Item 1. Business.
General
United Development Funding III, L.P. was organized on June 13, 2005 as a Delaware limited partnership. Our principal purpose is to originate, acquire, service, and otherwise manage, either alone or in association with others, a diversified portfolio of mortgage loans that are secured by real property or equity interests in entities that hold real property already subject to other mortgages (including mortgage loans that are not first in priority) and participation interests in mortgage loans, and to issue or acquire an interest in credit enhancements to borrowers, such as guaranties or letters of credit.
We concentrate on making development loans to single-family lot developers who sell their lots to national and regional home builders, as well as making loans to national home builders and entities created by home builders in conjunction with our general partner or affiliates of our general partner for the acquisition of property and development of residential lots. We seek to make or acquire loans primarily with respect to projects where the completed subdivision will consist of homes at or below the median price of the U.S. housing market.
Our general partner is UMTH Land Development, L.P., a Delaware limited partnership (“Land Development”). Land Development is responsible for our overall management, conduct and operation. Our general partner has authority to act on our behalf in all matters respecting us, our business and our property. The limited partners shall take no part in the management of our business or transact any business for us and shall have no power to sign for or bind us; provided, however, that the limited partners, by a majority vote and without the concurrence of the general partner, have the right to: (a) amend the Agreement of Limited Partnership, as amended (the “Partnership Agreement”), governing the Partnership, (b) dissolve the Partnership, (c) remove the general partner or any successor general partner, (d) elect a new general partner, and (e) approve or disapprove a transaction entailing the sale of all or substantially all of the real properties acquired by the Partnership.
On May 15, 2006, our Registration Statement on Form S-11, covering an initial public offering (the “Offering”) of up to 12,500,000 units of limited partnership interest at a price of $20 per unit, was declared effective under the Securities Act of 1933, as amended. The Registration Statement also covered up to 5,000,000 units of limited partnership interest to be issued pursuant to our distribution reinvestment plan (“DRIP”) for $20 per unit. We have the right to reallocate the units of limited partnership interest we are offering between the primary offering and our DRIP, and pursuant to Supplement No. 8 to our prospectus regarding the Offering, which was filed with the Securities and Exchange Commission on September 4, 2008, we reallocated the units being offered such that 16,250,000 units are being offered pursuant to the primary offering and 1,250,000 units are being offered pursuant to the DRIP. Our initial public subscribers were accepted as limited partners on July 3, 2006. As of December 31, 2008, we had issued an aggregate of 15,019,292 units of limited partnership interest in the Offering, consisting of 14,739,257 units that have been issued to our limited partners in exchange for gross proceeds of approximately $294.9 million (approximately $259.6 million, net of costs associated with the Offering) and another 415,660 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $8.3 million, minus 135,625 units of limited partnership interest that have been repurchased pursuant to our unit redemption program for approximately $2.7 million. Our limited partnership units are not currently listed on a national exchange, and we do not expect any public market for the units to develop.
Our Partnership Agreement provides that we will continue in existence until December 31, 2028, unless sooner terminated as provided in the Partnership Agreement or unless such term is extended by the General Partner and the majority vote of the Limited Partners.
We will experience a relative increase in liquidity as subscriptions for units are received and accepted, and if we obtain a new credit facility to provide transitory indebtedness. We will experience a relative decrease in liquidity as Offering proceeds are expended in connection with the funding and acquisition of mortgage loans, as amounts that may be drawn under a new credit facility are repaid, as we pay or reimburse selling commissions and other organization and Offering expenses, and as we cease accepting subscriptions for units for our primary offering.
Loan Portfolio
As of December 31, 2008, we had originated 49 loans (14 of which were repaid in full by the respective borrowers) with an aggregate principal amount of approximately $386 million. As of December 31, 2008, there are approximately $56.4 million of commitments to be funded, including approximately $25.3 million to related parties, under the terms of mortgage notes receivable and participation interests.
Approximately 95% of the outstanding aggregate principal amount of mortgage notes originated by us as of December 31, 2008 are secured by properties located throughout Texas, approximately 4% are secured by properties located in Colorado and approximately 1% are secured by properties located in Arizona. Approximately 49% of the outstanding aggregate principal amount of mortgage notes originated by us as of December 31, 2008 are secured by properties located in the Dallas, Texas area; approximately 31% are secured by properties located in the Austin, Texas area; approximately 8% are secured by properties located in the Houston, Texas area; approximately 6% are secured by properties located in the Lubbock, Texas area; approximately 1% are secured by properties located in the San Antonio, Texas area; approximately 4% are secured by properties located in the Denver, Colorado area; and approximately 1% are secured by properties located in the Kingman, Arizona area. Security for such loans takes the form of either a direct security interest represented by a first or second lien on the respective property and/or an indirect security interest represented by a pledge of the ownership interests of the entity which holds title to the property. Fifteen of the 35 loans outstanding as of December 31, 2008, representing approximately 67% of the aggregate principal amount of the outstanding loans, are made with respect to projects that are presently selling finished home lots to national public or regional private homebuilders, or are made with respect to a project in which one of these homebuilders holds an option to purchase the finished home lots and has made a significant forfeitable earnest money deposit. Twenty of the 35 loans outstanding as of December 31, 2008, representing approximately 64% of the aggregate principal amount of the outstanding loans, are made to developer entities which hold ownership interests in projects other than the project funded by us. Fourteen of the 35 loans outstanding as of December 31, 2008, representing approximately 72% of the aggregate principal amount of the outstanding loans, are secured by multiple single-family residential communities. Nineteen of the 35 loans outstanding as of December 31, 2008, representing approximately 58% of the aggregate principal amount of the outstanding loans, are secured by a personal guarantee of the developer in addition to a lien on the real property or the equity interests in the entity that holds the real property.
The average interest rate payable with respect to the 35 loans outstanding as of December 31, 2008 is 14.2%, and the average term of the loans is approximately 26 months.
Investment Objectives and Policies
Principal Investment Objectives
Our principal investment objectives are:
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to make, originate or acquire a participation interest in mortgage loans (secured by first priority or junior priority liens against real property or liens against equity interests of entities that hold real property) typically in the range of $500,000 to $10 million, and to provide credit enhancements to real estate developers and regional and national homebuilders who acquire real property, subdivide such real property into single-family residential lots and sell such lots to homebuilders or build homes on such lots;
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to produce net interest income from the interest on loans that we originate or purchase or in which we acquire a participation interest;
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to produce a profitable fee from our credit enhancement transactions;
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to produce income through origination, commitment and credit enhancement fees charged to borrowers;
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to maximize distributable cash to investors; and
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to preserve, protect and return capital contributions.
Investment Policy
We derive a substantial portion of our income by originating, purchasing, participating in and holding for investment mortgage and mezzanine loans made directly by us or indirectly through our affiliates to persons and entities for the acquisition and development of parcels of real property as single-family residential lots that will be marketed and sold to home builders. We also offer credit enhancements to developers in the form of loan guaranties to third-party lenders, letters of credit issued for the benefit of third-party lenders and similar credit enhancements. In the typical credit enhancement transaction, we charge the borrower a credit enhancement fee generally equal to 3% to 7% of the projected maximum amount of our outstanding credit enhancement obligation for each 12-month period such obligation is outstanding, in addition to any costs that we may incur in providing the credit enhancement. We cannot guarantee that we will obtain a 3% to 7% credit enhancement fee. The actual amount of such charges will be based on the risk perceived by our general partner to be associated with the transaction, the value of the collateral associated with the transaction, our security priority as to the collateral associated with the transaction, the form and term of the credit enhancement, and our overall costs associated with providing the credit enhancement.
We intend to reinvest the principal repayments we receive on loans to create or invest in new loans during the term of the Partnership. However, following the seventh anniversary of the effectiveness of the Offering on May 15, 2006, a limited partner may elect to receive his or her pro rata share of any loan principal repayments. Any capital not reinvested will be used first to return our limited partners’ capital contributions and then to pay distributions to our limited partners. Within 20 years after termination of the Offering, we will either (1) make an orderly disposition of investments and distribute the cash to investors or (2) upon approval of limited partners holding more than 50% of the outstanding units, continue the operation of the Partnership for the term approved by the limited partners.
Cash available for distributions are the funds received by us from operations (other than proceeds from a capital transaction or a liquidating distribution), less cash used by us to pay our expenses, debt payments, and amounts set aside to create a retained earnings reserve (currently at 9.5% of our net income; the retained earnings reserve is intended to recover some of the organization and offering expenses incurred in connection with the Offering). Our general partner receives a monthly distribution for promotional and carried interest from the cash available for distributions. Monthly distributions are currently paid to the limited partners as a 9.75% annualized return on a pro rata basis based on the number of days the limited partner has been invested in the Partnership. Retained earnings would contain a surplus if the cash available for distribution less the 9.5% reserve exceeded the monthly distributions to the general partner and limited partners. Retained earnings would contain a deficit if cash available for distributions less the 9.5% reserve is less than the monthly distributions to the general partner and limited partners. It is the intent of management to monitor and distribute such surplus on an annual basis. The chart below summarizes the approximate amount of distributions to our general partner and limited partners, the retained earnings reserve and the retained earnings deficit and surplus as of December 31, 2008 and 2007, respectively:
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(1) approximately $14.8 million paid in cash and approximately $8.3 million reinvested in 415,660 units of limited partnership interest under the DRIP.
(2) approximately $3.4 million paid in cash and approximately $1.6 million reinvested in 79,614 units of limited partnership interest under the DRIP.
Security
Our mortgage notes receivable are generally secured by:
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the parcels of land to be developed;
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in certain cases, a pledge of some or all of the equity interests in the developer entity;
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in certain cases, additional assets of the developer, including parcels of undeveloped and developed real property; and
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in certain cases, personal guaranties of the principals of the developer entity.
If there is no third-party financing for a development project, our lien on the subject parcels is a first priority lien. If there is third-party financing, our lien on the subject parcels is subordinate to such financing. We enter each loan prepared to assume or retire any senior debt if necessary to protect our capital. We seek to enter into agreements with third-party lenders that require the third-party lenders to notify us of a default by the developer under the senior debt and allow us to assume or retire the senior debt upon any default under the senior debt. As of December 31, 2008, 21% of the aggregate principal amount of mortgage notes we have originated was in a first lien position, 8% of the aggregate principal amount of mortgage notes we have originated was in a subordinate lien position, and 71% of the aggregate principal amount of mortgage notes we have originated was secured by a pledge of partnership interests or by both a subordinate lien position and a pledge of partnership interests.
Most of our real estate loans, including loans made to entities affiliated with our general partner, have the benefit of unconditional guaranties of the developer and/or its parent company and pledges of additional assets of the developer.
Underwriting Criteria
When selecting mortgage loans and investments that we intend to originate or purchase, our general partner adheres to the following underwriting criteria:
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Liens. All loans and investments made by us must be evidenced by a note and must be secured (1) by a first or second lien that is insured by a title insurance company, (2) by a pledge of the partnership interests in the special purpose entity holding the property or by both a subordinate lien position and a pledge of the partnership interests in the special purpose entity, or (3) by a commitment as to the priority of the loan or the condition of title; in addition, our loans and investments may be secured by a pledge of additional ownership interests of the developer and its affiliates in other development projects.
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Interest Rate. We seek to originate loans bearing interest at rates ranging from 10% to 16% per annum.
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Term and Amortization. We currently do not have a policy that establishes a minimum or maximum term for the loans we may make, nor do we intend to establish one. Loans typically are structured as interest-only notes with balloon payments or reductions to principal tied to net cash from the sale of developed lots and the release formula created by the senior lender, i.e., the conditions under which principal is repaid to the senior lender, if any.
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Geographical Boundaries. We may buy or originate loans in any of the 48 contiguous United States. As of December 31, 2008, we have originated loans in Texas, Colorado, Arizona and New Mexico.
Credit Facility
On December 29, 2008, a revolving credit facility (the “Revolving Credit Facility”) that we had entered into in December 2006, with Premier Bank, a Missouri banking association d/b/a Premier Bank of Texas, which permitted us to borrow up to an aggregate outstanding principal amount of $10 million, was terminated. The terminated Revolving Credit Facility was secured by a first priority lien upon all of the Partnership’s existing and future acquired assets. In consideration for the origination of the terminated Revolving Credit Facility, we paid an origination fee in the amount of approximately $113,000, which was amortized over the two-year term of the terminated Revolving Credit Facility. The annual interest rate on the terminated Revolving Credit Facility was equal to the prime rate of interest as quoted in the Wall Street Journal (3.25% at December 29, 2008 and 7.25% at December 31, 2007).
We utilized the terminated Revolving Credit Facility as transitory indebtedness to provide liquidity and to reduce and avoid the need for large idle cash reserves, including usage to fund identified investments pending receipt of proceeds from the sale of our units. Proceeds from the sale of our units were used to repay the terminated Revolving Credit Facility. We used the terminated Revolving Credit Facility as a portfolio administration tool and not to provide long-term or permanent leverage on our investments. As of December 31, 2007, approximately $2.3 million was outstanding on the terminated Revolving Credit Facility. No balance was outstanding at the time of termination of the Revolving credit facility. Interest expense related to the terminated Revolving Credit Facility was approximately $1,500 and $256,500 for the years ended December 31, 2008 and 2007, respectively.
Borrowing Policies
The Partnership Agreement authorizes us to borrow funds up to an amount equal to 70% of the aggregate fair market value of all of our mortgage notes receivable. We are permitted by our Partnership Agreement to borrow money to:
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acquire or make mortgage loans;
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prevent defaults under senior loans or discharge them entirely if that becomes necessary to protect our interests; or
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assist in the development or sale of any real property that we have taken over as a result of default.
If our general partner determines it is advantageous to us, we may borrow money only if such borrowings do not constitute “acquisition indebtedness” as such term is defined in Section 514 of the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), and the Treasury Regulations and rulings thereunder. Our use of leverage increases our risk of loss, however, because defaults on indebtedness secured by our assets may result in lenders initiating foreclosure of our assets.
Investment Limitations
We have not invested as a general or limited partner in other limited partnerships, even though we are permitted to do so under limited circumstances, as provided by our Partnership Agreement and the North American Securities Administrators Association (“NASAA”) Mortgage Program Guidelines.
We do not underwrite securities of other issuers or invest in securities of other issuers for the purpose of exercising control. Notwithstanding the foregoing, we may invest in joint ventures or partnerships and in corporations in which real estate is the principal asset, provided that such acquisition can best be effected by the acquisition of the securities of such corporation, subject to the limitations set forth below.
We will not engage in the following activities:
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acquire assets in exchange for units of limited partnership interest;
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issue units of limited partnership interest after the termination of the Offering; or
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make loans to our general partner or its affiliates except as permitted by our Partnership Agreement and the NASAA Mortgage Program Guidelines. Such loans are permitted under our Partnership Agreement and the NASAA Mortgage Program Guidelines if an independent advisor issues an opinion to the effect that the proposed loan is fair and at least as favorable to us as a loan to an unaffiliated borrower in similar circumstances.
Our general partner continually reviews our investment activity to attempt to ensure that we do not come within the application of the Investment Company Act of 1940, as amended. Among other things, our general partner monitors the proportion of our portfolio that is placed in various investments so that we do not come within the definition of an “investment company” under the Investment Company Act. See “Item 1A, Risk Factors - Risks Related to Our Business In General - Limited partners’ returns will be reduced if we are required to register as an Investment Company under the Investment Company Act of 1940.”
Conflicts of Interest
We do not have any officers, employees or directors, and we depend entirely on our general partner and its affiliates to manage our operations. As a result, we are subject to various conflicts of interest arising out of our relationship with our general partner and its affiliates, including conflicts related to the arrangements pursuant to which our general partner and its affiliates will be compensated by us. All of our agreements and arrangements with our general partner and its affiliates, including those relating to compensation, are not the result of arm’s length negotiations.
Our general partner, who will make all of our investment decisions, will be responsible for managing our affairs on a day-to-day basis and for identifying and making loans on our behalf. UMT Holdings, L.P. (“UMT Holdings”) holds 99.9% of the limited partnership interests in our general partner. UMT Services, Inc. (“UMT Services”) owns the remaining 0.1% of the limited partnership interests in our general partner and serves as its general partner. Theodore “Todd” F. Etter, Jr. and Hollis M. Greenlaw, who are directors of UMT Services, own 100% of the equity interests in UMT Services.
Our general partner was organized in March 2003 and serves as the asset manager for United Development Funding, L.P. (“UDF I”) and United Development Funding II, L.P. (“UDF II”), each a Delaware limited partnership and related party. An affiliate of our general partner serves as the advisor to United Mortgage Trust (“UMT”), a real estate investment trust organized under the laws of the state of Maryland, and to United Development Funding IV (“UDF IV”), a newly organized Maryland real estate investment trust. Our general partner manages and is also the general partner of United Development Funding Land Opportunity Fund, L.P., a Delaware limited partnership and related party (“UDF LOF”). UDF I, UDF II, UDF LOF and UDF IV are real estate finance companies that engage in the business in which we engage and intend to engage.
