UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2017
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Transition Period From ________ to ________
Commission File Number 333-203707
SHEPHERD’S FINANCE, LLC
(Exact name of registrant as specified on its charter)
| Delaware | 36-4608739 | |
| (State or other jurisdiction of | (I.R.S. Employer | |
| Incorporation or organization) | Identification No.) |
13241 Bartram Park Blvd., Suite 2401, Jacksonville, Florida 32258
(Address of principal executive offices)
(302)-752-2688
(Registrant’s telephone number including area code)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K. [X]
Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer | [ ] | Accelerated filer | [ ] |
| Non-accelerated filer | [ ] | Smaller reporting company | [X] |
| Emerging growth company | [X] |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
DOCUMENTS INCORPORATED BY REFERENCE:
None.
FORM 10-K
SHEPHERD’S FINANCE, LLC
TABLE OF CONTENTS
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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this Form 10-K of Shepherd’s Finance, LLC, other than historical facts, may be considered forward-looking statements within the meaning of the federal securities laws. Words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “continue,” “predict,” or other similar words identify forward-looking statements. Forward-looking statements appear in a number of places in this report, including without limitation, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and include statements regarding our intent, belief or current expectation about, among other things, trends affecting the markets in which we operate, our business, financial condition and growth strategies. Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those predicted in the forward-looking statements as a result of various factors, including but not limited to those set forth in “Item 1A. Risk Factors.” If any of the events described in “Risk Factors” occur, they could have an adverse effect on our business, consolidated financial condition, results of operations and cash flows.
When considering forward-looking statements, our risk factors, as well as the other cautionary statements in this report and in our Form S-1 Registration Statement, should be kept in mind. Do not place undue reliance on any forward-looking statement. We are not obligated to update forward-looking statements.
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Purpose and History
Our business is focused on commercial lending to participants in the residential construction and development industry. We believe this market is underserved because of the lack of traditional lenders currently fully participating in the market. We were originally formed as a Pennsylvania limited liability company on May 10, 2007. To meet our business objectives, we changed our name to Shepherd’s Finance, LLC on December 2, 2011. We converted to a Delaware limited liability company on March 29, 2012. We are located in Jacksonville, Florida. As used in this report, “we,” “us,” “our,” and “Company” refer to Shepherd’s Finance, LLC.
The commercial loans we extend are secured by mortgages on the underlying real estate. We extend and service commercial loans to small-to-medium sized homebuilders for the purchase of lots and/or the construction of homes thereon. In some circumstances, the lot is purchased with an older home on the lot which is then either removed or rehabilitated. If the home is rehabilitated, the loan is referred to as a “rehab” loan. We also extend and service loans for the purchase of undeveloped land and the development of that land into residential building lots. In addition, we may, depending on our cash position and the opportunities available to us, do none, any or all of the following: purchase defaulted unsecured debt from suppliers to homebuilders at a discount (and then secure that debt with real estate or other collateral), and purchase defaulted secured debt from financial institutions at a discount.
Experience and Resources
Our Chief Executive Officer (“CEO”), Mr. Wallach, has been in the housing industry since 1985. He was the Chief Financial Officer of a multi-billion-dollar supplier of building materials to home builders for 11 years. He also was responsible for that company’s lending business for 20 years. During those years, he was responsible for the creation and implementation of many secured lending programs to builders. Some of these were performed fully by that company, and some were performed in partnership with banks. In general, the creation of all loans, and the resolution of defaulted loans, was his responsibility, whether the loans were company loans or loans in partnership with banks. Through these programs, he was responsible for the creation of approximately $2,000,000,000 in loans which generated interest spread of $50,000,000, after deducting for loan losses. Through the years, he managed the development of systems for reducing and managing the risks and losses on defaulted loans. Mr. Wallach also was responsible for that company’s unsecured debt to builders, which reached over $300,000,000 at its peak. He also gained experience in securing defaulted unsecured debt.
In addition to our Executive Vice President of Operations has 12 years of experience in this type of lending. Our CEO and Executive Vice President of Operations have a combined 36 years of experience in this type of lending. Our Chief Financial Officer (“CFO”), who started with us in November 2017 as our Controller and was promoted to CFO in January 2018, has eleven years of public accounting experience.
Opportunity, Strategy, and Approach
Background and Strategy
Finance markets are highly fragmented, with numerous large, mid-size, and small lenders and investment companies, such as banks, savings and loan associations, credit unions, insurance companies, and institutional lenders, all competing for investment opportunities. Many of these market participants have experienced losses, as a result of the housing market (which started to decline in 2006, reached its bottom in 2008, and is not back to historical norms as of December 31, 2017), and their participation in lending in it. As a result of credit losses and restrictive government oversight, the financial institutions are not participating in this market to the extent they had before the credit crisis (as evidenced by the general lack of availability of construction financing and the higher cost of financing for the deals actually done). We believe that these lenders, while increasing their willingness and capacity to lend, will be unable to satisfy the current demand for residential construction financing, creating attractive opportunities for niche lenders such as us for many years to come. Our goal is not to be a customer’s only source of commercial lending, but an extra, more user-friendly piece of their financing. In 2017, while more small banks returned to the construction lending market, the demand for our loan products has increased. We attribute this to our sales staff, an increase in the number of small home builders in the market, and an improving housing market.
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Our loans are marketed by lending representatives who work for us and are driven to maintain long-term customer relationships. Compensation for loan originators is focused on the profitability of loans originated, not simply the volume of loans originated. As of January 1, 2018, we have retained 14 [full-time] employees (four of which are lending representatives) including our CEO. In his previous experience, our CEO had a nationwide staff of 20 lenders working in the field.
Our efforts are designed to create a loan portfolio that includes some or all of the following investment characteristics: (i) provides current income; (ii) is well-secured by residential real estate; (iii) is short term in nature; and (iv) provides high interest spreads.
Our investment policies may be amended or changed at any time by our board of managers. In the years ahead, we plan on continuing our expansion of lending, increasing our geographic diversity, growing our rehab lending program, and improving our financial performance. We will be adding systems and people to accomplish these goals.
As we continue to grow our business, we are focusing some of our efforts on our rehab program, which we believe in the long run will face less bank competition.
Risk and Mitigation
We believe that while creating speculative construction loans is a high-risk venture, the reduction in competition, the differences in our lending versus typical small bank lending, and our loss mitigation techniques will all help this to continue to be a profitable business.
We engage in various activities to try to mitigate the risks inherent in this type of lending by:
| ● | Keeping the loan-to-value ratio (“LTV”), between 60% and 75% on a portfolio basis, however, individual loans may, from time to time, have a greater LTV; | |
| ● | Generally using deposits from the builder on home construction loans to ensure the completion of the home. Lending losses on defaulted loans are usually a higher percentage when the home is not built, or is only partially built; | |
| ● | Having a higher yield than other forms of secured real estate lending; | |
| ● | Using interest escrows from our loans; | |
| ● | Aggressively working with builders who are in default on their loan before and during foreclosure. This technique generally yields a reduced realized loss; and | |
| ● | Market grading. We review all lending markets, analyzing their historic housing start cycles. Then, the current position of housing starts is examined in each market. Markets are classified into volatile, average, or stable, and then graded based on that classification and our opinion of where the market is in its housing cycle. This grading is then used to determine the builder deposit amount, LTV, and yield. |
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We believe the following table contains items that differentiate us from our competitors:
| Item | Our Methods | Comments | ||
| Lending Regulation | We follow various state and federal laws, but are not regulated and controlled by bank examiners from the government. We follow best practices we have learned through our experience, some of which are required of banks. | For instance, banks are not required to buy title insurance by law, but typically banks do purchase title insurance for the properties on which they lend. We generally do not, as it is very difficult to collect on title policies. Instead, we use title searches to protect our interests. | ||
| FDIC Insurance | We do not offer FDIC insurance to our unsecured notes investors. | Our yield to our customers, and our cost of funds is typically higher than that of most banks. We charge our borrowers higher interest rates than do most banks. We also save money by not paying for FDIC insurance. | ||
| Capital Structure | Typically, our unsecured notes offer through our notes program are due in one to four years, or when the Note matures. | This results in liquidity risk (i.e. funding borrowing requests or maturities of debt). | ||
| Community Reinvestment Act (CRA)1 | We do not participate in the CRA. | Our sole purpose in making each individual loan is to maximize our returns while maintaining proper risk management. | ||
| Leverage | We try to maintain a 15% ratio of equity (including redeemable preferred equity) to loan assets. | Our equity to loan asset ratio was 16.2% as of December 31, 2017. The higher the ratio, the more potential losses the company can absorb without impacting debt holders. | ||
| Product Diversification | We generally make loans to builders to purchase lots and/or to construct or rehab homes. | We have extensive experience in our field. | ||
| Geographic Diversity | We lend in 16 states as of December 31, 2017. | We believe that this geographic diversity helps in down markets, as not all housing markets decrease at the same rate and time. | ||
| Governmental Bailouts | Most likely not eligible. | We are not likely to be eligible for bank bailouts, which have happened periodically. We maintain a better leverage ratio to counter this. | ||
| Underwriting | We focus on items that, in our experience, tend to predict risk. | These items include, using collateral, controlling LTVs, controlling the number of loans in one subdivision, underwriting appraisals, conducting property inspections, maintaining certain files and documents similar to those that a bank might maintain. |
Lines of Business
Our efforts are designed to create a portfolio that includes some or all of the following investment characteristics: (i) provides current income; (ii) is well-secured by residential real estate; (iii) is short term in nature; and (iv) provides high interest spreads. While we primarily provide commercial construction loans to homebuilders (for residential real estate), we may also purchase defaulted unsecured debt from suppliers to homebuilders at a discount (and then secure that debt with real estate or other collateral), purchase defaulted secured debt from financial institutions at a discount, and purchase real estate in which we will operate our business.
Our investment policies may be amended or changed at any time by our board of managers.
1 The CRA subjects a bank who receives FDIC insurance to regulatory assessment to determine if the bank meets the credit needs of its entire community, and to consider that determination in its evaluation of any application made by the bank for, among other things, approval of the acquisition or establishment of a bank branch.
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Commercial Construction Loans to Homebuilders
We extend and service commercial loans to small-to-medium sized homebuilders for the purchase of lots and/or the construction of homes thereon. Our customers generally benefit from doing business with us not just because they are able to sell additional homes (which we finance), but because, as they build additional homes, they are able to increase sales of homes that are built as contracted homes, where the eventual home owner obtains the loan. Builders generally have more success selling homes when a model or spec home is available for customers to see. We also extend and service loans for the purchase of undeveloped land and the development of that land into residential building lots. In addition, we lend money to purchase and rehabilitate older existing homes. Most of the loans are for “spec homes” or “spec lots,” meaning they are built or developed speculatively (with no specific end-user home owner in mind).
In a typical home construction transaction, a homebuilder obtains a loan to purchase a lot and build a home on that lot. In some cases, the builder has a contract with a customer to purchase the home upon its completion. In other cases, the home is built as a spec home, but the homebuilder believes it will sell before or shortly after completion, and therefore, building the home before it is under contract will increase the homebuilder’s sales and profitability. The builder may also believe that the construction of a spec home will increase the number of contract sales he will have in a given year, as it may be easier to sell contract homes when the customer can see the builder’s work in the spec home. In some cases, these speculatively built homes are constructed with the intention to keep them as a model for a period of time, to increase contract sales, and then be sold. These are called model homes. While we may lend to a homebuilder for any of these types of new construction homes, about 81% of our construction loans to date have been spec homes and 19% have been contracts.
In a typical rehab transaction, we fund all or a portion of the purchase price, and then all of the cost to complete the project. In some circumstances, we are unable to see the inside of the home prior to closing, so we assume that anything from drywall to completion needs to be redone, as well as what we can see from the outside. Because we are flexible in our need to see the inside of the home, and we only use experienced builders as customers for this type of lending, we believe that we are different than banks.
We fund the loans that we originate using available cash resources that are generated primarily from borrowings, our purchase and sale agreements, proceeds from the Notes (“Notes”) offered pursuant to our public offering (“Notes Program”), equity, and net operating cash flow. We intend to continue funding loans we originate using the same sources.
There is a seasonal aspect to home construction, and this affects our monthly cash flow. In general, since the home construction loans we create will last less than a year on average, and since we are geographically diverse, the seasonality impact is somewhat mitigated.
Generally, our real estate loans are secured by one or more of the following:
| ● | the parcels of land to be developed; | |
| ● | finished lots; | |
| ● | new or rehabbed single-family homes; | |
| ● | in most cases, personal guarantees of the principals of the borrower entity. |
Most of our lending is based on the following general policies:
| Customer Type | Small-to-Medium Size Homebuilders |
| Loan Type | Commercial |
| Loan Purpose | Construction/Rehabilitation of Homes or Development of Lots |
| Security | Homes, Lots, and/or Land |
| Priority | Generally, our loans are secured by a first priority mortgage lien; however, we may make loans secured by a second or other lower priority mortgage lien. |
| Loan-to-Value Averages | 60-75% |
| Loan Amounts | Average home construction loan $300,000, development loans vary greatly |
| Term | Demand, however most home construction loans typically payoff in under one year, and development loans are typically three to five-year projects. |
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| Rate | Cost of Funds (“COF”) plus 2%, minimum rate of 7% |
| Origination Fee | 5% for home construction loans, development loans on a case by case basis |
| Title Insurance | Only on high risk loans and rehabs |
| Hazard Insurance | Always |
| General Liability Insurance | Always |
| Credit | Builder should have significant building experience in the market, be building in the market currently, be able to make payments of interest, be able to make the required deposit, have acceptable personal credit, and have open lines of credit (unsecured) with suppliers reasonably within terms. Required deposits may be able to be avoided if we do not fund the purchase of land. We generally do not advertise to find customers, but use our loan representatives. We believe this approach will allow us to focus our efforts on builders that meet our acceptable risk profile. |
| Third Party Guarantor | None, however the loans are generally guaranteed by the owners of the borrower |
We may change these policies at any time based on then-existing market conditions or otherwise, at the discretion of our CEO and board of managers.
The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2017:
(All dollar [$] amounts shown in table in thousands).
| State | Number
of Borrowers | Number
of Loans | Value
of Collateral (1) | Commitment Amount | Amount
Outstanding | Loan
to Value Ratio(2) | Loan Fee | |||||||||||||||||
| Colorado | 3 | 6 | $ | 3,224 | $ | 2,196 | $ | 925 | 68 | % | 5 | % | ||||||||||||
| Delaware | 1 | 1 | 244 | 171 | 147 | 70 | % | 5 | % | |||||||||||||||
| Florida | 15 | 54 | 25,368 | 16,555 | 10,673 | 65 | % | 5 | % | |||||||||||||||
| Georgia | 7 | 13 | 8,932 | 5,415 | 3,535 | 61 | % | 5 | % | |||||||||||||||
| Indiana | 2 | 2 | 895 | 566 | 356 | 63 | % | 5 | % | |||||||||||||||
| Michigan | 4 | 25 | 7,570 | 4,717 | 2,611 | 62 | % | 5 | % | |||||||||||||||
| New Jersey | 2 | 11 | 3,635 | 2,471 | 1,227 | 68 | % | 5 | % | |||||||||||||||
| New York | 1 | 5 | 1,756 | 929 | 863 | 53 | % | 5 | % | |||||||||||||||
| North Carolina | 3 | 6 | 1,650 | 1,155 | 567 | 70 | % | 5 | % | |||||||||||||||
| Ohio | 1 | 1 | 711 | 498 | 316 | 70 | % | 5 | % | |||||||||||||||
| Oregon | 1 | 1 | 607 | 425 | 76 | 70 | % | 5 | % | |||||||||||||||
| Pennsylvania | 2 | 20 | 15,023 | 7,649 | 5,834 | 51 | % | 5 | % | |||||||||||||||
| South Carolina | 7 | 18 | 4,501 | 3,058 | 1,445 | 68 | % | 5 | % | |||||||||||||||
| Tennessee | 1 | 2 | 690 | 494 | 494 | 72 | % | 5 | % | |||||||||||||||
| Utah | 1 | 2 | 790 | 553 | 344 | 70 | % | 5 | % | |||||||||||||||
| Virginia | 1 | 1 | 335 | 235 | 150 | 70 | % | 5 | % | |||||||||||||||
| Total | 52 | (4) | 168 | $ | 75,931 | $ | 47,087 | $ | 29,563 | 62 | %(3) | 5 | % | |||||||||||
| (1) | The value is determined by the appraised value. | |
| (2) | The loan to value ratio is calculated by taking the commitment amount and dividing by the appraised value. | |
| (3) | Represents the weighted average loan to value ratio of the loans. | |
| (4) | We have one builder in two states. |
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2018 Outlook
In 2018, we anticipate using proceeds from the Notes Program, the purchase and sale agreements, and other sources to generate additional loans (mostly spec home construction loans), increase loan balances, and increase our customer and geographic diversity.
Commercial Loans – Real Estate Development Loan Portfolio Summary
In a typical development transaction, a homebuilder/developer purchases a specific parcel or parcels of land. Developers must secure financing in order to pay the purchase price for the land as well as to pay expenses incurred while developing the lots. This is the financing we provide. Once financing has been secured, the lot developers create individual lots. Developers secure permits allowing the property to be developed and then design and build roads and utility systems for water, sewer, gas, and electricity to service the property. The individual lots are then sold before a home is built on them; paid off, built on and then sold; or built on, then sold and paid off (in these cases, we may subordinate our loan to the home construction loan).
The following is a summary of our loan portfolio to builders for land development as of December 31, 2017 which we refer to throughout this report as the (“Pennsylvania Loans”):
(All dollar [$] amounts shown in table in thousands).
| State | Number
of Borrowers | Number
of Loans | Value
of Collateral(1) | Commitment Amount(3) | Amount
Outstanding | Loan
to Value Ratio(2) | Loan Fee | Interest Rate | ||||||||||||||||||||||
| Pennsylvania | 1 | 3 | $ | 4,997 | $ | 4,600 | $ | 2,811 | 56 | % | $ | 1,000 | COF plus 7% | |||||||||||||||||
| (1) | The value is determined by the appraised value adjusted for remaining costs to be paid and third-party mortgage balances. Part of this collateral is $1,240 of preferred equity in our Company. In the event of a foreclosure on the property securing certain of our loans, a portion of our collateral is preferred equity in our Company, which might be difficult to sell, which could impact our ability to eliminate the loan balance. | |
| (2) | The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value. | |
| (3) | The commitment amount does not include letters of credit and cash bonds, as the sum of the total balance outstanding including the cash bonds plus the letters of credit and remaining to fund for construction is less than the $4,600 commitment amount. |
Credit Quality Information
See the notes to our financial statements for credit quality information.
Competition
Historically, our industry has been highly competitive. We compete for opportunities with numerous public and private investment vehicles, including financial institutions, specialty finance companies, mortgage banks, pension funds, opportunity funds, hedge funds, REITs, and other institutional investors, as well as individuals. Many competitors are significantly larger than us, have well-established operating histories and may have greater access to capital, resources and other advantages over us. These competitors may be willing to accept lower returns on their investments or to modify underwriting standards and, as a result, our origination volume and profit margins could be adversely affected.
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We believe that this is a good time to extend commercial loans to builders in the residential real estate market because, currently, this market appears underserved, home values are average, and many of our competitors have sustained losses due to declines in home values in the second half of the previous decade and, therefore, are reluctant to lend in this space at this time. We expect our loans to be different than other lenders in the markets in which we are active. Typically, the differences are:
| ● | our loans may have a higher fee; | |
| ● | our loans typically require a small deposit which is refundable, versus a large upfront payment for the lot which is not refundable; and | |
| ● | some of our loans may have lower costs as a result of not requiring title insurance. |
Regulatory Matters
Financial Regulation
Our operations are not subject to the stringent regulatory requirements imposed upon the operations of commercial banks, savings banks, and thrift institutions. We are not subject to periodic compliance examinations by federal or state banking regulators. Further, our Notes are not certificates of deposit or similar obligations or guaranteed by any depository institution and are not insured by the FDIC or any governmental or private insurance fund, or any other entity.
The Investment Company Act of 1940
An investment company is defined under the Investment Company Act of 1940, as amended (the “Investment Company Act”), to include any issuer engaged primarily in the business of investing, reinvesting, or trading in securities. Absent an exemption, investment companies are required to register as such with the SEC and to comply with various governance and operational requirements. If we were considered an “investment company” within the meaning of the Investment Company Act, we would be subject to numerous requirements and restrictions relating to our structure and operation. If we were required to register as an investment company under the Investment Company Act and to comply with these requirements and restrictions, we may have to make significant changes in our proposed structure and operations to comply with exemption from registration, which could adversely affect our business. Such changes may include, for example, limiting the range of assets in which we may invest. We intend to conduct our operations so as to fit within an exemption from registration under the Investment Company Act for purchasing or otherwise acquiring mortgages and other liens on and interest in real estate. In order to satisfy the requirements of such exemption, we may need to restrict the scope of our operations.
Environmental Compliance
We do not believe that compliance with federal, state, or local laws relating to the protection of the environment will have a material effect on our business in the foreseeable future. However, loans we extend or purchase are secured by real property. In the course of our business, we may own or foreclose and take title to real estate that could be subject to environmental liabilities with respect to these properties. We (or our loan customers) may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation, and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances or chemical release at a property. The costs associated with the investigation or remediation activities could be substantial. In addition, if we become the owner of or discover that we were formerly the owner of a contaminated site, we may be subject to common law claims by third-parties based on damages and costs resulting from environmental contamination emanating from the property. To date, we have not incurred any significant costs related to environmental compliance and we do not anticipate incurring any significant costs for environmental compliance in the future. Generally, when we are lending on property which is being developed into single family building lots, an environmental assessment is done by the builder for the various governmental agencies. When we lend for new construction on newly developed lots, the lots have generally been reviewed while they were being developed. We also perform our own physical inspection of the lot, which includes assessing potential environmental issues. Before we take possession of a property through foreclosure, we again assess the property for possible environmental concerns, which, if deemed to be a significant risk compared to the value of the property, could cause us to forego foreclosure on the property and to seek other avenues for collection.
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Below are risks and uncertainties that could adversely affect our operations that we believe are material to investors. Other risks and uncertainties may exist that we do not consider material based on the information currently available to us at this time.
Risks Related to our Business
Our business is not industry-diversified and the homebuilding industry has undergone a significant downturn. Further deterioration in industry or economic conditions could further decrease demand and pricing for new homes and residential home lots. A decline in housing values similar to the recent national downturn in the real estate market would have a negative impact on our business. Smaller value declines will also have a negative impact on our business. These factors may decrease the likelihood we will be able to generate enough cash to repay the Notes.
Developers and homebuilders to whom we may make loans use the proceeds of our loans to develop raw land into residential home lots and construct homes. The developers obtain the money to repay our development loans by selling the residential home lots to homebuilders or individuals who will build single-family residences on the lots, or by obtaining replacement financing from other lenders. A developer’s ability to repay our loans is based primarily on the amount of money generated by the developer’s sale of its inventory of single-family residential lots. Homebuilders obtain the money to repay our loans by selling the homes they construct or by obtaining replacement financing from other lenders, and thus, the homebuilders’ ability to repay our loans is based primarily on the amount of money generated by the sale of such homes.
The homebuilding industry is cyclical and is significantly affected by changes in industry conditions, as well as in general and local economic conditions, such as:
| ● | employment level and job growth; | |
| ● | demographic trends, including population increases and decreases and household formation; | |
| ● | availability of financing for homebuyers; | |
| ● | interest rates; | |
| ● | affordability of homes; | |
| ● | consumer confidence; | |
| ● | levels of new and existing homes for sale, including foreclosed homes and homes held by investors and speculators; and | |
| ● | housing demand generally. |
These conditions may occur on a national scale or may affect some of the regions or markets in which we operate more than others.
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We generally lend a percentage of the values of the homes and lots. These values are determined shortly prior to the lending. If the values of homes and lots in markets in which we lend drop fast enough to cause the builders losses that are greater than their equity in the property, we will be forced to liquidate the loan in a fashion which will cause us to lose money. If these losses when combined and added to our other expenses are greater than our revenue from interest charged to our customers, we will lose money overall, which will hurt our ability to pay interest and principal on the Notes. Values are typically affected by demand for homes, which can change due to many factors, including but not limited to, demographics, interest rates, overall economy, cost of building materials and labor, availability of financing for end-users, inventory of homes available and governmental action or inaction. The tightening credit markets have made it more difficult for potential homeowners to obtain financing to purchase homes. If housing prices decline or sales in the housing market decline, our customers may have a hard time selling their homes at a profit. This could cause the amount of defaulted loans that we will own to increase. An increase in defaulted loans would reduce our revenue and could lead to losses on our loans. A decline in housing prices will further increase our losses on defaulted loans. If the amount of defaulted loans or the loss per defaulted loan is large enough, we will operate at a loss, which will decrease our equity. This could cause us to become insolvent, and we will not be able to pay back Note holders’ principal and interest on the Notes.
