.As of October 31, 2006, four homes are in escrow at an average price of$690,000, and nine additional homes are under construction and have beenreleased for sale.

*Beaumont*. Weacquired 102 lots in the City of Beaumont during the third quarter of 2005.Following construction of infrastructure, construction of homes averaging 2,500square feet began during the first quarter of 2006, and sales commenced duringMarch 2006. We delivered 10 homes during the nine months ended September 2006at an average price of $393,000 and delivered one additional home in October.As of October 31, 2006, seven homes are in escrow at an average price of$414,000 and 15 additional homes are completed or under construction and havebeen released for sale.

**Special Dividend and Financing Transactions**

On September 15, 2006 we entered into financing transactions with KeyBankand other lenders that provided us with th**e** $125 millionTerm Loan and the $100 million Revolving Loan described in Notes 4 and 5 to theConsolidated Financial Statements set forth above.  The Term Loan was used to pay a $12.50 pershare special dividend, totaling $135.7 million, to our stockholders, As of September30, 2006, $9 million of the $100 million Revolving Loan was outstanding and hadbeen drawn to fund construction of our Brightwater project. Under the Term Loanagreement, we were required to enter into a swap agreement to hedge againstrisks associated with fluctuating interests rates related to $62.5 million offloating rate debt. On September 15, 2006 we entered into an interest rate swaptransaction to effectively fix the interest rate on $62.5 million in floatingrate debt at 8.015% per annum. The swap transaction terminates in September2008. Since we do not use derivative financial instruments for tradingpurposes, the swap did not qualify for hedge accounting under SFAS No. 133. Thefair value of the interest rate swap agreement represents the spread betweenthe interest rate we paid and the interest rate we would receive over theremaining life of the agreement, however, this was not considered material atSeptember 30, 2006. The change in fair value of the interest rate swapagreement during the nine months ended September 30, 2006 was not material tous. The counterparties to the interest rate swap agreement are financialinstitutions.

The tax characterization of dividends depends upon the availability of a company’searnings and profits, as defined by the Internal Revenue Code, first for thecurrent year and then on an accumulated basis. If the distribution isdetermined to be out of earnings and profits, it is characterized as an ordinarydividend. If current and accumulated earnings and profits are negative, thedistribution is characterized as a non-dividend distribution. The results of adetailed earnings and profits study indicated that we had negative accumulatedearnings and profits and we expect to have no earnings and profits for 2006.Therefore, the special dividend should be characterized as a non-dividenddistribution when reported on IRS Form 1099. We will provide this informationregarding the distribution to various tax reporting services for use inpreparing the IRS Form 1099 to stockholders to report the special dividendreceived from us in 2006. Stockholders should consult their tax advisors fordetails as to what impact the tax treatment of this distribution will have intheir individual tax situations.

**Critical Accounting Policies**

In the preparationof the Consolidated Financial Statements, we applied accounting principlesgenerally accepted in the United States of America. The application ofgenerally accepted accounting principles may require management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying results. Listed below are those policies andestimates that we believe are critical and require the use of complex judgmentin their application. In particular, our critical accounting policies andestimates include the evaluation of the impairment of long-lived assets and theevaluation of the probability of being able to realize the future benefitsindicated by our significant federal tax net operating losses, as discussedfurther in Notes 2 and 6 to the Consolidated Financial Statements.

*Impairmentof Long-Lived Assets*

We assess theimpairment of real estate inventories and other long-lived assets in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” which requires that animpaired asset, for which costs cannot be recovered from estimated undiscountedfuture cash flows, be written down to fair value. Long-lived assets arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. As provided bySFAS No. 144, 

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impairment is evaluatedby comparing an asset’s carrying value to the undiscounted estimated cash flowsexpected from the asset’s operations and eventual disposition. If the sum ofthe undiscounted estimated future cash flows is less than the carrying value ofthe asset, an impairment loss is recognized based on the fair value of theasset. If impairment occurs, the fair value of an asset for purposes of SFASNo. 144 is deemed to be the amount a willing buyer would pay a willing sellerfor such asset in a current transaction. These assets are carried at cost, unlessthe carrying amount of the parcel or subdivision is determined not to be fullyrecoverable, in which case the impaired real estate is written down to fairvalue. Given the significance of the carrying value of real estate inventories,the application of SFAS No. 144 in evaluating any potential impairment iscritical to our consolidated financial statements, as discussed further in Note2 to the Consolidated Financial Statements.

