| PMC COMMERCIAL TRUST /TX “Item 1A Risk Factors |
| ” Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control |
| Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-K will prove to be accurate |
| In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved |
| Forward-looking statements speak only as of the date they are made |
| We do not undertake to update them to reflect changes that occur after the date they are made |
| BUSINESS INTRODUCTION PMC Commercial Trust (“PMC Commercial” and together with its wholly-owned subsidiaries, the “Company,” “our” or “we”) is a real estate investment trust (“REIT”) that primarily originates loans to small businesses collateralized by first liens on the real estate of the related business |
| Our loans are primarily to borrowers in the limited service hospitality industry |
| We also originate loans for commercial real estate primarily in the service, retail, multi-family and manufacturing industries |
| In addition, our investments include the ownership of commercial properties in the hospitality industry |
| Our common shares are traded on the American Stock Exchange under the symbol “PCC” On February 29, 2004, PMC Capital, Inc |
| (“PMC Capital”), our affiliate through common management, merged with and into PMC Commercial |
| Our mission is to derive income primarily from the origination of real estate collateralized loans and from ownership in income producing real estate |
| Through conservative underwriting and exceptional service, we strive to provide our shareholders with the highest dividend, consistent with the focus on preservation of investment capital |
| We generated revenue primarily from the yield earned on our investments, rental income from property ownership and other fee income from our lending activities |
| Our operations are centralized in Dallas, Texas and include originating, servicing and selling commercial loans and property ownership |
| During the years ended December 31, 2005 and 2004, our total revenues were approximately dlra25dtta6 million and dlra21dtta2 million, respectively, and our net income was approximately dlra11dtta3 million and dlra24dtta8 million, respectively |
| Our 2004 net income includes an extraordinary gain of approximately dlra11dtta6 million from negative goodwill resulting from the merger |
| Consolidated Financial Statements and Supplementary Data” for additional financial information |
| Our wholly-owned lending subsidiaries are: First Western SBLC, Inc |
| First Western is licensed as a small business lending company (“SBLC”) that originates loans through the Small Business Administration’s (“SBA”) 7(a) Guaranteed Loan Program (“SBA 7(a) Loan Program”) |
| PMCIC and Western Financial are small business investment companies (“SBICs”) |
| First Western is currently a “Preferred Lender,” as designated by the SBA, in Dallas, Texas and Oklahoma City, Oklahoma and originates, sells and services small business loans throughout the continental United States |
| As a non-bank SBA 7(a) Loan Program lender, First Western is able to originate loans on which a substantial portion of the loan (generally 75prca) is guaranteed as to payment of principal and interest by the SBA A market exists for the sale of the guaranteed portion of First Western’s loans and we receive cash premiums at the time of sale that 2 _________________________________________________________________ [63]Table of Contents approximate up to 10prca of the principal amount of the loan sold |
| To the extent we were to increase our volume of loans originated by our SBLC, there should be a corresponding increase in premiums received |
| In addition, due to the existence of the SBA guarantee, we are able to originate loans in industries that we would typically not lend to due to the profitability of the loan including the premium received |
| ” As a REIT, we seek to maximize shareholder value through long-term growth in dividends paid to our shareholders |
| We must distribute at least 90prca of our REIT taxable income to shareholders to maintain our REIT status |
| ” We pay dividends from the cash flow generated from operations |
| Our ability to generate interest income, as well as other loan related fees, is dependent upon economic, regulatory and competitive factors that influence interest rates and loan originations and our ability to source financing for investment activities |
| The amount of income earned varies based on the volume of loans funded, the timing and amount of structured loan financings, the volume of loans which prepay and the resultant applicable prepayment fees, if any, the mix of loans (construction versus non-construction), the interest rate on loans originated and the general level of interest rates |
| Generally, in order to fund new loans, we need to borrow funds or sell loans |
| Since 1996, our primary source of funds has been structured loan transactions |
| In a structured loan transaction, we contribute loans receivable to a special purpose entity (“SPE”) in exchange for cash and a subordinate financial interest in that entity |
| If the SPE meets the definition of a qualifying special purpose entity (“QSPE”), we account for the transaction as a sale of our loans receivable; and as a result, neither the loans receivable contributed to the QSPE nor the notes payable issued by the QSPE are included in our consolidated financial statements |
| ” We operate in two identifiable reportable segments: (i) the lending division, which originates loans to small businesses primarily in the hospitality industry, which comprised 90prca of our total assets at December 31, 2005, and (ii) the property division, which owns our hotel properties and operates certain of our hotel properties, which comprised 10prca of our total assets at December 31, 2005 |
| We are in the process of selling most of our assets in the property division to focus our operations on the lending division |
| See detailed financial information regarding our segments in “Item 8 |
| ” LENDING ACTIVITIES Overview Our lending division originates loans to small businesses, primarily in the hospitality industry |
| For the year ended December 31, 2005, total revenues and income from continuing operations of our lending division were approximately dlra24dtta2 million (94prca of our total revenues) and dlra12dtta4 million, respectively |
| This compares favorably with our total revenues and income from continuing operations of our lending division during 2004 of dlra19dtta9 million and dlra10dtta5 million, respectively |
| The increased revenues and income from continuing operations were primarily a result of increases in variable interest rates |
| Total assets allocated to the lending division were approximately dlra232dtta6 million (90prca of our total assets) at December 31, 2005 |
| ” We are a national lender that primarily originates small business loans in the limited service sector of the hospitality industry |
| By utilizing our SBA 7(a) Loan Program, we increased our loan originations to the convenience store and gas station, restaurant, service, retail and commercial real estate industries |
| In addition to first liens on real estate of the related business, our loans are generally personally guaranteed by the principals of the entities obligated on the loans |