Because we were organized and will be operated by our general partner, conflicts of interest will not be resolved through arm’s length negotiations but through the exercise of our general partner’s judgment consistent with its fiduciary responsibility to the limited partners and our investment objectives and policies. See Item 13, “Certain Relationships and Related Transactions, and Director Independence - Policies and Procedures for Transactions with Related Persons,” for a discussion of our policies and procedures for resolving potential conflicts of interest.
Housing Industry
The U.S. housing market has suffered declines over the past three years, particularly in geographic areas that had experienced rapid growth, steep increases in property values and speculation. Although our general partner believes that the housing markets in the geographic areas in which we have invested will not be significantly impacted by the general decline in the U.S. housing market, our general partner does believe that the publicly traded national homebuilders with which it does business are reducing and will continue to reduce supply and inventory overhang of new single-family residences and, as a result, will likely reduce the number of new homes they construct in 2009 as compared to the number of new homes constructed in 2008. We expect to see continued healthy demand for our products as the supply of finished new homes and land are once again aligned with market demand.
Competition
Real estate financing is a very competitive industry. Our principal competitors are mortgage banks and other lenders. We compete with many other entities engaged in real estate investment activities, including individuals, corporations, bank and insurance company investment accounts, real estate investment trusts, other real estate limited partnerships and other entities engaged in real estate investment activities, many of which have greater resources than we do. Banks and larger real estate programs may enjoy significant competitive advantages that result from, among other things, a lower cost of capital and enhanced operating efficiencies. In addition, the proliferation of the Internet as a tool for loan origination has made it very inexpensive for new competitors to participate in the real estate finance industry. We believe that the demand for development loans is increasing, which may cause more lenders and equity participants to enter this market. Our ability to make or purchase a sufficient number of loans and investments to meet our objectives will depend on the extent to which we can compete successfully against these other lenders, including lenders that may have greater financial or marketing resources, greater name recognition or larger customer bases than we have. Our competitors may be able to undertake more effective marketing campaigns or adopt more aggressive pricing policies than we can, which may make it more difficult for us to attract customers. Increased competition could result in lower revenues and higher expenses, which would reduce our profitability.
Regulations
All real property and the operations conducted on real property are subject to federal, state and local laws, ordinances and regulations relating to environmental protection and human health and safety. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, and the remediation of contamination associated with disposals. Under limited circumstances, a secured lender, in addition to the owner of real estate, may be liable for clean-up costs or have the obligation to take remedial actions under environmental laws, including, but not limited to, the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, or CERCLA. Some of these laws and regulations may impose joint and several liability for the costs of investigation or remediation of contaminated properties, regardless of fault or the legality of the original disposal. In addition, the presence of these substances, or the failure to properly remediate these substances, may adversely affect our ability to sell such property or to use the property as collateral for future borrowing.
Employees
We have no employees; however, our general partner and an affiliate of our general partner have a staff of employees who perform a range of services for us, including originations, acquisitions, asset management, accounting, legal and investor relations.
Financial Information About Industry Segments
Our current business consists only of originating, acquiring, servicing and managing mortgage loans on real property and issuing or acquiring an interest in credit enhancements to borrowers. We internally evaluate our activities as one industry segment, and, accordingly, we do not report segment information.
Available Information
We electronically file an annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports with the Securities and Exchange Commission (“SEC”). Copies of our filings with the SEC may be obtained from our web site at http://www.udfonline.com or at the SEC’s website, at http://www.sec.gov. Access to these filings is free of charge.
Item 1A.
Item 1A. Risk Factors.
The factors described below represent our principal risks. Other factors may exist that we do not consider to be significant based on information that is currently available or that we are not currently able to anticipate.
Risks Related to an Investment in UDF III
There is no public trading market for our units; therefore, it will be difficult for limited partners to sell their units.
There is no public trading market for our units of limited partnership interest, and we do not expect one to ever develop. Our Partnership Agreement restricts our ability to participate in a public trading market or anything substantially equivalent to a public trading market by providing that any transfer that may cause us to be classified as a publicly traded partnership as defined in Section 7704 of the Internal Revenue Code shall be deemed void and shall not be recognized by us. Because our classification as a publicly traded partnership may significantly decrease the value of limited partners’ units, our general partner intends to use its authority to the maximum extent possible to prohibit transfers of units that could cause us to be classified as a publicly traded partnership. As a result, it will be difficult for limited partners to sell their units.
Our units have limited transferability and lack liquidity.
Except for certain intra-family transfers, limited partners are limited in their ability to transfer their units. Our Partnership Agreement and certain state regulatory agencies have imposed restrictions relating to the number of units limited partners may transfer. In addition, the suitability standards imposed on prospective investors also apply to potential subsequent purchasers of our units. If limited partners are able to find a buyer for their units, they may not sell their units to such buyer unless the buyer meets the suitability standards applicable to him or her. Accordingly, it will be difficult for a limited partner to sell their units promptly or at all. Limited partners may not be able to sell their units in the event of an emergency, and if they are able to sell their units, they may have to sell them at a substantial discount. It is also likely that the units would not be accepted as the primary collateral for a loan.
Limited partners will not have the opportunity to evaluate our loans prior to their origination or purchase.
We invest substantially all of the Offering proceeds available for investments, after the payment of fees and expenses, in the financing of raw or partially developed land for residential use, although we are not limited to such investments. Loans that we originate and/or purchase must meet our underwriting criteria. We rely entirely on our general partner with respect to the acquisition of our investments, and limited partners are not able to evaluate such investments. We cannot be sure that we will be successful in obtaining suitable investments. If we are unable to identify loans that satisfy our underwriting criteria or we are unable to invest in loans that satisfy our underwriting criteria in a timely fashion, our business strategy and operations may be adversely affected.
If we, through our general partner, are unable to find suitable investments, then we may not be able to achieve our investment objectives or pay distributions.
Our ability to achieve our investment objectives and to pay distributions is dependent upon the performance of our general partner in the identification of real estate loans and the determination of any financing arrangements. Investors must rely entirely on the management ability of our general partners. We cannot be sure that our general partner will be successful in obtaining suitable investments on financially attractive terms or that, if it makes investments on our behalf, our objectives will be achieved. If we, through our general partner, are unable to find suitable investments, it will be solely at the discretion of our general partner what action, if any, will be taken. In such an event, our ability to achieve our investment objectives and pay distributions to our limited partners would be adversely affected.
Competition with third parties in financing properties may reduce our profitability and the return on our limited partners’ investments.
Real estate financing is a very competitive industry. Our principal competitors are mortgage banks and other lenders. We also compete with many other entities engaged in real estate investment activities, including individuals, corporations, bank and insurance company investment accounts, real estate investment trusts, other real estate limited partnerships and other entities engaged in real estate investment activities, many of which have greater resources than we do. Banks and larger real estate programs may enjoy significant competitive advantages that result from, among other things, a lower cost of capital and enhanced operating efficiencies. In addition, the proliferation of the Internet as a tool for loan origination has made it very inexpensive for new competitors to participate in the real estate finance industry. Our ability to make or purchase a sufficient number of loans and investments to meet our objectives will depend on the extent to which we can compete successfully against these other lenders, including lenders that may have greater financial or marketing resources, greater name recognition or larger customer bases than we have. Our competitors may be able to undertake more effective marketing campaigns or adopt more aggressive pricing policies than we can, which may make it more difficult for us to attract customers. Increased competition could result in lower revenues and higher expenses, which would reduce our profitability.
The homebuilding industry is undergoing a significant downturn, and its duration and ultimate severity are uncertain. Further deterioration in industry or economic conditions or in the broader economic conditions of the markets where we operate could further decrease demand and pricing for new homes and residential home lots and have additional adverse effects on our operations and financial results.
Developers to whom we make loans and with whom we enter into subordinate debt positions will use the proceeds of our loans and investments to develop raw real estate into residential home lots. The developers obtain the money to repay our development loans by reselling the residential home lots to homebuilders or individuals who build single-family residences on the lots. The 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.
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:
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employment levels and job growth;
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demographic trends, including population increases and decreases and household formation;
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availability of financing for homebuyers;
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interest rates;
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affordability of homes;
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consumer confidence;
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levels of new and existing homes for sale, including foreclosed homes; and
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housing demand.
These may occur on a national scale or may affect some of the regions or markets in which we operate more than others. An oversupply of alternatives to new homes, such as existing homes, including homes held for sale by investors and speculators, foreclosed homes, and rental properties, can also reduce the homebuilder’s ability to sell new homes, depress new home prices, and reduce homebuilder margins on the sales of new homes, which likely would reduce the amount and price of the residential home lots sold by the developers to which we have loaned money and/or increase the absorption period in which such home lots are purchased.
Also, historically, the homebuilding industry uses expectations for future volume growth as the basis for determining the optimum amount of land and lots to own. In light of the much weaker market conditions encountered in 2006, which further deteriorated in 2007 and 2008, we believe that expectations have changed and that the homebuilding industry significantly slowed its purchases of land and lots as part of its strategy to reduce inventory to better match the reduced rate of production.
During 2008, the difficult conditions within the homebuilding industry became progressively more challenging as demand for new homes continued to decline in many markets. On January 29, 2009, a joint release from the U.S. Department of Housing and Urban Development and the Census Bureau estimated the sale of new single-family homes to be at a seasonally-adjusted rate of 331,000, 44.8% below the December 2008 estimate. The median sales price of new houses sold in December 2008 was $230,600; the average sales price was $291,800. The seasonally-adjusted estimate of new houses for sale at the end of December was 357,000, 27.8% below the December 2008 estimate, representing a supply of 12.9 months at the December 2008 sales rate.
In such a business climate, developers to which we have loaned money may be unable to generate sufficient income from the resale of single-family residential lots to repay our loans. Accordingly, continued or further deterioration of homebuilding conditions or in the broader economic conditions of the markets where we operate could cause the number of homebuyers to decrease, which would increase the likelihood of defaults on our development loans and, consequently, reduce our ability to pay distributions to our limited partners.
We believe that housing market conditions will continue to be challenging and may deteriorate further. We cannot predict the duration or ultimate severity of these challenging conditions. However, it is our intention to invest in stable markets demonstrating strong housing fundamentals and correcting markets with strong housing fundamentals. Our operations could be negatively affected to the extent that the housing industry downturn is prolonged or becomes more severe.
The reduction in availability of mortgage financing and the volatility and reduction in liquidity in the financial markets have adversely affected our business, and the duration and ultimate severity of the effects are uncertain.
During 2007 and 2008, the mortgage lending industry experienced significant instability due to, among other things, defaults on subprime loans and a resulting decline in the market value of such loans. In light of these developments, lenders, investors, regulators and other third parties questioned the adequacy of lending standards and other credit requirements for several loan programs made available to borrowers in recent years. This has led to reduced investor demand for mortgage loans and mortgage-backed securities, tightened credit requirements, reduced liquidity and increased credit risk premiums. A deterioration in credit quality among subprime and other nonconforming loans has caused almost all lenders to eliminate subprime mortgages and most other loan products that are not conforming loans, FHA/VA-eligible loans or jumbo loans (which meet conforming underwriting guidelines other than loan size). Fewer loan products and tighter loan qualifications and any other limitations or restrictions on the availability of those types of financings in turn make it more difficult for some borrowers to finance the purchase of new homes and for some buyers of existing homes from move-up new home buyers to finance the purchase of the move-up new home buyer’s existing home. These factors have served to reduce the affordability of homes and the pool of qualified homebuyers and made it more difficult to sell to first time and first time move-up buyers which have long made up a substantial part of the affordable housing market. These reductions in demand increase the likelihood of defaults on our development loans and, consequently, reduce our ability to pay distributions to our limited partners, and the duration and severity of the effects remain uncertain.
We also believe that the liquidity provided by Fannie Mae and Freddie Mac (“Government Sponsored Enterprises” or “GSEs”) to the mortgage industry is very important to the housing market. These entities have recently reported losses as a result of deteriorating housing and credit market conditions. These losses have reduced their equity and limited their ability to acquire mortgages. The director of the Federal Housing Finance Agency (FHFA), James B. Lockhart III, on September 7, 2008 announced his decision to place two GSEs, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), into a conservatorship run by FHFA. That plan contained three measures: an increase in the line of credit available to the GSEs from the U.S. Treasury, so as to provide liquidity; the right of the U.S. Treasury to purchase equity in the GSEs, so as to provide capital; and a consultative role for the Federal Reserve in a reformed GSE regulatory system. The U.S. Treasury’s support of the two GSEs while under conservatorship of the FHFA is intended to promote stability in the secondary mortgage market and lower the cost of funding. The GSEs will modestly increase their mortgage-backed securities portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10% per year, largely through natural run off, eventually stabilizing at a lower, less risky size. To further support the availability of mortgage financing for millions of Americans, the U.S. Treasury is initiating a temporary program to purchase GSE mortgage-backed securities. This program will expire with the U.S. Treasury’s temporary authorities in December 2009. Any limitations or restrictions on the availability of such financing or on the liquidity provided by such enterprises could adversely affect interest rates and mortgage availability and could cause the number of homebuyers to decrease, which would increase the likelihood of defaults on our loans and, consequently, reduce our ability to pay distributions to our limited partners.
The homebuilding industry’s strategies in response to the adverse conditions in the industry have had limited success, and the continued implementation of these and other strategies may not be successful.
Most homebuilders were focused in 2007 and 2008 on generating positive operating cash flow and reducing finished new home inventories, and have done so in many cases by significantly reducing the new home prices and increasing the level of sales incentives. Notwithstanding these sales strategies, homebuilders in 2008 continued to experience an elevated rate of sales contract cancellations. We believe that the increase in the cancellation rate is largely due to a decrease in consumer confidence, due principally to the constant and negative national housing, financial industry, and economic news, and continued price declines and increases in the level of sales incentives for both new and existing homes in many markets. A more restrictive mortgage lending environment and the inability of some buyers to sell their existing homes have also impacted cancellations. Many of the factors that affect new sales and cancellation rates are beyond the control of the homebuilding industry.
A decrease in the number of new homes sold would increase the likelihood of defaults on our loans and, consequently, reduce our ability to pay distributions to our limited partners. It is uncertain how long the reduction in sales and the increased level of cancellations will continuee.
Increases in interest rates, reductions in mortgage availability or increases in other costs of owning a home could prevent potential customers from buying new homes and adversely affect our business or our 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 historical lows and a variety of mortgage products were available. As a result, homeownership 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. As a result, more people were able to qualify for mortgage financing.
During 2007 and 2008, the mortgage lending industry 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. The deterioration in credit quality has caused almost all lenders to eliminate subprime mortgages and most other loan products that are not eligible for sale to Fannie Mae or Freddie Mac or loans that do not meet Federal Housing Administration (FHA) and Veterans Administration (VA) requirements. In general, fewer loan products, tighter loan qualifications and a reduced willingness of lenders to make loans in turn 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.
We believe that the liquidity provided by Fannie Mae and Freddie Mac to the mortgage industry has been very important to the housing market. These entities have recently required substantial injections of capital from the federal government. These injections have been accompanied by criticism that the pool of homebuyers these institutions seek to assist should be reduced. Any reduction in the availability of the financing provided by these institutions could adversely affect interest rates, mortgage availability and the sales of new homes and mortgage loans.
In recent years a growing number of homebuyers used down payment assistance programs, which allowed them to receive gift funds from non-profit corporations as a down payment. Homebuilders had been a source of funding for these programs. However, the American Housing Rescue and Foreclosure Prevention Act of 2008 eliminated seller-funded down payment assistance on FHA-insured loans approved on or after October 1, 2008. With the elimination of these gift fund programs, we expect that homebuilders will seek other financing alternatives to assist their customers, and seek down payment programs for those customers who meet applicable guidelines. There can be no assurance, however, that any such alternative programs are available or as attractive to homebuyers as the programs previously offered, and new home sales could suffer.
Because of the decline in the availability of other mortgage products, FHA and VA mortgage financing support has become a more important factor in marketing new homes. The American Housing Rescue and Foreclosure Prevention Act of 2008, however, includes a provision that increases a buyer’s down payment from at least 3.0% to at least 3.5% of the appraised value of the property on FHA- insured loans. This down payment requirement may impact the ability of homebuilders that meet the FHA guidelines to obtain financing. Additionally, this limitation and other limitations or restrictions on the availability of FHA and VA financing could adversely affect interest rates, mortgage availability and new home sales and mortgage loans.
We believe that the availability of FHA and VA mortgage financing is an important factor in marketing affordable homes. Any limitations or restrictions on the availability of the financing provided by them could adversely affect interest rates, mortgage financing and new homes sales.