The Bolsa Chicaproperty is our largest asset. Prior to the December 2005 receipt of ourBrightwater permit, the property was included in land held for futuredevelopment or sale. In December 2005, we sold approximately 146 acres of theproperty to the State of California. Beginning in December 2005, the remainingportion consisting of approximately 214 acres is included in real estateinventories.

In accordance withSFAS No. 144, in developing estimated future cash flows for impairment testing,we incorporated our own market assumptions including those regarding homeprices, infrastructure, home-building costs, and financing costs regarding realestate inventories.  Additionally, asappropriate, we identify alternative courses of action to recover the carryingvalue of our long-lived assets and evaluate all likely alternatives under aprobability-weighted approach as described in SFAS No. 144.

The estimationprocess involved in the determination of value is inherently uncertain becauseit requires estimates as to future events and market conditions. Suchestimation process assumes our ability to complete development and dispositionof our real estate properties in the ordinary course of business based onmanagement’s present plans and intentions. Economic, market, and environmentalconditions may affect management’s development and marketing plans. Inaddition, the implementation of such development and marketing plans could beaffected by the availability of future financing for development andconstruction activities. The development of our Brightwater project isdependent upon various economic factors. Accordingly, the amount ultimatelyrealized from such project may differ materially from current estimates and theproject’s carrying value.

*Basis ofConsolidation*

Certain of ourwholly-owned subsidiaries are members in joint ventures involved in thedevelopment and sale of residential projects and residential loan production.Our consolidated statements include our accounts and all of our majority-ownedand controlled subsidiaries and joint ventures. The financial statements of jointventures in which we generally have a controlling or majority economic interest(and thus are controlled by us) are consolidated with our financial statements.Minority interest represents the equity interest of our joint venture partnerfor one consolidated venture. Our investments in unconsolidated joint venturesare accounted for using the equity method when we do not have voting oreconomic control of the venture operations.

*IncomeTaxes*

We account forincome taxes on the liability method. Deferred income taxes are determinedbased on the difference between the financial statement and tax bases of assetsand liabilities. The liability method requires an evaluation of the probabilityof being able to realize the future benefits indicated by deferred tax assets,such as tax net operating losses. A valuation allowance related to the deferredtax asset is recorded when it is more likely than not that some portion or allof the deferred tax asset will not be realized. Given the significance of ourhistorical federal tax net operating losses, as discussed in Note 6 to theConsolidated Financial Statements, the application of our policy in evaluatingthe expected future benefit of net operating losses is critical. In applyingthose policies, estimates and judgments affect the amounts at which certainassets and liabilities are recorded. We apply our accounting policies on aconsistent basis. As circumstances change, they are considered in our estimatesand judgments, and future changes in circumstances could result in changes inamounts at which assets and liabilities are recorded.

We remain subject to the general rules of Section382, which limit the availability of net operating losses if an ownershipchange occurs. If we were to experience another ownership change, the amount ofnet operating losses available would generally be limited to an annual amountequal to (i) the value of our equity immediately before the ownership change,multiplied by the long-term tax-exempt rate (4.52% as of October 2006) plus (ii)recognized built-in-gains, defined as those gains recognized within five yearsof the ownership change subject to an overall limitation of the net unrealizedbuilt-in gains

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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 October 26, 2006, we haveexperienced a three-year cumulative ownership shift of approximately 35%, ascomputed 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 $129 million netoperating loss carryovers (“NOLs”). While the Company remains subject to theInternal Revenue Code’s section 382, which limits the availability of NOLs inthe event of an ownership change, the Company would have five years from thedate of any such ownership change to recognize its built in gains and utilizeits NOLs. With the recent commencement of construction at Brightwater, theCompany believes it will fully utilize its NOLs within the next five years ifan ownership change does occur; however, the Board may reinstitute the 5%ownership limitation if currently unanticipated events so require.