| In addition to our historical underwriting criteria, we are now originating loans utilizing underwriting criteria which generally have higher loan-to-value ratios than we had prior to the merger (ie, SBA 7(a) Loan Program) |
| As a result, our loans may incur losses in future periods in greater amounts than had historically been realized |
| ” We identify loan origination opportunities through personal contacts, internet referrals, attendance at trade shows and meetings, correspondence with local chambers of commerce, direct mailings, advertisements in trade publications and other marketing methods |
| We also generated loans through referrals from lawyers, accountants, real estate and loan brokers and existing borrowers |
| Payments are often made to non-affiliated individuals who 3 _________________________________________________________________ [64]Table of Contents assist in generating loan applications, with such payments generally not exceeding 1prca of the principal amount of the originated loan |
| Limited Service Hospitality Industry Our loans are generally collateralized by first liens on limited service hospitality properties and are typically made for owner-operated facilities operating under national franchises |
| We believe that franchise operations offer attractive lending opportunities because such businesses generally employ proven business concepts, have national reservation systems, have consistent product quality, are screened and monitored by franchisors and generally have a higher rate of success when compared to other independently operated hospitality businesses |
| The prevailing lodging industry perception for 2006 and 2007 is more optimistic than 2005 |
| Lodging demand in the United States appears to correlate to changes in the United States Gross Domestic Product (“US GDP”) growth, with typically a two to three quarter lag |
| Therefore, given the relatively strong US GDP growth in the past year, an improvement in 2006 and 2007 lodging demand is predicted by industry analysts |
| Such improvement will be dependent upon several factors including: the strength of the economy, the correlation of hotel demand to new hotel supply and the impact of global or domestic events on travel and the hotel industry |
| Leading industry analysts, PricewaterhouseCoopers LLP, have published reports that predict the industry’s results will continue to improve in 2006 and 2007 |
| Loan Originations and Underwriting We originate mortgage loans to small businesses primarily collateralized by commercial real estate |
| We believe that we successfully compete in certain sectors of the commercial real estate finance market due to our understanding of our borrowers’ businesses, the flexible loan terms that we offer and our responsive customer service |
| Our approach to assessing new commercial mortgage loans requires an analysis of the property operator, the replacement cost of the collateral, its liquidation value and an analysis of local market conditions |
| We also consider the underlying cash flow of the tenant or owner-occupant as well as more traditional real estate underwriting criteria such as: • The components and value of the borrower’s collateral (primarily real estate); • The ease with which the collateral can be liquidated; • The industry and competitive environment in which the borrower operates; • The financial strength of the guarantors; • The existence of any secondary repayment sources; and • The existence of a franchise relationship |
| Upon receipt of a completed loan application, our credit department conducts: (i) a detailed analysis of the potential loan, which typically includes an appraisal and a valuation by our credit department of the property that will collateralize the loan to ensure compliance with loan-to-value percentages, (ii) a site inspection for real estate collateralized loans, (iii) a review of the borrower’s business experience, (iv) a review of the borrower’s credit history, and (v) an analysis of the borrower’s debt-service-coverage and debt-to-equity ratios |
| All appraisals must be performed by an approved, licensed third party appraiser and based on the market value, replacement cost and cash flow value approaches |
| We utilize nationwide independent appraisal firms and local market economic information to the extent available |
| We believe that our typical loan is distinguished from those of some of our competitors by the following characteristics: • Substantial down payments are required |
| We usually require an initial down payment of not less than 20prca of the value of the property which is collateral for the loan at the time of such loan |
| Our experience has shown that the likelihood of full repayment of a loan increases if the owner/operator is required to make an initial and substantial financial commitment to the property which is collateral for the loan |
| Generally, we will not make a loan in an amount greater than either the replacement cost of the property which is collateral for the loan or the current appraised value of the property which is collateral for the loan |
| For example, a hotel property may have been originally constructed for a cost of dlra2cmam000cmam000, with the owner/operator borrowing dlra1cmam600cmam000 of that amount |
| At the time of the borrower’s loan refinancing request, the property securing the loan is appraised at dlra4cmam000cmam000 |
| Some of our competitors might loan from 70prca to 90prca or more of the new 4 _________________________________________________________________ [65]Table of Contents appraised value of the property and permit the owner/operator to receive a cash distribution from the proceeds |
| Generally, we would not permit this type of “cash-out” distribution |
| • The obligor is personally liable for the loan |
| We generally require the principals of the borrower to personally guarantee the loan |
| While prior to 2003 we historically originated fixed-rate loans, we do not expect to originate a significant amount of additional fixed-rate loans in the near future since our sources of funds are primarily variable-rate and fixed-rate competitors typically have a lower cost of funds |
| Management continually evaluates potential sources of capital with a fixed-rate cost of funds to determine if a fixed-rate loan product would be feasible |
| Due to the current fixed-rate cost of funds for smaller companies like ours, it does not appear that a significant amount of fixed-rate capital is available to us with a cost that allows us to generate appropriate spreads to compensate us for the commensurate risk of the loans that could be originated |
| We will continue to monitor the leverage market for possible fixed-rate sources of capital and, to the extent we identify an appropriate source, we would establish a fixed-rate lending product |
| Management’s Discussion and Analysis of Financial Condition and Results of Operations — Current Operating Overview and Economic Factors — Lending Division |