The homebuilding industry could experience adverse conditions, and the industry’s implementation of strategies in response to such conditions may not be successful.
The United States homebuilding industry experienced a significant downturn beginning in 2007. During the course of the downturn, many homebuilders focused on generating positive operating cash flow, resizing and reshaping their product for a more price-conscious consumer and adjusting finished new home inventories to meet demand, and did so in many cases by significantly reducing the new home prices and increasing the level of sales incentives. Notwithstanding these strategies, homebuilders continued to experience an elevated rate of sales contract cancelations, as many of the factors that affect new sales and cancelation rates are beyond the control of the homebuilding industry. Although the homebuilding industry recently experienced positive gains, there can be no assurance that these gains will continue. The homebuilding industry could suffer similar, or worse, adverse conditions in the future. Continued decreases in new home sales would increase the likelihood of defaults on our loans and, consequently, reduce our ability to repay Note holders’ principal and interest on the Notes.
We have $30,043,000 of loan assets as of December 31, 2017. A 35% reduction in total collateral value would reduce our earnings and net worth by $1,145,000. Larger reductions would result in lower earnings and lower net worth.
As of December 31, 2017, we had $30,043,000 of loan assets on our books. These assets are recorded on our balance sheet at the lower of the loan amount or the value of the collateral after deduction for expected selling expenses. A reduction in the value of the underlying collateral could result in significant losses. A 35% reduction, for instance, would result in a $1,145,000 loss. Accordingly, our business is subject to risk of a loss of a portion of our Note holders’ investments if such a reduction were to occur.
We have $2,811,000 of development loan assets as of December 31, 2017, which unlike our construction loans, are long term loans. This longer duration as well as the nature of collateral (raw ground and lots) creates more risk for that portion of our portfolio.
Development loans are riskier than construction loans for two reasons: the duration of the loan and the nature of the collateral. The duration (being three to five years as compared to less than one year on construction loans) allows for a greater period of time over which the collateral value could decrease. Also, the collateral value of development loans is more likely to change in greater percentages than that of built homes. For example, during a 70% reduction in housing starts, newly completed homes still have value, but lots may be worthless. This added risk to this portion of our portfolio adds risk to our investors as our net worth would be significantly impacted by losses.
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Currently, we are reliant on a single developer and homebuilder, the Hoskins Group, who is concentrated in the Pittsburgh, Pennsylvania market, for a material portion of our revenues and a portion of our capital.
As of December 31, 2017, 22% of our outstanding loan commitments consisted of loans made to Benjamin Marcus Homes, LLC and Investor’s Mark Acquisitions, LLC, both of which are owned by Mark Hoskins (collectively all three parties referred to herein as the “Hoskins Group”). The Hoskins Group is concentrated in the Pittsburgh, Pennsylvania market. The Hoskins Group also has a preferred equity interest in us. Therefore, currently, we are reliant upon a single developer and homebuilder who is concentrated in a single city, for a significant portion of our revenues and a portion of our capital. Any event of bankruptcy, insolvency, or general downturn in the business of this developer and homebuilder or in the Pittsburgh housing market generally will have a substantial adverse financial impact on our business and our ability to pay back Note holders’ investments in the Notes in the long term. Adverse conditions affecting the local housing market could include, but are not limited to, declines in new housing starts, declines in new home prices, declines in new home sales, increases in the supply of available building lots or built homes available for sale, increases in unemployment, and unfavorable demographic changes.
We have foreclosed assets as of December 31, 2017, which unlike our loans, are generally recorded on our balance sheet at the value of the collateral.
A reduction in the value of the underlying collateral of our foreclosed assets could result in significant losses. For example, a 35% reduction in the value of the underlying collateral would result in a $363,000 loss. While we are not carrying large balances of foreclosed assets, our business is subject to increased risk of not being able to repay timely our Note holders’ investments if such a reduction were to occur.
Increases in interest rates, reductions in mortgage availability, or increases in other costs of home ownership could prevent potential customers from buying new homes and adversely affect our business and financial results.
Most new home purchasers finance their home purchases through lenders providing mortgage financing. Prior to the recent volatility in the financial markets, interest rates were at historically low levels and a variety of mortgage products were available. As a result, home ownership became more accessible. The mortgage products available included features that allowed buyers to obtain financing for a significant portion or all of the purchase price of the home, had very limited underwriting requirements or provided for lower initial monthly payments. Accordingly, more people were qualified for mortgage financing.
Since 2007, the mortgage lending industry has experienced significant instability, beginning with increased defaults on subprime loans and other nonconforming loans and compounded by expectations of increasing interest payment requirements and further defaults. This, in turn, resulted in a decline in the market value of many mortgage loans and related securities. Lenders, regulators and others questioned the adequacy of lending standards and other credit requirements for several loan products and programs offered in recent years. Credit requirements tightened, and investor demand for mortgage loans and mortgage-backed securities declined. In general, fewer loan products, tighter loan qualifications, and a reduced willingness of lenders to make loans make it more difficult for many buyers to finance the purchase of homes. These factors serve to reduce the pool of qualified homebuyers and made it more difficult to sell to first-time and move-up buyers.
Mortgage rates may rise significantly in over the next several years. The benefit of recent trends loosening credit to potential end users of homes may be outweighed by the rise of interest rates for those borrowers, which might lower demand for new homes.
A reduction in the demand for new homes may reduce the amount and price of the residential home lots sold by the developers and homebuilders to which we loan money and/or increase the amount of time such developers and homebuilders must hold the home lots in inventory. These factors increase the likelihood of defaults on our loans, which would adversely affect our business and consolidated financial results.
Most of our assets are commercial construction loans to homebuilders and/or developers which are a higher than average credit risk, and therefore could expose us to higher rates of loan defaults, which could impact our ability to repay amounts owed to Note holders.
Our primary business is extending commercial construction loans to homebuilders, along with some loans for land development. These loans are considered higher risk because the ability to repay depends on the homebuilder’s ability to sell a newly built home. These homes typically are not sold by the homebuilder prior to commencement of construction. Therefore, we may have a higher risk of loan default among our customers than other commercial lending companies. If we suffer increased loan defaults, in any given period, our operations could be materially adversely affected, and we may have difficulty making our principal and interest payments on the Notes.
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If we lose or are unable to hire or retain competent personnel, we may be delayed or unable to implement our business plan, which would adversely affect our ability to repay the Notes.
We do not have an employment agreement with any of our employees and cannot guarantee that they will remain affiliated with us. We do not have key man insurance on any key employees as well. If any of our key employees were to cease their affiliation with us, our consolidated operating results would suffer. We believe that our future success depends, in part, upon our ability to hire and retain additional personnel. We cannot assure Note holders that we will be successful in attracting and retaining such personnel, which could hinder our ability to implement our business plan.
Employee misconducts could harm us by subjecting us to monetary loss, significant legal liability, regulatory scrutiny, and reputational harm.
Our reputation is critical to maintaining and developing relationships with our existing and potential customers and third parties with whom we do business. There is a risk that our employees could engage in misconduct that adversely affects our business. For example, if an employee were to engage-or be accused of engaging-in illegal or suspicious activities including fraud or theft, we could suffer direct losses from the activity, and in addition we could be subject to regulatory sanctions and suffer serious harm to our reputation, financial condition, customer relationships, and ability to attract future customers or employees. Employee misconduct could prompt regulators to allege or to determine based upon such misconduct that we have not established adequate supervisory systems and procedures to inform employees of applicable rules or to detect and deter violations of such rules. It is not always possible to deter employee misconduct, and the precautions we take to detect and prevent misconduct may not be effective in all cases. Misconduct by our employees, or even unsubstantiated allegations of misconduct, could result in a material adverse effect on our reputation and our business.
We are susceptible to customer fraud, which could cause us to suffer losses on our loan portfolio.
Because most of our customers do not publicly report their financial condition, we are susceptible to a customer’s fraud, which could cause us to suffer losses on our loan portfolio. The failure of a customer to accurately report its financial position, compliance with loan covenants, or eligibility for additional borrowings could result in our providing loans that do not meet our underwriting criteria, defaults in loan payments, and the loss of some or all of the principal of a particular loan or loans.
We have entered into purchase and sale agreements with third parties to sell them portions of some of our loans. This will increase our leverage. While the agreements are intended to increase our profitability, large loan losses and/or idle cash, could actually reduce our profitability, which could impair our ability to pay principal and/or interest on the Notes.
The purchase and sale agreements we entered into have allowed us to increase our loan assets and debt. If loans that we create have significant losses, the benefit of larger balances can be outweighed by the additional loan losses. Also, while these transactions are booked as secured financing, they are not lines of credit. Accordingly, we will have increased our loan balances without increasing our lines of credit, which can cause a decrease in liquidity. One solution to this liquidity problem is having idle cash for liquidity, which then could reduce our profitability. If either of these problems is persistent and/or significant, our ability to pay interest and principal on our Notes may be impaired.
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Management has broad discretion over the use of proceeds from this offering, and it is possible that the funds will not be used effectively to generate enough cash for payment of principal and interest on the Notes.
We expect to use the proceeds from this offering for purposes detailed in our prospectus under the “Questions and Answers” and “Use of Proceeds” sections. Because no specific allocation of the proceeds is required in the indenture, our management will have broad discretion in determining how the proceeds of the offering will be used.
Additional competition may decrease our profitability, which would adversely affect our ability to repay the Notes.
We may experience increased competition for business from other companies and financial institutions that are willing to extend the same types of loans that we extend at lower interest rates and/or fees. These competitors also may have substantially greater resources, lower cost of funds, and a better-established market presence. If these companies increase their marketing efforts to our market niche of borrowers, or if additional competitors enter our markets, we may be forced to reduce our interest rates and fees in order to maintain or expand our market share. Any reduction in our interest rates, interest income, or fees could have an adverse impact on our profitability and our ability to repay the Notes.
Our real estate loans are illiquid, which could restrict our ability to respond rapidly to changes in economic conditions.
The real estate loans we currently hold and intend to extend are illiquid. As a result, our ability to sell under-performing loan in our portfolio or respond to changes in economic, financial, investment, and other conditions may be very limited. We cannot predict whether we will be able to sell any real estate loan for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a loan. The relative illiquidity of our loan assets may impair our ability to generate sufficient cash to make required interest and principal payments on the Notes.
We need to improve our systems and procedures as we grow. Failure to do so would adversely affect our ability to repay the Notes.
Initially all of our computer systems used excel spread sheets and other methods a small company would use. Over time, we added a loan document system which many banks use to produce closing documents for loans. We are replacing our excel spread sheet system for investors in 2018 with a proprietary system that we have been developing. We also plan on replacing our loan asset tracking system in 2018 or 2019 with another proprietary system. If either of these systems fail, or we do not replace our loan asset tracking system soon, we may be unable to function properly as a business.
If we do not meet the requirements to maintain effective internal controls over financial reporting, our ability to raise new capital will be harmed.
If we do not maintain effective internal controls over our financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act, then it could result in delaying future SEC filings or future offerings. If future SEC filings or future offerings are delayed, it could have an extreme negative impact on our cash flow causing us to default on our obligations.
We are subject to risk of significant losses on our loans because we do not require our borrowers to insure the title of their collateral for our loans.
It is customary for lenders extending loans secured by real estate to require the borrower to provide title insurance with minimum coverage amounts set by the lender. We do not require most of our homebuilders to provide title insurance on their collateral for our loans to them. This represents an additional risk to us as the lender. The homebuilder may have a title problem which normally would be covered by insurance, but may result in a loss on the loan because insurance proceeds are not available.
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If a large number of our current and prospective borrowers are unable to repay their loans within a normal average number of months, we will experience a significant reduction in our income and/or liquidity, and may not be able to repay the Notes as they become due.
Construction loans that we extend are expected to be repaid in a normal average number of months, typically eight months, depending on the size of the loan. Development loans are expected to last for many years. We have interest paid on a monthly basis, but also charge a fee which will be earned over the life of the loan. If these loans are repaid over a longer period of time, the amount of income that we receive on these loans expressed as a percentage of the outstanding loan amount will be reduced, and fewer loans with new fees will be able to be made, since the cash will not be available. This will reduce our income as a percentage of the Notes, and if this percentage is significantly reduced it could impair our ability to pay principal and interest on the Notes.
Our cost of funds is substantially higher than that of banks.
Because we do not offer FDIC insurance, and because we want to grow our Note program faster than most banks want to grow their CD base, our Notes offer significantly higher rates than bank CDs. This may make it more difficult for us to compete against banks when they rejoin our niche lending market in large numbers. This could result in losses which could impair or eliminate our ability to pay interest and principal on our outstanding Notes.
We are subject to the general market risks associated with real estate construction and development.
Our financial performance depends on the successful construction and/or development and sale of the homes and real estate parcels that serve as security for the loans we make to homebuilders and developers. As a result, we are subject to the general market risks of real estate construction and development, including weather conditions, the price and availability of materials used in construction of homes and development of lots, environmental liabilities and zoning laws, and numerous other factors that may materially and adversely affect the success of the projects.
Our operations are not subject to the stringent banking regulatory requirements designed to protect investors, so repayment of Note holders’ investments is completely dependent upon our successful operation of our business.
Our operations are not subject to the stringent regulatory requirements imposed upon the operations of commercial banks, savings banks, and thrift institutions, and are not subject to periodic compliance examinations by federal or state banking regulators. For example, we are not well diversified in our product risk, and we cannot benefit from government programs designed to protect regulated financial institutions. Therefore, an investment in our Notes does not have the regulatory protections that the holder of a demand account or a certificate of deposit at a bank does. The return on any Notes purchased by a Note holder is completely dependent upon our successful operations of our business. To the extent that we do not successfully operate our business, our ability to pay interest and principal on the Notes will be impaired.
We are an “emerging growth company” under the federal securities laws and are subject to reduced public company reporting requirements.
In April 2012, President Obama signed into law the Jumpstart Our Business Startups Act, or the JOBS Act. We are an “emerging growth company,” as defined in the JOBS Act, and are eligible to take advantage of certain exemptions from, or reduced disclosure obligations relating to, various reporting requirements that are normally applicable to public companies.
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We will remain an “emerging growth company” until the earliest of (1) the last day of the first fiscal year in which we have total annual gross revenues of $1 billion or more, (2) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement, (3) the date on which we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act (which would occur if the market value of our common equity held by non-affiliates exceeds $700 million, measured as of the last business day of our most recently completed second fiscal quarter, and we have been publicly reporting for at least 12 months) or (4) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period. Under the JOBS Act, emerging growth companies are not required to (1) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting, pursuant to Section 404 of the Sarbanes-Oxley Act, (2) comply with new requirements adopted by the Public Company Accounting Oversight Board, or the PCAOB, which require mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor must provide additional information about the audit and the issuer’s financial statements, (3) comply with new audit rules adopted by the PCAOB after April 5, 2012 (unless the SEC determines otherwise), (4) provide certain disclosures relating to executive compensation generally required for larger public companies or (5) hold shareholder advisory votes on executive compensation.
Additionally, the JOBS Act provides that an “emerging growth company” may take advantage of an extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies. This means an “emerging growth company” can delay adopting certain accounting standards until such standards are otherwise applicable to private companies. We intend to take advantage of such extended transition period. Since we will not be required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies, our financial statements may not be comparable to the financial statements of companies that comply with public company effective dates. If we were to subsequently elect to instead comply with these public company effective dates, such election would be irrevocable pursuant to Section 107 of the JOBS Act.
We are exposed to risk of environmental liabilities with respect to properties of which we take title. Any resulting environmental remediation expense may reduce our ability to repay the Notes.
In the course of our business, we may foreclose and take title to real estate that could be subject to environmental liabilities. We may be held liable to a governmental entity or to third-parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances or chemical release at any property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third-parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity, and results of operations could be materially and adversely affected.
Risks Related to Conflicts of Interest
Our CEO (who is also on our board of managers) will face conflicts of interest as a result of the secured affiliated loans made to us, which could result in actions that are not in the best interests of our Note holders.
As of December 31, 2017, we had borrowed $0 from the 2007 Daniel M. Wallach Legacy Trust, with availability on that line of credit of $250,000, and $0 from Daniel M. Wallach, our CEO (who is also on our Board of managers), and his wife, Joyce Wallach, with availability on that line of credit of $1,250,000. These affiliate loans are collateralized by a lien against all of our assets. The Notes are subordinated in right of payment to all secured debt, including these affiliate loans. Pursuant to each promissory note, the affiliates have the option of funding any amount up to the face amount of the note, in the lender’s sole and absolute discretion. Therefore, Mr. Wallach will face conflicts of interest in deciding whether and when to exercise any rights pursuant to the promissory notes and pledge agreement. If these Wallach affiliates exercise their rights to collect on their collateral upon a default by us, we could lose some or all of our assets, which could have a negative effect on our ability to repay the Notes.
Our CEO will face conflicts of interest as a result of his equity ownership in the Company, which could result in actions that are not in Note holders’ best interests.
As of December 31, 2017, our CEO beneficially owned 96% of the common equity of the Company. As of January 1, 2018, our CEO beneficially owns 92% of the common equity of the Company. Since the Company is taxed as a partnership for federal income tax purposes, all profits and losses flow through to the equity owners. Therefore, Mr. Wallach and his affiliated equity owners of the Company will be motivated to distribute profits to the equity owners on an annual basis, rather than retain earnings in the Company for Company purposes. There is currently no limit in the indenture or otherwise on the amount of funds that may be distributed by the Company to its equity owners. If substantial funds are distributed to the equity owners, the liquidity and capital resources of the Company will be reduced and our ability to repay the Notes may be negatively impacted.
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We have two lines of credit from affiliates which allow us to incur a significant amount of secured debt. These lines are collateralized by a lien against all of our assets. Our purchase and sale agreements function as secured debt as well. We expect to incur a significant amount of additional debt in the future, including issuance of the Notes, which will subject us to increased risk of loss.
As of December 31, 2017, we had $0 of secured debt outstanding on our senior debt lines of credit to affiliates of $1,500,000, with availability of $1,500,000 and the capacity to sell portions of many loans under the terms of our purchase and sale agreements. The lines of credit are from affiliates. The affiliate loans are collateralized by a lien against all of our assets. The purchase and sale agreements and other secured debt are with third-parties and are collateralized by loans. We have a senior subordinated note for $279,000 and a line of credit from a bank with a maximum outstanding balance of $500,000 which is senior unsecured. In addition, we expect to incur a significant amount of additional debt in the future, including issuance of the Notes, borrowing under credit facilities and other arrangements. The Notes will be subordinated in right of payment to all secured debt, including the affiliate loans. Therefore, in the event of a default on the secured debt, affiliates of our Company, including Mr. Wallach, have the right to receive payment ahead of Note holders, as do other secured debt holders, such as the loan purchasers under the purchase and sale agreements. Accordingly, our business is subject to increased risk of a total loss of our Note holders’ investments if we are unable to repay all of our secured debt.
Risks Related to Liquidity
We depend on the availability of significant sources of credit to meet our liquidity needs and our failure to maintain these sources of credit could materially and adversely affect our liquidity in the future.
We plan to maintain our purchase and sale agreements and our lines of credit so that we may draw funds when necessary to meet our obligation to redeem maturing Notes, pay interest on the Notes, meet our commitments to lend money to our customers, and for other general corporate purposes. Certain features of the purchase and sale agreements with third parties have added liquidity and flexibility, which have lessened the need for the lines of credit from affiliates; however, we do plan to replace our line of credit from affiliates with a line of credit from a financial institution. If we fail to maintain liquidity through our purchase and sale agreements and lines of credit, we will be more dependent on the proceeds from the Notes for our continued liquidity. If the sale of the Notes is significantly reduced or delayed for any reason we fail to obtain or renew a line of credit; or we default on our line of credit, our ability to meet our obligations, including our Note obligations, could be materially adversely affected, and we may not have enough cash to pay back Note holders’ investments. Also, the failure to maintain an active line of credit (and therefore using cash for liquidity instead of a borrowing line), even though we have liquidity from the Notes, will reduce our earnings, because we will be paying interest on the Notes, while we are holding cash instead of reducing our borrowings.
We have unfunded commitments to builders as of December 31, 2017. If every builder borrowed every amount allowed (which would mean all of their homes were complete) and no builders paid us back, we would need to fund that amount. While some of that amount would automatically come from our purchase and sale agreements, the rest would have to come from our Notes program and/or our lines of credit. Therefore, we may not have the ability to fund our commitments to builders.
As of December 31, 2017, we have $19,312,000 of unfunded commitments to builders. If every builder borrowed every amount allowed and no builders repaid us then we would need to fund that amount. Lines of credit, payoffs from builders, and immediate investments in our Notes may not be enough to fund our commitments to builders as they become payable. If we default on these obligations, then we may face any one or more of the following: a higher default rate, lawsuits brought by customers, an eventual lack of business from borrowers, missed principal and interest payments to Note holders and holders of other debt, and a lack of desire for investors to invest in our Notes Program. Therefore, we could default on our repayment obligations to our Note holders.
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We have two secured lines of credit, one of which expires in 2018 and the other in 2019. Failure of those lines to renew could strain our ability to pay other obligations.
Our $1,325,000 line of credit due in July 2018 is funded by a group of companies, the majority of which were owned by an individual who died after the line was created. We do not know whether this line will be renewed. Our $4,000,000 secured line is due in January 2019. It is too early to tell what the renewal risk is for this line. If we are unable to renegotiate or extend our lines of credit, then we may default. Therefore, we could default on repayment obligations to some of our debt holders, which could include our Note holders.
If the proceeds from the issuance of the Notes exceed the cash flow needed to fund the desirable business opportunities that are identified, we may not be able to invest all of the funds in a manner that generates sufficient income to pay the interest and principal on the Notes.
Our ability to pay interest on our debt, including the Notes, pay our expenses, and cover loan losses is dependent upon interest and fee income we receive from loans extended to our customers. If we are not able to lend to a sufficient number of customers at high enough interest rates, we may not have enough interest and fee income to meet our obligations, which could impair our ability to pay interest and principal on the Notes. If money brought in from new Notes and from repayments of loans from our customers exceeds our short-term obligations such as expenses, Notes interest and redemptions, and line of credit principal and interest, then it is likely to be held as cash, which will have a lower return than the interest rate we are paying on the Notes. This will lower earnings and may cause losses which could impair our ability to repay the principal and interest on the Notes.
The indenture does not contain the type of covenants restricting our actions, such as restrictions on creating senior debt, paying distributions to our owners, merging, recapitalizing, and/or entering into highly leveraged transactions. The indenture does not contain provisions requiring early payment of Notes in the event we suffer a material adverse change in our business or fail to meet certain financial standards. Therefore, the indenture provides very little protection of Note holders’ investments.
The Notes do not have the benefit of extensive covenants. The covenants in the indenture are not designed to protect Note holders’ investments if there is a material adverse change in our consolidated financial condition, results of operations, or cash flows. For example, the indenture does not contain any restrictions on our ability to create or incur senior debt or other debt to pay distributions to our equity holders, including our Chief Executive Officer. It also does not contain any financial covenants (such as a fixed charge coverage or a minimum amount of equity) to help ensure our ability to pay interest and principal on the Notes. The indenture does not contain provisions that permit Note holders to require that we redeem the Notes if there is a takeover, recapitalization or similar restructuring. In addition, the indenture does not contain covenants specifically designed to protect Note holders if we engage in a highly leveraged transaction. Therefore, the indenture provides very little protection of Note holders’ investments.
Payment on the Notes is subordinate to the payment of our outstanding present and future senior debt, if any. Since there is no limit to the amount of senior debt we may incur, our present and future senior debt may make it difficult to repay the Notes.
As of December 31, 2017, we had $0 of senior debt outstanding on our senior debt lines of credit of $1,500,000, with availability of $1,500,000. Our purchase and sale agreements and secured lines of credit with third-parties also function as senior debt. The balance on those purchase and sale agreements was $11,644,000 on December 31, 2017, and is expected to grow in the future. We also have senior subordinated notes which are senior to the Notes of $279,000 as of December 31, 2017. In January 2017, we entered into a line of credit agreement which is senior unsecured, with a maximum outstanding balance of $500,000. The Notes are subordinate and junior in priority to any and all of our senior debt and senior subordinated debt, and equal to any and all non-senior debt, including other Notes. The Notes are senior to junior subordinated notes. There are no restrictions in the indenture regarding the amount of senior debt or other indebtedness that we may incur. Upon the maturity of our senior debt, by lapse of time, acceleration or otherwise, the holders of our senior debt have first right to receive payment, in full, prior to any payments being made to a Note holder or to other non-senior debt. Therefore, upon such maturity of our senior debt Note holders would only be repaid in full if the senior debt is satisfied first and, following satisfaction of the senior debt, if there is an amount sufficient to fully satisfy all amounts owed under the Notes and any other non-senior debt.