Even if potential customers do not need financing, changes in interest rates and the availability of mortgage financing products may make it harder for them to sell their current homes to potential buyers who need financing.
A reduction in the demand for new homes may reduce the amount and price of the residential home lots sold by the developers to which we have loaned money and/or increase the absorption period in which such home lots are purchased and, consequently, increase the likelihood of defaults on our development loans.
We may suffer from delays in locating suitable investments, particularly as a result of the current economic environment and capital constraints, which could adversely affect the return on limited partners’ investments.
We could suffer from delays in locating suitable investments, particularly as a result of the current economic environment, capital constraints and our reliance on our general partner. Capital constraints at the heart of the current credit crisis have reduced the number of real estate lenders able or willing to finance development, construction and the purchase of homes, thus reducing the number of homebuilders and developers that are able to receive such financing. In the event that homebuilders and developers fail or reduce the number of their development and homebuilding projects, resulting in a reduction of new loan applicants, the availability of investments for us would also decrease. Such decreases in the demand for secured loans could leave us with excess cash. In such instances, we plan to make short-term, interim investments with proceeds available from sales of units and hold these interim investments, pending investment in suitable loans. Interest returns on these interim investments are usually lower than on secured loans, which may reduce our ability to pay distributions to our limited partners, depending on how long these interim investments are held.
When we invest in short-term, interim investments using proceeds from the sale of units, those limited partners will nevertheless participate pro rata in our distributions of income with holders of units whose sale proceeds have been invested in secured loans. This will favor, for a time, holders of units whose purchase monies were invested in interim investments, to the detriment of holders of units whose purchase monies are invested in normally higher-yielding secured loans.
Increases in interest rates could increase the risk of default under our development loans.
Developers to whom we make loans and with whom we enter into subordinate debt positions will use the proceeds of our loans and investments to develop raw real estate into residential home lots. The developers obtain the money to repay our development loans by reselling the residential home lots to home builders or individuals who build a single-family residence on the lot. The 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. If interest rates increase, the demand for single-family residences is likely to decrease. In such an interest rate climate, developers to which we have loaned money may be unable to generate sufficient income from the resale of single-family residential lots to repay our loans. Accordingly, increases in single-family mortgage interest rates could cause the number of homebuyers to decrease, which would increase the likelihood of defaults on our development loans and, consequently, reduce our ability to pay distributions to our limited partners.
Adverse market and economic conditions will negatively affect our returns and profitability.
Our results are sensitive to changes in market and economic conditions such as the level of employment, consumer confidence, consumer income, the availability of consumer and commercial financing, interest rate levels, supply of new and existing homes, supply of finished lots and the costs associated with constructing new homes and developing land. We may be affected by market and economic challenges, including the following, any of which may result from a continued or exacerbated general economic slowdown experienced by the nation as a whole or by the local economies where properties subject to our mortgage loans may be located:
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poor economic conditions may result in a slowing of new home sales and corresponding lot purchases by builders resulting in defaults by borrowers under our mortgage loans;
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job transfers and layoffs may cause new home sales to decrease;
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lack of liquidity in the secondary mortgage market;
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tighter credit standards for home buyers;
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general unavailability of commercial credit; and
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illiquidity of financial institutions.
The length and severity of any economic downturn cannot be predicted. Our operations could be negatively affected to the extent that an economic downturn is prolonged or becomes more severe.
The loans we make will have a higher risk than conventional real estate loans on residential properties.
We originate and purchase loans in respect of affiliated and unaffiliated third parties which are used by the borrowers to develop vacant parcels. Improvements made by such borrowers may, but will not necessarily, increase the value of the subject parcels. The loans are represented by notes that are secured by either a subordinated lien on the parcel if the developer has a development loan senior to our loan, or a first lien if we are the senior lender. In some instances where the subject parcel is encumbered by a lien in favor of a third party, we may, at our option, become the senior lender in order to protect the priority of our lien on the parcels. Our loans may also be secured by other assets of the developer. While we seek to obtain an unconditional guarantee of the developer and/or its parent companies to further secure the developer’s obligations to us, we cannot assure limited partners that we will obtain such an unconditional guarantee in all cases. If a default occurs under one or more of our loans, payments to us could be reduced or postponed. Further, in the event of a default, we may be left with a security or ownership interest in an undeveloped or partially developed parcel of real estate, which may have less value than a developed parcel. The guarantee of the developer and/or its parent companies and other pledged assets, if any, may be insufficient to compensate us for any difference in the amounts due to us under a development loan and the value of our interest in the subject parcel.
Decreases in the value of the property underlying our loans may decrease the value of our assets.
All of the loans we have made and, we expect, all of the loans we will make, are or will be secured by (1) an underlying real property interest in the parcel to be developed, (2) a pledge of some or all of the equity interests in the developer entity, (3) personal guaranties of the principals of the developer entity, and/or (4) by a pledge of other assets owned by the developer or of ownership interests in the developer entity. To the extent that the value of the property that serves as security for these loans or investments is lower than we expect, the value of our assets, and consequently our ability to pay distributions to our limited partners, will be adversely affected.
We are subject to the general market risks associated with real estate development.
Our financial performance depends on the successful development and sale of the real estate parcels that serve as security for the loans we make to developers. As a result, we are subject to the general market risks of real estate development, including weather conditions, the price and availability of materials used in the development of the lots, environmental liabilities and zoning laws, and numerous other factors that may materially and adversely affect the success of the development projects. In the event the market softens, the developer may require additional funding and such funding may not be available. In addition, if the market softens, the amount of capital required to be advanced and the required marketing time for such development may both increase, and the developer’s incentive to complete a particular real estate development may decrease. Such circumstances may reduce our profitability and the return on the limited partners’ investments.
The prior performance of real estate investment programs sponsored by affiliates of our general partner may not be an indication of our future results.
We were formed in June 2005 and our general partner was formed in March 2003. Although key personnel of our general partner are experienced in operating businesses similar to our business, investors should not rely on the past performance of any other businesses of our key personnel, general partner, or affiliates to predict our future results. To be successful in this market, we must, among other things:
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identify and acquire investments that further our investment strategy;
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increase awareness of the United Development Funding name within the investment products market;
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establish and maintain our network of licensed securities brokers and other agents;
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attract, integrate, motivate and retain qualified personnel to manage our day-to-day operations;
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respond to competition both for investment opportunities and potential investors in us; and
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continue to build and expand our operations structure to support our business.
We cannot guarantee that we will succeed in achieving these goals, and our failure to do so could cause limited partners to lose all or a portion of their investment.
Limited partners must rely on our general partner for management of our business and will have no right or power to take part in our management.
Our future success will depend on the continued services of our general partner and its key personnel to manage the Partnership. Our general partner will provide all management and administrative services to us, and our limited partners will have no right or power to take part in our management. Our Partnership Agreement does not require our general partner to dedicate a minimum amount of time to the management of our business. Moreover, without the consent of our limited partners, our general partner may assign its general partnership interest in us to any person or entity that acquires substantially all of our general partners’ assets or equity interests. In the event that our general partner is unable or unwilling to continue to provide management services to us, our ability to execute our strategy and meet our business objectives could be materially adversely affected.
If we lose or are unable to obtain key personnel, our ability to implement our investment strategy could be delayed or hindered.
Our success depends on the diligence, experience and skill of the officers and employees of our general partner. Although our general partner or its affiliates have employment contracts with key personnel, these agreements are terminable at will, and we cannot guarantee that such persons will remain affiliated with our general partner or its affiliates. We have obtained a life insurance policy on Mr. Hollis M. Greenlaw. We have not obtained life insurance policies on any other key personnel involved in our operations and, therefore, have no insulation against extraneous events that may adversely affect their ability to implement our investment strategies. We believe that our future success depends, in large part, upon our general partner’s ability to hire and retain highly skilled managerial, operational and marketing personnel. Competition for highly skilled managerial, operational and marketing personnel is intense, and we cannot assure limited partners that we will be successful in attracting and retaining such personnel. The loss of any key person could harm our business, financial condition, cash flow and results of operations. If we lose or are unable to obtain the services of key personnel, our ability to implement our investment strategy could be delayed or hindered.
Our rights and the rights of our limited partners to recover claims against our general partner are limited.
Our Partnership Agreement provides that our general partner will have no liability, and that we will indemnify our general partner for any obligations, losses, damages, costs or other liabilities, arising out of any action or failure to act that the general partner in good faith determines was in our best interest, provided its action or failure to act did not constitute negligence or misconduct. As a result, we and our limited partners may have more limited rights against our general partner than might otherwise exist under common law. In addition, we may be obligated to fund the defense costs incurred by our general partner in some cases.
Risks Related to Conflicts of Interest
We will be subject to conflicts of interest arising out of our relationships with our general partner and its affiliates, including the material conflicts discussed below. When conflicts arise between us and our general partner and its affiliates, they may not be resolved in our favor, which could cause our operating results to suffer.
Our general partner has equity interests and/or profit participations in developments we finance and may have a greater incentive to make loans with respect to such development, which may or may not be subordinate to our mortgage loans, to preserve and/or enhance its economic interests in such development.
We have made loans and provided credit enhancement transactions to affiliates of our general partner. Any mortgage loan or any credit enhancement to any affiliate or our general partner must meet certain requirements, including receipt of a fairness opinion from an independent advisor as to the fairness of such mortgage loan or credit enhancement. Our general partner may choose to deploy and allocate funds for mortgage loans or credit enhancement transactions to affiliates of our general partner rather than to loans or credit enhancement transactions to unaffiliated third parties that may offer less risk of loss. If an affiliate of our general partner has an equity interest or participation interest in a development that requires a loan or credit enhancement, then our general partner may have a greater incentive to make a loan with respect to such development to preserve and/or enhance its economic interest in such development. Moreover, so long as it determines that it is advisable to do so in the exercise of its fiduciary duties to us, the general partner may cause us to make a loan or provide a credit enhancement to one of its affiliates in connection with a development in which such affiliates of our general partner hold an interest instead of another development in which affiliates of the general partner do not hold an interest.
Our general partner is the general partner for UDF LOF. An affiliate of our general partner is the advisor to UMT and UDF IV. Our general partner is an affiliate of the general partner of UDF I and UDF II and provides asset management services to UDF I, UDF II, UDF IV and UDF LOF. Our general partner may not always be able to allocate investment opportunities on a pro rata basis among us, UDF I, UDF II, UDF IV and UDF LOF.
Our general partner seeks to equitably apportion among us and the other United Development Funding programs all suitable investment opportunities of which it becomes aware. We entered into a participation agreement with UDF I and UDF II pursuant to which we invest in the same loans and transactions as UDF I and UDF II on a pro rata basis based on the amount of capital held by each entity that is available for investment. However, circumstances may arise, due to availability of capital or other reasons, when it is not possible for us to make an investment on such pro rata basis. Our general partner may determine not to invest in otherwise suitable investments in which other United Development Funding programs will participate in order for us to avoid unrelated business taxable income, or “UBTI,” which is generally defined as income derived from any unrelated trade or business carried on by a tax-exempt entity or by a partnership of which it is a member, and which is generally subject to taxation. We cannot assure limited partners that we will be able to invest in all investment opportunities of which our general partner becomes aware that may be suitable for us on a pro rata basis or otherwise.
Our founders may form other companies that will engage in the same business as we will, and we may not always be able to participate in investment opportunities on a pro rata basis between us and such other companies.
Our general partner and its affiliates may engage in additional real estate-related activities in the future, including the activities in which we engage, and may form new entities to engage in these activities. If new companies are formed for the purpose of engaging in the businesses in which we engage, our founders intend to allocate investment opportunities among us, UDF I, UDF II, UDF IV, UDF LOF and the new entities equitably. However, we cannot assure limited partners that we will be able to participate in all or any investment opportunities in which such other companies participate, on an equitable basis or otherwise.
Certain of the principals of our general partner will face conflicts of interest relating to the extension and purchase of loans, and such conflicts may not be resolved in our favor.
Certain of the principals of our general partner are also principals, directors, employees, officers and equity holders of other entities, including UDF I, UDF II, UDF IV, UDF LOF, UMT Holdings and UMT Services, and they may also in the future hold positions with, and interests in, other entities engaged in real estate activities. These multiple responsibilities may create conflicts of interest for these individuals if they are presented with opportunities that may benefit us and their other affiliates. These individuals may be incentivized to allocate opportunities to other entities rather than to us if they are more highly compensated based on investments made by other entities. In determining which opportunities to allocate to us and to their other affiliates, these individuals will consider the investment strategy and guidelines of each entity. Because we cannot predict the precise circumstances under which future potential conflicts may arise, we intend to address potential conflicts on a case-by-case basis. There is a risk that our general partner will choose an investment for us that provides lower returns to us than a loan made by one of our affiliates. Our Partnership Agreement provides that it shall be deemed not to be a breach of any obligation our general partner has to us or our limited partners for the general partner or its affiliates to engage in other business activities in preference to or to the exclusion of us. The Partnership Agreement also expressly states that the general partner has no obligation to present business opportunities to us.
We will face risks relating to joint ventures with our affiliates and third parties that are not present with other methods of investing in mortgage loans.
We may enter into joint ventures with certain of our affiliates, as well as third parties, for the funding of loans. We may also purchase loans in joint ventures or in partnerships or other co-ownership arrangements with our affiliates, the sellers of the loans, affiliates of the sellers, developers or other persons. Such investments may involve risks not otherwise present with other methods of investment in mortgages, including, for example:
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the possibility that our co-venturer or partner in an investment might become bankrupt, in which case our investment might become subject to the rights of the co-venturer or partner’s creditors and we may be forced to liquidate our investment before we otherwise would choose to do so;
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that such co-venturer or partner may at any time have economic or business interests or goals that are or that become inconsistent with our business interests or goals, which may cause us to disagree with our co-venturer or partner as to the best course of action with respect to the investment and which disagreements may not be resolved to our satisfaction;
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that such co-venturer or partner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives, which may cause us not to realize the return anticipated from our investment; or,
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that it may be difficult for us to sell our interest in any such co-venture or partnership.
Moreover, in the event we determine to foreclose on the collateral underlying a non-performing loan, we may be required to obtain the cooperation of our co-venturer or partner to do so. We anticipate that we will co-invest with our affiliates in certain loans, in which case we expect to enter into an inter-creditor agreement that will define our rights and priority with respect to the underlying collateral. Our inability to foreclose on a property acting alone may cause significant delay in the foreclosure process, in which time the value of the property may decline.
Our general partner will face additional conflicts of interest relating to co-investments with affiliated entities and may make decisions that disproportionately benefit one or more of our affiliated entities instead of us.
Affiliates of our general partner have sponsored private and public placement offerings on behalf of UDF I, UDF II, UDF IV and UDF LOF, all of which are unspecified, or “blind pool,” programs. Because our general partner or its affiliates will have advisory and management arrangements with these other United Development Funding programs, it is likely that they will encounter opportunities to invest in or acquire interests in mortgage loans, mezzanine loans, participations and/or properties to the benefit of one of the United Development Funding programs, but not others. Our general partner or its affiliates may make decisions to finance certain properties, which decisions might disproportionately benefit a United Development Funding program other than us. In such event, our results of operations and ability to pay distributions to our unit holders could be adversely affected.
Because our general partner and its affiliates control us, UDF I, UDF II, UDF IV and UDF LOF, agreements and transactions among the parties with respect to any co-investment among two or more of such parties will not have the benefit of arm’s length negotiation of the type normally conducted between unrelated co-venturers. Under these co-investment arrangements, we may not have a first priority position with respect to the underlying collateral. In the event that a co-venturer has a right of first refusal to buy out the other co-venturer, it may be unable to finance such buy-out at that time. In addition, to the extent that our co-venturer is an affiliate of our general partner, certain conflicts of interest will exist.
Employees of our general partner will face conflicts of interest relating to the allocation of their time and other resources among the various entities that they serve or have interests in, and such conflicts may not be resolved in our favor.
Certain of the employees of our general partner will face competing demands relating to their time and resources because they are also affiliated with entities with investment programs similar to ours, and they may have other business interests as well, including business interests that currently exist and business interests they develop in the future. Because these persons have competing interests for their time and resources, they may have conflicts of interest in allocating their time between our business and these other activities. As a result, they may devote less time and resources to our business than is necessary. If this occurs, our business, financial condition and results of operations may suffer.
There is no separate counsel for certain of our affiliates and us, which could result in conflicts of interest.
Morris, Manning & Martin, LLP acts as legal counsel to us, our general partner and certain of its affiliates. If the interests of the various parties become adverse, under the Code of Professional Responsibility of the legal profession, Morris, Manning & Martin, LLP may be precluded from representing any one or all of such parties. If any situation arises in which our interests appear to be in conflict with those of the general partner or its affiliates, additional counsel may be retained by one or more of the parties to assure that their interests are adequately protected.