| ” General information on our loans receivable, net, was as follows: At December 31, 2005 2004 Weighted Weighted Average Average Loans receivable, net Interest Loans receivable, net Interest Amount % Rate Amount % Rate (Dollars in thousands) Variable-rate - LIBOR $ 120cmam645 76dtta6 % 8dtta3 % $ 84cmam689 66dtta1 % 6dtta4 % Fixed-rate 18cmam651 11dtta8 % 9dtta4 % 28cmam100 21dtta9 % 9dtta7 % Variable rate - prime 18cmam278 11dtta6 % 8dtta7 % 15cmam445 12dtta0 % 6dtta6 % Total $ 157cmam574 100dtta0 % 8dtta5 % $ 128cmam234 100dtta0 % 7dtta1 % Our variable-rate loans receivable generally require monthly payments of principal and interest, reset on a quarterly basis, to amortize the principal over the remaining life of the loan |
| Fixed-rate loans receivable generally require level monthly payments of principal and interest calculated to amortize the principal over the remaining life of the loan |
| 5 _________________________________________________________________ [66]Table of Contents Loan Activity The following table details our loan activity for the years indicated: Years Ended December 31, 2005 2004 2003 2002 2001 (In thousands) Loans receivable, net — beginning of year $ 128cmam234 $ 50cmam534 $ 71cmam992 $ 78cmam486 $ 65cmam645 Loans originated 58cmam852 53cmam659 31cmam320 32cmam776 51cmam683 Loans acquired in the merger (1) — 55cmam144 — — — Principal collections (2) (13cmam826 ) (23cmam196 ) (5cmam655 ) (11cmam637 ) (4cmam965 ) Repayments of SBA 504 program loans (3) (2cmam180 ) (1cmam621 ) (1cmam963 ) (631 ) (970 ) Loans sold (4) (7cmam785 ) (6cmam222 ) — — — Loans transferred to AAL (5) (5cmam657 ) (2cmam115 ) — — — Structured loan sales (6) — — (45cmam456 ) (27cmam286 ) (32cmam662 ) Loan deemed to be repurchased from QSPE (7) — 2cmam126 — — — Other adjustments (8) (64 ) (75 ) 296 284 (245 ) Loans receivable, net — end of year $ 157cmam574 $ 128cmam234 $ 50cmam534 $ 71cmam992 $ 78cmam486 ____________ (1) Represents the estimated fair value of loans acquired from PMC Capital in the merger |
| (2) Represents scheduled principal payments and prepayments |
| (3) Represents second mortgages obtained through the SBA 504 Program which are repaid by certified development companies |
| (4) Represents the guaranteed portion of SBA 7(a) Loan Program loans sold through private placements to either dealers in government guaranteed loans or institutional investors |
| (5) Loans receivable on which the collateral was foreclosed upon and the assets were subsequently classified as assets acquired in liquidation (“AAL”) |
| (6) Loans receivable which were sold as part of structured loan sale transactions |
| (7) Represents a loan receivable at its estimated fair value deemed to be repurchased from one of our QSPEs as a result of a delinquent loan on which we initiated foreclosure on the underlying collateral and were contractually allowed to repurchase from our QSPE (8) Represents the change in loan loss reserves, discounts and deferred commitment fees |
| Quarterly Loan Originations The following table is a breakdown of loans originated on a quarterly basis during the years indicated: Years Ended December 31, 2005 2004 2003 2002 2001 (In thousands) First Quarter $ 8cmam251 $ 6cmam609 $ 9cmam009 $ 6cmam346 $ 9cmam761 Second Quarter 11cmam236 17cmam255 12cmam103 6cmam506 22cmam567 Third Quarter 15cmam010 14cmam998 5cmam557 10cmam044 10cmam097 Fourth Quarter 24cmam355 14cmam797 4cmam651 9cmam880 9cmam258 Total $ 58cmam852 $ 53cmam659 $ 31cmam320 $ 32cmam776 $ 51cmam683 6 _________________________________________________________________ [67]Table of Contents Loan Portfolio Statistics Information on our loans receivable, loans which have been sold and on which we have retained interests (the “Sold Loans”) and our loans receivable combined with our Sold Loans (the “Aggregate Portfolio”) was as follows: At December 31, 2005 2004 Aggregate Sold Loans Aggregate Sold Loans Portfolio Loans (1) Receivable Portfolio Loans (1) Receivable (Dollars in thousands, except footnotes) Portfolio outstanding (2) $ 447cmam220 $ 288cmam652 $ 158cmam568 $ 468cmam158 $ 339cmam301 $ 128cmam857 Weighted average interest rate 8dtta8 % 8dtta9 % 8dtta5 % 7dtta8 % 8dtta0 % 7dtta1 % Annualized average yield (3) 9dtta4 % 9dtta6 % 8dtta9 % 8dtta9 % 8dtta9 % 8dtta7 % Weighted average contractual maturity (in years) 15dtta3 14dtta6 16dtta8 15dtta5 15dtta1 16dtta5 Delinquent and problem loans (4) $ 1cmam587 $ — $ 1cmam587 $ 6cmam861 $ 3cmam150 $ 3cmam711 Hospitality industry concentration % 91dtta5 % 89dtta6 % 94dtta9 % 91dtta0 % 89dtta5 % 94dtta7 % Texas concentration % (5) 24dtta0 % 28dtta9 % 14dtta9 % 24dtta7 % 28dtta7 % 14dtta3 % ____________ (1) In addition to loans of the QSPEs, includes SBA 7(a) Loan Program loans |
| (2) Loan portfolio outstanding before loan loss reserves and deferred commitment fees |
| Loans receivable includes the principal balance remaining on underlying loans receivable in our 1998 structured loan financing transaction of dlra10dtta8 million and dlra12dtta9 million at December 31, 2005 and 2004, respectively |
| (3) For the periods ended December 31, the calculation of annualized average yield divides our interest income, prepayment fees and other loan related fees, adjusted by the provision for (reduction of) loan losses, by the weighted average outstanding portfolio |
| (4) Includes loans which are either past due greater than 60 days or the collection of the balance of principal and interest is considered unlikely and on which the fair value of the collateral is less than the remaining unamortized principal balance (“Problem Loans”) |
| The balance does not include the principal balance of loans which have been identified as potential problem loans for which it is expected that a full recovery of the principal balance will be received through either collection efforts or liquidation of collateral (“Special Mention Loans”) |
| (5) We also had a concentration of approximately 10prca of loans receivable in Arizona at December 31, 2005 |
| No other concentrations greater than or equal to 10prca existed at December 31, 2005 for our loans receivable, Sold Loans or Aggregate Portfolio |
| Industry Concentration The distribution of our loan portfolio by industry was as follows at December 31, 2005: Loans Receivable Aggregate Portfolio Number Number of of Loans Cost (1) % Loans Cost (1) % (Dollars in thousands) Hotels and motels 160 $ 150cmam435 94dtta9 % 350 $ 409cmam104 91dtta5 % Gasoline/service stations 17 2cmam761 1dtta7 % 25 11cmam641 2dtta6 % Apartments 3 2cmam043 1dtta3 % 9 8cmam752 2dtta0 % Restaurants 15 1cmam398 0dtta9 % 16 3cmam237 0dtta7 % Retail, other 10 638 0dtta4 % 10 2cmam275 0dtta5 % Services 19 542 0dtta3 % 26 4cmam611 1dtta0 % Other 16 751 0dtta5 % 22 7cmam600 1dtta7 % 240 $ 158cmam568 100dtta0 % 458 $ 447cmam220 100dtta0 % ____________ (1) Loan portfolio outstanding before loan loss reserves and deferred commitment fees |
| 7 _________________________________________________________________ [68]Table of Contents SBA Programs General We utilize programs established by the SBA to generate loan origination opportunities and provide us with a funding source as follows: • We participate as a private lender in the SBA 504 Program which allows us to originate first mortgage loans with lower loan-to-value ratios; • We have an SBLC that originates loans through the SBA’s 7(a) Loan Program; • We have two licensed SBICs regulated under the Small Business Investment Act of 1958, as amended (“SBIA”) |
| Our SBICs use long-term funds provided by the SBA, together with their own capital, to provide long-term collateralized loans to eligible small businesses, as defined under SBA regulations |