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Additional competition for investment dollars may decrease our liquidity, which would adversely affect our ability to repay the Notes.
We could experience increased competition for investment dollars from other companies and financial institutions that are willing to offer higher interest rates. We may be forced to increase our interest rates in order to maintain or increase the issuance of Notes. Any increase in our interest rates could have an adverse impact on our liquidity and our ability to meet a debt covenant under any future lines of credit obtained and/or to repay the Notes.
If we are unable to meet our Note maturity and redemption obligations, and we are unable to obtain additional financing or other sources of capital, we may be forced to sell off our operating assets or we might be forced to cease our operations, and Note holders could lose some or all of their investment.
Our Notes have maturities ranging from one year to four years. In addition, holders of our Notes may request redemption upon death. We intend to pay our Note maturity and redemption obligations using our normal cash sources, such as collections on our loans to customers, as well as proceeds from the Notes Program. We may experience periods in which our Note maturity and redemption obligations are high. Since our loans are generally repaid when our borrower sells a real estate asset, our operations and other sources of funds may not provide sufficient available cash flow to meet our continued Note maturity and redemption obligations. While we have secured lines of credit from affiliates of up to $1,500,000 with no borrowings as of December 31, 2017, our affiliates are not obligated to fund our borrowing requests. Our secured line of credit with an outside party is only $500,000 (which was undrawn on December 31, 2017.) For all of these reasons we may be substantially reliant upon the net offering proceeds we receive from the Notes Program to pay these obligations. If we are unable to repay or redeem the principal amount of the Notes when due, and we are unable to obtain additional financing or other sources of capital, we may be forced to sell off our operating assets or we might be forced to cease our operations, and Note holders could lose some or all of their investment.
There is no “early warning” on the Notes if we perform poorly. Only interest and principal payment defaults on the Notes can trigger a default on the Notes prior to a bankruptcy.
There are a limited number of performance covenants to be maintained under the Notes and/or the indenture. Therefore, no “early warning” of a possible default by us exists. Under the indenture, only (i) the non-payment of interest and/or principal on the Notes by us when payments are due, (ii) our bankruptcy or insolvency, or (iii) a failure to comply with provisions of the Notes or the indenture (if such failure is not cured or waived within 60 days after receipt of a specific notice) could cause a default to occur.
Note holders do not have the opportunity to evaluate our investments before they are made.
We intend to use the net offering proceeds in accordance with the “Use of Proceeds” section of our prospectus, including investment in secured real estate loans for the acquisition and development of parcels of real property as single-family residential lots and/or the construction of single-family homes. Since we have not identified any investments that we will make with the net proceeds of this offering, we are generally unable to provide Note holders with information to evaluate the potential investments we may make with the net offering proceeds before purchasing the Notes. Note holders must rely on our management to evaluate our investment opportunities, and we are subject to the risk that our management may not be able to achieve our objectives, may make unwise decisions or may make decisions that are not in our best interest.
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In the event of a foreclosure on the property securing certain of our loans, a portion of our collateral is preferred equity in our Company, which might be difficult to sell in order to reduce the loan balance.
Some of the collateral securing the Pennsylvania Loans is preferred equity in our Company, which has a book value of $1,240,000 as of December 31, 2017. If the borrower defaults on the loan and we are forced to use collateral to repay the loan, we will need to sell this preferred interest in us to a third-party. There is no liquid market for this instrument, so we then can give no assurance as to our ability to generate any amount of proceeds from that collateral.
Because we require a substantial amount of cash to service our debt, we may not be able to pay our obligations under the Notes.
To service our total indebtedness, we require a significant amount of cash. Our ability to generate cash depends on many factors, including our successful financial and operating performance. We cannot assure Note holders that our business plans will succeed or that we will achieve our anticipated financial results, which may prevent us from being able to pay our obligations under the Notes.
The indenture and terms of our Notes do not restrict our use of leverage. A relatively small loss can cause over leveraged companies a material adverse change in their financial position. If this happened to us, it may make it difficult to repay the Notes.
Financial institutions which are federally insured typically have 8-12% of their total assets in equity. A reduction in their loan assets due to losses of 2% reduces their equity by roughly 20%. Our company had 16% and 17% of our loan assets in equity as of December 31, 2017 and 2016, respectively. If we allow our assets to increase without increasing our equity, we could have a much lower equity as a percentage of assets than we have today, which would increase our risk of nonpayment on the Notes. Note holders have no structural mechanism to protect them from this action, and rely solely on us to keep equity at a satisfactory ratio.
We expect to be substantially reliant upon the net offering proceeds we receive from the sale of our Notes to meet principal and interest obligations on previously issued Notes.
We intend to use the net offering proceeds from the Notes Program to, among other things, make payments on other borrowings, fund redemption obligations, make interest payments on the Notes, and to run our business to the extent that other sources of liquidity from our operations (e.g., repayment of loans we have previously extended to our customers) and our credit line are inadequate. However, these other sources of liquidity are subject to risks. Our operations alone may not produce a sufficient return on investment to repay interest and principal on our outstanding Notes. We may not be able to obtain or retain a line of credit. We may not be able to attract new investors, have sufficient loan repayments, or have sufficient borrowing capacity when we need additional funds to repay principal and interest or redeem our outstanding Notes. If any of these things occur, our liquidity and capital needs may be severely affected, and we may be forced to sell off our loan receivables and other operating assets, or we might be forced to cease our operations.
If we default in our Note payment obligations, the indenture agreement provides that the trustee could accelerate all payments due under the Notes, which would further negatively affect our consolidated financial position and cash flows.
Our obligations with respect to the Notes are governed by the terms of indenture agreement with U.S. Bank as trustee. Under the indenture, in addition to other possible events of default, if we fail to make a payment of principal or interest under any Note and this failure is not cured within 30 days, then we will be deemed in default. Upon such a default, the trustee or holders of 25% in principal of the outstanding Notes could declare all principal and accrued interest immediately due and payable. If our total assets do not cover these payment obligations, then we would most likely be unable to make all payments under the Notes when due, and we might be forced to cease our operations.
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There is no sinking fund to ensure repayment of the Notes at maturity, so Note holders are totally reliant upon our ability to generate adequate cash flows.
We do not contribute funds to a separate account, commonly known as a sinking fund, to repay the Notes upon maturity. Because funds are not set aside periodically for the repayment of the Notes over their respective terms, Note holders must rely on our consolidated cash flows from operating, investing and financing activities and other sources of financing for repayment, such as funds from the Notes Program, loan repayments, and other borrowings. To the extent cash flows from operations and other sources are not sufficient to repay the Notes, Note holders may lose all or part of their investment.
If a large number of our Note holders die, we may be unable to repay their investments.
Upon the death of an investor, if requested by the executor or administrator of the investor’s estate (or if the Note is held jointly, by the surviving joint investor), we are obligated to redeem his or her Notes without any interest penalty. Such redemption requests are not subject to our consent but may be subject to restrictions in the indenture. If a large number of our investors, or a single investor holding a significant portion of the Notes, die within a short period of time, we could be faced with a large number of redemption requests. If the amounts of those redemptions are too high, and we cannot offset them with loan repayments, secure new financing, or issue additional Notes, we may not have the liquidity to redeem the investments.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
As of December 31, 2017, we operate an office in Jacksonville, Florida, which we own. We entered into a mortgage on our office building for $660,000 in January 2018 after construction was completed.
| (a) | As of the date of this filing, we are not aware that we or our members are a party to any pending or threatened legal proceeding or proceeding by a governmental authority that would have a material adverse effect on our business. | |
| (b) | None. |
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCK HOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
(All dollar [$] amounts shown in thousands.)
| (a) | Common Equity |
As of December 31, 2017, we had 2,629 Class A common membership units (“Class A Common Units”) outstanding, held by our eight members. There is no established trading market for our Class A Common Units. As of December 31, 2017, 96% of our outstanding Class A Common Units are beneficially owned by our CEO (who is also on our board of managers), Daniel M. Wallach, and his wife, Joyce S. Wallach.
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In March 2017, our Executive Vice President of Operations and each of our three independent board members acquired the remaining 4% of Class A Common Units outstanding. For the fiscal years ended December 31, 2017 and 2016, we declared and paid total distributions to the holders of our Class A Common Units of $373 and $436, respectively, which distributions were declared and paid on a quarterly basis.
In January 2018, our Executive Vice President of Operations and CFO acquired 1% and 2% of our Class A Common Units, respectively, by purchasing such Class A Common Units from Mr. and Mrs. Wallach. In addition, in March 2018, William Myrick, a former member of our board of managers, acquired 14.3% of our Class A Common Units by purchasing those Class A Common Units from Mr. and Mrs. Wallach for $1,000. Mr. Myrick resigned his position on the board of managers effective March 2018 and now serves as our Executive Vice President of Sales.
Preferred Equity
Series B Preferred Units
As of December 31, 2017, the Hoskins Group (consisting of Benjamin Marcus Homes, LLC, Investor’s Mark Acquisitions, LLC, and Mark L. Hoskins) owns a total of 12.4 Series B cumulative preferred units (“Series B Preferred Units”), which were issued for a total of $1,240. Of that total, 0.9 and 1.4 Series B Preferred Units were issued to the Hoskins Group during 2017 and 2016, respectively, pursuant to an agreement whereby the Hoskins Group agreed to purchase 0.1 Series B Preferred Units upon each closing of a lot sale in the subdivisions in which we lend the Hoskins Group development funds. The Series B Preferred Units are redeemable by the Company at any time. The Series B Preferred Units have a fixed value which is their purchase price, and preferred liquidation and distribution rights. Yearly distributions of 10% of the Series B Preferred Units’ value (providing profits are available) will be made quarterly. The Hoskins Group’s Series B Preferred Units are also used as collateral for that group’s loans to the Company.
The transactions in Series B Preferred Units described above were effected in private transactions exempt from the registration requirements of the Securities Act under Section 4(a)(2) of the Securities Act. The transactions described above did not involve any public offering, were made without general solicitation or advertising, and the buyer represented to us that it is an “accredited investor’’ within the meaning of Rule 501 of Regulation D promulgated under the Securities Act, with access to all relevant information necessary to evaluate the investment in the Series B Preferred Units.
Series C Preferred Units
Series C cumulative preferred units (“Series C Preferred Units”) were issued to Margaret Rauscher IRA LLC (Margaret Rauscher is the wife of one of our independent managers, Eric A. Rauscher) in March 2017 and to an IRA owned by William Myrick, a former independent manager, in April 2017. The Series C Preferred Units are redeemable by the Company at any time, upon a change of control or liquidation, or by the investor any time after 6 years from the initial date of purchase. The Series C Preferred Units have a fixed value which is their purchase price and preferred liquidation and distribution rights. Yearly distributions of 12% of the Series C Preferred Units’ value (provided profits are available) will be made quarterly. This rate may increase if our Notes Program interest rates rise above 12%. Dividends may be reinvested monthly into additional Series C Preferred Units.
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Investors in the Series C Preferred Units may elect to reinvest their distributions in additional Series C Preferred Units (the “Series C Reinvestment Program”). Pursuant to the Series C Reinvestment Program, we issued the following Series C Preferred Units during 2017:
| Date | Recipient | Series C Preferred Units Issued | Distribution Proceeds | |||||||
| March 31, 2017 | Margaret Rauscher IRA LLC | 0.0212903 | $ | 2.12903 | ||||||
| William Myrick (IRA) | - | - | ||||||||
| April 30, 2017 | Margaret Rauscher IRA LLC | 0.0442129 | 4.42129 | |||||||
| William Myrick (IRA) | 0.0300670 | 3.00670 | ||||||||
| May 31, 2017 | Margaret Rauscher IRA LLC | 0.0446550 | 4.46550 | |||||||
| William Myrick (IRA) | 0.0566763 | 5.66763 | ||||||||
| June 30, 2017 | Margaret Rauscher IRA LLC | 0.0451016 | 4.51016 | |||||||
| William Myrick (IRA) | 0.0572431 | 5.72431 | ||||||||
| July 31, 2017 | Margaret Rauscher IRA LLC | 0.0455526 | 4.55526 | |||||||
| William Myrick (IRA) | 0.0578155 | 5.78155 | ||||||||
| August 31, 2017 | Margaret Rauscher IRA LLC | 0.0460081 | 4.60081 | |||||||
| William Myrick (IRA) | 0.0583936 | 5.83936 | ||||||||
| September 30, 2017 | Margaret Rauscher IRA LLC | 0.0464682 | 4.64682 | |||||||
| William Myrick (IRA) | 0.0589776 | 5.89776 | ||||||||
| October 31, 2017 | Margaret Rauscher IRA LLC | 0.0469329 | 4.69329 | |||||||
| William Myrick (IRA) | 0.0595674 | 5.95674 | ||||||||
| November 30, 2017 | Margaret Rauscher IRA LLC | 0.0474022 | 4.74022 | |||||||
| William Myrick (IRA) | 0.0601630 | 6.01630 | ||||||||
| December 31, 2017 | Margaret Rauscher IRA LLC | 0.0478762 | 4.78762 | |||||||
| William Myrick (IRA) | 0.0607647 | 6.07647 | ||||||||
| Total | 0.9351681 | $ | 93.51682 | |||||||
The proceeds received from the sales of the Series C Preferred Units discussed above were used for the funding of construction loans. The transactions in Series C Preferred Units described above were effected in private transactions exempt from the registration requirements of the Securities Act under Section 4(a)(2) of the Securities Act. The transactions described above did not involve any public offering, were made without general solicitation or advertising, and the buyer represented to us that it is an “accredited investor’’ within the meaning of Rule 501 of Regulation D promulgated under the Securities Act, with access to all relevant information necessary to evaluate the investment in the Series C Preferred Units.
| (b) | Notes Program |
We registered up to $70,000 in Fixed Rate Subordinated Notes in our public offering (SEC File No. 333-203707, effective September 29, 2015). As of December 31, 2017, we had issued a gross amount of $14,614 in Notes pursuant to our public offering. From September 29, 2015 through December 31, 2017, we incurred expenses of $193 in connection with the issuance and distribution of the Notes, which were paid to third parties. These expenses were not for underwriters or discounts, but were for advertising, printing, and professional services. Net offering proceeds as of December 31, 2017 were $14,421, 100% of which was used to increase loan balances.
| (c) | None. |
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ITEM 6. SELECTED FINANCIAL DATA
(All dollar [$] amounts shown in thousands.)
The following selected consolidated financial data should be read together with our consolidated financial statements and accompanying notes and “Management Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this document. The selected consolidated financial data in this section is not intended to replace our consolidated financial statements and the accompanying notes. Our historical results and information are not necessarily indicative of our future results.
The summary consolidated financial data as of and for the fiscal years ended December 31, 2017 and 2016 is derived from our audited consolidated financial statements included elsewhere in this document. The summary consolidated financial data as of and for the fiscal years ended December 31, 2015, 2014, and 2013 is derived from our audited consolidated financial statements not included in this document.
As of, and for, the years ended December 31,
| 2017 | 2016 | 2015 | 2014 | 2013 | ||||||||||||||||
| (Audited) | (Audited) | (Audited) | (Audited) | (Audited) | ||||||||||||||||
| Operations Data | ||||||||||||||||||||
| Net interest income | ||||||||||||||||||||
| Interest income | $ | 5,812 | $ | 3,640 | $ | 1,863 | $ | 1,138 | $ | 596 | ||||||||||
| Interest expense | 2,707 | 1,748 | 864 | 433 | 157 | |||||||||||||||
| Provision for Loan losses | 44 | 16 | 59 | 22 | – | |||||||||||||||
| Net interest income after loan loss provision | 3,061 | 1,876 | 940 | 683 | 439 | |||||||||||||||
| Non-Interest Income | ||||||||||||||||||||
| Gain from foreclosure of assets | 77 | 72 | 105 | – | – | |||||||||||||||
| Non-Interest Expense | ||||||||||||||||||||
| Selling, general and administrative expenses | 2,090 | 1,319 | 547 | 390 | 415 | |||||||||||||||
| Impairment loss on foreclosed assets | 266 | 111 | – | – | – | |||||||||||||||
| Net income | $ | 782 | $ | 518 | $ | 498 | $ | 293 | $ | 24 | ||||||||||
| Balance Sheet Data | ||||||||||||||||||||
| Cash and cash equivalents | $ | 3,478 | $ | 1,566 | $ | 1,341 | $ | 558 | $ | 722 | ||||||||||
| Accrued interest on loans | 720 | 280 | 146 | 78 | 27 | |||||||||||||||
| Property, plant and equipment | 910 | 69 | – | – | ||||||||||||||||
| Other assets | 168 | 82 | 14 | 13 | 14 | |||||||||||||||
| Loans receivable, net | 30,043 | 20,091 | 14,060 | 8,097 | 4,045 | |||||||||||||||
| Foreclosed assets | 1,036 | 2,798 | 965 | – | – | |||||||||||||||
| Total assets | 36,355 | 24,886 | 16,526 | 8,746 | 4,808 | |||||||||||||||
| Customer interest escrow | 935 | 812 | 498 | 318 | 255 | |||||||||||||||
| Accounts payable, accrued interest payable and other accrued expenses | 2,058 | 1,363 | 539 | 199 | 59 | |||||||||||||||
| Notes payable unsecured, net of deferred financing costs | 16,904 | 11,962 | 8,497 | 5,172 | 2,590 | |||||||||||||||
| Notes payable secured | 11,644 | 7,322 | 3,683 | – | – | |||||||||||||||
| Notes payable related parties | – | – | – | – | – | |||||||||||||||
| Due to preferred equity member | 31 | 28 | 25 | – | – | |||||||||||||||
| Total liabilities | 31,572 | 21,487 | 13,242 | 5,689 | 2,904 | |||||||||||||||
| Redeemable preferred equity | 1,097 | – | – | – | – | |||||||||||||||
| Members’ capital | 3,686 | 3,399 | 3,284 | 3,057 | 1,904 | |||||||||||||||
| Members’ contributions | 90 | 140 | 10 | 1,000 | – | |||||||||||||||
| Members’ distributions | (585 | ) | (543 | ) | (281 | ) | (140 | ) | (22 | ) | ||||||||||
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(All dollar [$] amounts shown in thousands.)
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and the notes thereto contained elsewhere in this report. See also “Cautionary Note Regarding Forward-Looking Statements” preceding Part I.
Overview
We were organized in the Commonwealth of Pennsylvania in 2007 under the name 84 RE Partners, LLC and changed our name to Shepherd’s Finance, LLC on December 2, 2011. We converted to a Delaware limited liability company on March 29, 2012. Our business is focused on commercial lending to participants in the residential construction and development industry. We believe this market is underserved because of the lack of traditional lenders currently participating in the market. We are located in Jacksonville, Florida. Our operations are governed pursuant to our operating agreement.
The commercial loans we extend are secured by mortgages on the underlying real estate. We extend and service commercial loans to small-to-medium sized homebuilders for the purchase of lots and/or the construction of homes thereon. In some circumstances, the lot is purchased with an older home on the lot which is then either removed or rehabilitated. If the home is rehabilitated, the loan is referred to as a “rehab” loan. We also extend and service loans for the purchase of undeveloped land and the development of that land into residential building lots. In addition, we may, depending on our cash position and the opportunities available to us, do none, any or all of the following: purchase defaulted unsecured debt from suppliers to homebuilders at a discount (and then secure that debt with real estate or other collateral), purchase defaulted secured debt from financial institutions at a discount, and purchase real estate in which we will operate our business.
We had $30,043 and $20,091 in loan assets as of December 31, 2017 and 2016, respectively. As of December 31, 2017, and 2016, respectively, we had 168 and 69 construction loans in 16 and 15 states with 52 and 30 borrowers. As of December 31, 2017, and 2016 we had three development loans in Pittsburgh, Pennsylvania. We have various sources of funding, detailed below:
| December 31, 2017 | December 31, 2016 | |||||||
| Capital Source | ||||||||
| Purchase and sale agreements and other secured borrowings | $ | 11,644 | $ | 7,322 | ||||
| Secured line of credit from affiliates | – | – | ||||||
| Unsecured senior line of credit from a bank | – | – | ||||||
| Unsecured Notes through our Notes Program | 14,121 | 11,221 | ||||||
| Other unsecured debt | 3,069 | 1,152 | ||||||
| Preferred equity Series B units | 1,240 | 1,150 | ||||||
| Preferred equity Series C units | 1,097 | – | ||||||
| Common equity | 2,446 | 2,249 | ||||||
| Total | $ | 33,617 | $ | 23,094 | ||||
In 2017 and continuing into 2018, we worked on expanding our loan portfolio, while increasing capital and adding people and infrastructure to accommodate our expansion.
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Economic and Industry Dynamics
We found a niche in the home construction financing industry, to become the lender of choice or secondary lender to residential homebuilders during the absence of sufficient lending at the homebuilder’s local financial institution or community bank. Our customers increase their sales and profits by borrowing from us and, in return we generate positive returns on secured loans we make to them.
Perceived Challenges and Anticipated Responses
The following is not intended to represent a comprehensive list or description of the risks or challenges facing the Company. Currently, our management is most focused on the following challenges along with the corresponding actions to address those challenges:
| Perceived Challenges and Risks | Anticipated Management Actions/Response | ||
| Potential loan value-to-collateral value issues (i.e., being underwater on particular loans) | We manage this challenge by risk-rating both the geographic region and the builder, and then adjusting the loan-to-value (i.e., the loan amount versus the value of the collateral) based on risk assessments. Additionally, we collect a deposit up-front for construction loans. Despite these efforts, if values in a particular area of the country drop by 60%, we will have loaned more than the value of the collateral. We have found that the best solution to this risk is a speedy resolution of the loan, and helping the builder finish the home rapidly rather than foreclosing on the partially built home. Our experience in this area will help us limit, but not eliminate, the negative effects in the event of another economic downturn. | ||
| Concentration of loan portfolio (i.e., how many of the loans are of or with any particular type, customer, or geography) | As of December 31, 2017, and 2016, 22% and 37%, of our outstanding loan commitments consist of loans to one borrower, and the collateral is in one real estate market, Pittsburgh, Pennsylvania. Accordingly, the ultimate collectability of a significant portion of these loans is susceptible to changes in market conditions in that area. As of December 31, 2017, our next two largest customers make up 7% and 5% of our loan commitments, with loans in Sarasota, Florida and Orlando, Florida, respectively. As of December 31, 2016, our next two largest customers made up 11% and 6% of our loan commitments, with loans in Sarasota, Florida and Savannah, Georgia, respectively. In the upcoming years, we plan on continuing to increase our geographic and builder diversity while continuing to focus on our residential homebuilder customers. | ||
| Not having funds available to us to service the commitments we have | The typical construction loan has about 60% of its loan amount outstanding on average. That means that on average, about 40% of the commitment is not loaned, usually because the house is not complete. As of December 31, 2017, unfunded commitments totaled $19,312, which we will fund along with our purchase and sale agreement participants. However, if we are short on cash, we could do the following:
● raise interest rates on the Notes we offer to our investors to attract new Note investments;
● sell more secured interest on our loans; or
● draw down on our lines of credit from our affiliates. |
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| Nonpayment of interest by our customers | Most of our customers pay interest on a monthly basis, and these funds are used to, among other things, pay interest on our debt monthly. While we have the liquidity to withstand some nonpayment of interest, if a high percentage of our customers were not paying interest, it will impede our ability to pay our debts on time. | ||
| Nonperforming assets | As of December 31, 2017, we had $3,478 in cash and $1,036 in foreclosed assets. These items do not have a return. However, we do have the ability to repay most of our debt without penalty, if we believe that is appropriate. |
Opportunities
Although we can give no assurance as to our success, in the future, our management will focus its efforts on the following opportunities:
| ● | receiving money from the Notes and other sources of capital, sufficient to operate our business and allow for growth and diversification in our loan portfolio; | |
| ● | growing loan assets, staffing, and infrastructure to handle it. We hire office staff as loan volume grows, and hire the origination staff, which is field-based, as our liquidity allows for new loan originations. The goal for the field staff is to have a geographic coverage that eventually covers most of the continental U.S.; | |
| ● | obtaining lines of credit from financial institutions. We would like the maximum amount (the credit limit) to be 20% of our asset size, and our outstanding amounts to average 10% of our asset size. We added an unsecured line of credit in January 2017, but want more capacity in this area; and | |
| ● | retaining a portion of earnings to grow the equity of the Company. |
Understanding and Evaluating Our Operating Results
Our results of operations are driven by three major factors - interest spread, loan losses, and selling, general and administrative (SG&A) expenses.
Interest Spread
Interest spread is generally made up of the following three components:
● Difference between the interest rate received (on our loan assets) and the interest rate paid (on our borrowings).