*Homebuilding Revenues and Cost of Sales*

Our homebuilding operation generates revenues from the sale of homes tohomebuyers. The majority of these homes are designed to appeal to move-uphomebuyers and the homes are generally offered for sale in advance of theirconstruction. Sales contracts are usually subject to certain contingencies suchas the buyer’s ability to qualify for financing. Revenue from the sale of homesis recognized at closing when title passes to the buyer, and the earningsprocess is complete. As a result, our revenue recognition process does notinvolve significant judgments or estimates. However, we do rely on certainprojections and estimates to determine the related construction costs andresulting gross margins associated with revenues recognized. The cost of salesis recorded based upon total estimated costs within a subdivision and allocatedusing the relative sales value method. Our construction costs are comprised ofdirect and allocated costs, including estimated costs for future warranties andindemnities. Our estimates are based on historical results, adjusted forcurrent factors.

*Litigation Reserves*

We and certain ofour subsidiaries have been named as defendants in various cases arising in thenormal course of business and regarding assets and businesses disposed of by usor our former affiliates. See Notes 7 and 9 to the Consolidated FinancialStatements. 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 accountingpronouncements in Note 2 to the Consolidated Financial Statements.

**Resultsof Operations**

*ThreeMonths Ended September 30, 2006 Compared with the Three Months Ended September30, 2005*

We reported revenues of $24.8 million and grossoperating profit of $3.4 million for the third quarter of 2006, compared with $24.4million in revenues and gross operating profit of $4.9 million for the sameperiod of 2005. Revenues in the current period reflect deliveries of 36 homes,including 14 homes at the Alisal project in Lancaster, ten homes at theWoodhaven project in Beaumont, four homes at the Chandler Ranch project inNorth Corona and eight homes at the Rancho Santa Fe project.  The comparable period of the prior yearreflects deliveries of 45 homes, including 11 homes at the Jasper Ranch projectin Riverside, 13 homes at the Alisal project in Lancaster and 21 homes at theChino projects. The current quarter’s gross margin of 13.7% is significantlylower than the prior period gross margin of 20.1% due to the lowerprofitability of the Beaumont and North Corona homes delivered during thecurrent quarter as compared with the Riverside and Chino homes delivered duringthe comparable period of the prior year. Revenue per home increased by$147,000, reflecting the higher price level of homes in Rancho Santa Fecompared with homes in the Lancaster and Inland Empire projects in 2005. Thedecline in gross margin percentage reflects the recent slowdown in the SouthernCalifornia housing market and significantly lower levels of price appreciationsince acquisition of the land underlying the homes delivered during the threemonths ended September 30, 2006.

The $100,000 increase in selling, general andadministrative expenses during the third quarter of 2006, as compared with thethird quarter of 2005, primarily reflects an increase in selling expenses.

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The $500,000 increase in other income during the thirdquarter of 2006 compared with the third quarter of 2005 primarily reflectsinterest income on short-term investments during the 2006 period.

*Nine Months Ended September 30, 2006 Compared withNine Months Ended September 30, 2005*

We reported revenues of $71.5 million and grossoperating profit of $11.3 million for the first nine months of 2006 comparedwith $34.0 million in revenues and gross operating profit of $7.5 million forthe first nine months of 2005.  Ourrevenues during the current nine-month period were significantly higher thanthe prior nine-month period due to the higher number of homes delivered, whilethe average revenue per home increased by $57,000 to $633,000.  Revenues in the first nine months of 2006reflect deliveries of 113 homes, including 48 homes at our North Coronaproject, 40 homes at the Lancaster project, 14 homes at our Rancho Santa Feproject, 10 homes at our Beaumont (Woodhaven) project, and one home at theRiverside (Jasper Ranch) project.  Thecomparable period of the prior year reflects an aggregate of 59 homesdelivered, including 25 homes at the Chino project, 21 homes at the JasperRanch project and 13 homes at the Lancaster project.  The increase in revenue per home reflects thehigher price level of homes in Rancho Santa Fe compared with homes in theLancaster and Inland Empire projects in 2005. The homebuilding gross margin of15.8% for the first nine months of 2006 is significantly lower than the priorperiod gross margin of 22.1% and the average per unit gross margin decreased by$27,000 to $100,000.  The decline ingross margin percentage reflects the recent slowdown in the Southern Californiahousing market and significantly lower levels of price appreciation sinceacquisition of the land underlying the homes delivered during the nine monthsended September 30, 2006.