| Our regulated SBA subsidiaries are periodically examined and audited by the SBA to determine compliance with SBA regulations |
| SBA 504 Program The SBA 504 Program assists small businesses in obtaining subordinated, long-term financing by guaranteeing debentures available through certified development companies for the purpose of acquiring land, building, machinery and equipment and for modernizing, renovating or restoring existing facilities and sites |
| A typical finance structure for an SBA 504 Program project would include a first mortgage covering 50prca of the project cost from a private lender, a second mortgage obtained through the SBA 504 Program covering up to 40prca of the project cost and a contribution of at least 10prca of the project cost by the principals of the small businesses being assisted |
| The SBA does not guarantee the first mortgage |
| Although the total sizes of projects utilizing the SBA 504 Program are unlimited, currently the maximum amount of subordinated debt in any individual project is generally dlra1dtta5 million (or dlra2 million for certain projects) |
| Typical project costs range in size from dlra1 million to dlra6 million |
| SBA 7(a) Loan Program Under the SBA 7(a) Loan Program, the SBA guarantees 75prca of qualified loans over dlra150cmam000 with such individual guarantees not exceeding dlra1dtta5 million |
| While the eligibility requirements of the SBA 7(a) Loan Program vary by the industry of the borrower and other factors, the general eligibility requirements are that: (1) gross sales of the borrower cannot exceed dlra6dtta5 million, (2) liquid assets of the borrower and affiliates cannot exceed specified limits, and (3) the maximum aggregate SBA loan guarantees to a borrower cannot exceed dlra1dtta5 million |
| Maximum maturities for SBA 7(a) Loan Program loans are 25 years for real estate and between seven and 15 years for the purchase of machinery, furniture, fixtures and/or equipment |
| In order to operate as an SBLC, a licensee is required to maintain a minimum net worth (as defined by SBA regulations) of the greater of (1) 10prca of the outstanding loans receivable and other investments or (2) dlra1dtta0 million, as well as certain other regulatory restrictions such as change in control provisions |
| See “Item 1A Risk Factors |
| ” SBIC Program We originate loans to small businesses through our SBICs |
| SBICs are intended to stimulate the flow of private equity capital to eligible small businesses |
| Under present SBA regulations, eligible small businesses include businesses that have a net worth not exceeding dlra18 million and have average annual fully taxable net income not exceeding dlra6 million for the most recent two fiscal years |
| According to SBA regulations, SBICs may make long-term loans to small businesses and invest in the equity securities of such businesses |
| Under SBA regulations, an SBIC can issue debentures whose principal and interest is guaranteed to be paid to the debt holder in the event of non-payment by the SBIC As a result, the debentures’ costs of funds are usually lower compared to alternative fixed-rate sources of funds available to us |
| PROPERTY OWNERSHIP During the year ended December 31, 2005, total revenues and loss from continuing operations for our property division were approximately dlra1dtta4 million (6prca of our total revenues) and dlra3dtta4 million, respectively |
| At December 31, 2005, we reclassified nine of our 13 hotel properties to discontinued operations as they are considered “held-for-sale |
| ” Total assets allocated to the property division were approximately dlra26dtta6 million (10prca of total assets) at December 31, 2005 |
| 8 _________________________________________________________________ [69]Table of Contents At December 31, 2005, we owned 13 limited service hospitality properties (individually, a “Hotel Property”) |
| These properties were part of a sale and leaseback transaction commencing in 1998 with Arlington Hospitality, Inc |
| (“AHI”) whereby we purchased the properties from AHI and then leased the properties to a wholly-owned subsidiary of AHI, Arlington Inns, Inc |
| We concurrently entered into a Master Lease Agreement with AHI and AII covering all the properties and entered into a guaranty agreement with AHI whereby AHI guaranteed all obligations of AII under the individual property lease agreements |
| The Master Lease Agreement, as amended, with the individual property lease agreements being known as the “Lease Agreement |
| ” AII filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code (“Chapter 11”) on June 22, 2005 |
| AHI filed for bankruptcy protection under Chapter 11 on August 31, 2005 |
| On January 13, 2006, we received rejection notices on 12 of the individual property leases |
| One property was previously rejected during June 2005 and is currently being operated by us through a third party management company |
| As a result of the rejection of the leases, we have now taken possession of the properties and hired third party management companies to operate the properties |
| Accordingly, we are now subject to fluctuations in our operating results due to the underlying operations of the Hotel Properties whereas, prior to the rejection of the leases we were subject to credit risk of the underlying tenant |
| ” It is our intention to sell the properties in an orderly and efficient manner |
| Management believes that is it probable that we will sell the remaining Hotel Properties that are not subject to mortgages with significant prepayment penalties, within the next 12 months, although no assurances can be given that we will be able to do so |
| As a result, we anticipate owning no more than four of the Amerihost Hotel Properties at year-end 2006 |
| Management’s Discussion and Analysis of Financial Condition and Results of Operations — Current Operating Overview and Economic Factors — Property Division |
| ” STRUCTURED LOAN TRANSACTIONS General Structured loan transactions have historically been our primary method of obtaining funds for new loan originations |
| In a structured loan transaction, we contribute loans receivable to an SPE in exchange for a subordinate financial interest in that entity and obtain an opinion of counsel that the contribution of the loans receivable to the SPE constitutes a “true sale” of the loans receivable |
| The SPE issues notes payable (usually through a private placement) to third parties and then distributes a portion of the notes payable proceeds to us |
| The notes payable are collateralized solely by the assets of the SPE If the SPE meets the definition of a QSPE, we account for the structured loan transaction as a sale of our loans receivable; and as a result, neither the loans receivable contributed to the QSPE nor the notes payable issued by the QSPE are included in our consolidated financial statements |
| The terms of the notes payable issued by the QSPEs provide that the partners of these QSPEs are not liable for any payment on the notes |
| Accordingly, if the QSPEs fail to pay the principal or interest due on the notes, the sole recourse of the holders of the notes is against the assets of the QSPEs |