● Fee income. This fee is generally recognized over the life of the loan, based on the maximum allowed loan balance over the expected life of the loan. The amount of interest spread on these loans will depend on the life of the loans, as well as the fee percentage. As more competition comes into the residential construction lending market, we expect this portion of spread income to decrease as a percentage of assets.
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● Amount of nonperforming assets. Since we are paying interest on all money we borrow, any asset created or funded with borrowed funds that does not have an interest return costs us money. There is an interest expense for us, with no interest income to offset it. Generally, there are two types of nonperforming assets. The first is nonperforming loans and related foreclosed assets held, which do not generate interest income unless actually received in cash. The second nonperforming asset type is money borrowed which is not invested in loans. To mitigate the negative spread on unused borrowed funds (idle cash), we can use our lines of credit to handle daily liquidity. We would like to maintain a secured line of credit with a credit limit of 20% of our loan assets, and generally carry a balance of 10% of our loan assets on that line. This way, as money comes in from Notes or loan payoffs, it can be used to pay down the line, and as money goes out for Note redemptions and new loans created, money can be drawn on the line. This will help reduce any negative spread on idle cash. In January 2017, we obtained an unsecured line of credit, with a maximum borrowing limit of $500, which is 2% of our loan assets as of December 31, 2017. We have additional lines of credit which are secured lines. Those lines are typically fully borrowed (with the exception of our lines of credit to affiliates), and have not yet been used to handle daily liquidity.
We calculate interest spread by taking the difference between interest income and expense, and, when we express it as a percentage, by dividing it by our weighted average outstanding loan balance.
Loan Losses
The second major factor in determining our profitability is loan losses. Losses on loans occur with nonperforming loans (i.e., when customers are unable to repay their interest and/or principal). Normally, the loss in this situation is the difference between the collateral value and the loan value, less any costs of disposal. Homes which were constructed in the mid 2000’s created significant losses because many homes were worth less when completed than the appraised value at the time the loan was created. Losses also occur in loans when homes are partly built at the point of default, or never built. Generally, a declining real estate market will be the primary driver for loan losses. We believe that while current values may fall in some real estate markets, in general, values are average and represent an average risk, and that over the last several years in general, values have been rising. Another type of loss relating to loans is the loss which occurs when the loan becomes a foreclosed asset. At the initial conversion from loan to foreclosed asset, there is a calculation of current value of the real estate vs. the loan amount. If this amount is a loss and has not been provided for previously through our allowance for loan losses, there will be a loss in our consolidated financial statements, typically in the loan loss provision. If there is a gain it will show up in non-interest income. If during the ownership of the asset there is a reason to further write the item down, this loss shows as a non-interest expense. If upon sale there is a gain or loss, those items show up as non-interest gains or losses. Even though these items don’t impact interest spread, they are important pieces of our consolidated financial statements.
SG&A Expenses
SG&A expenses include costs that are not interest and loan/foreclosed asset losses. In 2017, we increased SG&A as compared to 2016 mostly due to increases in the number of employees. We anticipate SG&A expenses increasing as our loan balance increases in 2018; however, this SG&A increase will be partially offset by a reduction in our CEO compensation.
Critical Accounting Estimates
To assist in evaluating our consolidated financial statements, we describe below the critical accounting estimates that we use. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used, would have a material impact on our consolidated financial condition or results of operations.
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Loan Losses
Future losses on current loans are estimated in our financial statements. This estimate is important because it is on our largest asset (loans receivable). It is impossible to know what these losses will be, as the condition of the market cannot be determined, and specific situations with each loan are unpredictable and change constantly. Loan losses, as applicable, are accounted for both on the consolidated balance sheets and the consolidated statements of operations. On the consolidated statements of operations, management estimates the amount of losses to capture during the current year. This current period amount incurred is referred to as the loan loss provision. The calculation of our allowance for loan losses, which appears on our consolidated balance sheets, requires us to compile relevant data for use in a systematic approach to assess and estimate the amount of probable losses inherent in our commercial lending operations and to reflect that estimated risk in our allowance calculations. We use the policy summarized as follows:
We establish a collective reserve for all loans which are not more than 60 days past due at the end of each quarter. This collective reserve includes both a quantitative and qualitative analysis. In addition to historical loss information, the analysis incorporates collateral value, decisions made by management and staff, percentage of aging spec loans, policies, procedures, and economic conditions. We analyze the following:
| ● | Loans to one borrower with less than 10% of our total committed balances; and | |
| ● | Loans to one borrower with greater than or equal to 10% of our total committed balances. |
We individually analyze for impairment all loans which more than 60 days past are due at the end of each quarter. If required, the analysis includes a comparison of estimated collateral value to the principal amount of the loan.
For impaired loans, if the value determined is less than the principal amount due (less any builder deposit), then the difference is included in the allowance for loan loss. As values change, estimated loan losses may be provided for more or less than the previous period, and some loans may not need a loss provision based on payment history. For homes which are partially complete, we appraise on an as-is and completed basis and use the one that more closely aligns with our planned method of disposal for the property.
For loans greater than 12 months in age that are individually evaluated for impairment, appraisals have been prepared within the last 13 months. For all loans individually evaluated for impairment, there is also a broker’s opinions of value (“BOV”) prepared, if the appraisal is more than six months old. The lower of any BOV prepared in the last six months, or the most recent appraisal, is used, unless we determine a BOV to be invalid based on the comparable sales used. If we determine a BOV to be invalid, we will use the appraised value. Appraised values are adjusted down for estimated costs associated with asset disposal. Broker’s opinion of selling price, currently valid sales contracts on the subject property, or representative recent actual closings by the builder on similar properties may be used in place of a broker’s opinion of value.
Appraisers are state certified, and are selected by first attempting to utilize the appraiser who completed the original appraisal report. If that appraiser is unavailable or unreasonably expensive, we use another appraiser who appraises routinely in that geographic area. BOVs are created by real estate agents. We try to first select an agent we have worked with, and then, if that fails, we select another agent who works in that geographic area.
Currently, fair value of collateral has the potential to impact the calculation of the loan loss provision. Specifically, relevant to the allowance for loan loss reserve is the fair value of the underlying collateral supporting the outstanding loan balances. Fair value measurements are an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Due to a rapidly changing economic market, an erratic housing market, the various methods that could be used to develop fair value estimates, and the various assumptions that could be used, determining the collateral’s fair value requires significant judgment.
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| December 31, 2017 | ||||
| Loan Loss | ||||
| Provision | ||||
| Change in Fair Value Assumption | Higher/(Lower) | |||
| Increasing fair value of the real estate collateral by 35%* | $ | – | ||
| Decreasing fair value of the real estate collateral by 35%** | $ | 1,145 | ||
* Increases in the fair value of the real estate collateral do not impact the loan loss provision, as the value generally is not “written up.”
**If the loans were nonperforming, assuming a book amount of the loans outstanding of $30,043, and the fair value of the real estate collateral on all outstanding loans was reduced by 35%, an addition to the loan loss provision of $1,145 would be required.
Foreclosed Assets
Foreclosed assets, as applicable, are accounted for both on the consolidated balance sheets and the consolidated statements of operations. On the consolidated statements of operations, management estimates the amount of impairment to capture when a loan is converted to a foreclosed asset, the impairment when the value of an asset drops below its carrying amount, and any loss or gain upon final disposition of the asset. The calculation of the impairment, which appears on our consolidated balance sheets as a reduction in the asset, requires us to compile relevant data for use in a systematic approach to assess and estimate the value of the asset and therefore any required impairment thereof. We use the policy summarized as follows:
For properties which exist in the condition in which we intend to sell them, we obtain an appraisal of the assets current value. We reduce the appraised value by 10% to account for selling costs. This amount is used to initially book the asset. Typically, prior to the initial booking of the foreclosed asset, the loan has already been reserved to this level. If during ownership, the value of the foreclosed asset drops, an additional impairment is recorded. For assets that need to be improved prior to sale, the above calculation is performed at the time of the booking of the foreclosed asset (an appraisal “as-is”), but subsequent to that, we look at the to be completed value minus 10% and subtract off the estimated cost of remaining work to be done. If this results in additional impairment, it is booked in non-interest expense. For assets which are going to be improved, while the asset is a loan (before it becomes a foreclosed asset) the calculation of the specific loan loss reserve is done based on the to be completed value as compared to the book value plus estimated completion costs. This can result in an impairment at the initial booking of the foreclosed asset.
The fair value of real estate will impact our foreclosed asset value, which is booked at 100% of fair value (after selling costs are deducted). Fair value measurements are an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
| December 31, 2017 | ||||
| Foreclosed | ||||
| Assets | ||||
| Change in Fair Value Assumption | Higher/(Lower) | |||
| Increasing fair value of the foreclosed asset by 35%* | $ | – | ||
| Decreasing fair value of the foreclosed asset by 35% | $ | (363 | ) | |
* Increases in the fair value of the foreclosed assets do not impact the carrying value, as the value generally is not “written up.” Those gains would be recognized at the sale of the asset.
Other Loss Contingencies
Other loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Disclosure is required when there is a reasonable possibility that the ultimate loss will exceed the recorded provision. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as courts, arbitrators, juries, or regulators.
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Accounting and Auditing Standards Applicable to “Emerging Growth Companies”
We are an “emerging growth company” under the recently enacted JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (1) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (2) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (3) comply with any new requirements adopted by the Public Company Accounting Oversight Board, or the PCAOB, requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (4) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. We intend to take advantage of such extended transition period. Since we will not be required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies, our consolidated financial statements may not be comparable to the financial statements of companies that comply with public company effective dates. If we were to subsequently elect to instead comply with these public company effective dates, such election would be irrevocable pursuant to Section 107 of the JOBS Act.
Other Significant Accounting Policies
Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the consolidated financial statements. Policies related to credit quality information, fair value measurements, offsetting assets and liabilities, related party transactions and revenue recognition require difficult judgments on complex matters that are often subject to multiple and recent changes in the authoritative guidance. Certain of these matters are among topics currently under reexamination or have recently been addressed by accounting standard setters and regulators. Specific conclusions have not been reached by these standard setters, and outcomes cannot be predicted with confidence. Also, see Note 2 of our consolidated financial statements, as they discuss accounting policies that we have selected from acceptable alternatives.
Consolidated Results of Operations
Key financial and operating data for the years ended December 31, 2017 and 2016 are set forth below. For a more complete understanding of our industry, the drivers of our business, and our current period results, this discussion should be read in conjunction with our consolidated financial statements, including the related notes and the other information contained in this document.
Accounting principles generally accepted in the United States of America (U.S. GAAP) require that we report financial and descriptive information about reportable segments and how these segments were determined. Our management determines the allocation and performance of resources based on operating income, net income and operating cash flows. Segments are identified and aggregated based on the products sold or services provided and the market(s) they serve. Based on these factors, management has determined that our ongoing operations are in one segment, commercial lending.
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Below is a summary of our income statement for the years ended December 31, 2017 and 2016:
| 2017 | 2016 | |||||||
| Net Interest Income | ||||||||
| Interest and fee income on loans | $ | 5,812 | $ | 3,640 | ||||
| Interest expense: | ||||||||
| Interest related to secured borrowings | 1,047 | 570 | ||||||
| Interest related to unsecured borrowings | 1,660 | 1,178 | ||||||
| Interest expense | $ | 2,707 | $ | 1,748 | ||||
| Net interest income | 3,105 | 1,892 | ||||||
| Less: Loan loss provision | 44 | 16 | ||||||
| Net interest income after loan loss provision | 3,061 | 1,876 | ||||||
| Non-Interest Income | ||||||||
| Gain on foreclosure of assets | 77 | 44 | ||||||
| Gain on sale of foreclosed assets | – | 28 | ||||||
| Total non-interest income | 77 | 72 | ||||||
| Income | 3,138 | 1,948 | ||||||
| Non-Interest Expense | ||||||||
| Selling, general and administrative | 2,090 | 1,319 | ||||||
| Impairment loss on foreclosed assets | 266 | 111 | ||||||
| Total non-interest expense | 2,356 | 1,430 | ||||||
| Net income | $ | 782 | $ | 518 | ||||
| Earned distribution to preferred equity holder | 212 | 107 | ||||||
| Net income attributable to common equity holders | $ | 570 | $ | 411 | ||||
Interest Spread
The following table displays a comparison of our interest income, expense, fees and spread for the years ended December 31, 2017 and 2016:
| 2017 | 2016 | |||||||||||||||
| Interest Income | * | * | ||||||||||||||
| Interest income on loans | $ | 3,914 | 14 | % | $ | 2,413 | 13 | % | ||||||||
| Fee income on loans | 1,898 | 7 | % | 1,227 | 7 | % | ||||||||||
| Interest and fee income on loans | 5,812 | 21 | % | 3,640 | 20 | % | ||||||||||
| Interest expense – secured | 1,047 | 4 | % | 570 | 3 | % | ||||||||||
| Interest expense – unsecured | 1,447 | 5 | % | 911 | 5 | % | ||||||||||
| Amortization of offering costs | 213 | 1 | % | 267 | 2 | % | ||||||||||
| Interest expense | 2,707 | 10 | % | 1,748 | 10 | % | ||||||||||
| Net interest income (spread) | 3,105 | 11 | % | 1,892 | 10 | % | ||||||||||
| Weighted average outstanding loan asset balance | $ | 27,269 | $ | 18,249 | ||||||||||||
*annualized amount as percentage of weighted average outstanding gross loan balance
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There are three main components that can impact our interest spread:
● Difference between the interest rate received (on our loan assets) and the interest rate paid (on our borrowings). The loans we have originated have interest rates which are based on our cost of funds, with a minimum cost of funds of 5%. For most loans, the margin is fixed at 2%. Future loans are anticipated to be originated at approximately the same 2% margin. This component is also impacted by the lending of money with no interest cost (our equity). Our interest income on loans was higher in 2017 vs. 2016 by 1%. This increase was due to: 1) an increase in the rate we are charging on our development loans, and 2) an increase in the rate charged to builders beyond our standard rates (typically due to the age of the loan). While our average construction loan lasts for eight months, those that go beyond twelve months pay a higher rate of interest, even though they are paying interest on time. Our interest expense in 2017 was the same percentage cost as 2016 (10%).
The difference between the interest income and interest expense was 4% and 3% for 2017 and 2016, respectively. This was due to the interest income increasing, as discussed in the previous paragraph. We anticipate similar numbers in 2018 to the past two years, with some of the same reasons impacting the difference (the percentage of development loans compared to total loans, and the percentage of outstanding dollars on construction loans paying higher than standard rates).
● Fee income. The Pennsylvania Loans originated in December 2011 had a net origination fee of $924. This fee was recognized over the life of the loans, and was fully recognized as of August 2016. Our construction loans have a 5% fee on the amount we commit to lend, which is amortized over the expected life of each of those loans. When loans pay back quicker than their expected life, the remaining unrecognized fee is recognized upon the termination of the loan. For both 2017 and 2016, fee income was 7% of the average outstanding balance on all loans. The decrease in fee income from the development loans in the later part of 2016 and all of 2017 was offset by a higher percentage of our loans being construction loans. In the future, we anticipate creating loans with fees ranging between 4% and 5% of the collateral loan amount, and we anticipate that our fee percentage in 2018 will be similar.
● Amount of nonperforming assets. Generally, we have three types of nonperforming assets that negatively affect interest spread: loans not paying interest, foreclosed assets, and cash. We had two nonperforming loans in the first half of 2017, which terminated in the second half of 2017. Our foreclosed asset balance decreased to $1,036 at December 31, 2017, compared to $2,798 at December 31, 2016. The amount of nonperforming assets is expected to rise over the next twelve months, both due to work expected on the two lots we currently own and due to idle cash increases which are anticipated due to large borrowing inflows.
Loan Loss Provision
We recorded $44 and $16 in the years ended December 31, 2017 and 2016, respectively, in loss reserve related to our collective reserve (loans not individually impaired) and $0 in both years for our specific reserve (for loans individually impaired). We anticipate that the collective and specific reserves will increase as our loan balances rise throughout 2018.
Non-Interest Income
We recognized foreclosed gains of $0 and $44 in the years ended December 31, 2017 and 2016, respectively, from the initial foreclosure of assets. This represents the difference between our loan book value and the appraised value, net of selling costs, of the real estate. We also sold a foreclosed asset in both 2017 and 2016 and recognized gains of $77 and $28, respectively. We do not anticipate revenue in this area in 2018.
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SG&A Expenses
The following table displays our SG&A expenses for the years ended December 31, 2017 and 2016:
| 2017 | 2016 | |||||||
| Selling, general and administrative expenses | ||||||||
| Legal and accounting | $ | 196 | $ | 167 | ||||
| Salaries and related expenses | 1,435 | 798 | ||||||
| Board related expenses | 108 | 112 | ||||||
| Advertising | 59 | 46 | ||||||
| Rent and utilities | 33 | 19 | ||||||
| Loan and foreclosed asset expenses | 57 | 62 | ||||||
| Travel | 78 | 35 | ||||||
| Other | 124 | 80 | ||||||
| Total SG&A | $ | 2,090 | $ | 1,319 | ||||
Our payroll cost was significantly higher in 2017 as our staff grew. We anticipate continuing to grow our staff in 2018, however we also anticipate that our CEO will receive significantly less pay in 2018, which may partially offset some of these increases.
Impairment Loss on Foreclosed Assets
We recorded $266 and $111 in the years ended December 31, 2017 and 2016, respectively, in impairment losses of our foreclosed assets (real estate taken in foreclosure). These losses are generally due to either decreases in value or cost overruns in completion. We may have more impairment in 2018 either on our existing or acquired foreclosed assets.
Consolidated Financial Position
Cash and Cash Equivalents
We try to avoid borrowing on our line of credit from affiliates. To accomplish this, we must carry some cash for liquidity. This amount generally grows as our Company grows. At December 31, 2017 and 2016, we had $3,478 and $1,566, respectively, in cash. See our Liquidity and Capital Resources section for more information.
Deferred Financing Costs, Net
We expect that the gross deferred financing amount will continue to increase over time as the anticipated financing costs are deferred when paid, and expensed over the life of the debt associated with the financing using the effective interest method. We also expect that the amortization expense and the accumulated amortization will increase in 2018 as compared to 2017. The deferred financing costs are reflected as a reduction in the unsecured Notes Program.
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The following is a roll forward of deferred financing costs:
| December 31, 2017 | December 31, 2016 | |||||||
| Deferred financing costs, beginning balance | $ | 1,014 | $ | 935 | ||||
| Additions | 88 | 79 | ||||||
| Deferred financing costs, ending balance | $ | 1,102 | $ | 1,014 | ||||
| Less accumulated amortization | (816 | ) | (603 | ) | ||||
| Deferred financing costs, net | $ | 286 | $ | 411 | ||||
The following is a roll forward of the accumulated amortization of deferred financing costs:
| December 31, 2017 | December 31, 2016 | |||||||
| Accumulated amortization, beginning balance | $ | 603 | $ | 336 | ||||
| Additions | 213 | 267 | ||||||
| Accumulated amortization, ending balance | $ | 816 | $ | 603 | ||||
Loans Receivable
Commercial Loans – Construction Loan Portfolio Summary
The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2017:
| State | Number
of Borrowers | Number
of Loans | Value
of Collateral (1) | Commitment Amount | Amount
Outstanding | Loan
to Value Ratio(2) | Loan Fee | |||||||||||||||||
| Colorado | 3 | 6 | $ | 3,224 | $ | 2,196 | $ | 925 | 68 | % | 5 | % | ||||||||||||
| Delaware | 1 | 1 | 244 | 171 | 147 | 70 | % | 5 | % | |||||||||||||||
| Florida | 15 | 54 | 25,368 | 16,555 | 10,673 | 65 | % | 5 | % | |||||||||||||||
| Georgia | 7 | 13 | 8,932 | 5,415 | 3,535 | 61 | % | 5 | % | |||||||||||||||
| Indiana | 2 | 2 | 895 | 566 | 356 | 63 | % | 5 | % | |||||||||||||||
| Michigan | 4 | 25 | 7,570 | 4,717 | 2,611 | 62 | % | 5 | % | |||||||||||||||
| New Jersey | 2 | 11 | 3,635 | 2,471 | 1,227 | 68 | % | 5 | % | |||||||||||||||
| New York | 1 | 5 | 1,756 | 929 | 863 | 53 | % | 5 | % | |||||||||||||||
| North Carolina | 3 | 6 | 1,650 | 1,155 | 567 | 70 | % | 5 | % | |||||||||||||||
| Ohio | 1 | 1 | 711 | 498 | 316 | 70 | % | 5 | % | |||||||||||||||
| Oregon | 1 | 1 | 607 | 425 | 76 | 70 | % | 5 | % | |||||||||||||||
| Pennsylvania | 2 | 20 | 15,023 | 7,649 | 5,834 | 51 | % | 5 | % | |||||||||||||||
| South Carolina | 7 | 18 | 4,501 | 3,058 | 1,445 | 68 | % | 5 | % | |||||||||||||||
| Tennessee | 1 | 2 | 690 | 494 | 494 | 72 | % | 5 | % | |||||||||||||||
| Utah | 1 | 2 | 790 | 553 | 344 | 70 | % | 5 | % | |||||||||||||||
| Virginia | 1 | 1 | 335 | 235 | 150 | 70 | % | 5 | % | |||||||||||||||
| Total | 52 | (4) | 168 | $ | 75,931 | $ | 47,087 | $ | 29,563 | 62 | %(3) | 5 | % | |||||||||||
| (1) | The value is determined by the appraised value. | |
| (2) | The loan to value ratio is calculated by taking the commitment amount and dividing by the appraised value. | |
| (3) | Represents the weighted average loan to value ratio of the loans. | |
| (4) | We have one builder in two states. |
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The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2016:
| State | Number
of Borrowers | Number
of Loans | Value
of Collateral (1) | Commitment Amount | Amount
Outstanding | Loan
to Value Ratio(2) | Loan Fee | |||||||||||||||||
| Colorado | 1 | 3 | $ | 1,615 | $ | 1,131 | $ | 605 | 70 | % | 5 | % | ||||||||||||
| Connecticut | 1 | 1 | 715 | 500 | 479 | 70 | % | 5 | % | |||||||||||||||
| Delaware | 1 | 2 | 244 | 171 | 40 | 70 | % | 5 | % | |||||||||||||||
| Florida | 7 | 15 | 14,014 | 8,548 | 4,672 | 61 | % | 5 | % | |||||||||||||||
| Georgia | 4 | 9 | 6,864 | 4,249 | 2,749 | 62 | % | 5 | % | |||||||||||||||
| Idaho | 1 | 1 | 319 | 215 | 205 | 67 | % | 5 | % | |||||||||||||||
| Michigan | 1 | 1 | 210 | 126 | 118 | 60 | % | 5 | % | |||||||||||||||
| New Jersey | 1 | 3 | 977 | 719 | 528 | 74 | % | 5 | % | |||||||||||||||
| New York | 1 | 4 | 1,745 | 737 | 685 | 42 | % | 5 | % | |||||||||||||||
| North Carolina | 2 | 2 | 1,015 | 633 | 216 | 62 | % | 5 | % | |||||||||||||||
| Ohio | 1 | 1 | 1,405 | 843 | 444 | 60 | % | 5 | % | |||||||||||||||
| Pennsylvania | 2 | 15 | 12,725 | 6,411 | 5,281 | 50 | % | 5 | % | |||||||||||||||
| South Carolina | 5 | 7 | 2,544 | 1,591 | 783 | 63 | % | 5 | % | |||||||||||||||
| Tennessee | 1 | 3 | 1,080 | 767 | 430 | 71 | % | 5 | % | |||||||||||||||
| Utah | 1 | 2 | 715 | 500 | 252 | 70 | % | 5 | % | |||||||||||||||
| Total | 30 | 69 | $ | 46,187 | $ | 27,141 | $ | 17,487 | 59 | %(3) | 5 | % | ||||||||||||
Commercial Loans – Real Estate Development Loan Portfolio Summary
The following is a summary of our loan portfolio to builders for land development as of December 31, 2017 and December 31, 2016:
| Year | State | Number of Borrowers | Number of Loans | Value of Collateral(1) | Commitment Amount(3) | Gross
Amount Outstanding | Loan
to Value Ratio(2) | Loan
Fee | ||||||||||||||||||
| 2017 | Pennsylvania | 1 | 3 | $ | 4,997 | $ | 4,600 | $ | 2,811 | 56 | % | $ | 1,000 | |||||||||||||
| 2016 | Pennsylvania | 1 | 3 | 6,586 | 5,931 | 4,082 | 62 | % | 1,000 | |||||||||||||||||
| (1) | The value is determined by the appraised value adjusted for remaining costs to be paid and third-party mortgage balances. Part of this collateral is $1,240 in 2017 and $1,150 in 2016 of preferred equity in our Company. In the event of a foreclosure on the property securing these loans, the portion of our collateral that is preferred equity in our Company might be difficult to sell, which could impact our ability to eliminate the loan balance. |
| (2) | The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value calculated as described above. |
| (3) | The commitment amount does not include letters of credit and cash bonds, as the sum of the total balance outstanding including the cash bonds plus the letters of credit and remaining to fund for construction is less than the $4,600 commitment amount. |
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Financing receivables are comprised of the following:
| December 31, 2017 | December 31, 2016 | |||||||
| Loans receivable, gross | $ | 32,375 | $ | 21,569 | ||||
| Less: Deferred loan fees | (847 | ) | (618 | ) | ||||
| Less: Deposits | (1,497 | ) | (861 | ) | ||||
| Plus: Deferred origination expense | 109 | 55 | ||||||
| Less: Allowance for loan losses | (97 | ) | (54 | ) | ||||
| Loans receivable, net | $ | 30,043 | $ | 20,091 | ||||
In 2018, we anticipate continued growth in our loans receivable, net, and all of the items that comprise it (seen in the chart above).