The $1.3 million increase inselling, general and administrative expenses during the first nine months of2006 compared with the first nine months of 2005 primarily reflects a $768,000increase in the accrual for incentive-formula bonuses related to the increasedprofitability of our homebuilding business, and an approximately $200,000increase in legal and professional fees related to our analysis of strategicalternatives.

The $1.3 million increase in otherincome during the nine months ended September 30, 2006 as compared with thesame period last year primarily reflects increased interest income onshort-term investments during the 2006 period.

During the quarter ended March 31,2005, we recorded reversals of valuation allowances on post-Reorganization NOLsof $4.7 million following the Coastal Commission’s approval of the developmentplan for 349 homes on the Upper Mesa (see Note 6 to the Consolidated FinancialStatements), which is reflected in Results of Operations for the nine monthsended September 30, 2005.

*PaymentsUnder Contractual Obligations*

We have entered into certain contractual obligationsto make future payments for items such as loans, project debt, lease agreementsand liability insurance.  A summary ofthe payments due under specified contractual obligations, aggregated bycategory of contractual obligation, for specified time periods is presentedbelow as of September 30, 2006 (in millions):
|                            | ** ** | **Payments due by period** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | ** **                                | ** ** | **Less** | ** ** | ** ** | ** ** | ** ** | ** ** | **More** | ** ** |
| ** **                 | ** ** | ** **                                | ** ** | **than 1** | ** ** | **1-3** | ** ** | **4-5** | ** ** | **than 5** | ** ** |
| ** **                 | ** ** | **Total**                                 | ** ** | **year** | ** ** | **years** | ** ** | **years** | ** ** | **years** | ** ** |
| Revolving Loan             |       | $                                         | 9.0        |   | $ | — |   | $ | 9.0 |   | $ | — |   | $ | — |   |
| Term Loan                  |       | 125.0                                     |       | — |   | 40.0 |   | 85.0 |   | — |   |
| Other project debt         |       | 57.1                                      |       | 57.1 |   | — |   | — |   | — |   |
| Operating leases           |       | .1                                        |       | .1 |   | — |   | — |   | — |   |
| Insurance premium  payable |       | 2.8                                       |       | 2.8 |   | — |   | — |   | — |   |
| Total                      |       | $                                         | 194.0      |   | $ | 60.0 |   | $ | 49.0 |   | $ | 85.0 |   | $ | — |   |

 

Our purchase contracts which are made in the normalcourse of our homebuilding business for land acquisition and constructionsubcontracts are generally cancelable at will. Other contractual obligationsincluding our tax liabilities, accrued benefit liability for a frozenretirement plan and other accrued pensions, home warranty reserves and contingentindemnity and environmental obligations are estimated based on various factors.Payments are not due as of a given date, but rather are dependent upon theincurrence of professional services, the lives of annuitants and other factors.

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The estimation process involved in the determination of carrying valuesof these obligations is inherently uncertain since it requires estimates as tofuture events and contingencies. We have provided additional disclosure in Item1. “Legal Proceedings” and in Note 7 to our Consolidated Financial Statements.