| We have no obligation to pay the notes, nor do the holders of the notes have any recourse against our assets |
| We are the servicer of the loans pursuant to the transaction documents and are paid a fee of 30 basis points per year based on the principal outstanding |
| When a structured loan sale transaction is completed: (1) our ownership interests in the QSPEs are accounted for as retained interests in transferred assets (“Retained Interests”) and are recorded at the present value of the estimated future cash flows to be received from the QSPE and (2) the difference between (i) the carrying value of the loans receivable sold and (ii) the sum of (a) the cash received and (b) the relative fair value of our Retained Interests, constitutes the gain or loss on sale |
| Gains or losses on these sales may represent a material portion of our net income in the period in which the transactions occur |
| A structured loan financing is similar to a structured loan sale, with the exception that the transaction is not treated as a sale for financial reporting purposes |
| Therefore, the loans receivable contributed to the SPE and the notes payable issued by the SPE are included in our consolidated financial statements and as a result, the ownership interest in the SPE is not accounted for as a retained interest |
| Even though the loans receivable and the notes payable are included on our balance sheets from the structured loan financing transaction completed by PMC Commercial in 1998, PMC Commercial has no obligation to pay the notes, nor do the holders of the notes have any recourse against PMC Commercial’s assets |
| The terms of the notes payable issued by the SPE provide that PMC Commercial is not liable for payment on the notes |
| Accordingly, even though the loans receivable and the notes payable of the SPE are included in our consolidated financial statements, if the SPE fails to pay the principal or 9 _________________________________________________________________ [70]Table of Contents interest on the notes, the sole recourse of the holders of the notes is against the loans receivable and any other assets of the SPE Our structured loan sale transactions and structured loan financing transactions receive opinions from outside counsel that opine to the legal sale of the loans to the legal entity formed in connection with the securitization |
| All of our securitization transactions provide a clean-up call |
| A clean-up call is an option allowed by the transaction documents to repurchase the transferred assets when the amount of the outstanding assets (or corresponding notes payable outstanding) falls to a level at which the cost of servicing those assets becomes burdensome |
| The clean-up call option regarding a loan in a QSPE or SPE is exercised by the party that contributed the loan to the QSPE or SPE As a result of the characteristics underlying the structured loan transaction not satisfying the requirements of off-balance sheet accounting treatment, the 1998 securitization originated by PMC Commercial was considered a structured loan financing transaction |
| Since we have historically relied on structured loan transactions as our primary source of operating capital to fund new loan originations, any adverse changes in our ability to complete this type of transaction, including any negative impact on the asset-backed securities market for the type of product we generate, could have a detrimental effect on our ability to generate funds to originate loans |
| See “Item 1A — Risk Factors |
| ” Structured Loan Sale Transactions General As of December 31, 2005, the QSPEs consisted of: • PMC Capital, LP 1998-1 (the “1998 Partnership”) and its related general partner; • PMC Capital, LP 1999-1 (the “1999 Partnership) and its related general partner; • PMC Joint Venture, LP 2000 (the “2000 Joint Venture”) and its related general partner; • PMC Joint Venture, LP 2001 (the “2001 Joint Venture”) and its related general partner; • PMC Joint Venture, LP 2002-1 (the “2002 Joint Venture”) and its related general partner; and, • PMC Joint Venture, LP 2003-1 (the “2003 Joint Venture,” and together with the 2000 Joint Venture, the 2001 Joint Venture and the 2002 Joint Venture, the “Joint Ventures”) and its related general partner |
| As a result of the merger, we acquired PMC Capital’s subordinate interests in the Joint Ventures and 100prca of the subordinate interests in the 1998 Partnership and the 1999 Partnership (collectively, the “Acquired Structured Loan Sale Transactions”) |
| We previously owned subordinate interests in the Joint Ventures (the “Originated Structured Loan Sale Transactions”) |
| Even though we now own 100prca of the subordinate interest in each of the Joint Ventures, since a portion was obtained through acquisition, we recorded these investments separately |
| At the date of acquisition, the fair value of the Acquired Structured Loan Sale Transactions became our cost |
| In addition, First Western has Retained Interests related to the sale of loans originated pursuant to the SBA 7(a) Loan Program |
| 2003 Structured Loan Sale Transaction On October 7, 2003, we completed a structured loan sale transaction of a pool of variable-rate loans receivable |
| PMC Commercial and PMC Capital contributed loans receivable of dlra45dtta4 million and dlra57dtta8 million, respectively, to the 2003 Joint Venture |
| The 2003 Joint Venture issued, through a private placement, approximately dlra92dtta9 million of its 2003 Loan-Backed Floating Rate Notes (the “2003 LP Notes”) of which approximately dlra40dtta9 million was allocated to us based on our ownership percentage in the 2003 Joint Venture |
| The 2003 LP Notes, issued at par, have a stated maturity in 2023, bear interest, reset on a quarterly basis, at the 90-day LIBOR plus 1dtta25prca, and are collateralized by the loans receivable contributed by us and PMC Capital to the 2003 Joint Venture |
| We accounted for this transaction as a sale, recorded a gain of dlra711cmam000 and recorded our Retained Interests at an initial amount of dlra8cmam698cmam000 during 2003 |
| At inception of the 2003 Joint Venture, we had a subordinate interest of 44prca in the limited partnership based on our share of the capital |
| 10 _________________________________________________________________ [71]Table of Contents Originated Structured Loan Sale Transactions Information relating to our Originated Structured Loan Sale Transactions was as follows: 2000 Joint 2001 Joint 2002 Joint 2003 Joint Venture Venture Venture Venture (Dollars in thousands) Transaction date 12/18/00 06/27/01 04/12/02 10/07/03 Principal amount of loans sold: At time of sale $ 55cmam675 $ 32cmam662 $ 27cmam286 $ 45cmam456 At December 31, 2005 $ 31cmam092 $ 24cmam075 $ 20cmam352 $ 31cmam102 Structured notes: At time of sale $ 49cmam550 $ 30cmam063 $ 24cmam557 $ 40cmam910 At December 31, 2005 $ 26cmam756 $ 21cmam508 $ 17cmam613 $ 31cmam180 Weighted average interest rate on loans (1): At time of sale 9dtta63 % 9dtta62 % 9dtta23 % L+4dtta02 % At December 31, 2005 9dtta55 % 9dtta67 % 9dtta54 % L+4dtta02 % Required overcollateralization: At time of sale (2) 11dtta0 % 8dtta0 % 10dtta0 % 10dtta0 % At December 31, 2005 (3) 17dtta8 % 10dtta9 % 13dtta4 % 14dtta6 % Interest rate on the structured notes payable (1) 7dtta28 % 6dtta36 % 6dtta67 % L+1dtta25 % Rating of structured notes (4) “Aaa” “Aaa” “Aaa” “Aaa” Cash reserve requirement (5) 6dtta0 % 6dtta0 % 6dtta0 % 6dtta0 % ____________ (1) Variable interest rates are denoted by the spread over the 90-day LIBOR (“L”) |