Roll forward of commercial loans:
| December 31, 2017 | December 31, 2016 | |||||||
| Beginning balance | $ | 20,091 | $ | 14,060 | ||||
| Additions | 33,451 | 23,184 | ||||||
| Payoffs/sales | (22,645 | ) | (15,168 | ) | ||||
| Moved to foreclosed assets | – | (1,639 | ) | |||||
| Change in deferred origination expense | 55 | 55 | ||||||
| Change in builder deposit | (636 | ) | (340 | ) | ||||
| Change in loan loss provision | (44 | ) | (16 | ) | ||||
| New loan fees | (2,127 | ) | (1,270 | ) | ||||
| Earned loan fees | 1,898 | 1,225 | ||||||
| Ending balance | $ | 30,043 | $ | 20,091 | ||||
Credit Quality Information
Finance Receivables – By risk rating:
| December 31, 2017 | December 31, 2016 | |||||||
| Pass | $ | 25,656 | $ | 18,275 | ||||
| Special mention | 6,719 | 3,294 | ||||||
| Classified – accruing | – | – | ||||||
| Classified – nonaccrual | – | – | ||||||
| Total | $ | 32,375 | $ | 21,569 | ||||
Please see our notes to consolidated financial statements for more information about the ratings in the table above.
Finance Receivables – Method of impairment calculation:
| December 31, 2017 | December 31, 2016 | |||||||
| Performing loans evaluated individually | $ | 14,992 | $ | 12,424 | ||||
| Performing loans evaluated collectively | 17,383 | 9,145 | ||||||
| Non-performing loans without a specific reserve | – | – | ||||||
| Non-performing loans with a specific reserve | – | – | ||||||
| Total evaluated collectively for loan losses | $ | 32,375 | $ | 21,569 | ||||
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Below is an aging schedule of loans receivable as of December 31, 2017, on a recency basis:
| No.
Accts. | Unpaid Balances | % | ||||||||||
| Current loans (current accounts and accounts on which more than 50% of an original contract payment was made in the last 59 days) | 153 | $ | 26,421 | 82 | % | |||||||
| 60-89 days | 18 | 5,954 | 18 | % | ||||||||
| 90-179 days | – | – | 0 | % | ||||||||
| 180-269 days | – | – | 0 | % | ||||||||
| Subtotal | 171 | $ | 32,375 | 100 | % | |||||||
| Interest only accounts (Accounts on which interest, deferment, extension and/or default charges were received in the last 60 days) | – | $ | – | - | % | |||||||
| Partial Payment accounts (Accounts on which the total received in the last 60 days was less than 50% of the original contractual monthly payment. “Total received” to include interest on simple interest accounts, as well as late charges on deferment charges on pre-computed accounts.) | – | $ | – | - | % | |||||||
| Total | 171 | $ | 32,375 | 100 | % | |||||||
Below is an aging schedule of loans receivable as of December 31, 2016, on a recency basis:
| No.
Accts. | Unpaid Balances | % | ||||||||||
| Current loans (current accounts and accounts on which more than 50% of an original contract payment was made in the last 59 days) | 71 | $ | 18,617 | 86 | % | |||||||
| 60-89 days | 1 | 2,952 | 14 | % | ||||||||
| 90-179 days | – | – | – | % | ||||||||
| 180-269 days | – | – | – | % | ||||||||
| Subtotal | 72 | $ | 21,569 | 100 | % | |||||||
| Interest only accounts (Accounts on which interest, deferment, extension and/or default charges were received in the last 60 days) | – | $ | – | – | % | |||||||
| Partial Payment accounts (Accounts on which the total received in the last 60 days was less than 50% of the original contractual monthly payment. “Total received” to include interest on simple interest accounts, as well as late charges on deferment charges on pre-computed accounts.) | – | $ | – | – | % | |||||||
| Total | 72 | $ | 21,569 | 100 | % | |||||||
| 39 |
Below is an aging schedule of loans receivable as of December 31, 2017, on a contractual basis:
| No.
Accts. | Unpaid Balances | % | ||||||||||
| Contractual Terms - All current Direct Loans and Sales Finance Contracts with installments past due less than 60 days from due date. | 153 | $ | 26,421 | 82 | % | |||||||
| 60-89 days | 18 | 5,954 | 18 | % | ||||||||
| 90-179 days | – | – | 0 | % | ||||||||
| 180-269 days | – | – | 0 | % | ||||||||
| Subtotal | 171 | $ | 32,375 | 100 | % | |||||||
| Interest only accounts (Accounts on which interest, deferment, extension and/or default charges were received in the last 60 days) | – | $ | – | – | % | |||||||
| Partial Payment accounts (Accounts on which the total received in the last 60 days was less than 50% of the original contractual monthly payment. “Total received” to include interest on simple interest accounts, as well as late charges on deferment charges on pre-computed accounts.) | – | $ | – | – | % | |||||||
| Total | 171 | $ | 32,375 | 100 | % | |||||||
Below is an aging schedule of loans receivable as of December 31, 2016, on a contractual basis:
| No.
Accts. | Unpaid Balances | % | ||||||||||
| Contractual Terms - All current Direct Loans and Sales Finance Contracts with installments past due less than 60 days from due date. | 71 | $ | 18,617 | 86 | % | |||||||
| 60-89 days | 1 | 2,952 | 14 | % | ||||||||
| 90-179 days | – | – | 0 | % | ||||||||
| 180-269 days | – | – | 0 | % | ||||||||
| Subtotal | 72 | $ | 21,569 | 100 | % | |||||||
| Interest only accounts (Accounts on which interest, deferment, extension and/or default charges were received in the last 60 days) | – | $ | – | – | % | |||||||
| Partial Payment accounts (Accounts on which the total received in the last 60 days was less than 50% of the original contractual monthly payment. “Total received” to include interest on simple interest accounts, as well as late charges on deferment charges on pre-computed accounts.) | – | $ | – | – | % | |||||||
| Total | 72 | $ | 21,569 | 100 | % | |||||||
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Foreclosed Assets
Roll forward of foreclosed assets for the years ended December 31, 2017 and 2016:
| 2017 | 2016 | |||||||
| Beginning balance | $ | 2,798 | $ | 965 | ||||
| Additions from loans | – | 1,813 | ||||||
| Additions for construction/development | 317 | 566 | ||||||
| Sale proceeds | (1,890 | ) | (463 | ) | ||||
| Gain on Sale | 77 | 28 | ||||||
| Impairment loss on foreclosed assets | (266 | ) | (111 | ) | ||||
| Ending balance | $ | 1,036 | $ | 2,798 | ||||
We started 2016 with five foreclosed assets. One sold in 2016. We added a new one in 2016. In 2017, we did not add any new foreclosed assets, and we sold one. That left us with four foreclosed assets at the end of 2017. The impairments we recognized in both 2016 and 2017 were on two of the foreclosed assets we still own. We look to sell some of the four assets that we own in 2018. Two of the assets are built homes, and two are lots on which we are building homes.
Customer Interest Escrow
The Pennsylvania Loans called for a funded interest escrow account which was funded with proceeds from the Pennsylvania Loans. The initial funding on that interest escrow was $450. The balance as of December 31, 2017 and 2016 was $466 and $541, respectively. To the extent the balance is available in the interest escrow, interest due on certain loans is deducted from the interest escrow on the date due. The interest escrow is increased by 20% of lot payoffs on the same loans, and by interest and/or distributions on a loan in which we are the borrower and Investor’s Mark Acquisitions, LLC is the lender and on the Series B preferred equity. All of these transactions are noncash to the extent that the total escrow amount does not need additional funding.
We have 30 and 16 other loans active as of December 31, 2017 and 2016, respectively, which also have interest escrows. The cumulative balance of all interest escrows other than the Pennsylvania Loans was $469 and $271 as of December 31, 2017 and 2016, respectively. We anticipate a moderate growth in the interest escrow balance during 2018.
Roll forward of interest escrow for the years ended December 31, 2017 and 2016:
| 2017 | 2016 | |||||||
| Beginning balance | $ | 812 | $ | 498 | ||||
| Preferred equity dividends | 115 | 104 | ||||||
| Additions from Pennsylvania Loans | 480 | 956 | ||||||
| Additions from other loans | 1,163 | 430 | ||||||
| Interest, fees, principle or repaid to borrower | (1,635 | ) | (1,176 | ) | ||||
| Ending balance | $ | 935 | $ | 812 | ||||
Notes Payable Unsecured
Notes payable unsecured as of December 31, 2017 and 2016 was $16,904 and 11,962, respectively. A significant portion of the notes payable was from our Notes offering in the amounts of $14,121 and $11,221 as of December 31, 2017 and 2016, respectively. The unsecured portion of the Swanson line of credit (see Lines of Credit below) was $1,904 and $0 for December 31, 2017 and 2016, respectively. We expect our notes payable unsecured balance to increase as we raise funds to cover our expected growth in loan assets.
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Secured Borrowings
Purchase and Sale Agreements
We have two purchase and sale agreements where we are the seller of portions of loans we create. The two purchasers are Builder Finance, Inc. (“Builder Finance”) and S.K. Funding, LLC (“S.K. Funding”).
In July 2017, we entered into the Sixth Amendment (the “Sixth Amendment”) to our Loan Purchase and Sale Agreement (the “Agreement”) with S.K. Funding. The purpose of the Sixth Amendment was to allow S.K. Funding to purchase portions of the Pennsylvania Loans for a purchase price of $3,000 under parameters different from those specified in the Agreement. The Pennsylvania Loans purchased pursuant to the Sixth Amendment consist of a portion of the loans to the Hoskins Group. We will continue to service the loans. The timing of the Company’s principal and interest payments to S.K. Funding under the Sixth Amendment, and S.K. Funding’s obligation to fund the Pennsylvania Loans, vary depending on the total principal amount of the Pennsylvania Loans outstanding at any time. The Pennsylvania Loans had a principal amount in excess of $4,000 as of the effective date of the Sixth Amendment. While the total principal amount of the Pennsylvania Loans exceeds $1,000, S.K. Funding must fund (by paying the Company) the amount by which the total principal amount of the Pennsylvania Loans exceeds $1,000, with such total amount funded not exceeding $3,000. The interest rate accruing to S.K. Funding under the Sixth Amendment is 10.5% calculated on a 365/366-day basis. When the total principal amount of the Pennsylvania Loans is less than $4,000, the Company will also repay S.K. Funding’s principal as principal payments are received on the Pennsylvania Loans from the underlying borrowers in the amount by which the total principal amount of the Pennsylvania Loans is less than $4,000 until S.K. Funding’s principal has been repaid in full. S.K. Funding will continue to be obligated, as described in this paragraph, to fund (by paying the Company) the Pennsylvania Loans for any increases in the outstanding balance of the Pennsylvania Loans up to no more than a total outstanding amount of $4,000.
The Sixth Amendment has a term of 24 months from the effective date and will automatically renew for additional six-month terms unless either party gives written notice of its intent not to renew the Sixth Amendment at least six months prior to the end of a term. Further, no Protective Advances (as such term is defined in the Agreement) will be required with respect to the Pennsylvania Loans. S.K. Funding will have a priority position as compared to the Company in the case of a default by any of the borrowers.
Lines of Credit
In July 2017, we entered into a line of credit agreement with a group of lenders (“Shuman”). The line is secured with assignments of certain notes and mortgages and carries a total cost of funds to us of 10%. The maximum amount we can draw on the line is $1,325, which was fully borrowed as of December 31, 2017. The Shuman line of credit is due in July 2018.
In October 2017, we entered into a Line of Credit Agreement (the “LOC Agreement”) with Paul Swanson (the “Lender”). Pursuant to the LOC Agreement, the Lender will provide us with a revolving line of credit (the “Line of Credit”) not to exceed $4,000. The LOC Agreement is effective as of October 23, 2017 and will terminate 15 months after that date unless extended by the Lender for one or more additional 15-month periods. We may terminate the LOC Agreement by providing the Lender with notice at least 60 days in advance of the original termination or any renewal termination date.
The Line of Credit requires monthly payments of interest only during the term of the Line of Credit, with the principal balance due upon termination. The unpaid principal amounts advanced on the Line of Credit bear interest for each day until due at a fixed rate per annum (computed on the basis of a year of 360 days for actual days elapsed) for each day at 9%. We may, at our option, choose to prepay the principal, interest, or other amounts due from us under the Line of Credit in whole or in part at any time.
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We are pledging, and will continue to pledge in the future, certain of our commercial loans as collateral for the Line of Credit (the “Collateral Loans”) pursuant to the Collateral Assignment of Notes and Documents dated as of October 23, 2017. The amount outstanding under the Line of Credit may not exceed 67% of the aggregate amount outstanding on the Collateral Loans then pledged to secure the Line of Credit. Our obligation to repay the Line of Credit is evidenced by two Promissory Notes from us dated October 23, 2017 (the “Promissory Notes”), one evidencing a promise to repay the secured portion of the Line of Credit and one evidencing a promise to repay the unsecured portion of the Line of Credit. As of December 31, 2017, the secured portion of the borrowings was $2,096 and the unsecured was $1,904.
R. Scott Summers, P.L.L.C., a West Virginia professional limited liability company (the “Custodian”) will serve as the custodian to hold the Collateral Loans for the benefit of the Lender pursuant to the Custodial Agreement dated as of October 23, 2017 between us, the Lender, and the Custodian. The Custodian is owned by R. Scott Summers, an investor in our public Notes offering and the son of Kenneth R. Summers, one of our independent managers. The Custodian is responsible for certifying to the Lender that it has received the relevant Collateral Loan assignment documentation from us. We are responsible for paying the Custodian’s monthly fee, which is equal to 1% interest on the amount of the Collateral Loans outstanding in the Custodian’s custody.
Summary
The secured borrowings are detailed below:
| December 31, 2017 | December 31, 2016 | |||||||||||||||
| Due From | Due From | |||||||||||||||
| Book Value of | Shepherd’s | Book Value of | Shepherd’s | |||||||||||||
| Loans which | Finance to Loan | Loans which | Finance to Loan | |||||||||||||
| Served
as Collateral | Purchaser
or Lender | Served
as Collateral | Purchaser
or Lender | |||||||||||||
| Loan purchaser | ||||||||||||||||
| Builder Finance | $ | 7,483 | $ | 4,089 | $ | 5,779 | $ | 2,517 | ||||||||
| S.K. Funding | 9,128 | 4,134 | 7,770 | 4,805 | ||||||||||||
| Shuman | 1,747 | 1,325 | – | – | ||||||||||||
| Paul Swanson | 2,518 | 2,096 | – | – | ||||||||||||
| Total | $ | 20,876 | $ | 11,644 | $ | 13,549 | $ | 7,322 | ||||||||
As of December 31, 2016, the $7,770 of loans which served as collateral for S.K. Funding did not include the book value of the foreclosed assets which also secure their position, which amount was $1,813.
We anticipate growing our secured borrowings as our loan assets grown.
Contractual Obligations
The following table shows the maturity of outstanding debt as of December 31, 2017. Note that all of our secured debt is listed as current because each advance is due when the loan serving as collateral is repaid, and those loans are demand loans. Also, the accrued interest column includes interest we have not yet incurred.
| Year Maturing | Total
Amount Maturing | Public Offering | Other
Unsecured | Purchase
and Sale Agreements | ||||||||||||
| < 1 year | $ | 18,681 | $ | 4,633 | $ | 2,404 | $ | 11,644 | ||||||||
| 1-3 years | 10,153 | 9,488 | 665 | – | ||||||||||||
| 3-5 years | – | – | – | – | ||||||||||||
| >5 years | – | – | – | – | ||||||||||||
| Total | $ | 28,834 | $ | 14,121 | $ | 3,069 | $ | 11,644 | ||||||||
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We are obligated to lend money to customers based on agreements we have with them. We do not always have the maximum amount obligated outstanding at any given time. The amount we have not loaned, but are obligated to lend, under certain conditions is a potential liquidity use. This amount was $19,312 as of December 31, 2017 and $11,503 as of December 31, 2016. See Note 10 of our consolidated 2017 financial statements for more information regarding contractual obligations.
Liquidity and Capital Resources
Our operations are subject to certain risks and uncertainties, particularly related to the concentration of our current operations, a significant portion of which is to a single customer and geographic region, as well as the evolution of the current economic environment and its impact on the United States real estate and housing markets. Both the concentration of risk and the economic environment could directly or indirectly cause or magnify losses related to certain transactions and access to and cost of adequate financing.
The Company’s anticipated primary sources of liquidity are:
| Item | December 31, 2017 | December 31, 2016 | Comment | |||||||
| Secured debt | $ | 16,286 | $ | 8,882 | We have two purchase and sale agreements and two secured lines of credit. Both lines of credit mature in 2018. We anticipate this source of liquidity to grow in 2018 as our loan assets grow. | |||||
| Unsecured debt | 11,391 | 5,524 | Our current Notes offering will expire in September 2018, and we anticipate conducting another offering, as this source of capital needs to grow with our projected increase in loan balances in 2018. We do not offer demand deposits (i.e. a checking account) due to the liquidity consequences. | |||||||
| Interest Income | 3,914 | 2,413 | We are somewhat dependent on our larger borrowers to pay interest. We tie our interest rate to the cost of our funds. We anticipate this source to increase in proportion to our increase in loan balances. | |||||||
| Funds from the sale of foreclosed assets | 1,890 | 463 | We anticipate this number in 2018 to be between the last two years. | |||||||
| Funds from our unsecured line of credit | - | - | During 2017 we borrowed against our $500 line of credit with Builder Finance and anticipate borrowing again in 2018 as liquidity dictates. | |||||||
| Cash on hand | 3,478 | 1,566 | ||||||||
The Company’s anticipated primary uses of liquidity are:
| Item | December 31, 2017 | December 31, 2016 | Comment | |||||||
| Unfunded and new loans | $ | 19,312 | $ | 11,503 | We have loan commitments which are unfunded which will need to be funded as the collateral of these loans is built. As we create new loans, some portion of those will be funded at the initial creation of the loan, and then the rest over time. The new loans are not included in the numbers to the left. | |||||
| Payments on secured debt | 11,964 | 5,243 | As loans mature and payoff, we must either replace the collateral with new collateral, or repay the funds borrowed against that loan. | |||||||
| Payments on unsecured debt | 6,574 | 2,247 | We anticipate this number growing in 2018. | |||||||
| Distributions to owners | 487 | 540 | This number is likely to grow in 2018 as our earnings should grow. | |||||||
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Priority of Borrowings
The following table displays our borrowings and a ranking of priority in the legal sense of liquidation. The lower the number, the higher the priority.
| Priority Rank | December 31, 2017 | December 31, 2016 | ||||||||
| Borrowing Source | ||||||||||
| Purchase and sale agreements and other secured borrowings | 1 | $ | 11,644 | $ | 7,322 | |||||
| Secured line of credit from affiliates | 2 | – | – | |||||||
| Unsecured line of credit (senior) | 3 | – | – | |||||||
| Other unsecured debt (senior subordinated) | 4 | 279 | 279 | |||||||
| Unsecured Notes through our public offering, gross | 5 | 14,121 | 11,221 | |||||||
| Other unsecured debt (subordinated) | 5 | 2,617 | 700 | |||||||
| Other unsecured debt (junior subordinated) | 6 | 173 | 173 | |||||||
| Total | $ | 28,834 | $ | 19,695 | ||||||
Inflation, Interest Rates, and Housing Starts
Since we are in the housing industry, we are affected by factors that impact that industry. Housing starts impact our customers’ ability to sell their homes. Faster sales mean higher effective interest rates for us, as the recognition of fees we charge is spread over a shorter period. Slower sales mean lower effective interest rates for us. Slower sales are likely to increase the default rate we experience.
Housing inflation has a positive impact on our operations. When we lend initially, we are lending a percentage of a home’s expected value, based on historical sales. If those estimates prove to be low (in an inflationary market), the percentage we loaned of the value actually decreases, reducing potential losses on defaulted loans. The opposite is true in a deflationary housing price market. It is our opinion that values are average in many of the housing markets in the U.S. today, and our lending against these values is safer than loans made by financial institutions in 2006 to 2008.
Interest rates have several impacts on our business. First, rates affect housing (starts, home size, etc.). High long-term interest rates may decrease housing starts, having the effects listed above. Higher interest rates will also affect our investors. We believe that there will be a spread between the rate our Notes yield to our investors and the rates the same investors could get on deposits at FDIC insured institutions. We also believe that the spread may need to widen if these rates rise. For instance, if we pay 7% above average CD rates when CDs are paying 0.5%, when CDs are paying 3%, we may have to have a larger than 7% difference. This may cause our lending rates, which are based on our cost of funds, to be uncompetitive. High interest rates may also increase builder defaults, as interest payments may become a higher portion of operating costs for the builder. Below is a chart showing three-year U.S. treasury rates, which are being used by us here to approximate CD rates. Short term interest rates have risen slightly but are generally low historically.
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Market Yield on U.S. Treasury Securities at 3-Year Constant Maturity
(Source: Federal Reserve)
Housing prices are also generally correlated with housing starts, so that increases in housing starts usually coincide with increases in housing values, and the reverse is generally true. Below is a graph showing single family housing starts from 2000 through today.
(Source: U.S. Census Bureau)
To date, changes in housing starts, CD rates, and inflation have not had a material impact on our business.
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Off-Balance Sheet Arrangements
As of December 31, 2017, we had no off-balance sheet transactions, nor do we currently have any such arrangements or obligations.
Recent Accounting Pronouncements
See Note 2 to our consolidated financial statements for a description of new or recent accounting pronouncements.
Subsequent Events
See Note 13 to our consolidated financial statements for subsequent events.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and supplementary data filed as part of this annual report are set forth beginning on page F-1 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
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ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of the end of the period covered by this report, management including our CEO (our principal executive officer) and CFO (our principal financial officer) evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Based upon, and as of the date of, the evaluation, our CEO (our principal executive officer) and CFO (our principal financial officer) concluded that the disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported as and when required. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports we file and submit under the Exchange Act is accumulated and communicated to our management, including our CEO (our principal executive officer) and CFO (our principal financial officer), as appropriate to allow timely decisions regarding required disclosure.
Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for us. Our CEO evaluated, as of December 31, 2017, the effectiveness of our internal control over financial reporting. In making this assessment, our CEO used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework (2013). Based on this evaluation, our CEO concluded that our internal control over financial reporting was effective as of December 31, 2017.
During the fourth quarter of 2017, the Company hired a CFO to further implement segregation of duties between the CEO, CFO, and Vice President of Operations. In addition, the Company developed a proprietary system for our investors that will replace our Excel spreadsheet system in 2018. The development of the proprietary system was designed in part to enhance the overall system of internal controls over financial reporting through further automation through various business process. Except for the hiring of a CFO and developing a new proprietary system, there has been no change in our internal control over financial reporting during the year ended December 31, 2017, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
During the fourth quarter of 2017, there was no information required to be disclosed in a report on Form 8-K which was not disclosed in a report on Form 8-K.
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ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Managers and Executive Officers
Included below is certain information about our managers and executive officers. Messrs. Wallach and Summers were appointed to initial terms of one year, two years, and three years, respectively. Following the expiration of these initial terms, our managers are elected to three-year staggered terms pursuant to our current operating agreement, which was adopted on November 6, 2017. In March 2013, Mr. Wallach’s initial one-year term expired and he was elected to a three-year term expiring in March 2016 and a second three-year term expiring in March 2019. In March 2014, Mr. Summer’s initial one-year term expired and he was elected to a three-year term expiring in March 2017 and a second three-year term expiring in March 2020. In March 2015, Eric A. Rauscher was suggested by the members, recommended by the nominating and corporate governance committee of the board of managers, and was appointed by the board of managers to an initial three-year term.