Risks Related to Our Business in General
The Delaware Revised Uniform Limited Partnership Act does not grant limited partners any voting rights, and limited partners’ rights are limited under our Partnership Agreement.
A vote of a majority of the units of limited partnership interest is sufficient to take the following actions:
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to amend our Partnership Agreement;
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to dissolve and terminate UDF III;
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to remove our general partner; and
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to authorize a merger or a consolidation of UDF III.
These are the only significant voting rights granted to our limited partners under our Partnership Agreement. In addition, Delaware law does not grant limited partners any specific voting rights.
Our Partnership Agreement provides that limited partners may vote on only a few operational matters, including the removal of our general partner. However, limited partners will be bound by the majority vote on matters requiring approval of a majority of the units of limited partnership interest even if limited partners do not vote with the majority on any such matter. Therefore, limited partners will have little to no control over our day-to-day operations.
Our general partner will make all decisions with respect to our management and determine all of our major policies, including our financing, growth, investment strategies and distributions. Our general partner may revise these and other policies without a vote of our limited partners. Therefore, limited partners will be relying almost entirely on our general partner for our management and the operation of our business. Our general partner may only be removed under certain conditions, as set forth in our Partnership Agreement. If our general partner is removed, it will receive payment equal to the fair market value of its interests in UDF III as agreed upon by our general partner and us, or by arbitration if we are unable to agree.
Limited partners’ returns will be reduced if we are required to register as an investment company under the Investment Company Act of 1940.
We are not registered as an investment company under the Investment Company Act of 1940 (the “Investment Company Act”). If we were obligated to register as an investment company, we would have to comply with a variety of substantive requirements under the Investment Company Act imposing, among other things:
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limitations on capital structure;
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restrictions on specified investments;
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prohibitions on transactions with affiliates; and
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compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations.
We intend to conduct our operations so as not to become regulated as an investment company under the Investment Company Act. We intend to qualify for an exclusion from registration under Section 3(c)(5)(C) of the Investment Company Act, which generally means that at least 55% of our portfolio must be comprised of qualifying real estate assets and at least another 25% of our portfolio must be comprised of additional qualifying real estate assets and real estate-related assets. Although we monitor our portfolio periodically and prior to each acquisition, we may not be able to maintain this exclusion from registration. How we determine to classify our assets for purposes of the Investment Company Act will be based in large measure upon no-action positions taken by the Securities and Exchange Commission in the past. These no-action positions were issued in accordance with factual situations that may be substantially different from the factual situations we may face, and a number of these no-action positions were issued more than ten years ago. No assurance can be given that the Securities and Exchange Commission will concur with our classification of our assets. Future revisions to the Investment Company Act or further guidance from the Securities and Exchange Commission may cause us to lose our exclusion from registration or force us to re-evaluate our portfolio and our investment strategy. Such changes may prevent us from operating our business successfully.
To maintain compliance with the Investment Company Act exclusion, we may be unable to sell assets we would otherwise want to sell and may need to sell assets we would otherwise wish to retain. In addition, we may have to acquire additional assets that we might not otherwise have acquired or may have to forego opportunities to acquire assets that we would otherwise want to acquire and would be important to our investment strategy. Further, we may not be able to invest in a sufficient number of qualifying real estate assets and/or real estate-related assets to comply with the exclusion from registration.
Failure to maintain an exclusion from registration under the Investment Company Act would require us to significantly restructure our business plan. For example, because affiliate transactions are severely limited under the Investment Company Act, we would not be able to enter into transactions with any of our affiliates if we are required to register as an investment company, and we may be required to terminate our agreements with affiliates, which could have a material adverse effect on our ability to operate our business and pay distributions.
Limited partners are limited in their ability to sell their units pursuant to our redemption program.
Any investor requesting repurchase of their units pursuant to our unit redemption program will be required to certify to us that such investor acquired the units by either (1) a purchase directly from us or (2) a transfer from the original subscriber by way of a bona fide gift not for value to, or for the benefit of, a member of the subscriber’s immediate or extended family or through a transfer to a custodian, trustee or other fiduciary for the account of the subscriber or his/her immediate or extended family in connection with an estate planning transaction, including by bequest or inheritance upon death or by operation of law. Limited partners should also be fully aware that our unit redemption program contains certain restrictions and limitations. Units will be redeemed on a monthly basis, pro rata among all limited partners requesting redemption in such month, with a priority given to redemptions upon the death or disability of a limited partner, next to limited partners who demonstrate, in the discretion of our general partner, another involuntary exigent circumstance, such as bankruptcy, and, finally, to other redemption requests. We will not redeem in excess of 5% of the weighted average number of units outstanding during the 12-month period immediately prior to the date of redemption. In addition, the cash available for redemption generally will be limited to 1% of the operating cash flow from the previous fiscal year, plus any net proceeds from our DRIP. Further, our general partner reserves the right to terminate, suspend, or amend the unit redemption program at any time. Therefore, limited partners should not assume that they will be able to sell any of their units back to us pursuant to our redemption program.
If limited partners are able to resell their units to us pursuant to our redemption program, they will likely receive substantially less than the fair market value for such units.
Except upon the death of a limited partner, the purchase price for units we repurchase under our redemption program, for the period beginning after a limited partner has held the units for a period of one year, will be (1) 92% of the purchase price for any units held less than two years, (2) 94% of the purchase price of any units held for at least two years but less than three years, (3) 96% of the purchase price of any units held at least three years but less than four years, (4) 98% of the purchase price of any units held at least four years but less than five years and (5) the lesser of the purchase price for any units held at least five years or the then-current fair market value of such units as determined by our annual valuations. In addition, the price we will pay for redeemed units will be offset by any net proceeds from capital transactions previously distributed to the redeeming limited partner as a return of capital. Accordingly, limited partners would likely receive less by selling their units back to us than they would receive if our investments were sold for their estimated values and such proceeds were distributed in our liquidation.
Our limited partners’ interest in us may be diluted if the price we pay in respect of units redeemed under our unit redemption program exceeds the net asset value of our units.
The prices we may pay for units redeemed under our unit redemption program may exceed the net asset value of such units at the time of redemption. If this were to be the case, investors who do not elect or are unable to have some or all of their units redeemed under our unit redemption program would suffer dilution in the value of their units as a result of redemptions. We have created a reserve from our net interest income and net proceeds from capital transactions to recover some of the organization and offering expenses, including selling commissions and marketing support fees, we incur in connection with the Offering in order to cause the net asset value of the Partnership to be on parity with or greater than the amount we may pay for units under our unit redemption program. However, it is likely that non-redeeming unit holders will experience dilution as a result of redemptions which occur at a time when the net asset value has decreased, regardless of the reserve.
We will have broad discretion in how we use the net proceeds of the Offering.
We will have broad discretion in how to use the net proceeds of the Offering, and limited partners will be relying on our judgment regarding the application of these proceeds. Limited partners will not have the opportunity to evaluate the manner in which the net proceeds of the Offering are invested or the economic merits of particular assets to be acquired or loans to be made.
The general partner’s profits interest may create an incentive for the general partner to make speculative investments.
Because our general partner’s participation in cash available for distribution is largely subordinate to the payment of cumulative distributions to our limited partners, our general partner’s interest is not wholly aligned with those of our limited partners. The subordinated nature of our general partner’s interest means that our general partner is less likely to receive distributions if our investments result only in minimal returns. Our general partner’s subordinated profits interest in us may create an incentive for the general partner to cause us to make investments that have a higher potential return but are riskier or more speculative than would be the case in the absence of this profits interest.
We established the offering price for our units on an arbitrary basis; as a result, the offering price for our units and the price at which units will be redeemed pursuant to our unit redemption program are not related to any independent valuation.
Our general partner has arbitrarily determined the selling price of the units and the price at which units will be redeemed pursuant to our unit redemption program. Such prices bear no relationship to our book or asset values, or to any other established criteria for valuing outstanding units of limited partnership interest or other ownership interests.
Payment of fees to our general partner and its affiliates will reduce cash available for investment and distribution.
Our general partner and its affiliates perform services for us in connection with the offer and sale of the units, the selection and acquisition of our investments, and the administration of our investments. They are paid fees for these services, which reduce the amount of cash available for investment in properties or distribution to limited partners.
We are under no obligation to pay cash distributions. Distributions may be paid from capital and there can be no assurance that we will be able to pay or maintain cash distributions, or that distributions will increase over time.
There are many factors, including factors beyond our control that can affect the availability and timing of cash distributions to limited partners. Distributions will be based principally on cash available from our loans, real estate securities and other investments. The amount of cash available for distributions will be affected by our ability to invest in mortgage loans, mezzanine loans or participations in loans as Offering proceeds become available, the yields on the mortgage loans in which we invest, amounts set aside to create a retained earnings reserve (currently at 9.5% of our net income) and our operating expense levels, as well as many other variables. Actual cash available for distributions may vary substantially from estimates. We are under no obligation to pay cash distributions and we can provide no assurance that we will be able to pay or maintain distributions or that distributions will increase over time. Nor can we give any assurance that income from the loans we make or acquire, or in which we participate, will increase or that future investments will increase our cash available for distributions to limited partners. Our actual results may differ significantly from the assumptions used by our general partner in establishing the distribution rate to limited partners.
There are no limitations on our general partner’s ability to declare distributions in excess of available cash. We may fund our distributions from borrowings or the net proceeds of the Offering. Accordingly, the amount of distributions paid at any time may not reflect current cash flow from our investments. To the extent distributions are paid from the proceeds of the Offering or from borrowings, we will have less capital available to invest in mortgage loans, which may negatively impact our ability to make investments and substantially reduce current returns to our limited partners. In that event, we may not be able to invest the anticipated minimum of 85.44% of the proceeds of the Offering until such time as we have sufficient cash flows from operations to fund our distributions. In addition, our general partner, in its discretion, may reinvest or retain for working capital any portion of our cash on hand. We cannot assure limited partners that sufficient cash will be available to pay distributions to limited partners.
The failure of any bank in which we deposit our funds could reduce the amount of cash we have available to pay distributions and make additional investments.
We intend to diversify our cash and cash equivalents among several banking institutions in an attempt to minimize exposure to any one of these entities. We expect that we will have cash and cash equivalents and restricted cash deposited in certain financial institutions in excess of federally insured levels. If any of the banking institutions in which we have deposited funds ultimately fails, we may lose our deposits over any federally insured amount. The loss of our deposits could reduce the amount of cash we have available to distribute or invest and could result in a decline in the value of our limited partners’ investments.
Risks Related to the Mortgage Lending Business
Defaults on our mortgage loans will reduce our income and limited partner distributions.
Because most of our assets are mortgage loans, failure of a borrower to pay interest or repay a loan will have adverse consequences on our income. For example,
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failure by a borrower to repay loans or interest on loans will reduce our income and consequentially, distributions to our limited partners;
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we are required to pay loan servicing fees to our general partner on delinquent loans;
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we may not be able to resolve the default prior to foreclosure of the property securing the loan;
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we may be required to expend substantial funds for an extended period to develop foreclosed properties;
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the subsequent income and sale proceeds we receive from the foreclosed properties may be less than competing investments; and
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the proceeds from sales of foreclosed properties may be less than our investments in the properties.
Investments in land development loans present additional risks compared to loans secured by operating properties.
We may invest up to 25% of the gross Offering proceeds in loans to purchase or develop unimproved land. For purposes of this limitation, “unimproved real property” is defined as real property which has the following three characteristics: (a) an equity interest in real property which was not acquired for the purpose of producing rental or other income; (b) has no development or construction in process on such land; and (c) no development or construction on such land is planned in good faith to commence within one year. Land development mortgage loans may be riskier than loans secured by improved properties, because:
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the application of the loan proceeds to the development project must be assured;
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during development, the property does not generate income for the borrower to make loan payments;
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the completion of the planned development may require additional development financing by the borrower and may not be available;
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depending on the sale of lots to homebuilders, demand for lots may decrease, causing the price of the lots to decrease;
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there is no assurance that we will be able to sell unimproved land promptly if we are forced to foreclose upon it; and
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lot sale contracts are generally not “specific performance” contracts, and the developer may have no recourse if a homebuilder elects not to purchase lots.
Investments in second, mezzanine and wraparound mortgage loans present additional risks compared to loans secured by first deeds of trust.
We expect that we will be the junior lender with respect to many of our loans. We will invest in second mortgage loans and, in some instances, mezzanine and wraparound mortgage loans. A wraparound, or all-inclusive, mortgage loan is a loan in which the lender combines the remainder of an old loan with a new loan at an interest rate that blends the rate charged on the old loan with the current market rate. In a second mortgage loan and in a mezzanine loan, our rights as a lender, including our rights to receive payment on foreclosure, will be subject to the rights of the prior mortgage lender. In a wraparound mortgage loan, our rights will be similarly subject to the rights of any prior mortgage lender, but the aggregate indebtedness evidenced by our loan documentation will be the prior mortgage loans in addition to the new funds we invest. Under a wraparound mortgage loan, we would receive all payments from the borrower and forward to any senior lender its portion of the payments we receive. Because all of these types of loans are subject to the prior mortgage lender’s right to payment on foreclosure, we incur a greater risk when we invest in each of these types of loans.
Many of our loans will require balloon payments, which are riskier than loans with fully amortized payments.
We anticipate that substantially all of our loans will have balloon payments. A balloon payment is a large principal balance that is payable after a period of time during which the borrower has repaid none or only a small portion of the principal balance. Loans with balloon payments are riskier than loans with even payments of principal over an extended time period, such as 15 or 30 years, because the borrower’s repayment often depends on its ability to refinance the loan or sell the developed lots profitably when the loan comes due. There are no specific criteria used in evaluating the credit quality of borrowers for mortgage loans requiring balloon payments. Furthermore, a substantial period of time may elapse between the review of the financial statements of the borrower and the date when the balloon payment is due. As a result, there is no assurance that a borrower will have sufficient resources to make a balloon payment when due.
Suitable mortgage loans may not be available to us from time to time, which could reduce the returns on our limited partners’ investments.
We receive referrals by commercial loan brokers and other referral sources. In the event that the supply of such referrals or new applicants decreases, the availability of loans for us to invest in would also decrease. Decreases in loan referrals or new applicants would typically occur in a recessionary economy, as there would be reduced activity in the real estate market and, hence, reduced demand for financing. Such decreases in the demand for mortgage loans could leave us with excess cash. In such instances, we plan to make short-term, interim investments with proceeds available from sales of units and hold these, pending investment in suitable mortgage loans. Interest returns on those investments are usually lower than on mortgage loans, which may reduce the yield to holders of units, depending on how long these non-mortgage investments are held.
When we invest in non-mortgage, short-term investments using proceeds from the sale of units, the purchasers of those units will nevertheless participate equally in our distributions of income with holders of units whose sale proceeds have been invested in mortgage loans. This will favor, for a time, holders of units whose purchase monies were invested in non-mortgage investments, to the detriment of holders of units whose purchase monies are invested in normally higher-yielding mortgage loans.
The interest-only loans we make or acquire may be subject to greater risk of default and there may not be sufficient funds or assets remaining to satisfy our loans, which may result in losses to us.
We will make and acquire interest-only loans. Interest-only loans typically cost the borrower less in monthly loan payments than fully-amortizing loans which require a payment on principal as well as interest. This lower cost may enable a borrower to acquire a more expensive property than if the borrower was entering into a fully-amortizing mortgage loan. Borrowers utilizing interest-only loans are dependent on the appreciation of the value of the underlying property, and the sale or refinancing of such property, to pay down the interest-only loan since none of the principal balance is being paid down with the borrowers’ monthly payments. If the value of the underlying property declines due to market or other factors, it is likely that the borrower would hold a property that is worth less than the mortgage balance on the property. Thus, there may be greater risk of default by borrowers who enter into interest-only loans. In addition, interest-only loans include an interest reserve in the loan amount. If such reserve is required to be funded due to a borrower’s non-payment, the loan-to-value ratio for that loan will increase, possibly above generally acceptable levels. In the event of a defaulted interest-only loan, we would acquire the underlying collateral which may have declined in value. In addition, there are significant costs and delays associated with the foreclosure process. Any of these factors may result in losses to us.
Larger loans result in less diversity and may increase risk.
We intend to invest in loans that individually constitute an average amount equal to the lesser of (a) 1% to 5% of the total amount raised in the Offering, or (b) $2.5 million to $12.5 million. However, we may invest in larger loans depending on such factors as our performance and the value of the collateral. These larger loans are riskier because they may reduce our ability to diversify our loan portfolio. Our larger loans will not exceed an amount equal to 20% of the total capital contributions to be raised in the Offering.
The concentration of loans with a common borrower may increase our risks.