| (2) The required overcollateralization percentage at time of sale represents the portion of our Sold Loans retained by the QSPEs whose value is included in Retained Interests |
| (3) The required overcollateralization percentage at December 31, 2005 was larger than the required overcollateralization percentage at time of sale since all principal payments received on the underlying loans receivable are paid to the noteholders |
| (4) Structured notes issued by the QSPEs were rated by Moody’s Investors Service, Inc |
| (5) The cash reserve requirement is 6prca of the principal amount of loans outstanding |
| Transactions all have minimum reserve requirements of 2prca of the principal balance sold at the time of the sale |
| 11 _________________________________________________________________ [72]Table of Contents Acquired Structured Loan Sale Transactions Information relating to our Acquired Structured Loan Sale Transactions was as follows: 1998 1999 2000 2001 2002 2003 Partnership Partnership Joint Venture Joint Venture Joint Venture Joint Venture (Dollars in thousands) Principal amount of loans sold: At February 29, 2004 $ 21cmam702 $ 29cmam800 $ 17cmam345 $ 37cmam191 $ 36cmam102 $ 56cmam424 At December 31, 2005 $ 15cmam994 $ 20cmam203 $ 11cmam188 $ 25cmam100 $ 22cmam491 $ 44cmam470 Structured notes: At February 29, 2004 $ 21cmam221 $ 26cmam394 $ 15cmam636 $ 33cmam324 $ 32cmam932 $ 50cmam774 At December 31, 2005 $ 15cmam240 $ 16cmam795 $ 9cmam941 $ 21cmam223 $ 18cmam232 $ 41cmam602 Weighted average interest rate on loans (1): At February 29, 2004 P+1dtta22 % 9dtta40 % 9dtta20 % 9dtta64 % 9dtta58 % L+4dtta02 % At December 31, 2005 P+1dtta15 % 9dtta09 % 9dtta06 % 9dtta67 % 9dtta63 % L+4dtta02 % Required overcollateralization (2) (3): At February 29, 2004 10dtta5 % 12dtta0 % 15dtta7 % 10dtta6 % 12dtta0 % 10dtta2 % At December 31, 2005 10dtta5 % 17dtta7 % 24dtta4 % 15dtta7 % 19dtta2 % 13dtta0 % Mortgage-backed security (4) 5dtta0 % — — — — — Interest rate on structured notes (1) P-1dtta00 % 6dtta60 % 7dtta28 % 6dtta36 % 6dtta67 % L+1dtta25 % Rating of structured notes (5) “Aaa” “Aaa” “Aaa” “Aaa” “Aaa” “Aaa” Cash reserve requirement (6) $ 1cmam329 6dtta0 % 6dtta0 % 6dtta0 % 6dtta0 % 6dtta0 % ____________ (1) Variable interest rates are denoted by the spread over (under) the prime rate (“P”) or the 90-day LIBOR (“L”) |
| (2) The required overcollateralization percentage at February 29, 2004 represents the portion of our Sold Loans retained by the QSPEs whose value is included in Retained Interests |
| (3) For the majority of the Acquired Structured Loan Sale Transactions, the required overcollateralization percentage at December 31, 2005 was larger than the required overcollateralization percentage at February 29, 2004 since all principal payments received on the underlying loans receivable are paid to the noteholders |
| (5) Structured notes issued by the QSPEs were rated by Moody’s Investors Service, Inc |
| (6) The cash reserve requirement is 6prca of the principal amount of loans outstanding for all transactions with the exception of the 1998 Partnership |
| Transactions all have minimum reserve requirements of 2prca of the principal balance sold at the time of the sale |
| The 1998 Partnership is currently at its minimum requirement |
| Retained Interests As a result of our structured loan sale transactions, we have Retained Interests representing our residual interest in the loans sold to the QSPEs |
| When we securitize loans, we are required to recognize Retained Interests, which represent our right to receive net future cash flows, at their fair value |
| Our Retained Interests consist of (i) the required overcollateralization, which is the retention of a portion of each of the Sold Loans, (ii) the reserve fund, which represents the required cash balance owned by the QSPE and (iii) the interest-only strip receivable, which represents the future excess funds to be generated by the QSPE after payment of all obligations of the QSPE Our Retained Interests are subject to credit, prepayment and interest rate risks |
| The estimated fair value of our Retained Interests is determined based on the present value of estimated future cash flows that we will receive from the QSPEs |
| The estimated future cash flows are calculated based on assumptions concerning, among other things, loan losses and prepayment speeds |
| On a quarterly basis, we measure the fair value of, and record income relating to, the Retained Interests based upon the future anticipated cash flows discounted based on an estimate of market interest rates for investments of this type |
| Any appreciation of the Retained Interests is included in our balance sheet in beneficiaries’ equity |
| Any depreciation of Retained Interests is either included in our statement of income as either a realized loss (if there is a reduction in expected future cash flows) or on the balance sheet in beneficiaries’ equity as an unrealized loss |
| We retain a portion of the default and prepayment risk associated with the underlying loans of our Retained Interests |
| Actual defaults and prepayments, with respect to estimating future cash flows for purposes of valuing our 12 _________________________________________________________________ [73]Table of Contents Retained Interests will vary from our assumptions, possibly to a material degree, and slower (faster) than anticipated prepayments of principal or lower (higher) than anticipated loan losses will increase (decrease) the fair value of our Retained Interests and related cash flows |
| We regularly measure our loan loss, prepayment and other assumptions against the actual performance of the loans sold |
| Although we believe that assumptions made as to the future cash flows are reasonable, actual rates of loss or prepayments will vary from those assumed and the assumptions may be revised based upon changes in facts or circumstances |
| See “Item 1A — Risk Factors — Investments General — There is no market for our Retained Interests and the value is volatile |
| ” In accordance with generally accepted accounting principles, our consolidated financial statements do not include the assets, liabilities, partners’ capital, revenues or expenses of the QSPEs |
| As a result, at December 31, 2005 and 2004, our consolidated balance sheets do not include dlra276dtta1 million and dlra321dtta4 million in assets, respectively, and dlra220dtta8 million and dlra263dtta4 million in liabilities, respectively, related to these structured loan sale transactions recorded by the QSPEs |
| At December 31, 2005, the partners’ capital of the QSPEs was approximately dlra55dtta3 million compared to the value of the associated Retained Interests of dlra62dtta2 million |
| As a REIT, PMC Commercial is generally not subject to Federal income tax (including any applicable alternative minimum tax) to the extent that it distributes at least 90prca of its REIT taxable income to shareholders |
| Certain of PMC Commercial’s subsidiaries, including First Western and PMCIC, have elected to be treated as taxable REIT subsidiaries; thus, their earnings are subject to US Federal income tax |