Daniel M. Wallach, age 50, is our CEO and a manager. He has been our CEO since our Company was founded and, prior to the addition of the two independent managers in March 2012, he was our sole manager. Mr. Wallach has over 25 years of experience in finance and real estate. Prior to his time with us, most recently, from May 2011 to July 2011, Mr. Wallach was an Executive Vice President for ProBuild Holdings, a building material supplier to homebuilders. Before that, from 1985 to 1989, and 1990 to April 2011, Mr. Wallach held various positions with 84 Lumber Company and affiliates, including Chief Financial Officer and Director. 84 Lumber is a building material supplier to homebuilders and was, at that time, one of our affiliates. At 84 Lumber, Mr. Wallach oversaw the company’s financial and accounting function, including all aspects related to financial reporting, debt financing, customer financing, customer credit and management information systems. Mr. Wallach was also intimately involved with the creation of 84 FINANCIAL, L.P., a finance company affiliated with and owned by 84 Lumber, which had investment objectives similar to ours. Mr. Wallach has also held operational and finance positions with a mortgage brokerage firm and a building contractor. He graduated from Washington and Jefferson College in Washington, Pennsylvania with a B.A. in Business Administration.
Barbara L. Harshman, age 42, is our Executive Vice President of Operations, a position to which she was appointed in July, 2015. She was hired in August 2012 as Vice President of Operations. Prior to joining the Company, from 2005 to 2012, Ms. Harshman worked in various positions in 84 Lumber Company’s lending operations, including Vice President of Lending. Ms. Harshman also worked as a credit manager for 84 Lumber during 2004 and 2005, where she managed a portfolio of $35,000,000 of unsecured debt owed by builders. Ms. Harshman graduated from Baylor University with a B.A. in Anthropology.
Catherine Loftin, age 39, is our Chief Financial Officer, a position to which she was appointed in January 2018. Ms. Loftin previously served as our Controller from November 2017 until her appointment as Chief Financial Officer. Prior to joining the Company, Ms. Loftin was the Corporate Controller for Lucas Group from November 2016 to June 2017. Prior to Lucas Group, Ms. Loftin was a Division Controller for Pulte Group from July 2014 through November 2016. Prior to Pulte Group, Ms. Loftin was the Director of Financial Reporting for DS Services Holdings, Inc. from November 2013 to April 2014. Ms. Loftin spent a majority of her career with Simmons Bedding Company as Manager of Financial Reporting from 2006 to 2013. Ms. Loftin started her accounting career with PricewaterhouseCoopers, after an internship with PricewaterhouseCoopers. Ms. Loftin received her Bachelors of Business of Administration from the Terry College of Business School at the University of Georgia, and her Masters of Accounting from Kennesaw State University’s Cole’s College of Business.
William Myrick, age 56, is our Executive Vice President of Sales, a position to which he was appointed in March 2018. Mr. Myrick was one of our independent managers from March 2012 to March 2018. He has been involved in lumber and building materials for over 35 years. From July 2012 through December 2017, Mr. Myrick was the CEO of American Builders Supply, a building material supplier to homebuilders, where he was responsible for all aspects of the management of that business. From January 2007 to July 2011, he held various executive officer positions with ProBuild Holdings, including, most recently, CEO, and was responsible for all aspects of the management of ProBuild’s business. From 1982 to January 2007, Mr. Myrick was with 84 Lumber Company, where he held positions including, most recently, Chief Operating Officer. Mr. Myrick served as a director of ProBuild from July 2010 to July 2011, and currently serves as a director of American Builders Supply, a position he has held since July 2012. He is a graduate of the Advanced Management Program from Harvard Business School.
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Kenneth R. Summers, age 72, is one of the independent managers, to which he was elected in March 2012. Mr. Summers retired from United Bank, Inc. of Morgantown, West Virginia in July 2011, but continues to be associated with United Bank, a regional bank. Prior to retirement, he had been an Executive Vice President for United Bank since 2001. In that role he was responsible for the expansion and recognition of the bank’s franchise in north central West Virginia. Mr. Summers has over 30 years of experience as a community bank executive. He graduated from the University of Charleston with a B.S. in Accounting and Management.
Eric A. Rauscher, age 52, is one of the independent managers, to which he was elected in March 2015. Mr. Rauscher is a licensed insurance sales person and has worked in that industry since 1999. Prior to that, he spent over ten years as a field sales engineer. He graduated from Case Western Reserve University with a B.S. in Electrical Engineering and Applied Physics, with a minor in Economics.
Code of Ethics
Our board of managers adopted a Code of Ethics and Business Conduct on August 9, 2012 (the “Code of Ethics”), which contains general guidelines applicable to our employees, executive officers and the members of our board of managers with the purpose of promoting the following: (1) honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; (2) full, fair, accurate, timely and understandable disclosure in reports and documents that we file with, or submit to, the SEC and in other public communications made by us; (3) compliance with applicable laws and governmental rules and regulations; (4) the prompt internal reporting of violations of the Code of Ethics to an appropriate person or persons identified in the Code of Ethics; and (5) accountability for adherence to the Code of Ethics. A copy of the Code of Ethics is posted on our website at www.shepherdsfinance.com.
Audit Committee
Our board of managers has established a separately-designated audit committee, whose charter was adopted on August 9, 2012 and amended on October 30, 2013. The purpose of the audit committee is to oversee the Company’s accounting and financial reporting processes and the audit of the Company’s consolidated financial statements. Our audit committee consists of Messrs. Rauscher and Summers, two of the independent managers. We have no “audit committee financial expert” (as such term is defined in Item 407(d)(5)(ii) of Regulation S-K). We believe the cost to retain a financial expert at this time is prohibitive. However, our board of managers believes that each member of the audit committee has sufficient knowledge and relevant background experience to serve on the audit committee.
ITEM 11. EXECUTIVE COMPENSATION
Executive Officer Compensation
Historically we did not compensate our CEO for services rendered to us. In 2016 and 2017, we did compensate him. In 2018, due to tax law changes, we again are not compensating him. We compensate our Executive Vice President of Operations, and starting in 2018, our Chief Financial Officer. This discussion describes our compensation philosophy and policies.
Objectives of Executive Officer Compensation Program
The objectives of our executive compensation program are to attract, retain, and motivate highly talented executives and to align each executive’s incentives with our short-term and long-term objectives, while maintaining a healthy and stable financial position. Specifically, our executive compensation program is being designed to accomplish the following goals and objectives:
| ● | maintain a compensation program that is equitable in our marketplace; | |
| ● | provide opportunities that integrate pay with the short-term and long-term performance goals; | |
| ● | encourage and reward achievement of strategic objectives, while properly balancing a controlled risk-taking behavior; and | |
| ● | maintain an appropriate balance between base salary and short-term and long-term incentive opportunity. |
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Determining Executive Officer Compensation
The compensation committee of our board of managers is responsible for determining all aspects of our executive compensation program. The determination and assessment of executive compensation are primarily driven by the following three factors: (1) market data based on the compensation levels, programs and practices of other comparable companies for comparable positions, (2) our financial performance, and (3) executive officer performance. We believe these three factors provide a reasonably measurable assessment of executive performance in light of building value and creating a healthy financial position for us. We rely upon the judgment of the members of the compensation committee and not on rigid formulas or short-term changes in business performance in determining the amount and mix of compensation elements and whether each element provides the appropriate incentive and reward for performance that sustains and enhances our long-term growth.
Executive Officer Compensation Components
Base Salary
We provide each of our paid executive officers with a base salary to compensate such officer for services rendered throughout the year. Salaries are established annually based on the individual’s position, experience, performance, past and potential contribution to us, and level of responsibility, as well as our overall financial performance. No specific weighting is applied to any one factor considered, and the independent managers use their judgment and expertise in determining appropriate salaries within the parameters of the compensation philosophy.
Membership Interests
As the beneficial owner of 78.7% (as of March 1, 2018) of our outstanding common membership interests, Mr. Wallach’s interests are closely aligned with our success. Both our Executive Vice President of Operations and our Chief Financial Officer purchased 2% and our Executive Vice President of Sales purchased 14.3% of our outstanding common membership interests from Mr. and Mrs. Wallach. As we hire additional executive officers, we may use membership interests in some fashion as part of their compensation.
The following table provides a summary of the compensation received by our current executives for last two completed fiscal years:
| Name and Position | Year | Salary | Bonus(1) | Stock Awards | Option Awards | Non-Equity Incentive Plan Compensation | Non-Qualified Deferred Compensation Earnings | All Other Compensation(2) | Total | |||||||||||||||||||||||||||
| Daniel
M. Wallach, CEO | 2017 | $ | 156,352 | $ | 245,606 | $ | – | $ | – | $ | – | $ | – | $ | 48,865 | $ | 450,823 | |||||||||||||||||||
| 2016 | $ | 150,458 | $ | 45,000 | $ | – | $ | – | $ | – | $ | – | $ | – | $ | 195,458 | ||||||||||||||||||||
| Barbara L. Harshman, Executive Vice President of Operations | 2017 | 63,300 | 101,833 | – | – | – | – | 18,958 | 184,091 | |||||||||||||||||||||||||||
| 2016 | 56,784 | 19,046 | – | – | – | – | 17,065 | 92,895 | ||||||||||||||||||||||||||||
(1) Amounts in the Bonus column represent amounts paid in the period.
(2) Qualified Retirement Plan Contributions are shown here when funds are contributed to the plan.
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Changes for 2018
Mr. Wallach will receive a base salary of $54,180 for 2018. In addition, Mr. Wallach will receive the Company’s team bonus which will range between $0 and $14,400. However, some of the money he earned for bonuses and profit sharing in 2017 will be paid in 2018 and, therefore, is not reflected in the table above. Ms. Harshman will receive a base salary of $74,382 for 2018. In addition, Ms. Harshman is paid a bonus based on the improvement of the Company’s net income. In addition, Ms. Harshman received a bonus of $53,000 in both 2017 and 2018, which she used to purchase an additional 1% ownership interest from Mr. Wallach in January 2018. Catherine Loftin, our Chief Financial Officer, will receive a base salary of $90,522 for 2018. Both Ms. Loftin and Ms. Harshman will receive the team bonus, which will reward each between $0 and $14,400.
On March 1, 2018, William Myrick resigned his position as a member of our board of managers and on March 5, 2018 he became our Executive Vice President of Sales. Mr. Myrick will receive a base salary of $142,030 for 2018. In addition, Mr. Myrick will receive the team bonus, which will reward between $0 and $14,400.
Board of Managers Compensation
The following table provides a summary of the compensation received by our managers for the year ended December 31, 2017:
| Name | Fees Earned or Paid in Cash | Stock Awards | Option Awards | Non-Equity Incentive Plan Compensation | Change in Pension Value and Nonqualified Deferred Compensation | All Other Compensation | Total | |||||||||||||||||||||
| Daniel M. Wallach | $ | – | $ | – | $ | – | $ | – | $ | – | $ | – | $ | – | ||||||||||||||
| Kenneth R. Summers | 38,000 | – | – | – | – | – | 38,000 | |||||||||||||||||||||
| Eric A. Rauscher | 38,000 | – | – | – | – | – | 38,000 | |||||||||||||||||||||
| William Myrick | 32,000 | – | – | – | – | – | 32,000 | |||||||||||||||||||||
| Total | $ | 108,000 | $ | 108,000 | ||||||||||||||||||||||||
We paid each of the independent managers a retainer of $30,000 per year until 2018. In 2018, the $30,000 retainer has been reduced to $25,000. Our independent managers also receive fees of $2,000 for the first day and $1,200 for any additional days for meetings of the board of managers and committees attended in person, all or a portion of which may be allocated as reimbursement of expenses incurred in connection with attendance at meetings. The independent managers do not receive separate reimbursement of out-of-pocket expenses incurred in connection with attendance at meetings. Mr. Wallach receives no compensation for his services as a manager.
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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth the ownership of our outstanding membership interests as of December 31, 2017:
| Title of Class | Name and Address of Owner (1) | Number
of Units (2) | Percent
of Class | Dollar Value | Percentage of Total Equity | |||||||||||||
| Class A Common Units | Daniel M. Wallach and Joyce S. Wallach | 542.84 | 20.6 | % | 504,823 | 10.5 | % | |||||||||||
| Class A Common Units | 2007 Daniel M. Wallach Legacy Trust | 1,981.00 | 75.4 | % | 1,841,597 | 38.6 | % | |||||||||||
| Class A Common Units | Kenneth R. Summers | 26.29 | 1.0 | % | 24,442 | 0.5 | % | |||||||||||
| Class A Common Units | Eric A. Rauscher | 26.29 | 1.0 | % | 24,442 | 0.5 | % | |||||||||||
| Class A Common Units | William Myrick | 26.29 | 1.0 | % | 24,442 | 0.5 | % | |||||||||||
| Class A Common Units | Barbara Harshman | 13.64 | 0.5 | % | 13,641 | 0.3 | % | |||||||||||
| Class A Common Units | Barbara Harshman IRA | 12.65 | 0.5 | % | 12,651 | 0.3 | % | |||||||||||
| Subtotal of common voting equity | 2,629.00 | 100 | % | 2,446,038 | 51.2 | % | ||||||||||||
| Series C Preferred Units | Margret Rauscher IRA | 4.84 | 44.0 | % | 483,550 | 10.1 | % | |||||||||||
| Series C Preferred Units | William Myrick | 6.14 | 56.0 | % | 613,723 | 12.8 | % | |||||||||||
| Subtotal of Preferred Units | 10.98 | 100 | % | 1,097,273 | 22.9 | % | ||||||||||||
| Series B Preferred Units | Hoskins Group | 12.40 | 100.0 | % | 1,240,000 | 25.9 | % | |||||||||||
| Total Members’ Capital | 2,652.38 | 4,783,311 | 100 | % | ||||||||||||||
| (1) | The address of Daniel and Joyce Wallach, and the 2007 Daniel M. Wallach Legacy is 450-106 State Rd. 13 N, Box 243, Saint Johns, FL, 32259. The address of each Series B Preferred Units owner is PO Box 1287, McMurray, PA 15317. The address of William Myrick is 7894 Raphael Lane, Littleton, CO, 80125. The address of Margaret Rauscher IRA is 102 Tanglewood Drive McMurray, PA 15317. | |
| (2) | The units listed above are owned directly by the owners listed above. As of December 31, 2017, 96% of our outstanding common membership interests were beneficially owned by our CEO (who is also on our board of managers), Daniel M. Wallach, and his wife, Joyce S. Wallach. In January 2018 our CFO and Executive Vice Present of Operations both owned 2% of our outstanding common membership interest. As of March 1, 2018, William Myrick owned 15.3% of our outstanding common membership interests. |
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Transactions with Affiliates
On December 30, 2011, we obtained two demand loans from Mr. and Mrs. Wallach to finance our operations. These demand loans are collateralized by a lien against all of our assets and are senior in right of payment to the Notes. Mr. Wallach our CEO (who is also on our board of managers), is the beneficial owner of 96% of our outstanding common membership interests.
The first loan, in the original principal amount of $1,250,000, is payable to Daniel M. Wallach and Joyce S. Wallach, as tenants by the entirety (the “Wallach Loan”). The second loan, in the original principal amount of $250,000, is payable to the 2007 Daniel M. Wallach Legacy Trust (the “Trust Loan”). The total outstanding balance on these loans as of both December 31, 2017 and 2016 was $0. We have had no borrowings on the lines in 2017 and 2016. Each of the demand loans is evidenced by a promissory note, is payable upon demand of the lender and bears an interest rate equal to the lender’s cost of funds (defined in the promissory note as the weighted average price paid by the lender on or in connection with all of its borrowed funds). Pursuant to each promissory note, the affiliate has the option of funding any amount up to the face amount of the note, in the lender’s sole and absolute discretion. As of December 31, 2017, and 2016, the interest rate was 4.88% and 4.19%, respectively, for both the Wallach Loan and the Trust Loan.
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These transactions were approved by Mr. Wallach in his capacity as sole manager prior to the time we had independent managers. As the demand loans were made at rates equal to the lenders’ cost of funds, Mr. Wallach determined the terms of the demand loans to be as favorable to us as those generally available from unaffiliated third parties. The independent managers ratified and approved these transactions subsequent to the formation of the board of managers. See “Risk Factors — Risks Related to Conflicts of Interest — Our CEO (who is also one of our managers) will face conflicts of interest as a result of the secured affiliated loans made to us, which could result in actions that are not in the best interests of our Note holders.”
The Company has accepted new investments under the Notes program from employees, managers, members and relatives of managers and members, with $1,715,126 outstanding at December 31, 2017. The larger of these investments are detailed below:
(All dollar [$] amounts shown in table in thousands).
| Relationship to | Amount invested as of | Weighted
average interest rate as of | Interest
earned during the year ended | |||||||||||||||||||
| Shepherd’s | December 31, | December 31, | December 31, | December 31, | ||||||||||||||||||
| Investor | Finance | 2017 | 2016 | 2017 | 2017 | 2016 | ||||||||||||||||
| Eric Rauscher | Independent Manager | 475 | 600 | 10.00 | % | 36 | 45 | |||||||||||||||
| Wallach Family Irrevocable Educational Trust | Trustee is Member | 200 | 200 | 9.00 | % | 19 | 16 | |||||||||||||||
| David Wallach | Father of Member | 211 | 111 | 9.42 | % | 17 | 10 | |||||||||||||||
| Joseph Rauscher | Parents of Independent Manager | 195 | 186 | 9.33 | % | 15 | 16 | |||||||||||||||
| R. Scott Summers | Son of Independent Manager | 275 | 75 | 8.00 | % | 19 | 29 | |||||||||||||||
Hoskins Group’s Series B Preferred Equity
The Series B cumulative preferred membership units (“Series B Preferred Units”) of our membership interests were first issued to the Hoskins Group through a reduction in the SF Loan. They are redeemable only at the option of the Company or upon a change or control or liquidation. Ten Series B Preferred Units were issued for a total of $1,000,000. The Series B Preferred Units have a fixed value which is their purchase price, and preferred liquidation and distribution rights. Yearly distributions of 10% of the Series B Preferred Units’ value (providing profits are available) will be made quarterly. The Hoskins Group’s Series B Preferred Units are also used as collateral for that group’s loans to the Company. There is no liquid market for the Series B Preferred Units, so we can give no assurance as to our ability to generate any amount of proceeds from that collateral. In December 2015, the Hoskins Group agreed to purchase 0.1 Series B Preferred Units upon each closing of a lot sale in the subdivisions in which we lend the Hoskins Group development funds. They purchased 0.9, 1.4, and 0.1 Series B Preferred Units in 2017, 2016, and 2015, respectively.
| 54 |
Series C Preferred Equity
Series C cumulative preferred units (“Series C Preferred Units”) were issued to Margaret Rauscher IRA LLC (Margaret Rauscher is the wife of one of our independent managers, Eric A. Rauscher) in March 2017 and to an IRA owned by William Myrick, a former independent manager, in April 2017. They are redeemable by the Company at any time, upon a change of control or liquidation, or by the investor any time after 6 years from the initial date of purchase. The Series C Preferred Units have a fixed value which is their purchase price and preferred liquidation and distribution rights. Yearly distributions of 12% of the Series C Preferred Units’ value (provided profits are available) will be made quarterly. This rate can increase if any interest rate on our public Notes offering rises above 12%. Dividends can be reinvested monthly into additional Series C Preferred Units. The Series C Preferred Units have the same preferential rights as the Series B Preferred Units as more fully described in the following note.
Affiliate Transaction Policy
Our operating agreement provides that any future transaction involving the Company and an affiliate must be approved by a majority vote of independent managers not otherwise interested in the transaction upon a determination of such independent managers that the transaction is on terms no less favorable to the Company than could be obtained from an independent third party. An approval pursuant to this policy shall be set forth in the minutes of the Company and shall include a description of the transaction approved. The responsibility for reviewing and approving affiliate transactions has been delegated to the nominating and corporate governance committee of our board of managers, which is comprised entirely of independent managers.
Pursuant to our operating agreement, we must provide the independent managers with access, at our expense, to our legal counsel or independent legal counsel, as needed.
Board of Managers Independence
We have no securities listed for trading on a national securities exchange or in an automated inter-dealer quotation system of a national securities association, which has requirements that a majority of our board of managers be independent. For purposes of complying with the disclosure requirements of the Securities and Exchange Commission, we have adopted the definition of independence used by the New York Stock Exchange (NYSE). Under the NYSE’s definition of independence, Messrs. Summers and Rauscher each meet the definition of “independent.”
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
During the years ended December 31, 2017 and 2016, Carr, Riggs & Ingram, LLC (“CRI”) served as our independent registered public accounting firm and provided certain other services. CRI has served as our independent registered public accounting firm since 2011. The audit committee currently anticipates that it will engage CRI as our independent registered public accounting firm to audit our consolidated financial statements as of and for the year ending December 31, 2018, subject to agreeing on fee estimates for the audit work. The audit committee reserves the right, however, to select a new independent registered public accounting firm at any time in the future in its discretion if it deems such decision to be in our best interests. Any such decision would be disclosed in accordance with applicable securities laws.
Our audit committee reviewed the audit and non-audit services performed by CRI, as well as the fees charged by CRI for such services. In its review of the non-audit service fees, the audit committee considered whether the provision of such services is compatible with maintaining the independence of CRI. The aggregate agreed-upon and billed fees for professional accounting services provided by CRI, including the audits of our annual consolidated financial statements, for the years ended December 31, 2017 and 2016, respectively, are set forth in the table below.
| 55 |
| 2017 | 2016 | |||||||
| Audit Fees | $ | 127,334 | $ | 113,511 | ||||
| Audit-Related Fees* | 9,332 | 4,028 | ||||||
| Tax Fees | – | – | ||||||
| All Other Fees | – | – | ||||||
| Total | $ | 136,666 | $ | 117,539 | ||||
* Public offering assistance
Pre-Approval Policies
The audit committee charter imposes a duty on the audit committee to pre-approve all auditing services performed for us by our independent auditors, as well as all permitted non-audit services (including the fees and terms thereof) in order to ensure that the provision of such services does not impair the auditor’s independence. In determining whether or not to pre-approve services, the audit committee considers whether the service is permissible under applicable SEC rules. The audit committee may, in its discretion, delegate one or more of its members the authority to pre-approve any services to be performed by our independent registered public accounting firm, provided such pre-approval is presented to the full audit committee at its next scheduled meeting.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
| (a) | List of Documents Filed. | ||
| 1. | The list of the financial statements contained herein is set forth on page F-1 hereof. | ||
| 2. | All schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are not applicable and therefore have been omitted. | ||
| 3. | The Exhibits filed in response to Item 601 of Regulation S-K are listed on the Exhibit Index below. | ||
| (b) | See (a)3 above. | ||
| (c) | See (a)2 above. | ||
EXHIBIT INDEX
The following exhibits are included in this Annual Report on Form 10-K for the year ended December 31, 2017 (and are numbered in accordance with Item 601 of Regulation S-K).
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| 57 |
| 58 |
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| 101.INS** | XBRL Instance Document | |
| 101.SCH** | XBRL Schema Document | |
| 101.CAL** | XBRL Calculation Linkbase Document | |
| 101.DEF** | XBRL Definition Linkbase Document | |
| 101.LAB** | XBRL Label Linkbase Document | |
| 101.PRE** | XBRL Presentation Linkbase Document |
* Filed herewith.
**Pursuant to Regulation 406T of Regulation S-T, these Interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| SHEPHERD’S FINANCE, LLC | ||
| (Registrant) | ||
| Dated: March 23, 2018 | By: | /s/ Daniel M. Wallach |
| Daniel M. Wallach | ||
| CEO and Manager | ||
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
| Signature | Title | Date | ||
| /s/ Daniel M. Wallach | Chief Executive Officer and Manager | March 23, 2018 | ||
| Daniel M. Wallach | (Principal Executive Officer) | |||
| /s/ Catherine Loftin | Chief Financial Officer | March 23, 2018 | ||
| Catherine Loftin | (Principal Financial Officer and Principal Accounting Officer) | |||
| /s/ Kenneth R. Summers | Manager | March 23, 2018 | ||
| Kenneth Summers | ||||
| /s/ Eric A. Rauscher | Manager | March 23, 2018 | ||
| Eric Rauscher |
| 62 |
INDEX TO FINANCIAL STATEMENTS
| Audited Consolidated Financial Statements as of and for the years ended December 31, 2017 and 2016: | ||
| Report of Independent Registered Public Accounting Firm on Financial Statements | F-2 | |
| Consolidated Balance Sheets as of December 31, 2017 and 2016 | F-3 | |
| Consolidated Statements of Operations for the Years Ended December 31, 2017 and 2016 | F-4 | |
| Consolidated Statements of Changes in Members’ Capital for the Years Ended December 31, 2017 and 2016 | F-5 | |
| Consolidated Statements of Cash Flows for the Years Ended December 31, 2017 and 2016 | F-6 | |
| Notes to Consolidated Financial Statements | F-7 |
| F-1 |
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Managers and
Members of Shepherd’s Finance, LLC
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Shepherd’s Finance, LLC and affiliate (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of operations, changes in members’ capital, and cash flows for each of the years in the two-year period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Company as of 2017 and 2016, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to fraud or error. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
| /s/ Carr, Riggs & Ingram, LLC | |
We have served as the Company’s auditor since 2011.