**Liquidity and Capital Resources**

Year-over-year changes in the principal components of our liquidity andcapital resources are as follows (in millions, except percentages):
|                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Cash and cash  equivalents             |       | $                                                   | 12.2       |   | $ | 5.8 |   |
| Short-term investments                 |       | 1.3                                                 |       | — |   |
| Cash used in operating  activities     |       | (12.6                                               | )          | (62.4 | ) |
| Cash provided by  investing activities |       | 16.3                                                |       | .5 |   |
| Cash provided by financing activities  |       | .8                                                  |       | 58.7 |   |
|                                        |            |                                                     |            |  |  |  |  |

 

The principal assets in our portfolio are residential land which must beheld over an extended period of time in order to be developed to a conditionthat, in management’s opinion, will ultimately maximize our return.Consequently, we require significant capital to finance our real estatedevelopment and homebuilding operations. Historically, sources of capital haveincluded loan facilities secured by specific projects, asset sales andavailable internal funds. On September 15, 2006 we obtained the $100 millionRevolving Loan as a construction facility to finance infrastructure andhomebuilding activities at Brightwater as further described in Note 4 to theConsolidated Financial Statements. Our unrestricted cash and cash equivalentsplus short-term investments as of September 30, 2006 aggregated $13.5million.  For the year to date period, wehave primarily utilized internally generated cash to fund new construction atour homebuilding projects in order to reduce the negative arbitrage between interestcosts on project debt compared with interest income earned on short-terminvestments.

We have substantial borrowing capacity available. As of September 30,2006, based on construction in place, the immediately available borrowingcapacity on our construction loan facilities is approximately $2 million forBrightwater and $15 million for other projects, and additional facilityavailability for future construction costs is $89 million for Brightwater andapproximately $41 million for other projects. Discussions are underway with thecurrent lender to extend the $41.1 million Corona-Hellman project facilitywhich matures in January 2007. Loans on the Rancho Santa Fe, Beaumont  and Ontario projects which mature in February throughApril 2007 have automatic extensions available for six months, see Note 6 tothe Consolidated Financial Statements.

Our current and pending homebuilding projects (excluding Brightwater),which are primarily in the “Inland Empire” area of Southern California(Riverside and San Bernardino counties) and Lancaster in northeastern LosAngeles County, are currently expected to generate approximately $80 million ofpositive cash flows over the next three years, based on present economicconditions and market assumptions. However, any adverse change in suchconditions or assumptions would adversely impact the amount of our cash flows.

We are utilizing internally generated cash, and joint venturecontributions, to fund the Oxnard land development project. We currently expectto make aggregate additional capital contributions of approximately $800,000 tothe Oxnard joint venture during the next 12 months, bringing our total expectedinvestment in the project to $2.1 million.

We believe that our cash and cash equivalents, short-term investments,future real estate sales proceeds, and funds available under our current andfuture credit agreements will be sufficient to meet anticipated operating andcapital investment requirements, and project development costs for homebuildingprojects, the Oxnard land development projects, and general and administrativeexpenses, for at least the next 12 months.

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We are subject to the usual obligations associated with entering intocontracts for the purchase of land and improved homesites. The purchase ofproperties under these contracts is generally contingent upon satisfaction ofcertain requirements by the sellers, including obtaining applicable propertyentitlements. We also utilize option contracts with third-party land sellersand financial entities as a method of acquiring land in staged takedowns andminimizing the use of funds from other corporate financing sources. Theseoption contracts also help to manage the financial and market risk associatedwith land holdings. Purchase and option contracts generally require the paymentof a non-refundable cash deposit of 5% to 15% of the purchase price for theright to acquire lots over a specified period of time (usually one to twoyears) at predetermined prices. We have the right at our discretion toterminate our obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility. As ofSeptember 30, 2006, we have one consolidated land option deposit for $25,000which is non-refundable. In addition, our unconsolidated Oxnard joint venturehas land deposits.

We may enter into land development and homebuilding joint ventures fromtime to time as a means of expanding our market opportunities, establishingstrategic alliances, managing our risk profile and leveraging our capital base.These joint ventures may obtain secured acquisition, development andconstruction financing, which minimize the use of funds from other corporatefinancing sources.

*September30, 2006 Compared with December 31, 2005*

Cash used in homebuilding operations of $12.6 millionfor the first nine months of 2006 primarily reflects net real estate salesproceeds of $71.0 million from deliveries of 113 homes, offset by uses of cashfor investments in real estate inventories and construction costs of $76.5million. The most significant use of cash was payment of the special dividendof $135.7 million as described in Note 10 to the Consolidated FinancialStatements. The primary sources of cash during the period were borrowings fromour Senior Secured Term Loan of $125.0 million, as described in Note 5 to theConsolidated Financial Statements, Senior Secured Project Revolver debt of $9.0million, as described in Note 4 to the Consolidated Financial Statements, andnet sales of short-term investments of $29.0 million. These items, as well asother activity presented in the Statements of Cash Flows, resulted in a $4.5million increase in cash and cash equivalents.