| To the extent PMC Commercial’s taxable REIT subsidiaries retain their earnings and profits, these earnings and profits will be unavailable for distribution to our shareholders |
| PMC Commercial may, however, be subject to certain Federal excise taxes and state and local taxes on its income and property |
| If PMC Commercial fails to qualify as a REIT in any taxable year, it will be subject to Federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and will not be able to qualify as a REIT for four subsequent taxable years |
| REITs are subject to a number of organizational and operational requirements under the Code |
| See “Item 1A — Risk Factors — REIT Related Risks” for additional tax status information |
| EMPLOYEES We employed 45 individuals including marketing professionals, investment professionals, operations professionals and administrative staff as of December 31, 2005 |
| In addition, we have employment agreements with our executive officers |
| Annual base salary during the terms of the contracts does not exceed dlra350cmam000 for any one individual |
| Our operations are conducted from our Dallas, Texas office |
| We believe the relationship with our employees is good |
| COMPETITION In originating loans we compete with other specialty commercial lenders, banks, other REITs, savings and loan associations, insurance companies and other entities that originate loans |
| Many of these competitors have greater financial and managerial resources than us, are able to provide services we are not able to provide (ie, depository services), and may be better able to withstand the impact of economic downturns than we are |
| For our variable-rate loan product, we believe we compete effectively on the basis of interest rates, our long-term maturities and payment schedules, the quality of our service, our reputation as a lender, timely credit analysis and greater responsiveness to renewal and refinancing requests from borrowers |
| While we have originated fixed-rate loans, we do not expect to originate a significant amount of fixed-rate loans in the near future since our sources of funds are primarily variable-rate and due to competitors with a lower cost of funds able to provide a fixed-rate loan at rates below what we would have to generate |
| The limited service hospitality segment of the hotel business is highly competitive |
| As such, our Hotel Properties compete on the basis of price, quality, reputation, services and reservation systems, among other things |
| Other hotel owners may have greater resources than us and may be able to provide other services that we cannot |
| There is no assurance that we will be able to compete effectively and losses could result which could be material to our results of operations or financial condition |
| 13 _________________________________________________________________ [74]Table of Contents CUSTOMERS In relation to our lending division, we are not dependent upon a single borrower, or a few borrowers, whose loss would have a material adverse effect on us |
| In addition, we have not loaned more than 10prca of our assets to any single borrower |
| Our property division is currently dependent upon third party managers to operate the Hotel Properties |
| The loss of our third party managers as operators of our properties could have a material adverse effect on us |
| As a REIT, we would be required to find tenants or third party management companies for our Hotel Properties |
| Until such time as a new lease could be entered into or the property was sold, we would incur additional holding costs, legal fees and possibly costs to re-franchise the properties |
| AVAILABLE INFORMATION We file annual, quarterly, current and special reports and other information with the Securities and Exchange Commission (the “SEC”) |
| All documents may be located at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549 or you may obtain information on the operation of the Public Reference Room by calling 1-800-SEC-0330 |
| Our SEC filings are also available to the public, free of charge, from our internet site at www |
| com, as soon as reasonably practicable after the reports are filed with, or furnished to, the SEC or at the SEC’s internet site at www |
| Item 1A RISK FACTORS Management has identified the following important factors that could cause actual results to differ materially from those reflected in forward-looking statements or from our historical results |
| These factors, which are not all-inclusive, could have a material impact on our asset valuations, results of operations or financial condition |
| In addition, these factors could impair our ability to maintain dividend distributions at current levels |
| Investment Risks — Lending Activities Competition might prevent us from originating loans at favorable yields, which would harm our results of operations and our ability to continue paying dividends at current levels |
| Our net income depends on our ability to originate loans at favorable spreads over our borrowing costs |
| In originating loans, we compete with other specialty commercial lenders, banks, other REITs, savings and loan associations, insurance companies and other entities that originate loans, many of which have greater financial resources than us |
| As a result, we may not be able to originate sufficient loans at favorable spreads over our borrowing costs, which would harm our results of operations and consequently, our ability to continue paying dividends at current levels |
| There are significant risks in lending to small businesses |
| There is no publicly available information about these businesses; therefore, we must rely on our own due diligence to obtain information in connection with our investment decisions |
| Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by banks |
| A borrower’s ability to repay its loan may be adversely impacted by numerous factors, including a downturn in its industry or other negative economic conditions |
| Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in the collateral for the loan |
| In addition, small businesses typically depend on the management talents and efforts of one person or a small group of people for their success |
| The loss of services of one or more of these persons could have an adverse impact on the operations of the small business |
| Small companies are typically more vulnerable to customer preferences, market conditions and economic downturns and often need additional capital to expand or compete |
| These factors may have an impact on the ultimate recovery of our loans receivable from such businesses |
| Loans to small businesses, therefore, involve a high degree of business and financial risk, which can result in substantial losses and accordingly should be considered speculative |
| 14 _________________________________________________________________ [75]Table of Contents There is volatility in the valuation of our loans receivable which can require the establishment of loan loss reserves |
| There is typically no public market or established trading market for the loans we originate |
| The illiquid nature of our loans may adversely affect our ability to dispose of such loans at times when it may be advantageous for us to liquidate such investments |