We may invest in multiple mortgage loans that share a common borrower. We are permitted under the NASAA Mortgage Program Guidelines to invest up to 20% of our Offering proceeds in loans to a single borrower, and we may choose to invest up to the maximum limit imposed upon us. The bankruptcy, insolvency or other inability of any borrower that is the subject of multiple loans to pay interest or repay principal on its loans would have adverse consequences on our income and reduce the amount of funds available for distribution to investors. In addition, we expect to be dependent on a limited number of borrowers for a large portion of our business. The more concentrated our portfolio is with one or a few borrowers, the greater credit risk we face. The loss of any one of these borrowers would have a material adverse effect on our financial condition and results of operations.
Incorrect or changed property values could result in losses and decreased distributions to limited partners.
We depend primarily upon our real estate security to protect us on the loans that we make. We depend partly upon the skill of independent appraisers to value the security underlying our loans and partly upon our general partner’s internal underwriting and appraisal process. However, notwithstanding the experience of the appraisers selected by our general partner, they or the general partner may make mistakes, or regardless of decisions made at the time of funding, loan market conditions may deteriorate for various reasons, causing a decrease to the value of the security for our loans. As a result, there may be less security than anticipated at the time the loan was originally made. If there is less security and a default occurs, we may not recover the full amount of our loan, thus reducing the amount of funds available to distribute to limited partners.
Changes in market interest rates may reduce our income and limited partner distributions.
A substantial portion of all of our loans will be fixed-interest rate loans. Market interest rates on investments comparable to the units could materially increase above the general level of our fixed-rate loans. Our distributions could then be less than the yield limited partners may obtain from these other investments. We will also make loans with variable interest rates, which will cause variations in the yield to us from these loans. All of our variable rate loans contain a floor rate not lower than the original interest rate. We may make loans with interest rate guarantee provisions in them, requiring a minimum period of months or years of earned interest even if the loan is paid off during the guarantee period. The duration of the guarantee is subject to negotiation and will likely vary from loan to loan. Other than these provisions, the majority of our loans will not include prepayment penalties for a borrower paying off a loan prior to maturity. The absence of a prepayment penalty in our loans may lead borrowers to refinance higher interest rate loans in a market of falling interest rates. This would then require us to reinvest the prepayment proceeds in loans or alternative short-term investments with lower interest rates and a corresponding lower yield to limited partners. All of these risks increase as the length of maturity of a loan increases and the amount of cash available for new higher interest loans decreases. A material increase in market interest rates could result in a decrease in the supply of suitable mortgage loans to us, as there will likely be fewer attractive transactions for borrowers and less activity in the marketplace.
Some losses that borrowers might incur may not be insured and may result in defaults that would increase our limited partners’ risks.
Our loans require that borrowers carry adequate hazard insurance for our benefit. Some events are, however, either uninsurable or insurance coverage is economically not practicable. Losses from earthquakes, floods or mudslides, for example, may be uninsured and cause losses to us on entire loans. If a borrower allows insurance to lapse, an event of loss could occur before we become aware of the lapse and have time to obtain insurance ourselves. Insurance coverage may be inadequate to cover property losses, even though our general partner imposes insurance requirements on borrowers that it believes are adequate.
Foreclosures create additional ownership risks to us of unexpected increased costs or decreased income.
When we acquire property by foreclosure, we have economic and liability risks as the owner, including:
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less income and reduced cash flows on foreclosed properties than could be earned and received on mortgage loans;
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selling the lots to homebuilders;
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controlling development and holding expenses;
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coping with general and local market conditions;
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complying with changes in laws and regulations pertaining to taxes, use, zoning and environmental protections; and
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possible liability for injury to persons and property.
If any of these risks were to materialize, then the return on the particular investment could be reduced, and our business, financial condition and results of operations could be adversely affected.
If we were found to have violated applicable usury laws, we would be subject to penalties and other possible risks.
Usury laws generally regulate the amount of interest that may lawfully be charged on indebtedness. Each state has its own distinct usury laws. We believe that our loans will not violate applicable usury laws. There is a risk, however, that a court could determine that our loans do violate applicable usury laws. If we were found to have violated applicable usury laws, we could be subject to penalties, including fines equal to three times the amount of usurious interest collected and restitution to the borrower. Additionally, usury laws often provide that a loan that violates usury laws is unenforceable. If we are subject to penalties or restitution or if our loan agreements are adjudged unenforceable by a court, it would have a material, adverse effect on our business, financial condition and results of operations and we would have difficulty making distributions to our limited partners.
Borrowings may increase our limited partners’ risks if default occurs.
In the past, we have utilized the Revolving Credit Facility with Premier Bank as transitory indebtedness to provide liquidity and to reduce and avoid the need for large idle cash reserves, such as utilizing borrowings under the Revolving Credit Facility to fund identified investments pending receipt of proceeds from the sale of our units. Proceeds from the sale of our units were used to repay the Revolving Credit Facility. We used the Revolving Credit Facility as a portfolio administration tool and not to provide long-term or permanent leverage on our investments. Although we terminated the Revolving Credit Facility in December 2008, we are not precluded from entering into other transitory borrowing arrangements.
We and our limited partners will face increased risk as a result of any future borrowings. If the interest rates we are able to charge on our mortgage loans decrease below the interest rates we must pay on our borrowings, payments of interest due on our borrowings will decrease our income otherwise available for distribution to limited partners. In addition, if one of our mortgage loans goes into default and we are unable to obtain repayment of the principal amount of the loan through foreclosure or otherwise, payments of principal required on our borrowings will decrease the amount of cash we have available and could reduce the amounts we otherwise would have available for repurchases of units from limited partners.
General Risks Related to Investments in Real Estate
Our operating results will be affected by economic and regulatory changes that have an adverse impact on the real estate market in general.
Our operating results will be subject to risks generally incident to the ownership of assets related to the real estate industry, including:
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changes in interest rates and availability of permanent mortgage funds;
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changes in general economic or local conditions;
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changes in tax, real estate, environmental and zoning laws; and
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periods of high interest rates and tight money supply.
For these and other reasons, we cannot assure limited partners that we will be profitable or that we will realize growth in the amount of income we receive from our investments.
Dislocations in the credit markets and real estate markets could have a material adverse effect on our results of operations, financial condition and ability to pay distributions to limited partners.
Domestic and international financial markets currently are experiencing significant dislocations which have been brought about in large part by failures in the U.S. banking system. These dislocations have severely impacted the availability of credit and have contributed to rising costs associated with obtaining credit. If debt financing is not available on terms and conditions we find acceptable, we may not be able to obtain financing for investments. If this dislocation in the credit markets persists, our ability to borrow monies to finance investments in real estate assets will be negatively impacted. If we are unable to borrow monies on terms and conditions that we find acceptable, we likely will have to reduce the number of real estate investments we can make, and the return on the investments we do make likely will be lower. All of these events could have an adverse effect on our results of operations, financial condition and ability to pay distributions.
Our operating results may be negatively affected by potential development and construction delays and resultant increased costs and risks.
We may provide financing for borrowers that will develop and construct improvements to land at a fixed contract price. We will be subject to risks relating to uncertainties associated with re-zoning for development and environmental concerns of governmental entities and/or community groups and our developer’s ability to control land development costs or to build infrastructure in conformity with plans, specifications and timetables deemed necessary by builders. The developer’s failure to perform may necessitate legal action by us to compel performance. Performance may also be affected or delayed by conditions beyond the developer’s control. Delays in completion of construction could also give builders the right to terminate preconstruction lot purchase contracts. These and other such factors can result in increased costs to the borrower that may make it difficult for the borrower to make payments to us. Furthermore, we must rely upon projections of lot take downs, expenses and estimates of the fair market value of property when evaluating whether to make development loans. If our projections are inaccurate, and we are forced to foreclose on a property, our return on our investment could suffer.
The costs of compliance with environmental laws and other governmental laws and regulations may adversely affect our income and the cash available for any distributions.
All real property and the operations conducted on real property are subject to federal, state and local laws, ordinances and regulations relating to environmental protection and human health and safety. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, and the remediation of contamination associated with disposals. Under limited circumstances, a secured lender, in addition to the owner of real estate, may be liable for clean-up costs or have the obligation to take remedial actions under environmental laws, including, but not limited to, the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, or CERCLA. Some of these laws and regulations may impose joint and several liability for the costs of investigation or remediation of contaminated properties, regardless of fault or the legality of the original disposal. In addition, the presence of these substances, or the failure to properly remediate these substances, may adversely affect our ability to sell such property or to use the property as collateral for future borrowing.
If we foreclose on a defaulted loan to recover our investment, we may become subject to environmental liabilities associated with that property if we participate in the management of that property or do not divest ourselves of the property at the earliest practicable time on commercially reasonable terms. Environmental laws may impose restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require substantial expenditures. It is possible that property on which we foreclose may contain hazardous substances, wastes, contaminants or pollutants that we may be required to remove or remediate in order to clean up the property. If we foreclose on a contaminated property, we may also incur liability to tenants or other users of neighboring properties. We cannot assure limited partners that we will not incur full recourse liability for the entire cost of removal and cleanup, that the cost of such removal and cleanup will not exceed the value of the property, or that we will recover any of these costs from any other party. It may be difficult or impossible to sell a property following discovery of hazardous substances or wastes on the property. The cost of defending against claims of liability, of compliance with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury claims could materially adversely affect our business, assets or results of operations and, consequently, amounts available for distribution to limited partners.
Terrorist attacks or other acts of violence or war may affect the industry in which we operate, our operations, and our profitability.
Terrorist attacks may harm our results of operations and limited partners’ investments. We cannot assure limited partners that there will not be further terrorist attacks against the United States or U.S. businesses. These attacks or armed conflicts may directly or indirectly impact the value of the property underlying our loans. Losses resulting from these types of events are generally uninsurable. Moreover, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy. They could also result in economic uncertainty in the United States or abroad. Adverse economic conditions resulting from terrorist activities could negatively impact borrowers’ ability to repay loans we make to them or harm the value of the property underlying our loans, both of which would impair the value of our investments and decrease our ability to make distributions to limited partners.
We will be subject to risks related to the geographic concentration of the properties securing the loans and equity investments we make.
While we intend to enter into loans and agreements with respect to properties throughout the United States, we have thus far funded loans relating to properties located in Texas, Colorado, Arizona and New Mexico. We also expect to enter into transactions with respect to properties located in Florida, Nevada (Las Vegas), and California when homes and land inventories are aligned and prices correct in these markets. If the residential real estate market or general economic conditions in these geographic areas decline, the developers’ ability to sell completed project parcels located in these areas may be impaired, we may experience a greater rate of default on the loans we make with respect to properties in these areas and the value of the parcels that secure our loans in these areas could decline. Any of these events could materially adversely affect our business, financial condition or results of operations more so than if our investments were more geographically diversified.
We will be subject to a number of legal and regulatory requirements, including regulations regarding interest rates, mortgage laws, securities laws and tax laws, which may adversely affect our operations.
Federal and state lending laws and regulations generally regulate interest rates and many other aspects of real estate loans and contracts. Violations of those laws and regulations could materially adversely affect our business, financial condition and results of operations. We cannot predict the extent to which any law or regulation that may be enacted or enforced in the future may affect our operations. In addition, the costs to comply with these laws and regulations may adversely affect our profitability. Future changes to the laws and regulations affecting us, including changes to mortgage laws and securities laws and changes to the Internal Revenue Code applicable to the taxation of limited partnerships, could make it more difficult or expensive for us to comply with such laws or otherwise harm our business.
Federal Income Tax Risks
The Internal Revenue Service may challenge our characterization of material tax aspects of limited partners’ investments in our units.
An investment in units involves material income tax risks. Limited partners are urged to consult with their own tax advisor with respect to the federal, state and foreign tax considerations of an investment in our units. We will not seek any rulings from the Internal Revenue Service regarding any tax issues.
Investors may realize taxable income without cash distributions, and limited partners may have to use funds from other sources to pay their tax liabilities.
Limited partners will be required to report their allocable share of our taxable income on their personal income tax return regardless of whether they have received any cash distributions from us. It is possible that limited partners’ units will be allocated taxable income in excess of their cash distributions. We have established reserves for working capital, our unit redemption program and to recover some of the organization and offering expenses incurred in connection with the Offering. The establishment and maintenance of these reserves reduces the amount of cash otherwise distributable to limited partners and could result in limited partners not being distributed cash equal to their taxable income that results from the allocation of income from us. Further, if limited partners participate in our DRIP, they will be allocated their share of our net income, including net income allocable to units acquired pursuant to our DRIP, even though they will receive no cash distributions from us. We cannot assure limited partners that cash flow will be available for distribution in any year. As a result, limited partners may have to use funds from other sources to pay their tax liability.
We could be characterized as a publicly traded partnership, which would have an adverse tax effect on limited partners.
If the Internal Revenue Service were to classify us as a publicly traded partnership, we could be taxable as a corporation, and distributions made to limited partners could be treated as portfolio income to limited partners rather than passive income. We cannot assure limited partners that the Internal Revenue Service will not challenge our conclusion that we will not be classified as a publicly traded partnership or that we will not, at some time in the future, be treated as a publicly traded partnership due to the following factors:
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the complex nature of the Internal Revenue Service safe harbors;
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the lack of interpretive guidance with respect to such provisions; and
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the fact that any determination in this regard will necessarily be based upon facts that have not yet occurred.
The deductibility of losses will be subject to passive loss limitations, and therefore their deductibility will be limited.
Limited partnership units will be allocated their pro rata share of our tax losses. Section 469 of the Internal Revenue Code limits the allowance of deductions for losses attributable to passive activities, which are defined generally as activities in which the taxpayer does not materially participate. Any tax losses allocated to investors will be characterized as passive losses, and accordingly, the deductibility of such losses will be subject to these limitations. Losses from passive activities are generally deductible only to the extent of a taxpayer’s income or gains from passive activities and will not be allowed as an offset against other income, including salary or other compensation for personal services, active business income or “portfolio income,” which includes non-business income derived from dividends, interest, royalties, annuities and gains from the sale of property held for investment. Accordingly, limited partners may receive no current benefit from their share of tax losses unless they are currently being allocated passive income from other sources.
The Internal Revenue Service may challenge our allocations of profit and loss, and any reallocation of items of income, gain, deduction and credit could reduce anticipated tax benefits.
We cannot assure limited partners that the Internal Revenue Service will not successfully challenge the allocations in the Partnership Agreement and reallocate items of income, gain, loss, deduction and credit in a manner that reduces anticipated tax benefits. The tax rules applicable to allocation of items of taxable income and loss are complex. The ultimate determination of whether allocations adopted by us will be respected by the Internal Revenue Service will depend upon facts that will occur in the future and that cannot be predicted with certainty or completely controlled by us. If the allocations we use are not recognized, limited partners could be required to report greater taxable income or less taxable loss with respect to an investment in us and, as a result, pay more tax and associated interest and penalties. Our limited partners might also be required to incur the costs of amending their individual returns.
We may be audited, which could result in the imposition of additional tax, interest and penalties.
Our federal income tax returns may be audited by the Internal Revenue Service. Any audit of us could result in an audit of limited partners’ tax returns that may require adjustments of items unrelated to their investment in us, in addition to adjustments to various Partnership items. In the event of any such adjustments, limited partners might incur attorneys’ fees, court costs and other expenses contesting deficiencies asserted by the Internal Revenue Service. Limited partners may also be liable for interest on any underpayment and penalties from the date their taxes were originally due. The tax treatment of all Partnership items will generally be determined at the partnership level in a single proceeding rather than in separate proceedings with each partner, and our general partner is primarily responsible for contesting federal income tax adjustments proposed by the Internal Revenue Service. In this connection, our general partner may extend the statute of limitations as to all partners and, in certain circumstances, may bind the partners to a settlement with the Internal Revenue Service. Further, our general partner may cause us to elect to be treated as an electing large partnership. If it does, we could take advantage of simplified flow-through reporting of Partnership items. Adjustments to Partnership items would continue to be determined at the partnership level, however, and any such adjustments would be accounted for in the year they take effect, rather than in the year to which such adjustments relate. Our general partner will have the discretion in such circumstances either to pass along any such adjustments to the partners or to bear such adjustments at the partnership level.
State and local taxes and a requirement to withhold state taxes may apply, and if so, the amount of net cash from operations payable to limited partners would be reduced.
The state in which a limited partner resides may impose an income tax upon such limited partner’s share of our taxable income. Further, states in which we will own properties acquired through foreclosure may impose income taxes upon a limited partner’s share of our taxable income allocable to any Partnership property located in that state. Many states have also implemented or are implementing programs to require partnerships to withhold and pay state income taxes owed by non-resident partners relating to income-producing properties located in their states, and we may be required to withhold state taxes from cash distributions otherwise payable to limited partners. Limited partners may also be required to file income tax returns in some states and report their share of income attributable to ownership and operation by the Partnership of properties in those states. In the event we are required to withhold state taxes from limited partners’ cash distributions, the amount of the net cash from operations otherwise payable to limited partners would be reduced. In addition, such collection and filing requirements at the state level may result in increases in our administrative expenses that would have the effect of reducing cash available for distribution to limited partners. Limited partners are urged to consult with their own tax advisors with respect to the impact of applicable state and local taxes and state tax withholding requirements on an investment in our units.