The $500,000 increase in deferred tax assets primarilyreflects the net impact of increased net operating losses generated by taxdeductions related to stock options exercised.

The $124.5 million decrease in stockholders’ equityprimarily reflects the special dividend of $135.7 million, offset by net incomeof $4.4 million and the issuance of stock upon exercise of stock options andrelated income tax benefit of $6.7 million, as described in Note 10 to theConsolidated Financial Statements.

The $4.0 million increase in other assets primarilyreflects $3.1 million of deferred financing costs related to the Senior SecuredTerm Loan and Senior Secured Project Revolver, along with approximately$600,000 in contributions to the Oxnard joint venture.

On September 15,2006, we entered into the $100 million Revolving Loan and the $125 million TermLoan with KeyBank National Association, as a lender and agent for several otherlenders. These loans are described in greater detail in Notes 4 and 5 to theConsolidated Financial Statements set forth above.

The Revolving Loanwill fund the first $100 million of construction costs for the Brightwaterproject. Availability under the $100 million Revolving Loan is subject to theapplicable borrowing base limitations and includes financial covenants whichmay limit the amount that may be borrowed. Outstanding advances bear interestat our option at either (i) the Alternate Base rate (“Prime”) minus 25 basispoints or (ii) LIBOR plus 200 basis points.

OnSeptember 15, 2006, we borrowed the maximum Term Loan amount of $125million.  The Term Loan proceeds wereused to fund a “special dividend” of $12.50 per share, totaling $135.7 million,to common stockholders paid on September 28, 2006. Availability under the TermLoan is subject to the applicable borrowing base loan to value limitations andincludes financial covenants which may limit the amount that may beoutstanding. The outstanding balance bears interest at our option at either (i)the prime interest rate plus 25 basis points, or (ii) LIBOR plus 275 basispoints.

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**Off Balance Sheet Financing**

In the ordinarycourse of business, we enter into land option contracts in order to procureland for the construction of homes. The use of such option agreements allows usto reduce the risks associated with land ownership and development; reduce ourfinancial commitments, including interest and other carrying costs; andminimize land inventories. Under such land option contracts, we will fund aspecified option deposit or earnest money deposit in consideration for theright to purchase land in the future, usually at a predeterminedprice.  Our liability is generally limited to forfeiture of thenonrefundable deposits, letters of credit and other nonrefundable amountsincurred. As of September 30, 2006, we have one consolidated land optiondeposit of $25,000 and no material third party guarantees.

Wealso acquire land and conduct residential construction activities throughparticipation in joint ventures in which we hold less than a controllinginterest. Through joint ventures, we reduce and share our risk and also reducethe amount invested in land, while increasing our access to potential futurehome sites. The use of joint ventures also, in some instances, enables us toacquire land which we might not otherwise obtain or access on as favorableterms, without the participation of a strategic partner. While we view the useof unconsolidated joint ventures as beneficial to our homebuilding activities,we do not view them as essential to those activities.

Ourinvestment in unconsolidated joint ventures totaled $1.3 million and $700,000at September 30, 2006 and December 31, 2005, respectively. These joint ventureshad total assets of $8.1 million and $5.8 million as of September 30, 2006 andDecember 31, 2005, respectively, which included land deposits of $2.1 millionand $1.6 million, respectively. In certain instances, we may provide varyinglevels of guarantees on debt of unconsolidated joint ventures. As of September30, 2006, we provided no guarantees on debt of unconsolidated joint ventures.

Underthe requirements of FASB Interpretation No. 46(R), “Consolidation ofVariable Interest Entities” (“FASB Interpretation No. 46(R)”), certain of ourland option contracts may create a variable interest for us, with the landseller being identified as a VIE.  Incompliance with FASB Interpretation No. 46(R), we analyze our land optioncontracts and other contractual arrangements and consider whether we shouldconsolidate the fair value of certain VIEs from which we are purchasing landunder option contracts. At September 30, 2006, we had no deposits with VIEs.

**ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

We utilize variable rate debt financing for acquisition, development andconstruction of homes. The interest rates on our debt approximates the currentrates available for secured real estate financing with similar terms andmaturities, and as a result, their carrying amounts approximate fair value.While changes in interest rates generally do not impact the fair market valueof the debt instrument, they do affect our earnings and cash flows. Holding ourvariable rate debt balance constant as of September 30, 2006, each one pointpercentage increase in interest rates would result in an increase in variablerate interest incurred for the next 12 months of approximately $1.9 million.

We are exposed tomarket risks related to fluctuations in interest rates on our outstandingvariable rate debt. Other than an interest rate swap used to manage ourexposure to changes in interest rates on our variable rate-based Term Loan, wedid not utilize swaps, forward or option contracts on interest rates, or othertypes of derivative financial instruments as of or during the nine months endedSeptember 30, 2006. We do not enter into or hold derivatives for trading orspeculative purposes.

Under the TermLoan agreement, we were required to enter into a swap agreement to hedgeagainst risks associated with fluctuating interests rates related to $62.5million of floating rate debt. On September 15, 2006 we entered into aninterest rate swap transaction to effectively fix the interest rate on $62.5million in floating rate debt at 8.015% per annum. The swap transactionterminates in September 2008. Since we do not use derivative financialinstruments for trading purposes, the swap did not qualify for hedge accountingunder SFAS No. 133. The fair value of the interest rate swap agreementrepresents the spread between the interest rate we paid and the interest ratewe would receive over the remaining life of the agreement, however, this wasnot considered material at September 30, 2006. The change in fair value of theinterest rate swap agreement during the nine months ended September 30, 2006was not material to us. The counterparties to the interest rate swap agreementare financial institutions.

You should beaware that many of the statements contained in this section are forward lookingand should be read in conjunction with our disclosures under the heading “Forward-LookingStatements.”

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**ITEM 4 – EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES**

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

No matter how wella control system is conceived and operated, it can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Inaddition, the design of a control system must reflect the fact that there areresource constraints and the benefits of controls must be considered relativeto costs.  Therefore, no cost-effectivecontrol systems and no evaluation of controls can provide absolute assurancethat all control issues and instances of misstatements due to error or fraud,if any, within our company have been detected.

*Evaluationof Disclosure Controls and Procedures*

Our chiefexecutive officer and chief financial officer, with the assistance ofmanagement, evaluated the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended) as of the end of the period covered by thisreport (the “Evaluation Date”). Based on that evaluation, our chief executiveofficer and chief financial officer concluded that, as of the Evaluation Date,our disclosure controls and procedures were effective to ensure thatinformation required to be disclosed in our reports under the Exchange Act, isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and that such information is accumulated andcommunicated to management, including our chief executive officer and chieffinancial officer, as appropriate to allow timely decisions regarding requireddisclosure.

*Changes in Internal Controls*

There have been nosignificant changes in our internal control over financial reporting during thethree months ended September 30, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

**PART II –OTHER INFORMATION**

**ITEM 1 – LEGAL PROCEEDINGS**

We are involved inlitigation arising in the ordinary course of business, none of which isexpected to have a material adverse effect on our financial position or resultsof operations and we are subject to extensive and complex regulations thataffect the development and home building processes, including zoning, density,building standards, mortgage financing and product liability. These regulationsoften provide broad discretion to the administering governmental authorities.This can delay or increase the cost of development or homebuilding.

On October 13,2006, the California Department of Toxic Substances Control (“DTSC”) filed acivil complaint against our Hearthside Residential Corp. subsidiary (“HRC”) inthe Federal District Court for the Southern Division of the Central District ofCalifornia.  The DTSC’s complaintrequests that HRC pay for $1,004,000 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 duringSeptember 2005.  HRC’s remediation processwas approved by the DTSC in December 2005 when it issued a final acceptance ofthe remediation work.  The complaint alsoseeks an order for HRC to pay any future costs which may be incurred inconnection with further remediation, together with court costs and attorney’sfees.