| To the extent one or several of our borrowers experience significant operating difficulties and we are forced to liquidate the collateral underlying the loan, future losses may be substantial |
| The determination of whether significant doubt exists and whether a loan loss reserve is necessary for each loan requires judgment and consideration of the facts and circumstances existing at the evaluation date |
| Changes to the facts and circumstances of the borrower and/or the physical condition of the collateral underlying the loan, the hospitality industry and the economy may require the establishment of significant additional loan loss reserves |
| Changes in interest rates could negatively affect lending operations, which could result in reduced earnings |
| The net income of our lending operations is materially dependent upon the “spread” between the rate at which we borrow funds and the rate at which we loan these funds |
| During periods of changing interest rates, interest rate mismatches could negatively impact our net income, dividend yield, and the market price of our common shares |
| If the yield on loans originated with funds obtained from fixed-rate borrowings or preferred stock fails to cover the cost of such funds, our cash flow will be reduced |
| As a result of our dependence on variable-rate loans (all of our current commitments are for variable-rate loans), our interest income will be reduced during low interest rate environments |
| To the extent that LIBOR or the prime rate decreases from current levels, interest income on our currently outstanding loans receivable will decline |
| Changes in interest rates do not have an immediate impact on the interest income of our fixed-rate loans receivable |
| Our interest rate risk on our fixed-rate loans receivable is primarily due to loan prepayments and maturities |
| The average maturity of our loan portfolio is less than their average contractual terms because of prepayments |
| The average life of mortgage loans receivable tends to increase when the current mortgage rates are substantially higher than rates on existing mortgage loans receivable and, conversely, decrease when the current mortgage rates are substantially lower than rates on existing mortgage loans receivable (due to refinancings of fixed-rate loans receivable at lower rates) |
| We depend on the accuracy and completeness of information about potential borrowers and guarantors |
| In deciding whether or not to extend credit or enter into transactions with potential borrowers and/or their guarantors, we rely on information furnished to us by or on behalf of potential borrowers and/or guarantors, including financial statements, construction invoices and other financial information |
| We also rely on representations of potential borrowers and/or guarantors as to the accuracy and completeness of that information |
| Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that are materially misleading |
| Investment Risks — General There is no market for our Retained Interests and the value is volatile |
| Due to the limited number of entities that conduct transactions with similar assets, the relatively small size of our Retained Interests and the limited number of buyers for such assets, no readily ascertainable market exists for our Retained Interests |
| Therefore, our estimate of the fair value may vary significantly from what a willing buyer would pay for these assets |
| If a ready market existed for our Retained Interests, the value would be different and such difference may be significant |
| 15 _________________________________________________________________ [76]Table of Contents The following is a sensitivity analysis of our Retained Interests as of December 31, 2005 to highlight the volatility that results when prepayments, loan losses and discount rates are different than our assumptions: Estimated Fair Asset Changed Assumption Value Change (1) (In thousands) Losses increase by 50 basis points per annum (2) $ 60cmam260 (dlra2cmam731 ) Losses increase by 100 basis points per annum (2) $ 57cmam590 (dlra5cmam401 ) Rate of prepayment increases by 5prca per annum (3) $ 62cmam057 (dlra934 ) Rate of prepayment increases by 10prca per annum (3) $ 61cmam266 (dlra1cmam725 ) Discount rates increase by 100 basis points $ 60cmam677 (dlra2cmam314 ) Discount rates increase by 200 basis points $ 58cmam483 (dlra4cmam508 ) ____________ (1) Any depreciation of our Retained Interests is either included in the accompanying statement of income as a realized loss (if there is a reduction in expected future cash flows) or on our balance sheet in beneficiaries’ equity as an unrealized loss |
| (2) If we experience significant losses (ie, in excess of anticipated losses), the effect on our Retained Interests would first be to reduce the value of the interest-only strip receivables |
| To the extent the interest-only strip receivables could not fully absorb the losses, the effect would then be to reduce the value of our reserve funds and then the value of our required overcollateralization |
| (3) For example, an 8prca assumed rate of prepayment would be increased to 13prca or 18prca based on increases of 5prca or 10prca per annum, respectively |
| These sensitivities are hypothetical and should be used with caution |
| Values based on changes in these assumptions generally cannot be extrapolated since the relationship of the change in assumptions to the change in value may not be linear |
| The effect of a variation in a particular assumption on the estimated fair value of our Retained Interests is calculated without changing any other assumption |
| In reality, changes in one factor are not isolated from changes in another which might magnify or counteract the sensitivities |
| Changes in any of these assumptions or actual results which deviate from assumptions will affect the estimated fair value of our Retained Interests, possibly to a material degree |
| There can be no assurance as to the accuracy of these estimates |
| We have a concentration of investments in the hospitality industry and in certain states, which may negatively impact our financial condition and results of operations |
| Substantially all of our revenue is generated from loans collateralized by hospitality properties and the ownership of Hotel Properties |
| At December 31, 2005, our loans receivable were approximately 95prca concentrated in the hospitality industry and approximately 93prca of the loans sold to our QSPEs were concentrated in the hospitality industry |
| Any economic factors that negatively impact the hospitality industry, including terrorism, travel restrictions, bankruptcies or other political or geopolitical events, could have a material adverse effect on our financial condition and results of operations |
| At December 31, 2005, approximately 15prca of our loans receivable were collateralized by properties in Texas, approximately 10prca were collateralized by properties in Arizona and approximately 28prca of the loans sold to our QSPEs were collateralized by properties in Texas |
| No other state had a concentration of 10prca or greater of our loans receivable, loans sold to our QSPEs or Aggregate Portfolio at December 31, 2005 |
| See “Properties” in |