Enterprise, Alabama
March 23, 2018
| F-2 |
Shepherd’s Finance, LLC
As of December 31, 2017 and 2016
| (in thousands of dollars) | 2017 | 2016 | ||||||
| Assets | ||||||||
| Cash and cash equivalents | $ | 3,478 | $ | 1,566 | ||||
| Accrued interest receivable | 720 | 280 | ||||||
| Loans receivable, net | 30,043 | 20,091 | ||||||
| Foreclosed assets | 1,036 | 2,798 | ||||||
| Property, plant and equipment | 910 | 69 | ||||||
| Other assets | 168 | 82 | ||||||
| Total assets | $ | 36,355 | $ | 24,886 | ||||
| Liabilities and Members’ Capital | ||||||||
| Customer interest escrow | $ | 935 | $ | 812 | ||||
| Accounts payable and accrued expenses | 705 | 377 | ||||||
| Accrued interest payable | 1,353 | 986 | ||||||
| Notes payable secured | 11,644 | 7,322 | ||||||
| Notes payable unsecured, net of deferred financing costs | 16,904 | 11,962 | ||||||
| Due to preferred equity member | 31 | 28 | ||||||
| Total liabilities | $ | 31,572 | $ | 21,487 | ||||
| Commitments and Contingencies (Note 10) | ||||||||
| Redeemable Preferred Equity | ||||||||
| Series C preferred equity | $ | 1,097 | $ | - | ||||
| Members’ Capital | ||||||||
| Series B preferred equity | 1,240 | 1,150 | ||||||
| Class A common equity | 2,446 | 2,249 | ||||||
| Members’ capital | $ | 3,686 | $ | 3,399 | ||||
| Total liabilities and members’ capital | $ | 36,355 | $ | 24,886 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
| F-3 |
Shepherd’s Finance, LLC
Consolidated Statements of Operations
For the years ended December 31, 2017 and 2016
| (in thousands of dollars) | 2017 | 2016 | ||||||
| Net Interest Income | ||||||||
| Interest and fee income on loans | $ | 5,812 | $ | 3,640 | ||||
| Interest expense: | ||||||||
| Interest related to secured borrowings | 1,047 | 570 | ||||||
| Interest related to unsecured borrowings | 1,660 | 1,178 | ||||||
| Interest expense | $ | 2,707 | $ | 1,748 | ||||
| Net interest income | 3,105 | 1,892 | ||||||
| Less: Loan loss provision | 44 | 16 | ||||||
| Net interest income after loan loss provision | 3,061 | 1,876 | ||||||
| Non-Interest Income | ||||||||
| Gain on foreclosure of assets | – | 44 | ||||||
| Gain on sale of foreclosed assets | 77 | 28 | ||||||
| Total non-interest income | 77 | 72 | ||||||
| Income | 3,138 | 1948 | ||||||
| Non-Interest Expense | ||||||||
| Selling, general and administrative | 2,090 | 1,319 | ||||||
| Impairment loss on foreclosed assets | 266 | 111 | ||||||
| Total non-interest expense | 2,356 | 1,430 | ||||||
| Net income | $ | 782 | $ | 518 | ||||
| Earned distribution to preferred equity holder | 212 | 107 | ||||||
| Net income attributable to common equity holders | $ | 570 | $ | 411 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
| F-4 |
Shepherd’s Finance, LLC
Consolidated Statements of Changes In Members’ Capital
For the years ended December 31, 2017 and 2016
| (in thousands of dollars) | 2017 | 2016 | ||||||
| Members’ capital, beginning balance | $ | 3,399 | $ | 3,284 | ||||
| Net income | 782 | 518 | ||||||
| Contributions from members (preferred) | 90 | 140 | ||||||
| Earned distributions to preferred equity holders | (212 | ) | (107 | ) | ||||
| Distributions to common equity holders | (373 | ) | (436 | ) | ||||
| Members’ capital, ending balance | $ | 3,686 | $ | 3,399 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
| F-5 |
Shepherd’s Finance, LLC
Consolidated Statements of Cash Flows
For the years ended December 31, 2017 and 2016
| (in thousands of dollars) | 2017 | 2016 | ||||||
| Cash flows from operations | ||||||||
| Net income | $ | 782 | $ | 518 | ||||
| Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
| Amortization of deferred financing costs | 213 | 267 | ||||||
| Provision for loan losses | 44 | 16 | ||||||
| Net loan origination fees deferred (earned) | 229 | 45 | ||||||
| Change in deferred origination cost | (55 | ) | (55 | ) | ||||
| Impairment of foreclosed assets | 266 | 111 | ||||||
| Gain from sale of foreclosed assets | (77 | ) | (28 | ) | ||||
| Gain from foreclosure of assets | – | (44 | ) | |||||
| Net change in operating assets and liabilities | ||||||||
| Other assets | (86 | ) | (68 | ) | ||||
| Accrued interest on loans | (440 | ) | (263 | ) | ||||
| Customer interest escrow | 123 | 314 | ||||||
| Accounts payable and accrued expenses | 693 | 824 | ||||||
| Net cash provided by operating activities | 1,692 | 1,637 | ||||||
| Cash flows from investing activities | ||||||||
| Loan originations and principal collections, net | (10,171 | ) | (7,677 | ) | ||||
| Investment in foreclosed assets | (316 | ) | (566 | ) | ||||
| Proceeds from sale of foreclosed assets | 1,890 | 463 | ||||||
| Property, plant and equipment additions | (841 | ) | (69 | ) | ||||
| Net cash (used in) investing activities | (9,438 | ) | (7,849 | ) | ||||
| Cash flows from financing activities | ||||||||
| Contributions from redeemable preferred equity | 1,004 | – | ||||||
| Contributions from members (preferred) | 90 | 140 | ||||||
| Distributions to preferred equity holders | (114 | ) | (104 | ) | ||||
| Distributions to common equity holders | (373 | ) | (436 | ) | ||||
| Proceeds from secured notes payable | 16,286 | 8,882 | ||||||
| Repayments of secured notes payable | (11,964 | ) | (5,243 | ) | ||||
| Proceeds from unsecured notes payable | 11,391 | 5,524 | ||||||
| Redemptions/repayments of unsecured notes payable | (6,574 | ) | (2,247 | ) | ||||
| Deferred financing costs paid | (88 | ) | (79 | ) | ||||
| Net cash provided by financing activities | 9,658 | 6,437 | ||||||
| Net increase in cash and cash equivalents | 1,912 | 225 | ||||||
| Cash and cash equivalents | ||||||||
| Beginning of period | 1,566 | 1,341 | ||||||
| End of period | $ | 3,478 | $ | 1,566 | ||||
| Supplemental disclosure of cash flow information | ||||||||
| Cash paid for interest | $ | 2,145 | $ | 1,002 | ||||
| Non-cash investing and financing activities | ||||||||
| Earned but not paid distribution of preferred equity holder | $ | 98 | $ | 28 | ||||
| Foreclosed assets acquired in the settlement of loans | $ | - | $ | 1,813 | ||||
| Accrued interest reduction due to foreclosure | $ | - | $ | 130 | ||||
| Net change in loan origination fees due to foreclosure | $ | - | $ | (55 | ) | |||
The accompanying notes are an integral part of these consolidated financial statements.
| F-6 |
Shepherd’s Finance, LLC
Notes to Consolidated Financial Statements
Information presented throughout these notes to the consolidated financial statements is in thousands of dollars.
1. Description of Business
Shepherd’s Finance, LLC and subsidiary (the “Company”, “we”, or “our”) was originally formed as a Pennsylvania limited liability company on May 10, 2007. We are the sole member of a consolidating subsidiary, 84 REPA, LLC. The Company operated pursuant to an operating agreement by and among Daniel M. Wallach and the members of the Company from its inception through March 29, 2012, at which time it adopted an amended and restated operating agreement.
As of December 31, 2017, the Company extends commercial loans to residential homebuilders (in 16 states) to:
| ● | construct single family homes, | |
| ● | develop undeveloped land into residential building lots, and | |
| ● | purchase and improve for sale older homes. |
2. Summary of Significant Accounting Policies
Principles of Consolidation
These consolidated financial statements include the consolidated accounts of the Company’s subsidiary and reflect all adjustments (all of which are normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, operating results, and cash flows for the periods. All intercompany balances and transactions have been eliminated.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. It is reasonably possible that market conditions could deteriorate, which could materially affect our consolidated financial position, results of operations and cash flows. Among other effects, such changes could result in the need to increase the amount of our allowance for loan losses and impair our foreclosed assets.
Operating Segments
Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic (“ASC”) 280, Segment Reporting, requires that the Company report financial and descriptive information about reportable segments and how these segments were determined. We determine the allocation of resources and performance of business units based on operating income, net income and operating cash flows. Segments are identified and aggregated based on products sold or services provided. Based on these factors, we have determined that the Company’s operations are in one segment, commercial lending.
Revenue Recognition
Interest income generally is recognized on an accrual basis. The accrual of interest is generally discontinued on all loans past due 90 days or more. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income, unless management believes that the accrued interest is recoverable through liquidation of collateral. Interest received on nonaccrual loans is applied against principal. Interest on accruing impaired loans is recognized as long as such loans do not meet the criteria for nonaccrual status.
| F-7 |
Advertising
Advertising costs are expensed as incurred and are included in selling, general and administrative. Advertising expenses were $59 and $46 for the years ended December 31, 2017 and 2016, respectively.
Cash and Cash Equivalents
Management considers highly-liquid investments with original maturities of three months or less to be cash equivalents.
Fair Value Measurements
The Company follows the guidance of FASB ASC 825, Financial Instruments (ASC 825), and FASB ASC 820, Fair Value Measurements (ASC 820). ASC 825 permits entities to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. ASC 820 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Under this guidance, fair value measurements are not adjusted for transaction costs. This guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). See Note 3.
Loans Receivable
Loans are stated at the amount of unpaid principal, net of any allowances for loan losses, and adjusted for (1) the net unrecognized portion of direct costs and nonrefundable loan fees associated with lending, and (2) deposits made by the borrowers used as collateral for a loan and due back to the builder at or prior to loan payoff. The net amount of nonrefundable loan origination fees and direct costs associated with the lending process, including commitment fees, is deferred and accreted to interest income over the lives of the loans using a method that approximates the interest method.
A loan is classified as nonaccrual, and the accrual of interest on such loan is discontinued, when the contractual payment of principal or interest becomes 90 days past due. In addition, a loan may be placed on nonaccrual at any other time management has serious doubts about further collectability of principal or interest according to the contractual terms, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection or well-secured (i.e., the loan has sufficient collateral value). Loans are restored to accrual status when the obligation is brought current or has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans, or portions thereof, are charged off when deemed uncollectible. Once a loan is 90 days past due, management begins a workout plan with the borrower or commences its foreclosure process on the collateral.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio.
The Company establishes a collective reserve for all loans which are not more than 60 days past due at the end of each quarter. This collective reserve includes both a quantitative and qualitative analysis. In addition to historical loss information, the analysis incorporates collateral value, decisions made by management and staff, percentage of aging spec loans, policies, procedures, and economic conditions. The Company analyzes the following:
| ● | Loans to one borrower with less than 10% of the Company’s total committed balances; and | |
| ● | Loans to one borrower with greater than or equal to 10% of the Company’s total committed balances. |
The Company individually analyzes for impairment all loans which more than 60 days past are due at the end of each quarter. If required, the analysis includes a comparison of estimated collateral value to the principal amount of the loan.
Impaired loans, if the value determined is less than the principal amount due (less any builder deposit), then the difference is included in the allowance for loan loss. As values change, estimated loan losses may be provided for more or less than the previous period, and some loans may not need a loss provision based on payment history. As for homes which are partially complete, the Company will appraise on an as-is and completed basis, and use the appraised value that more closely aligns with our planned method of disposal for the property.
| F-8 |
Impaired Loans
A loan is considered to be impaired when it is probable the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement.
Foreclosed Assets
When a foreclosed asset is acquired in the settlement of a loan, the asset is booked at the as-is fair value minus expected selling costs establishing a new cost basis. The gain or loss is booked on our income statement as non-interest income or expense. If the fair value of the asset declines, a write-down is recorded through non-interest expense. While the initial valuation is done on an as-is basis, subsequent values are based on our plan for the asset. Assets which are not going to be improved are still evaluated on an as-is basis. Assets we intend to improve, are improving, or have improved are appraised based on the to-be-completed value, minus reasonable selling costs and the cost to complete.
Deferred Financing Costs, Net
Deferred financing cost consist of certain costs associated with financing activities related to the issuance of debt securities (deferred financing costs). These costs consist primarily of professional fees incurred related to the transactions. Deferred financing costs are amortized into interest expense over the life of the related debt. The deferred financing costs are reflected as a reduction in the unsecured notes offering liability.
Income Taxes
The entities included in the consolidated financial statements are organized as pass-through entities under the Internal Revenue Code. As such, taxes are the responsibility of the members. Other significant taxes for which the Company is liable are recorded on an accrual basis.
The Company applies FASB ASC 740, Income Taxes (ASC 740). ASC 740 provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the consolidated financial statements and requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s consolidated financial statements to determine whether the tax positions are “more-likely-than-not” to be sustained by the applicable tax authority. Tax positions with respect to income tax at the LLC level not deemed to meet the “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the appropriate period. Management concluded that there are no uncertain tax positions that should be recognized in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations for years prior to 2014.
The Company’s policy is to record interest and penalties related to taxes in interest expense on the consolidated statements of operations. There have been no significant interest or penalties assessed or paid.
Risks and Uncertainties
The Company is subject to many of the risks common to the commercial lending and real estate industries, such as general economic conditions, decreases in home values, decreases in housing starts, increases in interest rates, and competition from other lenders. At December 31, 2017, our loans were significantly concentrated in a suburb of Pittsburgh, Pennsylvania, so the housing starts and prices in that area are more significant to our business than other areas until and if more loans are created in other markets.
| F-9 |
Concentrations
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of loans receivable. Our concentration risks are summarized in the table below:
| December 31, 2017 | December 31, 2016 | |||||||||||
| Percent of | Percent of | |||||||||||
| Borrower | Loan | Borrower | Loan | |||||||||
| City | Commitments | City | Commitments | |||||||||
| Highest concentration risk | Pittsburgh, PA | 22 | % | Pittsburgh, PA | 37 | % | ||||||
| Second highest concentration risk | Sarasota, FL | 7 | % | Sarasota, FL | 11 | % | ||||||
| Third highest concentration risk | Orlando, FL | 5 | % | Savannah, GA | 6 | % | ||||||
Recent Accounting Pronouncements
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, amended existing guidance related to revenue from contracts with customers. This amendment supersedes and replaces nearly all existing revenue recognition guidance, including industry-specific guidance, establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. In addition, this amendment specifies that accounting for some costs to obtain or fulfill a contract with a customer. These amendments are effective for fiscal years beginning after December 15, 2018. This standard will be applied when appropriate to future transactions, although none are currently anticipated.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which introduces the current expected credit losses methodology. Among other things, the ASU requires the measurement of all expected credit losses for financial assets, including available-for-sale debt securities, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount. The new model will require institutions to calculate all probable and estimable losses that are expected to be incurred through the loan’s entire life. ASU 2016-13 also requires the allowance for credit losses for purchased financial assets with credit deterioration since origination to be determined in a manner similar to that of other financial assets measured at amortized cost; however, the initial allowance will be added to the purchase price rather than recorded as credit loss expense. The disclosure of credit quality indicators related to the amortized cost of financing receivables will be further disaggregated by year of origination (or vintage). Disaggregation by vintage will be optional for nonpublic business entities. Institutions are to apply the changes through a cumulative-effect adjustment to their retained earnings as of the beginning of the first reporting period in which the standard is effective. The amendments are effective for fiscal years beginning after December 15, 2020. Early application will be permitted for fiscal years beginning after December 15, 2018. The Company is currently evaluating the impact of these amendments on the consolidated financial statements.
Subsequent Events
Management of the Company has evaluated subsequent events through March 23, 2018, the date these consolidated financial statements were issued. See Note 13.
3. Fair Value
Utilizing ASC 820, the Company has established a framework for measuring fair value under U.S. GAAP using a hierarchy, which requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs. Fair value measurements are an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Three levels of inputs are used to measure fair value, as follows:
| F-10 |
| Level 1 – | quoted prices in active markets for identical assets or liabilities; | |
| Level 2 – | quoted prices in active markets for similar assets and liabilities and inputs that are observable for the asset or liability; or | |
| Level 3 – | unobservable inputs, such as discounted cash flow models or valuations. |
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
Fair Value Measurements of Non-Financial Instruments on a Recurring Basis
The Company has no non-financial instruments measured at fair value on a recurring basis.
Fair Value Measurements of Non-Financial Instruments on a Non-recurring Basis
Certain assets are measured at fair value on a non-recurring basis when there is evidence of impairment. The fair values of impaired loans with specific allocations of the allowance for loan losses are generally based on recent real estate appraisals of the collateral less estimated cost to sell. Declines in the fair values of other real estate owned subsequent to their initial acquisitions are also based on recent real estate appraisals less selling costs.
Impaired Loans
The appraisals used to establish the value of impaired loans are based on similar properties at similar times; however due to the differences in time and properties, the impaired loans are classified as Level 3. There were no impaired loan assets as of December 31, 2017 and 2016.
Foreclosed Assets
Foreclosed assets (upon initial recognition or subsequent impairment) are measured at fair value on a non-recurring basis.
Foreclosed assets, upon initial recognition, are measured and reported at fair value less cost to sell. Each reporting period, the Company remeasures the fair value of its significant foreclosed assets. Fair value is based upon independent market prices, appraised values of the foreclosed assets or management’s estimates of value, which the Company classifies as a Level 3 evaluation.
The following tables presents the balances of non-financial instruments measured at fair value on a non-recurring basis as of December 31, 2017 and 2016:
| Quoted Prices | ||||||||||||||||||||
| in Active | Significant | |||||||||||||||||||
| Markets for | Other | Significant | ||||||||||||||||||
| December 31, 2017 | Identical | Observable | Unobservable | |||||||||||||||||
| Carrying | Estimated | Assets | Inputs | Inputs | ||||||||||||||||
| Amount | Fair Value | Level 1 | Level 2 | Level 3 | ||||||||||||||||
| Foreclosed assets | $ | 1,036 | $ | 1,036 | $ | – | $ | – | $ | 1,036 | ||||||||||
| F-11 |
| Quoted Prices | ||||||||||||||||||||
| in Active | Significant | |||||||||||||||||||
| Markets for | Other | Significant | ||||||||||||||||||
| December 31, 2016 | Identical | Observable | Unobservable | |||||||||||||||||
| Carrying | Estimated | Assets | Inputs | Inputs | ||||||||||||||||
| Amount | Fair Value | Level 1 | Level 2 | Level 3 | ||||||||||||||||
| Foreclosed assets | $ | 2,798 | $ | 2,798 | $ | – | $ | – | $ | 2,798 | ||||||||||
Fair Value of Financial Instruments
ASC 825 requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturity of these instruments.
Loans Receivable and Commitments to Extend Credit
For variable rate loans that reprice frequently with no significant change in credit risk, estimated fair values of collateral are based on carrying values at both December 31, 2017 and 2016. Because the loans are demand loan and therefore have no known time horizon, there is no significant impact from fluctuating interest rates. For unfunded commitments to extend credit, because there would be no adjustment between fair value and carrying amount for the amount if actually loaned, there is no adjustment to the amount before it is loaned. The amount for commitments to extend credit is not listed in the tables below because there is no difference between carrying value and fair value, and the amount is not recorded on the consolidated balance sheets as a liability.
Interest Receivable
Interest receivable from our customers is due approximately 10 days after it is billed; therefore, the carrying amount approximates fair value for the years ended December 31, 2017 and 2016.
Customer Interest Escrow
The customer interest escrow does not yield interest to the customer, but because: 1) the customer loans are demand loans, 2) it is not possible to estimate how long the escrow will be in place, and 3) the interest rate which could be used to discount this amount is negligible, the fair value approximates the carrying value at both December 31, 2017 and 2016.
Borrowings under Credit Facilities
The fair value of the Company’s borrowings under credit facilities is estimated based on the expected cash flows discounted using the current rates offered to the Company for debt of the same remaining maturities. As all of the borrowings under credit facilities or the Notes are either payable on demand or at similar rates to what the Company can borrow funds for today, the fair value of the borrowings is determined to approximate carrying value at both December 31, 2017 and 2016. The interest on our Notes offering is paid to our Note holders either monthly or at the end of their investment, compounded on a monthly basis. For the same reasons as the determination for the principal balances on the Notes, the fair value approximates the carrying value for the interest as well.
| F-12 |
The table below is a summary of fair value estimates for financial instruments and the level of the fair value hierarchy (as discussed in Note 2) within which the fair value measurements are categorized at the periods indicated:
| Quoted Prices | ||||||||||||||||||||
| in Active | Significant | |||||||||||||||||||
| Markets for | Other | Significant | ||||||||||||||||||
| December 31, 2017 | Identical | Observable | Unobservable | |||||||||||||||||
| Carrying | Estimated | Assets | Inputs | Inputs | ||||||||||||||||
| Amount | Fair Value | Level 1 | Level 2 | Level 3 | ||||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Cash and cash equivalents | $ | 3,478 | $ | 3,478 | $ | 3,478 | $ | – | $ | – | ||||||||||
| Loans receivable, net | 30,043 | 30,043 | – | – | 30,043 | |||||||||||||||
| Accrued interest on loans | 720 | 720 | – | – | 720 | |||||||||||||||
| Financial Liabilities | ||||||||||||||||||||
| Customer interest escrow | 935 | 935 | – | – | 935 | |||||||||||||||
| Notes payable secured | 11,644 | 11,644 | – | – | 11,644 | |||||||||||||||
| Notes payable unsecured, net | 16,904 | 16,904 | – | – | 16,904 | |||||||||||||||
| Accrued interest payable | 1,353 | 1,353 | – | – | 1,353 | |||||||||||||||
| Quoted Prices | ||||||||||||||||||||
| in Active | Significant | |||||||||||||||||||
| Markets for | Other | Significant | ||||||||||||||||||
| December 31, 2016 | Identical | Observable | Unobservable | |||||||||||||||||
| Carrying | Estimated | Assets | Inputs | Inputs | ||||||||||||||||
| Amount | Fair Value | Level 1 | Level 2 | Level 3 | ||||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Cash and cash equivalents | $ | 1,566 | $ | 1,566 | $ | 1,566 | $ | – | $ | – | ||||||||||
| Loans receivable, net | 20,091 | 20,091 | – | – | 20,091 | |||||||||||||||
| Accrued interest on loans | 280 | 280 | – | – | 280 | |||||||||||||||
| Financial Liabilities | ||||||||||||||||||||
| Customer interest escrow | 812 | 812 | – | – | 812 | |||||||||||||||
| Notes payable secured | 7,322 | 7,322 | – | – | 7,322 | |||||||||||||||
| Notes payable unsecured, net | 11,962 | 11,962 | – | – | 11,962 | |||||||||||||||
| Accrued interest payable | 993 | 993 | – | – | 993 | |||||||||||||||
| F-13 |
4. Financing Receivables
Financing receivables are comprised of the following as of December 31, 2017 and 2016:
| December 31, 2017 | December 31, 2016 | |||||||
| Loans receivable, gross | $ | 32,375 | $ | 21,569 | ||||
| Less: Deferred loan fees | (847 | ) | (618 | ) | ||||
| Less: Deposits | (1,497 | ) | (861 | ) | ||||
| Plus: Deferred origination expense | 109 | 55 | ||||||
| Less: Allowance for loan losses | (97 | ) | (54 | ) | ||||
| Loans receivable, net | $ | 30,043 | $ | 20,091 | ||||
Commercial Construction and Development Loans
Commercial Loans – Construction Loan Portfolio Summary
As of December 31, 2017, we have 52 borrowers, all of whom, including our one development loan customer (the “Hoskins Group”), borrow money for the purpose of building new homes. The loans typically involve funding of the lot and a portion of construction costs, for a total of between 50% and 70% of the completed value of the new home. As the home is built during the course of the loan, the loan balance increases. The loans carry an interest rate of 2% more than our cost of funds, and we charge a loan fee. The cost of funds was 9.99% as of December 31, 2017 and the interest rate charged to most customers was 11.99%. The loans are demand loans. Most have a deposit from the builder during construction to help offset the risk of partially built homes, and some have an interest escrow to offset payment of monthly interest risk.