Legislative or regulatory action could adversely affect limited partners.
In recent years, numerous legislative, judicial and administrative changes have been made in the provisions of the federal income tax laws applicable to investments similar to an investment in our units. Additional changes to the tax laws are likely to continue to occur, and we cannot assure limited partners that any such changes will not adversely affect their taxation. Any such changes could have an adverse effect on an investment in our units or on the market value or the resale potential of our properties. Limited partners are urged to consult with their own tax advisor with respect to the impact of recent legislation on their investment in units and the status of legislative, regulatory or administrative developments and proposals and their potential effect on an investment in our units.
There are special considerations that apply to pension or profit sharing trusts or IRAs investing in our units, including potential adverse effects under ERISA and the Internal Revenue Code.
If limited partners are investing the assets of a pension, profit sharing, 401(k), Keogh or other qualified retirement plan, or the assets of an IRA, in our units of limited partnership interest, they should satisfy themselves that, among other things:
·
their investment is consistent with their fiduciary obligations under the Employee Retirement Income Security Act of 1974, as amended, or ERISA, and the Internal Revenue Code;
·
their investment is made in accordance with the documents and instruments governing their plan or IRA, including their plan’s investment policy;
·
their investment satisfies the prudence and diversification requirements of ERISA;
·
their investment will not impair the liquidity of the plan or IRA;
·
their investment will not produce UBTI for the plan or IRA;
·
they will be able to value the assets of the plan annually in accordance with ERISA requirements; and
·
their investment will not constitute a prohibited transaction under Section 406 of ERISA or Section 4975 of the Internal Revenue Code.
We may terminate the Offering or dissolve UDF III if our assets are deemed to be “plan assets” or if we engage in prohibited transactions.
If our assets were deemed to be assets of qualified plans investing as limited partners, known as “plan assets,” our general partner would be considered to be a plan fiduciary and certain contemplated transactions between our general partner or its affiliates and us may be deemed to be prohibited transactions subject to excise taxation under Section 4975 of the Internal Revenue Code. Additionally, if our assets were deemed to be plan assets, ERISA’s fiduciary standards would extend to the general partner as a plan fiduciary with respect to our investments. We have not requested an opinion of our counsel regarding whether or not our assets would constitute plan assets under ERISA, nor have we sought any rulings from the U.S. Department of Labor (the “Department of Labor”) regarding classification of our assets.
Department of Labor regulations defining plan assets for purposes of ERISA contain exemptions that, if satisfied, would preclude assets of a limited partnership such as ours from being treated as plan assets. We cannot assure limited partners that our Partnership Agreement and the Offering have been structured so that the exemptions in such regulations would apply to us, and although our general partner intends that an investment by a qualified plan in units will not be deemed an investment in our assets, we can make no representations or warranties of any kind regarding the consequences of an investment in our units by qualified plans in this regard. Plan fiduciaries are urged to consult with and rely upon their own advisors with respect to this and other ERISA issues that, if decided adversely to us, could result in prohibited transactions, which would cause the imposition of excise taxation and the imposition of co-fiduciary liability under Section 405 of ERISA in the event actions undertaken by us are deemed to be non-prudent investments or prohibited transactions.
In the event our assets are deemed to constitute plan assets, or if certain transactions undertaken by us are deemed to constitute prohibited transactions under ERISA or the Internal Revenue Code and no exemption for such transactions applies or is obtainable by us, our general partner has the right, but not the obligation, upon notice to all limited partners, but without the consent of any limited partner to:
· terminate the Offering;
·
compel a termination and dissolution of UDF III; or
·
restructure our activities to the extent necessary to comply with any exemption in the Department of Labor regulations or any prohibited transaction exemption granted by the Department of Labor or any condition that the Department of Labor might impose as a condition to granting a prohibited transaction exemption.
Adverse tax considerations may result because of minimum distribution requirements.
If limited partners intend to purchase units through their IRA, or if limited partners are a trustee of an IRA or other fiduciary of a retirement plan considering an investment in units, they must consider the limited liquidity of an investment in our units as it relates to applicable minimum distribution requirements under the Internal Revenue Code. If units are held and our investments have not generated sufficient income at such time as mandatory distributions are required to begin to an IRA beneficiary or qualified plan participant, Sections 408(a)(6) and 401(a)(9) of the Internal Revenue Code will likely require that a distribution-in-kind of the units be made to the IRA beneficiary or qualified plan participant. Any such distribution-in-kind of units must be included in the taxable income of the IRA beneficiary or qualified plan participant for the year in which the units are received at the fair market value of the units without any corresponding cash distributions with which to pay the income tax liability attributable to any such distribution. Also, fiduciaries of a retirement plan should consider that, for distributions subject to mandatory income tax withholding under Section 3405 of the Internal Revenue Code, the fiduciary may have an obligation, even in situations involving in-kind distributions of units, to liquidate a portion of the in-kind units distributed in order to satisfy such withholding obligations. There may also be similar state and/or local tax withholding or other obligations that should be considered.
UBTI may be generated with respect to tax-exempt investors.
We may incur indebtedness, which will cause re-characterization of a portion of our income allocable to tax-exempt investors as UBTI. If we generate UBTI, a trustee of a charitable remainder trust that has invested in us will lose its exemption from income taxation with respect to all of its income for the tax year in question. A tax-exempt limited partner other than a charitable remainder trust that has UBTI in any tax year from all sources of more than $1,000 will be subject to taxation on such income and will be required to file tax returns reporting such income.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
We do not maintain any physical properties.
Item 3.
Item 3. Legal Proceedings.
None.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Part II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market Information
There is no established trading market for our limited partnership units, and we do not expect that one will develop. This illiquidity creates a risk that a limited partner may not be able to sell units at a time or price acceptable to the limited partner. For the first two full fiscal years following the termination of the Offering, the value of our units will be deemed to be $20 and no valuation or appraisal work will be undertaken. Thereafter, we will prepare annual valuations of our units based upon the average weighted units outstanding divided into the sum of: (1) the unpaid principal balance of our performing loans, plus (2) cash balances, plus (3) appraised value of real estate owned as of the close of our fiscal year. Such estimated property values will be based upon annual valuations performed by the general partner, and no independent property appraisals will be obtained. While our general partner is required under the Partnership Agreement to obtain the opinion of an independent third party stating that its estimates of value are reasonable, the unit valuations provided by our general partner may not satisfy the technical requirements imposed on plan fiduciaries under ERISA. Similarly, the unit valuations provided by our general partner may be subject to challenge by the Internal Revenue Service if used for any tax (income, estate and gift, or otherwise) valuation purpose as an indicator of the fair market value of the units.
There can be no assurance, however, with respect to any estimate of value that we prepare, that:
·
the estimated value per unit would actually be realized by limited partners upon liquidation, because these estimates do not necessarily indicate that all loans will be paid in full;
·
our limited partners would be able to realize estimated net asset values if they were to attempt to sell their units, because no public market for our units exists or is likely to develop; or
·
that the value, or method used to establish value, would comply with ERISA or the Internal Revenue Code requirements.
Notwithstanding the above, in February 2009 the Financial Industry Regulatory Authority (“FINRA”) released Regulatory Notice 09-09. This notice confirms that the National Association of Securities Dealers (“NASD”) Rule 2340(c)(2) prohibits broker-dealers that are required to report an estimated value per unit for direct participation programs from using a per unit estimated value developed from data that is more than 18 months old. This means that broker-dealers participating in our Offering cannot use the last price paid to acquire a unit in our Offering as the estimated value per unit of our units of limited partnership interest beginning 18 months after the date we cease offering units in our Offering. We are currently evaluating the method that we will use to assist broker-dealers with this requirement.
Unit Redemption Program
Our Partnership Agreement includes a unit redemption program. Limited partners who have held their units for at least one year may receive the benefit of limited liquidity by presenting for redemption all or a portion of their units to us at any time in accordance with the procedures outlined herein. At that time, we may, subject to the conditions and limitations described below, redeem the units presented for redemption for cash to the extent that we have sufficient funds from operations available to us to fund such redemption.
Except as described below for redemptions upon the death of a limited partner (wherein the minimum holding period may be waived by our general partner), the purchase price for the redeemed units, for the period beginning after a limited partner has held the units for a period of one year, will be (1) 92% of the purchase price actually paid for any units held less than two years, (2) 94% of the purchase price actually paid for any units held for at least two years but less than three years, (3) 96% of the purchase price actually paid for any units held at least three years but less than four years, (4) 98% of the purchase price actually paid for any units held at least four years but less than five years and (5) the lesser of the purchase price actually paid for any units held at least five years or the then-current fair market value of such units as determined by the most recent annual valuation of our units. The price we will pay for redeemed units will be offset by any net proceeds from capital transactions previously distributed to the redeeming limited partner in respect of such units as a return of his or her capital contributions. In no event will the total amount paid for redeemed units, including any net proceeds from capital transactions previously distributed to the redeeming limited partner in respect of the redeemed units as a return of capital, exceed the then-current offering price. Distributions of cash available for distribution from our operations will not effect the price we will pay in respect of our redeemed units. Although we do not intend to make distributions in excess of available cash, we are not precluded from doing so. Any such distributions would be a return of capital to limited partners and would offset the price we will pay for redeemed units. Our general partner reserves the right in its sole discretion at any time and from time to time to (1) waive the one-year holding period in the event of the death or bankruptcy of a limited partner or other exigent circumstances, (2) reject any request for redemption, (3) change the purchase price for redemptions, or (4) terminate, suspend and/or reestablish our unit redemption program.
In addition, and subject to the conditions and limitations described below, we will redeem units upon the death of a limited partner who is a natural person, including units held by such limited partner through an IRA or other retirement or profit-sharing plan, after receiving written notice from the estate of the limited partner or the recipient of the units through request or inheritance. We must receive such written notice within 180 days after the death of the limited partner. If spouses are joint registered holders of units, the request to redeem the units may be made if either of the registered holders dies. If the limited partner is not a natural person, such as a trust, partnership, corporation or other similar entity, the right of redemption upon death does not apply.
The purchase price for units redeemed upon the death of a limited partner will be the lesser of (1) the price the limited partner actually paid for the units or (2) $20 per unit, limited to aggregate annual redemptions not to exceed 1% of units outstanding in the preceding twelve-month period. The price we will pay for units redeemed upon the death of a limited partner will be offset by any net proceeds from capital transactions previously distributed to the deceased limited partner, or his or her estate, in respect of such units as a return of capital contributions. In no event will the total amount paid for redeemed units, including any net proceeds from capital transactions previously distributed to the deceased limited partner, or his or her estate, in respect of the redeemed units as a return of capital, exceed the then-current offering price. Distributions of cash available for distribution from our operations will not effect the price we will pay in respect of our redeemed units. Although we do not intend to make distributions in excess of available cash, we are not precluded from doing so. Any such distributions would be a return of capital to limited partners and would offset the price we will pay for redeemed units.
We will redeem units upon the death or bankruptcy of a limited partner only to the extent that we decide to waive any applicable holding period requirements and have sufficient funds available to us to fund such redemption.
Our unit redemption program, including the redemption upon the death of a limited partner, is available only for limited partners who purchase their units directly from us or certain transferees, and is not intended to provide liquidity to any limited partner who acquired his or her units by purchase from another limited partner. In connection with a request for redemption, the limited partner or his or her estate, heir or beneficiary will be required to certify to us that the limited partner either (1) acquired the units to be repurchased directly from us or (2) acquired such units from the original subscriber by way of a bona fide gift not for value to, or for the benefit of, a member of the subscriber’s immediate or extended family (including the subscriber’s spouse, parents, siblings, children or grandchildren and including relatives by marriage) or through a transfer to a custodian, trustee or other fiduciary for the account of the subscriber or members of the subscriber’s immediate or extended family in connection with an estate planning transaction, including by bequest or inheritance upon death or operation of law.
We intend to redeem units monthly under the program. We will not redeem in excess of 5% of the weighted average number of units outstanding during the twelve-month period immediately prior to the date of redemption. Our general partner will determine from time to time whether we have sufficient excess cash from operations to repurchase units. Generally, the cash available for redemption will be limited to 1% of the operating cash flow from the previous fiscal year, plus any net proceeds from our DRIP. Our general partner, in its sole discretion, may choose to terminate or suspend our unit redemption program at any time it determines that such termination or suspension is in our best interest or to reduce the number of units purchased under the unit redemption program if it determines that the funds otherwise available to fund our unit redemption program are needed for other purposes. These limitations apply to all redemptions, including redemptions upon the death of a limited partner.
We cannot guarantee that the funds set aside for the unit redemption program will be sufficient to accommodate all requests made in any year. If we do not have such funds available at the time when redemption is requested, the limited partner or his or her estate, heir or beneficiary can (1) withdraw the request for redemption, or (2) ask that we honor the request at such time, if any, when sufficient funds become available. Such pending requests will be honored among all requesting limited partners in any given redemption period, as follows: first, pro rata as to redemptions upon the death of a limited partner; next, pro rata as to redemptions to limited partners who demonstrate, in the discretion of our general partner, another involuntary exigent circumstance, such as bankruptcy; and, finally, pro rata as to other redemption requests, if any, until all other requests for redemption have been met.
A limited partner or his or her estate, heir or beneficiary may present to us fewer than all of its units then-owned for redemption, provided, however, that the minimum number of units that must be presented for redemption shall be at least 25% of the holder’s units. A limited partner who wishes to have units redeemed must mail or deliver to us a written request on a form provided by us and executed by the limited partner, its trustee or authorized agent. An estate, heir or beneficiary that wishes to have units redeemed following the death of a limited partner must mail or deliver to us a written request on a form provided by us, including evidence acceptable to our general partner of the death of the limited partner, and executed by the executor or executrix of the estate, the heir or beneficiary, or their trustee or authorized agent. If the units are to be redeemed under the conditions outlined herein, we will forward the documents necessary to affect the redemption, including any signature guaranty we may require.
Our unit redemption program is only intended to provide limited interim liquidity for our limited partners until our liquidation, since there is no public trading market for our units and we do not expect that any market for our units will ever develop. Units owned by our general partner or its affiliates will not be redeemed pursuant to our unit redemption program. Neither our general partner nor any of its affiliates will receive any fee on the repurchase of units by us pursuant to the unit redemption program.
We will cancel the units we purchase under the unit redemption program and will not reissue the units unless they are first registered with the Securities and Exchange Commission under the Securities Act and under appropriate state securities laws or otherwise issued in compliance with such laws and our Partnership Agreement.
The foregoing provisions regarding the unit redemption program in no way limit our ability to repurchase units from limited partners by any other legally available means for any reason that our general partner, in its discretion, deems to be in our best interest.
As of December 31, 2008, 135,625 limited partnership units had been redeemed. As of December 31, 2007, no limited partnership units had been redeemed.
During the fourth quarter ended December 31, 2008, we redeemed units as follows:
_____________________
(1)
A description of the maximum number of units that may be purchased under our redemption program is included in the narrative preceding this table.
Holders
As of March 24, 2009 we had 16,740,552 limited partnership units outstanding that were held by a total of approximately 8,461 limited partners.
Distribution Reinvestment Plan
We have adopted a distribution reinvestment plan pursuant to which investors may elect to have a portion of the full amount of their distributions from us reinvested in additional units. As of December 31, 2008, we were offering 1,250,000 units for sale pursuant to our DRIP at $20 per unit, which will be available only until the termination of the Offering, which is anticipated to be May 15, 2009, unless extended by our general partner. See “Subsequent Events” below for a description of the additional reallocation of DRIP units on March 9, 2009.
Distributions
Cash available for distributions represents the funds received by us from operations (other than proceeds from a capital transaction or a liquidating distribution), less cash used by us to pay our expenses, debt payments, and amounts set aside to create a retained earnings reserve (currently at 9.5% of our net income; the retained earnings reserve is intended to recover some of the organization and offering expenses incurred in connection with the Offering). Our general partner receives a monthly distribution for promotional and carried interest from the cash available for distributions. Monthly distributions, which commenced in September 2006, are currently paid to the limited partners as a 9.75% annualized return on a pro rata basis based on the number of days in the Partnership. Retained earnings would contain a surplus if the cash available for distributions less the 9.5% reserve exceeded the monthly distribution to the general and limited partners. Retained earnings would contain a deficit if cash available for distributions less the 9.5% reserve is less than the monthly distribution to general and limited partners. It is the intent of management to monitor and distribute such surplus, if any, on an annual basis.