Since May 2004,HRC has received invoices from DTSC seeking reimbursement for these costs;however, HRC contends, based upon advice of counsel, that it is not responsiblefor such costs because neither HRC nor any affiliate ever developed or builtthe neighboring residential properties, neither HRC nor any affiliate generatedthe contamination, and the contamination did not emanate from the 43-acre siteHRC remediated and, therefore, it should not be part of the same “site” as thecontaminated residential properties. Furthermore, HRC has also disputed suchcharges due to the fact that DTSC did not present its bill in accordance withthe requirements of the applicable law. The Company’s subsidiary intends tovigorously defend itself in this matter. Therefore, the Company has not accruedfor any of DTSC’s $1,004,000 of claims related to these residential properties.

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See Note 9 to the Consolidated Financial Statementsabove, and “Item 1 - Business - Corporate Indemnification Matters” and “Item 3- Legal Proceedings” in our Annual Report on Form 10-K for the year endedDecember 31, 2005.

**ITEM 1A – RISK FACTORS THAT MAY AFFECT RESULTS OFOPERATIONS AND FINANCIAL CONDITION**

Set forth below is adiscussion of the material changes in our risk factors as previously disclosedin Item 1A of Part I of our Annual Report on Form 10-K for the year endedDecember 31, 2005.  The informationpresented below updates, and should be read in conjunction with, the riskfactors and other information disclosed in our Form 10-K.

*We have recently incurred asignificant amount of debt, and we may incur significant additional debt, whichcould prevent us from fulfilling our obligations and harm our financial health.*

As of September30, 2006, our total consolidated liabilities were approximately $216.9million.  In addition, subject to therestrictions in our credit facilities, we may incur significant additionalindebtedness.  There is no guarantee thatthis amount of additional borrowings, or any amounts, would be available tous.  In addition, as these and otherfactors change, the amount of additional senior borrowing we could incur underthese restrictions could increase or decrease significantly.

Our business maynot generate sufficient cash flow from operations and borrowings may not beavailable to us under our credit facilities in an amount sufficient to enableus to pay our debt service obligations or to fund our other liquidity needs. Wemay need to refinance all or a portion of our debt on or before maturity, whichwe may not be able to do on favorable terms or at all.

The amount of ourindebtedness could also have the following important consequences:

·      making us more vulnerable to a downturn inour business or in general economic conditions;

·      requiring us to dedicate a substantialportion of our cash flows from operations to payments on our debt and reducingour ability to use our cash flow for other purposes;

·      limiting our flexibility to engage incertain transactions or to plan for, or react to, changes in our business andthe homebuilding industry;

·      limiting our ability to obtain futurefinancing for working capital, capital expenditures, acquisitions, debtobligations and other general corporate requirements;  and

·      placing us at a disadvantage compared tocompetitors who have less debt than we do.

Our credit facilities impose restrictions on ouroperations and activities and require us to comply with certain financialcovenants, including restrictions on debt incurrence, sales of assets and cashdistributions by us. If we fail to comply with these restrictions or covenants,our debt could become due and payable prior to maturity.

There has not been any other material change in therisk factors disclosure from that contained in our Form 10-K for the fiscalyear ended December 31, 2005; however, the risks and uncertainties described inthe Form 10-K are not the only ones facing us. Other events that we do notcurrently anticipate or that we currently deem immaterial also may affect ourresults of operations and financial condition.

**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 |   | 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 beingfurnished solely to accompany this report pursuant to 18 U.S.C. Section 1350,and are 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 the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
| Date: November 9, 2006 | CALIFORNIA COASTAL COMMUNITIES, INC. |
|------------------------|--------------------------------------|
|                   |                                 |   |
|                   |                                 |   |
|                   | * *                             | By: | */s/ Sandra G. Sciutto* | * * |
|                   |                                 |   | SANDRA G. SCIUTTO |
|                   |                                 |   | Senior Vice President and |
|                   |                                 |   | Chief Financial Officer |

 

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