The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2017 and December 31, 2016:
| Year | Number of States | Number of Borrowers | Number of Loans | Value of Collateral(1) | Commitment Amount | Gross Amount Outstanding | Loan
to | Loan Fee | ||||||||||||||||||||||||
| 2017 | 16 | 52 | 168 | $ | 75,931 | $ | 47,087 | $ | 29,563 | 62 | %(3) | 5 | % | |||||||||||||||||||
| 2016 | 15 | 30 | 69 | 46,187 | 27,141 | 17,487 | 59 | %(3) | 5 | % | ||||||||||||||||||||||
| (1) | The value is determined by the appraised value. |
| (2) | The loan to value ratio is calculated by taking the commitment amount and dividing by the appraised value. |
| (3) | Represents the weighted average loan to value ratio of the loans. |
Commercial Loans – Real Estate Development Loan Portfolio Summary
The following is a summary of our loan portfolio to builders for land development as of December 31, 2017 and December 31, 2016.
| Year | State | Number of Borrowers | Number of Loans | Value of Collateral(1) | Commitment Amount | Gross
Amount Outstanding | Loan
to | Loan Fee | ||||||||||||||||||||||
| 2017 | Pennsylvania | 1 | 3 | $ | 4,997 | $ | 4,600 | (3) | $ | 2,811 | 56 | % | $ | 1,000 | ||||||||||||||||
| 2016 | Pennsylvania | 1 | 3 | 6,586 | 5,931 | (3) | 4,082 | 62 | % | 1,000 | ||||||||||||||||||||
| (1) | The value is determined by the appraised value adjusted for remaining costs to be paid and third-party mortgage balances. Part of this collateral is $1,240 in 2017 and $1,150 in 2016 of preferred equity in our Company. In the event of a foreclosure on the property securing these loans, the portion of our collateral that is preferred equity in our Company might be difficult to sell, which could impact our ability to eliminate the loan balance. |
| F-14 |
| (2) | The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value calculated as described above. |
| (3) | The commitment amount does not include letters of credit and cash bonds, as the sum of the total balance outstanding including the cash bonds plus the letters of credit and remaining to fund for construction is less than the $4,600 commitment amount. |
Credit Quality Information
The following table presents credit-related information at the “class” level in accordance with FASB ASC 310-10-50, Disclosures about the Credit Quality of Finance Receivables and the Allowance for Credit Losses. A class is generally a disaggregation of a portfolio segment. In determining the classes, the Company considered the finance receivable characteristics and methods it applies in monitoring and assessing credit risk and performance.
The following table summarizes finance receivables by the risk ratings that regulatory agencies utilize to classify credit exposure and which are consistent with indicators the Company monitors. Risk ratings are reviewed on a regular basis and are adjusted as necessary for updated information affecting the borrowers’ ability to fulfill their obligations.
The definitions of these ratings are as follows:
| ● | Pass – finance receivables in this category do not meet the criteria for classification in one of the categories below. | |
| ● | Special mention – a special mention asset exhibits potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects. | |
| ● | Classified – a classified asset ranges from: 1) assets that are inadequately protected by the current sound worth and paying capacity of the borrower, and are characterized by the distinct possibility that some loss will be sustained if the deficiencies are not corrected to 2) assets with weaknesses that make collection or liquidation in full unlikely on the basis of current facts, conditions, and values. Assets in this classification can be accruing or on non-accrual depending on the evaluation of these factors. |
Finance Receivables – By risk rating:
| December 31, 2017 | December 31, 2016 | |||||||
| Pass | $ | 25,656 | $ | 18,275 | ||||
| Special mention | 6,719 | 3,294 | ||||||
| Classified – accruing | – | – | ||||||
| Classified – nonaccrual | – | – | ||||||
| Total | $ | 32,375 | $ | 21,569 | ||||
| F-15 |
Finance Receivables – Method of impairment calculation:
| December 31, 2017 | December 31, 2016 | |||||||
| Performing loans evaluated individually | $ | 14,992 | $ | 12,424 | ||||
| Performing loans evaluated collectively | 17,383 | 9,145 | ||||||
| Non-performing loans without a specific reserve | – | – | ||||||
| Non-performing loans with a specific reserve | – | – | ||||||
| Total evaluated collectively for loan losses | $ | 32,375 | $ | 21,569 | ||||
At December 31, 2017 and 2016, there were no loans acquired with deteriorated credit quality, loans past due 90 or more days, impaired loans, or loans on nonaccrual status.
5. Foreclosed Assets
Roll forward of foreclosed assets for the years ended December 31, 2017 and 2016:
| 2017 | 2016 | |||||||
| Beginning balance | $ | 2,798 | $ | 965 | ||||
| Additions from loans | – | 1,813 | ||||||
| Additions for construction/development | 317 | 566 | ||||||
| Sale proceeds | (1,890 | ) | (463 | ) | ||||
| Gain on sale | 77 | 28 | ||||||
| Impairment loss on foreclosed assets | (266 | ) | (111 | ) | ||||
| Ending balance | $ | 1,036 | $ | 2,798 | ||||
6. Borrowings
The following table displays our borrowings and a ranking of priority:
| Priority Rank | December 31, 2017 | December 31, 2016 | ||||||||
| Borrowing Source | ||||||||||
| Purchase and sale agreements and other secured borrowings | 1 | $ | 11,644 | $ | 7,322 | |||||
| Secured line of credit from affiliates | 2 | – | – | |||||||
| Unsecured line of credit (senior) | 3 | – | – | |||||||
| Other unsecured debt (senior subordinated) | 4 | 279 | 279 | |||||||
| Unsecured Notes through our public offering, gross | 5 | 14,121 | 11,221 | |||||||
| Other unsecured debt (subordinated) | 5 | 2,617 | 700 | |||||||
| Other unsecured debt (junior subordinated) | 6 | 173 | 173 | |||||||
| Total | $ | 28,834 | $ | 19,695 | ||||||
The following table shows the maturity of outstanding debt as of December 31, 2017:
| Year Maturing | Total
Amount Maturing | Public Offering | Other Unsecured | Purchase
and Sale Agreements and other secured borrowings | ||||||||||||
| 2018 | $ | 18,681 | $ | 4,633 | $ | 2,404 | $ | 11,644 | ||||||||
| 2019 | 3,769 | 3,656 | 113 | – | ||||||||||||
| 2020 | 2,495 | 1,943 | 552 | – | ||||||||||||
| 2021 | 3,889 | 3,889 | – | – | ||||||||||||
| Total | $ | 28,834 | $ | 14,121 | $ | 3,069 | $ | 11,644 | ||||||||
| F-16 |
Purchase and Sale Agreements
We have two purchase and sale agreements where we are the seller of portions of loans we create. The two purchasers are Builder Finance, Inc. (“Builder Finance”) and S.K. Funding, LLC (“S.K. Funding”). Generally, the purchasers buy between 50% and 70% of each loan sold. They receive interest rates ranging from our cost of funds to the note rate charged to the borrower (interest rates were between 9% and 12% for both 2017 and 2016), and generally none of the loan fees we charge. We have the right to call some of the loans sold, with some restrictions. Once sold, the purchaser must fund their portion of the loans purchased. We service the loans. Also, there are limited put options in some cases, whereby the purchaser can cause us to repurchase a loan. The purchase and sale agreements are recorded as secured borrowings.
In July 2017, we entered into the Sixth Amendment (the “Sixth Amendment”) to our loan purchase and sale agreement (the “Agreement”) with S.K. Funding. The Agreement was originally entered into between the Company and Seven Kings Holdings, Inc. (“7Kings”). However, on or about May 7, 2015, 7Kings assigned its right and interest in the Agreement to S.K. Funding.
The purpose of the Sixth Amendment was to allow S.K. Funding to purchase portions of the Pennsylvania Loans for a purchase price of $3,000 under parameters different from those specified in the Agreement. The Pennsylvania Loans purchased pursuant to the Sixth Amendment consist of a portion of the loans to the Hoskins Group. We will continue to service the loans.
The timing of the Company’s principal and interest payments to S.K. Funding under the Sixth Amendment, and S.K. Funding’s obligation to fund the Pennsylvania Loans, vary depending on the total principal amount of the Pennsylvania Loans outstanding at any time. The Pennsylvania Loans had a principal amount in excess of $4,000 as of the effective date of the Sixth Amendment. While the total principal amount of the Pennsylvania Loans exceeds $1,000, S.K. Funding must fund (by paying the Company) the amount by which the total principal amount of the Pennsylvania Loans exceeds $1,000, with such total amount funded not exceeding $3,000. The interest rate accruing to S.K. Funding under the Sixth Amendment is 10.5% calculated on a 365/366-day basis. When the total principal amount of the Pennsylvania Loans is less than $4,000, the Company will also repay S.K. Funding’s principal as principal payments are received on the Pennsylvania Loans from the underlying borrowers in the amount by which the total principal amount of the Pennsylvania Loans is less than $4,000 until S.K. Funding’s principal has been repaid in full. S.K. Funding will continue to be obligated, as described in this paragraph, to fund (by paying the Company) the Pennsylvania Loans for any increases in the outstanding balance of the Pennsylvania Loans up to no more than a total outstanding amount of $4,000.
The Sixth Amendment has a term of 24 months from the effective date and will automatically renew for additional six-month terms unless either party gives written notice of its intent not to renew the Sixth Amendment at least six months prior to the end of a term. Further, no Protective Advances (as such term is defined in the Agreement) will be required with respect to the Pennsylvania Loans. S.K. Funding will have a priority position as compared to the Company in the case of a default by any of the borrowers.
Lines of Credit
In July 2017, we entered into a line of credit agreement with a group of lenders (“Shuman”). The line is secured with assignments of certain notes and mortgages and carries a total cost of funds to us of 10%. The maximum amount we can draw on the line is $1,325, which was fully borrowed as of December 31, 2017. It is due in July 2018.
In October 2017, we entered into a Line of Credit Agreement (the “LOC Agreement”) with Paul Swanson (the “Lender”). Pursuant to the LOC Agreement, the Lender will provide us with a revolving line of credit (the “Line of Credit”) not to exceed $4,000. The LOC Agreement is effective as of October 23, 2017 and will terminate 15 months after that date unless extended by the Lender for one or more additional 15-month periods. We may terminate the LOC Agreement by providing the Lender with notice at least 60 days in advance of the original termination or any renewal termination date.
| F-17 |
The Line of Credit requires monthly payments of interest only during the term of the Line of Credit, with the principal balance due upon termination. The unpaid principal amounts advanced on the Line of Credit bear interest for each day until due at a fixed rate per annum (computed on the basis of a year of 360 days for actual days elapsed) for each day at 9%. We may, at our option, choose to prepay the principal, interest, or other amounts due from us under the Line of Credit in whole or in part at any time.
We are pledging, and will continue to pledge in the future, certain of our commercial loans as collateral for the Line of Credit (the “Collateral Loans”) pursuant to the Collateral Assignment of Notes and Documents dated as of October 23, 2017. The amount outstanding under the Line of Credit may not exceed 67% of the aggregate amount outstanding on the Collateral Loans then pledged to secure the Line of Credit. Our obligation to repay the Line of Credit is evidenced by two Promissory Notes from us dated October 23, 2017 (the “Promissory Notes”), one evidencing a promise to repay the secured portion of the Line of Credit and one evidencing a promise to repay the unsecured portion of the Line of Credit. As of December 31, 2017, the secured portion of the borrowings was $2,096 and the unsecured was $1,904.
R. Scott Summers, P.L.L.C., a West Virginia professional limited liability company (the “Custodian”) will serve as the custodian to hold the Collateral Loans for the benefit of the Lender pursuant to the Custodial Agreement dated as of October 23, 2017 between us, the Lender, and the Custodian. The Custodian is owned by R. Scott Summers, an investor in our public Notes offering and the son of Kenneth R. Summers, one of our independent managers. The Custodian is responsible for certifying to the Lender that it has received the relevant Collateral Loan assignment documentation from us. We are responsible for paying the Custodian’s monthly fee, which is equal to 1% interest on the amount of the Collateral Loans outstanding in the Custodian’s custody.
Summary
The secured borrowings are detailed below:
| December 31, 2017 | December 31, 2016 | |||||||||||||||
| Book Value of | Due From Shepherd’s | Book Value of | Due From Shepherd’s | |||||||||||||
| Loans which | Finance to Loan | Loans which | Finance to Loan | |||||||||||||
| Served as | Purchaser or | Served as | Purchaser or | |||||||||||||
| Collateral | Lender | Collateral | Lender | |||||||||||||
| Loan purchaser | ||||||||||||||||
| Builder Finance | $ | 7,483 | $ | 4,089 | $ | 5,779 | $ | 2,517 | ||||||||
| S.K. Funding | 9,128 | 4,134 | 7,770 | 4,805 | ||||||||||||
| Shuman | 1,747 | 1,325 | – | – | ||||||||||||
| Paul Swanson | 2,518 | 2,096 | – | – | ||||||||||||
| Total | $ | 20,876 | $ | 11,644 | $ | 13,549 | $ | 7,322 | ||||||||
As of December 31, 2016, the $7,770 of loans which served as collateral for S.K. Funding did not include the book value of the foreclosed assets which also secure their position, which amount was $1,813.
| F-18 |
Unsecured Loans
We have various unsecured loans, the largest of which are listed in the table below:
| Description | Current maturity | Maximum amount | December 31, 2017 Balance | December 31, 2016 Balance | Annual Interest Rate | Interest Cost 2017 | Interest Cost 2016 | |||||||||||||||||||
| Swanson Unsecured Portion | June 2018 | $ | 4,000 | $ | 1,904 | $ | - | 10.0 | % | $ | 42 | $ | - | |||||||||||||
| 7Kings | August 2019 | 500 | 500 | 500 | 7.5 | % | 37 | 38 | ||||||||||||||||||
| Builder Finance | January 2019 | 500 | - | - | 10.0 | % | 22 | - | ||||||||||||||||||
We have several other unsecured Notes of lesser amounts with varying maturity dates.
Unsecured Notes through the Public Offering (Notes Program)
The effective interest rate on the borrowings at December 31, 2017 and 2016 was 9.21% and 8.26%, respectively, not including the amortization of deferred financing costs. There are limited rights of early redemption. We generally offer four durations at any given time, ranging anywhere from 12 to 48 months. The following table shows the roll forward of our Notes program:
| December 31, 2017 | December 31, 2016 | |||||||
| Gross notes outstanding, beginning of period | $ | 11,221 | $ | 8,496 | ||||
| Notes issued | 8,375 | 4,972 | ||||||
| Note repayments / redemptions | (5,475 | ) | (2,247 | ) | ||||
| Gross notes outstanding, end of period | 14,121 | 11,221 | ||||||
| Less deferred financing costs, net | 286 | 411 | ||||||
| Notes outstanding, net | $ | 13,835 | $ | 10,810 | ||||
The following is a roll forward of deferred financing costs:
| December 31, 2017 | December 31, 2016 | |||||||
| Deferred financing costs, beginning balance | $ | 1,014 | $ | 935 | ||||
| Additions | 88 | 79 | ||||||
| Deferred financing costs, ending balance | 1,102 | $ | 1,014 | |||||
| Less accumulated amortization | (816 | ) | (603 | ) | ||||
| Deferred financing costs, net | $ | 286 | $ | 411 | ||||
| F-19 |
The following is a roll forward of the accumulated amortization of deferred financing costs:
| December 31, 2017 | December 31, 2016 | |||||||
| Accumulated amortization, beginning balance | $ | 603 | $ | 336 | ||||
| Additions | 213 | 267 | ||||||
| Accumulated amortization, ending balance | $ | 816 | $ | 603 | ||||
7. Redeemable Preferred Equity
Series C cumulative preferred units (“Series C Preferred Units”) were issued to Margaret Rauscher IRA LLC (Margaret Rauscher is the wife of one of our independent managers, Eric A. Rauscher) in March 2017 and to an IRA owned by William Myrick, another one of our independent managers, in April 2017. They are redeemable by the Company at any time, upon a change of control or liquidation, or by the investor any time after 6 years from the initial date of purchase. The Series C Preferred Units have a fixed value which is their purchase price and preferred liquidation and distribution rights. Yearly distributions of 12% of the Series C Preferred Units’ value (provided profits are available) will be made quarterly. This rate can increase if any interest rate on our public Notes offering rises above 12%. Dividends can be reinvested monthly into additional Series C Preferred Units. The Series C Preferred Units have the same preferential rights as the Series B Preferred Units as more fully described in the following note.
Roll forward of redeemable preferred equity:
| December 31, 2017 | December 31, 2016 | |||||||
| Beginning balance | $ | – | $ | – | ||||
| Additions from new investment | 1,004 | – | ||||||
| Additions from reinvestment | 93 | – | ||||||
| Ending balance | $ | 1,097 | $ | – | ||||
The following table shows the earliest redemption options for investors in Series C Preferred Units as of December 31, 2017:
| Year Maturing | Total
Amount Redeemable | |||
| 2023 | $ | 1,097 | ||
| Total | $ | 1,097 | ||
8. Members’ Capital
There are currently two classes of units outstanding: Class A common units and Series B cumulative preferred units (“Series B Preferred Units”).
The Class A common units are held by eight members, all of whom have no personal liability. All Class A common members have voting rights in proportion to their capital account. There were 2,629 Class A common units outstanding at both December 31, 2017 and 2016.
| F-20 |
The Series B Preferred Units were issued to the Hoskins Group through a reduction in a loan issued by the Hoskins Group to the Company. In December 2015, the Hoskins Group agreed to purchase 0.1 Series B Preferred Units for $10 at each closing of a lot to a third party in the Hamlets and Tuscany subdivision. As of December 31, 2017, the Hoskins Group owns a total of 12.4 Series B Preferred Units, which were issued for a total of $1,240. Both the Series B Preferred Units and the Series C Preferred Units have the same basic preferential status as compared to the Class A common units, and are pari passu with each other. Both Preferred Unit types enjoy a liquidation preference and a dividend preference, as well as a 12-month recovery period for a shortfall in earnings.
There are two additional authorized unit classes: Class A preferred units and Class B profit units. Once Class B profit units are issued, the existing Class A common units will become Class A preferred units. Class A Preferred units will receive preferred treatment in terms of distributions and liquidation proceeds.
9. Related Party Transactions
The Company has a loan agreement with two of our larger members. The agreements layout the terms under which those members can lend money to us, providing that we desire the funds and the members wish to lend. The lines have not been used in 2017 or 2016. The rates on funds, if borrowed, are equal to those members’ cost of funds at the time of the advance.
An IRA owned by the wife of Eric A. Rauscher, one of our independent managers, and an IRA owned by William Myrick, also one of our independent managers, each own Series C Preferred Units, as more fully described in Note 7.
Each of our three independent managers and our Executive Vice President of Operations own 1% of our Class A common units.
One of our independent managers Kenneth R. Summers and his son are minor participants in the Shuman line of credit, which is more fully described in Note 6.
The Company has loan agreements with the Hoskins Group, as more fully described in Note 4 – Commercial Loans – Real Estate Development Loan Portfolio Summary
The Hoskins Group has a preferred equity interest in the Company, as more fully described in Note 8.
The Company has accepted new investments under the Notes Program from employees, managers, members and relatives of managers and members, with $1,715 and $2,197 outstanding at December 31, 2017 and 2016, respectively. The larger of these investments are detailed below:
(All dollar [$] amounts shown in table in thousands).
| Relationship to | Amount invested as of | Weighted
average interest rate as of | Interest
earned during the year ended | |||||||||||||||||||
| Shepherd’s | December 31, | December 31, | December 31, | December 31, | ||||||||||||||||||
| Investor | Finance | 2017 | 2016 | 2017 | 2017 | 2016 | ||||||||||||||||
| Eric Rauscher | Independent Manager | $ | 475 | $ | 600 | 10.00 | % | $ | 36 | $ | 45 | |||||||||||
| Wallach Family Irrevocable Educational Trust | Trustee is Member | 200 | 200 | 9.00 | % | 19 | 16 | |||||||||||||||
| David Wallach | Father of Member | 211 | 111 | 9.42 | % | 17 | 10 | |||||||||||||||
| Joseph Rauscher | Parents of Independent Manager | 195 | 186 | 9.33 | % | 15 | 16 | |||||||||||||||
| R. Scott Summers | Son of Independent Manager | 275 | 75 | 8.00 | % | 19 | 29 | |||||||||||||||
| F-21 |
10. Commitments and Contingencies
In the normal course of business there may be outstanding commitments to extend credit that are not included in the consolidated financial statements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon and some of the funding may come from the earlier repayment of the same loan (in the case of revolving lines), the total commitment amounts do not necessarily represent future cash requirements. The financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of amounts recognized in the consolidated financial statements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. Unfunded commitments to extend credit, which have similar collateral, credit risk and market risk to our outstanding loans, were $19,312 and $11,503 at December 31, 2017 and 2016, respectively.
11. Selected Quarterly Condensed Consolidated Financial Data (Unaudited)
Summarized unaudited quarterly condensed consolidated financial data for the quarters of 2017 and 2016 are as follows:
| Quarter 4 | Quarter 3 | Quarter 2 | Quarter 1 | Quarter 4 | Quarter 3 | Quarter 2 | Quarter 1 | |||||||||||||||||||||||||
| 2017 | 2017 | 2017 | 2017 | 2016 | 2016 | 2016 | 2016 | |||||||||||||||||||||||||
| Net Interest Income after Loan Loss Provision | $ | 802 | $ | 917 | $ | 725 | $ | 617 | $ | 491 | $ | 442 | $ | 464 | $ | 479 | ||||||||||||||||
| Non-Interest Income | – | – | – | 77 | 28 | – | 44 | – | ||||||||||||||||||||||||
| SG&A expense | 643 | 537 | 456 | 454 | 367 | 297 | 305 | 350 | ||||||||||||||||||||||||
| Impairment loss on foreclosed assets | 64 | 47 | 106 | 49 | 111 | – | – | – | ||||||||||||||||||||||||
| Net Income | $ | 95 | $ | 333 | $ | 163 | $ | 191 | $ | 41 | $ | 145 | $ | 203 | $ | 129 | ||||||||||||||||
| F-22 |
12. Non-Interest Expense Detail
The following table displays our selling, general and administrative expenses for the years ended December 31, 2017 and 2016:
| For
the Years Ended December 31, | ||||||||
| 2017 | 2016 | |||||||
| Selling, general and administrative expenses | ||||||||
| Legal and accounting | $ | 196 | $ | 167 | ||||
| Salaries and related expenses | 1,435 | 798 | ||||||
| Board related expenses | 108 | 112 | ||||||
| Advertising | 59 | 46 | ||||||
| Rent and utilities | 33 | 19 | ||||||
| Loan and foreclosed asset expenses | 57 | 62 | ||||||
| Travel | 78 | 35 | ||||||
| Other | 124 | 80 | ||||||
| Total SG&A | $ | 2,090 | $ | 1,319 | ||||
Printing costs are both for printing of investor related material and for the filing of documents electronically with the Securities and Exchange Commission..
13. Subsequent Events
Management of the Company has evaluated subsequent events through March 23, 2018, the date these consolidated financial statements were issued.
On January 2, 2018, our board of managers appointed Catherine Loftin to serve as our Chief Financial Officer. Previously, we did not have a Chief Financial Officer.
On January 5, 2018, we entered into the Twelfth Amendment (the “Amendment”) to the Credit Agreement (the “Credit Agreement”) with Benjamin Marcus Homes, L.L.C. (“BMH”) and Investor’s Mark Acquisitions, LLC (“IMA”). Pursuant to the Amendment, the balance of the BMH Loan (as defined in the Credit Agreement) is increased by the amount of money spent by BMH and IMA on a property that has been added as collateral to the BMH Loan. We will not require BMH or IMA to provide additional funds into the Interest Escrow (as defined in the Credit Agreement) as part of the funding of the BMH Loan increase. The Credit Agreement requires BMH and IMA to pay into the Interest Escrow an amount equal to 20% of the proceeds upon the payoff of each lot; provided, however, that lots which payoff in the six months following the date of the Amendment will have 100% of their proceeds applied towards principal repayment.
On January 19, 2018, the Company entered into a mortgage on the office building, which it owns and in which it operates, for $660 which is located at 13241 Bartram Park Blvd, Units 2401, 2405, 2409, and 2413.
On March 1, 2018, William Myrick, an independent manager, member of the Audit Committee, and member and Chairman of the Nominating and Corporate Governance Committee and Compensation Committee of the board of managers resigned from such positions. On March 1, 2018, in accordance with our operating agreement, the board of managers decreased the size of the board of managers from four managers to three managers. On March 5, 2018, our board of managers appointed Mr. Myrick as our Executive Vice President of Sales.
On March 1, 2018, Mr. Myrick purchased 14.3% of our Class A common equity for $1,000 from Daniel and Joyce Wallach.
On March 1, 2018, the Company borrowed $1,000 from the line of credit from Daniel Wallach and wife Joyce Wallach, which has remaining availability of $250.
| F-23 |