The chart below summarizes the amount of distributions to our general partner and limited partners, the retained earnings reserve and the retained earnings deficit and surplus as of December 31, 2008 and 2007, respectively:
___________________
(1)
approximately $14.8 million paid in cash and approximately $8.3 million reinvested in 415,660 units of limited partnership interest under the DRIP.
(2)
approximately $3.4 million paid in cash and approximately $1.6 million reinvested in 79,614 units of limited partnership interest under the DRIP.
Distributions to our general partner and limited partners in 2008 and 2007 were paid out of our cash flow from operations. There can be no assurance that future cash flow will support distributions at the current rate; however, we expect to continue to make distributions from cash available.
Recent Sales of Unregistered Securities
None.
Use of Proceeds from Registered Securities
On May 15, 2006, our Registration Statement on Form S-11 (Registration No. 333-127891), covering a public offering of our units of limited partnership interest, was declared effective under the Securities Act of 1933, as amended. The aggregate offering price for the units under the Offering is $350 million. At the time of effectiveness, the Registration Statement covered up to 12,500,000 units of limited partnership interest at a price of $20 per unit pursuant to the primary offering and up to 5,000,000 units of limited partnership interest to be issued pursuant to our DRIP for $20 per unit. We have the right to reallocate the units of limited partnership interest we are offering between the primary offering and our DRIP, and pursuant to Supplement No. 8 to our prospectus regarding the Offering, which was filed with the Securities and Exchange Commission on September 4, 2008, we reallocated the units being offered such that 16,250,000 units are being offered pursuant to the primary offering and 1,250,000 units are being offered pursuant to the DRIP. See “Subsequent Events” below for a description of the additional reallocation of units of limited partnership interests. Our limited partnership units are not currently listed on a national exchange, and we do not expect any public market for the units to develop.
The units are being offered by select members of FINRA on a “best efforts” basis, which means the selling group members will only be required to use their best efforts to sell the units and have no firm commitment or obligation to purchase any of the units.
On July 3, 2006, we accepted our initial public subscribers as limited partners. Since such time, we have admitted, and intend to continue to admit, new investors at least monthly. As of December 31, 2008, we had issued an aggregate of 15,019,292 units of limited partnership interest in the Offering, consisting of 14,739,257 units that have been issued to our limited partners in exchange for gross proceeds of approximately $294.9 million (approximately $259.6 million, net of costs associated with the Offering) and another 415,660 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $8.3 million, minus 135,625 units of limited partnership interest that have been repurchased pursuant to our unit redemption program for approximately $2.7 million. Of the Offering costs paid as of December 31, 2008, approximately $10.0 million was paid to our general partner or affiliates of our general partner for organizational and offering expenses, and approximately $25.3 million was paid to non-affiliates for commissions and dealer fees. As of December 31, 2007, we had issued an aggregate of 5,509,316 units of limited partnership interest in the Offering, consisting of 5,429,702 units that have been issued to our limited partners in exchange for gross proceeds of approximately $108.6 million (approximately $95.6 million, net of costs associated with the Offering), and another 79,614 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $1.6 million. Of the Offering costs paid as of December 31, 2007, approximately $3.8 million was paid to our general partner or affiliates of our general partner for organizational and Offering expenses, and approximately $9.2 million was paid to non-affiliates for commissions and dealer fees.
As of December 31, 2008, we had funded 49 loans, including 14 loans that have subsequently been repaid in full by the respective borrower. These loans total approximately $249.1 million for mortgage notes receivable, approximately $97.8 million for mortgages notes receivable - related party and approximately $39.3 million for participation interest - related party. We paid our general partner approximately $5.1 million as of December 31, 2008 for acquisition and origination fee expenses associated with such loans. As of December 31, 2007, we had funded 32 loans, including five loans that have subsequently been repaid in full by the respective borrower. These loans total approximately $99.8 million for mortgage notes receivable and approximately $32.7 million for mortgages notes receivable - related party. We paid our general partner approximately $2.9 million as of December 31, 2007 for acquisition and origination fee expenses associated with such loans.
Item 6.
Item 6. Selected Financial Data.
We present below selected financial information. We encourage you to read the financial statements and the notes accompanying the financial statements included in this Annual Report. This information is not intended to be a replacement for the financial statements.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis should be read in conjunction with our accompanying financial statements and the notes thereto:
Overview
On May 15, 2006, our Registration Statement on Form S-11, covering a public offering of our units of limited partnership interest, was declared effective under the Securities Act of 1933, as amended. The aggregate offering price for the units under the Offering is $350 million. At the time of effectiveness, the Registration Statement covered up to 12,500,000 units of limited partnership interest at a price of $20 per unit pursuant to the primary offering and up to 5,000,000 units of limited partnership interest to be issued pursuant to our DRIP for $20 per unit. On July 3, 2006, we accepted our initial public subscribers as limited partners. We have the right to reallocate the units of limited partnership interest we are offering between the primary offering and our DRIP, and pursuant to Supplement No. 8 to our prospectus regarding the Offering, which was filed with the Securities and Exchange Commission on September 4, 2008, we reallocated the units being offered such that 16,250,000 units are being offered pursuant to the primary offering and 1,250,000 units are being offered pursuant to the DRIP. See “Subsequent Events” below for a description of the additional reallocation of units of limited partnership interests.
We will experience a relative increase in liquidity as subscriptions for units are received and accepted. We will experience a relative decrease in liquidity as Offering proceeds are expended in connection with the funding and acquisition of mortgage loans, as we pay or reimburse selling commissions and other organization and Offering expenses, and as we cease accepting subscriptions for units from the primary Offering.
The net proceeds of the Offering will provide funds to enable us to fund or acquire loans. The number of loans we fund or acquire will depend upon the number of units sold and the resulting amount of the net proceeds available for investment in loans. In the event that the Offering is not fully sold, our ability to diversify our investments may be diminished.
Until required for the funding or acquisition of loans, net Offering proceeds will be kept in short-term, liquid investments. Our general partner, although not required to, has established retained earnings reserves out of cash flow generated by loans. Further, our general partner may establish reserves from gross Offering proceeds, cash flow generated by loans or out of net proceeds from loan repayments.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). The preparation of these financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a regular basis, we evaluate these estimates, including investment impairment. These estimates are based on management’s historical industry experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates. We have identified our most critical accounting policies to be the following:
Revenue Recognition
Interest income on mortgage investments is recognized over the life of the loan and recorded on the accrual basis. Income recognition is suspended for loans at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. As of December 31, 2008 and 2007, we were accruing interest on all mortgage notes receivable.
Credit enhancement fee - related party income is generated by a limited guaranty agreement with UMT, an affiliate of our general partner, whereby we agree to guarantee the repayment of an amount up to $30 million with respect to a secured line of credit between UMT and UDF I, another affiliate of our general partner. Such income is recognized on a monthly basis as collectability is deemed probable. As of December 31, 2007, UDF III was recognizing all credit enhancement fee income on its limited guaranty. Effective January 1, 2008, UDF I negotiated the release of this limited guaranty agreement; thus, we did not recognize any credit enhancement fee - related party income on the limited guaranty during 2008. See “- Off-Balance Sheet Arrangements” below for further discussion.
The Partnership generates mortgage and transaction service revenues by originating mortgage notes receivable and other loans. In accordance with Statement of Financial Accounting Standards (“SFAS”) 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, the Partnership defers recognition of income from nonrefundable commitment fees paid by the borrowers and recognizes such income on a straight-line basis over the expected life of such notes. The Partnership also expenses a 3% acquisition and origination fee (“placement fee”) paid to the general partner to provide for processing and origination costs associated with mortgage notes receivable held by the Partnership on a straight-line basis over the expected life of such notes. As of December 31, 2008 and 2007, approximately $3.6 million and $637,000, respectively, of these net deferred fees have been offset against mortgage notes receivable.
Determination of the Allowance for Loan Losses
The allowance for loan losses is our estimate of incurred losses in our portfolio of mortgage notes receivable and mortgage notes receivable - related party. We periodically perform detailed reviews of our portfolio of mortgage notes and other loans to determine if impairment has occurred and to assess the adequacy of the allowance for loan losses based on historical and current trends and other factors affecting credit losses. We charge additions to the allowance for loan losses to current period earnings through the provision for loan losses. Amounts determined to be uncollectible are charged directly against (and decrease) the allowance for loan losses (“charged off”), while amounts recovered on previously charged off accounts increase the allowance. We exercise significant judgment in estimating the timing, frequency and severity of losses, which could materially affect the provision for loan losses and, therefore, net income. As of December 31, 2008 and 2007, approximately $318,000 and $78,000, respectively, of allowance for loan losses had been offset against mortgage notes receivable.
Mortgage Notes Receivable and Mortgage Notes Receivable - Related Party
Mortgage notes receivable and mortgage notes receivable - related party are recorded at the lower of cost or estimated net realizable value. The mortgage investments are collateralized by land and related improvements to residential property owned by the borrowers and/or the ownership interests of the borrower. Currently, the mortgage notes receivable have a term ranging from two to 51 months. None of such mortgages are insured or guaranteed by a federally owned or guaranteed mortgage agency. We originate and/or acquire all mortgage notes receivable and intend to hold the mortgage notes receivable for the life of the notes.
Partnership Interest - Related Party
Participation interest - related party represents an Economic Interest Participation agreement with UMT, pursuant to which we purchased (i) an economic interest in a $45 million revolving credit facility from UMT to UDF I and (ii) a purchase option to acquire a full ownership participation interest in the credit facility. See “Item 13. Certain Relationships and Related Transactions, and Director Independence - Transactions with Related Persons” below for further discussion.
Cash Flow Distributions
Cash available for distributions represents the funds received by us from operations (other than proceeds from a capital transaction or a liquidating distribution), less cash used by us to pay our expenses, debt payments, and amounts set aside to create a retained earnings reserve (currently at 9.5% of our net income; the retained earnings reserve is intended to recover some of the organization and offering expenses incurred in connection with the Offering). Our general partner receives a monthly distribution for promotional and carried interest from the cash available for distributions. Monthly distributions are currently paid to the limited partners as a 9.75% annualized return on a pro rata basis based on the number of days in the Partnership. Retained earnings would contain a surplus if the cash available for distributions less the 9.5% reserve exceeded the monthly distribution to the general and limited partners. Retained earnings would contain a deficit if cash available for distributions less the 9.5% reserve is less than the monthly distribution to general and limited partners. It is the intent of management to monitor and distribute any surplus on an annual basis. As of December 31, 2008 and 2007, we had an approximately $2.2 million deficit in retained earnings and a $189,000 surplus in retained earnings, respectively, which is included in our limited partners’ capital account. Approximately $202,000 of the surplus as of December 31, 2007 was distributed in April 2008.
Results of Operations
We commenced active operations on July 3, 2006, when we accepted our initial public subscribers as limited partners. As a result, our results of operations for the year ended December 31, 2006 are not comparable to the results of operations for the years ended December 31, 2007 and 2008.
Revenues
Interest income for the years ended December 31, 2008, 2007 and 2006 were approximately $23.9 million, $7.8 million and $370,300, respectively. On July 3, 2006, we accepted our initial public subscribers as limited partners, resulting in the Partnership having funds available to originate mortgage notes receivable and other loans beginning in the third quarter of 2006. The increase in interest income for the years ended December 31, 2008 and 2007 is primarily the result of our increased mortgage notes receivable (including related party transactions) and participation interest - related party portfolios of approximately $252 million as of December 31, 2008 compared to $100 million and $17.8 million as of December 31, 2007 and 2006, respectively.
Credit enhancement fees - related party for the years ended December 31, 2007 and 2006 were approximately $595,600 and $75,600, respectively. In October 2006, we entered into a limited guaranty for the benefit of UMT. This limited guaranty was terminated and our contingent repayment obligation relieved effective January 1, 2008. Therefore, there was no credit enhancement fee - related party during 2008. See “ - Off-Balance Sheet Arrangements” below for further discussion.
Mortgage and transaction service revenues for the years ended December 31, 2008, 2007 and 2006 were approximately $1.9 million, $705,500 and $66,200, respectively. The Partnership generates mortgage and transaction service revenues by originating and acquiring mortgage notes receivable and other loans. In accordance with SFAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, we defer recognition of income from nonrefundable commitment fees and recognize such income on a straight-line basis over the expected life of such notes. The increase in mortgage and transaction service revenues for the years ended December 31, 2008 and 2007 is primarily the result of our increased mortgage notes receivable (including related party transactions) and participation interest - related party portfolio of approximately $252 million as of December 31, 2008 compared to $100 million and $17.8 million as of December 31, 2007 and 2006, respectively.
We expect revenues to increase in the near future as we continue to raise proceeds from the Offering and invest proceeds in additional loans.
Expenses
Interest expense for the years ended December 31, 2008, 2007 and 2006 was approximately $1,500, $256,500 and $4,400, respectively. Interest expense represents interest associated with the Revolving Credit Facility. We utilized the Revolving Credit Facility as transitory indebtedness to provide liquidity and to reduce and avoid the need for large idle cash reserves, including usage to fund identified investments pending receipt of proceeds from the sale of our units. We used the Revolving Credit Facility as a portfolio administration tool and not to provide long-term or permanent leverage on our investments. We entered into the Revolving Credit Facility in December 2006, and there was no interest expense prior to our entry into the Revolving Credit Facility. The Revolving Credit Facility was terminated in December 2008.
General and administrative expense for the years ended December 31, 2008, 2007 and 2006 was approximately $4.2 million, $1.6 million and $179,200, respectively. The increase in general and administrative expense primarily relates to increased costs associated with our directors’ and officers’ insurance premiums, placement fees, as well as legal and accounting fees.
We intend to grow our portfolio in conjunction with the increase in proceeds raised in the Offering. We intend to deploy such proceeds in a diversified manner to the borrowers and markets in which we have experience and as markets dictate in accordance with the economic factors conducive for a stable residential market. We expect interest expense, placement fees and general and administrative expense to increase commensurate with the growth of our portfolio.
Cash Flow Analysis
We commenced active operations on July 3, 2006, when we accepted our initial public subscribers as limited partners. As a result, our cash flows for the years ended December 31, 2008 and 2007 are not comparable to the cash flows for the year ended December 31, 2006.
Cash flows provided by operating activities for the years ended December 31, 2008 and 2007 were approximately $20.3 million and $6.3 million, respectively, and were comprised primarily of net income, offset slightly with accrued interest receivable. During the year ended December 31, 2006, cash provided by operating activities was approximately $224,000 and was comprised primarily of net income offset slightly with other assets.
Cash flows used in investing activities for the year ended December 31, 2008 and 2007 were approximately $152.6 million and $82.4 million, respectively, resulting from the origination of mortgage notes receivable and participation interest - related party. Cash flows used in investing activities for the year ended December 31, 2006 were approximately $17.8 million, resulting from the origination of mortgage notes receivable.
Cash flows provided by financing activities for the year ended December 31, 2008 and 2007 were approximately $147.2 million and $75.9 million, respectively, and were primarily the result of funds received from the issuance of limited partnership units, offset with payments of Offering costs. Cash flows provided by financing activities for the year ended December 31, 2006 were approximately $18.2 million, and were primarily the result of funds received from the issuance of limited partnership units and net proceeds from the Revolving Credit Facility.
Our cash and cash equivalents were approximately $15.5 million, $587,000 and $672,000 as of December 31, 2008, 2007 and 2006, respectively.
Liquidity and Capital Resources
Our liquidity requirements will be affected by (1) outstanding loan funding obligations, (2) our administrative expenses and (3) debt service on senior indebtedness required to preserve our collateral position. We expect that our liquidity will be provided by (1) loan interest, transaction fees and credit enhancement fee payments, (2) loan principal payments, (3) proceeds from the sale of units of our limited partnership interest, (4) sale of loan pools through securitization and direct sale of loans, (5) proceeds from our DRIP, and (6) credit lines available to us.
In most cases, loan interest payments will be funded by an interest reserve. Interest reserve accounts are funded as loan proceeds and are intended to provide cash for monthly interest payments until such time that revenue from the sale of land or developed lots is sufficient to meet the debt service obligations. In the event that interest reserves are exhausted prior to realization of sufficient cash from land or lot sales, a loan default may occur. Payment defaults and decreasing land and lot sales may result in less liquidity and affect our ability to meet our obligations and make distributions. The inability to sell additional partnership interests may result in our inability to fund loans, and the inability to sell loan pools may result in longer periods to return principal to our investors. Limited credit facilities may impact our ability to meet our obligations or expand our loan portfolio when other sources of cash are not sufficient.
Increased liquidity needs could result in the liquidation of loans to raise cash, thereby reducing the number and amount of loans outstanding and the resultant earnings realized. We have secured a Revolving Credit Facility that is utilized as transitory indebtedness to provide liquidity and to reduce and avoid the need for large idle cash reserves.
Subscription proceeds are held in escrow until investors are admitted as limited partners. We continue to admit new limited partners. Amounts associated with non-admitted subscriptions are reflected in “Restricted cash” and “Escrow payable” on our balance sheet.
Material Trends Affecting Our Business
We are a real estate finance limited partnership and derive a substantial portion of our income by originating, purchasing, participating in and holding for investment mortgage loans made directly by us to persons and entities for the acquisition and development of real property as single-family residential lots that will be marketed and sold to home builders. We intend to concentrate our lending activities in the southeast and southwest sections of the United States, particularly in Texas, Colorado, and Arizona. We believe these areas continue to experience demand for new construction of single-family homes; however, the U.S. housing market has suffered declines over the past three years, particularly in geographic areas that had experienced rapid growth, steep increases in property values and speculation. Additionally, we intend to concentrate our lending activities with national and regional homebuilders and developers who sell single-family residential home lots to such national and regional homebuilders. National and regional homebuilders are expected to reduce the number of new homes constructed in 2009 as compared to 2008. However, we expect to see continued healthy demand for our products as the supply of finished new homes and land is once again aligned with our market demand.
We believe that the demand for new homes continued to deteriorate progressively throughout 2008 and accelerated with the cascading events in credit and equity markets in September and October. Consumer confidence has sunk to historic lows. Market conditions remain challenging as many potential home buyers appear to have postponed the purchase of new homes until signs that the economy and employment are improving, or at least are not continuing to deteriorate. Our view is that the perspective of many potential home buyers has changed from “have home prices stabilized, and is this the right price at which to purchase a home?,” to “we will wait to purchase a home until such time as we are comfortable we are not going to lose our jobs.”
Nationally, the number of new single-family residential homes sold and average and median sales prices have been declining. The sales of new single-family residential homes in December 2008 were at a seasonally adjusted annual rate of 331,000 units, according to estimates released jointly by the U.S. Census Bureau and the Department of Housing and Urban Development. This is approximately 44.8% below the December 2007 estimate of 600,000. According to the same sources, the average sales price of new houses sold in 2008 was $291,800; the median sales price was $230,600. This is approximately 6.95% below the 2007 average new home sales price of $313,600. In addition, the median sales price is approximately 6.98% below the 2007 median new home sales price of $247,900. The seasonally adjusted estimate of new houses for sale at the end of December 2008 was 357,000, which represents a supply of 12.9 months at the December 2008 sales rate. We believe that this significant drop in the number of new houses for sale, year-over-year, by an estimated 137,000 units reflects the homebuilding industry’s extensive efforts to bring the new home market back to equilibrium by continuing to reduce new housing starts and selling existing new home inventory. We continue to believe that housing inventories will continue to fall until they reach between 350,000 and 375,000 units in the first half of 2009, a point we believe will mark a tightened housing market. We further believe that new home inventories are at or close to equilibrium and that what is necessary to regain prosperity in housing markets is the return of healthy levels of demand. Also, according to the sources identified above, new single-family residential home permits and starts have declined nationally, as a result and in anticipation of a rising supply of new single-family residential homes and a declining demand for new single-family residential homes. Single-family homes authorized by building permits in December 2008 were at a seasonally adjusted annual rate of 363,000 units. This is 49.2% below the December 2007 estimate of 714,000 units. Single-family home starts for December 2008 were at a seasonally adjusted annual rate of 398,000 units. This is 48.9% below the December 2007 estimate of 779,000 units.
The primary factors affecting new home sales are housing prices and home affordability, and housing demand. Housing supply may affect both new home prices and the demand for new homes. When new home supplies exceed new home demand, new home prices may generally be expected to decline. Declining new home prices may result in diminished new home demand as people postpone a new home purchase until such time as they are comfortable that stable price levels have been reached.
Housing markets generally remain difficult and generally are declining on a national basis with those declines and difficulties most pronounced in those markets that had experienced rapid growth, steep increases in property values and speculation, such as in California, Florida, Arizona and Nevada. However, a few markets, such as Texas, are continuing to remain fairly healthy, though weakened from 2007, compared to what has been occurring nationally. The table below illustrates the recent declines in home price appreciation nationally, as well as in California and Florida, while showing that Texas has not experienced such pronounced declines.
Source: Office of Federal Housing Enterprise Oversight
The Office of Federal Housing Enterprise Oversight (“OFHEO”) analyzes the combined mortgage records of Fannie Mae and Freddie Mac, which form the nation’s largest database of conventional, conforming mortgage transactions. OFHEO’s all-transactions house price index tracks average house price changes in repeat sales or refinancing of the same single-family properties and is based on data obtained from Fannie Mae and Freddie Mac for mortgages originated over the past 34 years.
The OFHEO 4th Quarter 2008 all-transactions house price index reports that over the past twelve months, home prices have risen on average 2.09% in Texas while home prices have fallen nationally 8.20% in that same period. Also, home prices in the states of Arizona, Florida, California and Nevada have fallen 15.18%, 19.51%, 20.51% and 21.78%, respectively, during that same period. According to that same source, only 21 states have seen home prices increase over the past twelve months, while twenty-nine states and the District of Columbia have seen home prices fall. The OFHEO reports that only three states, North Dakota, South Dakota and Texas have seen home prices rise by more than 2.0% over that period. The OFHEO also reports that only four states, Arizona, Florida, Nevada and California have seen home prices fall by more than 15.0% over that period.
As of December 31, 2008, substantially all of our loans, over 95% of our portfolio, were with respect to single-family residential development projects in Texas. Our Texas loans were in the markets of Austin, Houston, Dallas, San Antonio and Lubbock. Our remaining loans were made with respect to single-family residential development projects in Denver, Colorado (4%) and Kingman, Arizona (1%).
While housing woes beleaguer the national economy, Texas housing markets have held up as some of the best in the country. We believe the Texas markets have remained fairly healthy due to continued strong population and job growth, economies, housing affordability ratios, and home building and development discipline on the part of home builders and developers operating in Texas markets.
According to numbers publicly released by Residential Strategies, Inc. or Metrostudy, leading providers of primary and secondary market information, the median new home prices for 2008 in the metropolitan areas of Austin, Houston, Dallas, and San Antonio are $219,810, $205,878, $208,000, and $186,956, respectively. These amounts are below the 2008 national median sales price of new homes sold of $230,600. Using the Department of Housing and Urban Development’s estimated 2008 median family income for the respective metropolitan areas of Austin, Houston, Dallas, and San Antonio, the median income earner in those areas has 1.21 times, 1.14 times, 1.20 times, and 1.13 times the income required to qualify for a mortgage to purchase the median priced new home in the respective metropolitan area. Using the U.S. Census Bureau’s income data to project estimated median income for the United States for 2008 of $61,458 and the 2008 national median sales prices of new homes sold of $230,600, we conclude that the national median income earner has 1.03 times the income required to qualify for a mortgage loan to purchase the median priced new home in the United States. We further conclude that the aforementioned Texas metropolitan areas have new home housing affordability ratios that are 1.10 to 1.18 times the national new home housing affordability ratio. These numbers reflect the increase in home affordability in housing markets outside of Texas over the past 24 months as new home prices in other housing markets outside of Texas generally have fallen. The above housing affordability is determined as the ratio of median family income to the income required to qualify for a 90 percent, 30-year fixed-rate mortgage to purchase the median-priced new home, assuming an annual mortgage insurance premium of 50 basis points for private mortgage insurance and a cost that includes estimated property taxes and insurance for the home.
Additional indicators that provide insight into the extent of new home affordability are the ratio of new home prices to median income, and new home payments as a percentage of income. Historically, the ratio of new home prices to median income in stable markets is between 3 and 4, and the average monthly income to service a conforming mortgage has been between 19% and 25%, and 29% and 37% for the first time home purchase. Both nationally and within the four major Texas markets, new prices are affordable by each of these historical measures.
The Winter 2009 U.S. Market Risk Index, a study prepared by PMI Mortgage Insurance Co., the U.S. subsidiary of The PMI Group, Inc., which ranks the nation’s 50 largest metropolitan areas according to the likelihood that home prices will be lower in two years, reported that Texas cities lead the nation in home price stability. The San Francisco-based company recently analyzed housing price trends for its quarterly report, released January 14, 2009. The index also considers the impact of foreclosure rates and excess housing supply and the consequential impact on home prices. The study predicts there is less than a 1% chance that the Dallas/Fort Worth-area, Houston-area, San Antonio-area and Austin-area home prices will fall during the next two years. All Texas metropolitan areas included in the report are in the Top 12 least likely areas to experience a decline in home prices in two years, of the nation’s 50 largest metropolitan areas. Dallas-Plano-Irving, Texas is the nation’s least likely metropolitan area included in the study to see a price decline in the next two years, Fort Worth-Arlington, Texas is second-least likely, Houston-Sugar Land-Baytown, Texas is third-least likely, San Antonio, Texas is fifth-least likely and Austin, Texas is twelfth-least likely.
We also believe that changes in population and employment greatly affect new home demand. The United States Census Bureau reported in its 2008 Estimate of Population Change July 1, 2007 to July 1, 2008 that Texas led the country in population growth during that period. The estimate concluded that Texas grew by 483,542 people, or 2.00%, a number which was 1.28 times greater than the next closest state in terms of raw population growth, California, and more than 2.67 times the second closest state in terms of raw population growth, North Carolina. According to the same source, Texas also led the country in population growth during the period July 1, 2006 to July 1, 2007 with an estimated population growth of 496,751 people, or 2.12%. The United States Census Bureau also reported that Texas had the largest number of counties of any state, 19, among the 100 fastest-growing counties in the nation. Texas had the largest number of counties that added the largest number of residents between July 1, 2007 and July 1, 2008 - 6 of the top 15 counties were in Texas: Harris (Houston), Tarrant (Fort Worth), Bexar (San Antonio), Collin (North Dallas), Dallas (Dallas) and Travis (Austin). On March 19, 2009, the United States Census Bureau reported that Texas’ five major cities - Austin, Houston, San Antonio, Dallas and Fort Worth - were among the top ten in the nation for population growth from 2007 to 2008 for metropolitan statistical areas with a population estimate exceeding 1 million. Dallas-Fort Worth-Arlington led the nation in numerical population growth with an estimated population increase of 146,532, with Dallas-Plano-Irving having an estimated increase of 97,036 and Fort Worth-Arlington having an estimated increase of 49,496. Houston-Sugarland-Baytown was second in the nation in numerical population growth with an estimated increase of 130,185. Austin-Round Rock had an estimated population growth of 60,012 and San Antonio had an estimated population growth of 46,524 over this same period. The percentage increase in population for these major Texas cities ranged from 2.34% to 3.77%.
The United States Department of Labor reports that as of December 2008, Texas led the nation with the largest job gains over the past twelve months with 154,700 new jobs created. This is over 10.05 times greater than the number of jobs created during this period in the nation’s second largest state for job growth, Oklahoma, and more than 18.20 times the jobs created during this period in the nation’s third largest state for job growth, Louisiana. The United States Department of Labor reports that nationally, the United States lost approximately 2,956,000 jobs over that same period. The Texas metropolitan areas of Austin, Houston, Dallas, San Antonio and Lubbock experienced, during the last twelve months, the creation of 9,600, 57,300, 43,300, 14,900 and 1,500 new jobs, respectively. The largest over-the-year employment increase was recorded in Houston-Sugar Land-Baytown, Texas, followed by Dallas-Fort Worth-Arlington, Texas, and San Antonio, Texas. Austin-Round Rock, Texas had the 5th largest over-the-year employment increase. The United States Department of Labor reports that the over-the-year percentage increases in employment in the country’s large metropolitan areas were recorded in the four top metropolitan areas of Texas: Austin-Round Rock (+1.2%), Houston-Sugar Land-Baytown, (+2.2%), San Antonio (+1.8%), and Dallas-Fort Worth-Arlington, (+1.4%).
The United States Department of Labor reports that as of December 2008, the unemployment rate for Texas in December 2008 was 6.0%, up from 4.2% in December 2007. The national unemployment rate in December 2008 was 7.2%, up from 4.9% a year earlier. The unemployment rate for Austin-Round Rock, Texas in December 2008 was 5.2%, up from 3.6% in December 2007; Dallas-Fort Worth-Arlington, Texas was 5.5%, up from 4.4%; Houston-Sugar Land-Baytown, Texas was 5.5%, up from 4.4%; Lubbock, Texas was 3.8%, up from 3.3%; and San Antonio, Texas was 5.3%, up from 4.0%.
Due to the national and global recession, we believe that the Texas economy will slow in 2009 and that it is likely that Texas will suffer a net loss of jobs in 2009. The National Bureau of Economic Research has concluded that the U.S. economy entered into a recession in December 2007, ending an economic expansion that began in November 2001. We believe that the recent transition from significant month-over-month and year-over-year job gains in Texas, to month-over-month job losses indicates that the Texas economy slowed significantly in the fourth quarter of 2008 and also is at risk of recession. We further believe that the Texas economy will continue to outperform the national economy. According to the Texas Workforce Commission, Texas tends to enter into recessions after the national economy has entered a recession and tends to lead among states in the economic recovery.
In sharp contrast to the conditions of other homebuilding markets in the country where unsold housing inventory remains a challenge, in Texas markets, new home sales are greater than new home starts, which indicates that home builders in Texas are focused on maintaining a balance of new home demand and new home supply. Home builders and developers in Texas have remained disciplined on new home construction and project development. New home starts have been declining year-on-year and are outpaced by new home sales in all of our Texas markets where such data is readily available. Inventories of finished new homes and total new housing (finished vacant, under construction and model homes) remain at healthy and balanced levels in all four major Texas markets, Austin, Dallas-Fort Worth, Houston and San Antonio. Each major Texas market is experiencing a rise of finished lot inventories as homebuilders continue to reduce the number of new home starts, with Houston, San Antonio and Austin reaching slightly elevated levels of 30-36 months. A 24-28 month supply is considered equilibrium for finished lot supplies. Though the absolute number of finished lots has not changed significantly for several years, Dallas-Fort Worth has an estimated inventory of finished lots of approximately 52.8 months, which has been the result of a significant decline of new home starts.
Austin continues to be one of the strongest homebuilding markets in the country. Annual new home sales in Austin outpace starts 10,936 versus 8,988, with annual new home sales declining year-on-year by approximately 26%. With the decline in housing starts, the Austin new homebuilding market has changed from an area with a very tight lot supply to a market that is now generally balanced. Finished housing inventory and total new housing inventory (finished vacant, under construction and model homes) remain at healthy and balanced levels of 2.94 months and under 6.0 months, respectively. The considered equilibrium levels for finished housing inventory and total new housing inventory are a 2-to-2.5 month supply and a 6.0 month supply, respectively. Finished lot supplies have edged up to slightly elevated levels of 41.8 months. San Antonio is also a healthy homebuilding market. Annual new home sales in San Antonio outpace starts 10,778 versus 8,838, with annual new home sales declining year-on-year by approximately 31%. Finished housing inventory and total new housing inventory remain at healthy levels with a 2.6 month supply and 5.7 month supply, respectively, each within or below the considered equilibrium levels. Finished lot supplies have increased to 54.0 months. Houston is also a healthy homebuilding market. Annual new home sales in Houston outpace starts 31,284 versus 26,223, with annual new home sales declining year-on-year by approximately 26.8%. Finished housing inventory and total new housing inventory have been increasing to a 3.1 month supply and 7.5 month supply, respectively, each slightly above the considered equilibrium level. Finished lot supplies remain at slightly elevated levels of 33.2 months. Dallas-Fort Worth is also a healthy homebuilding market. Annual new home sales in Dallas-Fort Worth outpace starts 25,273 versus 19,512, with annual new home sales declining year-on-year by approximately 34.0%. Finished housing inventory and total new housing inventory have been increasing to a 3.4 month supply and 6.3 month supply, respectively, each slightly above the considered equilibrium level. Finished lot supplies remain at elevated levels of 58.0 months. All numbers are as publicly released by Residential Strategies, Inc. or Metrostudy, leading providers of primary and secondary market information.
The recent rise in supply of finished lot inventory in Texas markets is principally the result of market discipline, the decrease in the pace of annual starts and cessation of new developments, and not an increase in the raw number of developed lots. Annual starts in each of Austin, San Antonio, Houston and Dallas-Fort Worth are outpacing lot deliveries. With the discipline evident in these markets, we expect to see a continued decline in finished lot inventories in coming quarters as new projects have been significantly reduced.
The Real Estate Center at Texas A&M University has reported that the sales of existing homes remain healthy in our Texas markets, as well, but the year-over-year sales pace has fallen between 15% and 20% in each of the four largest Texas markets, although the supply of inventory levels generally have fallen. The number of months of home inventory for sale in Austin, San Antonio, Houston, Dallas, Fort Worth and Lubbock is 5.5 months, 7.6 months, 6.5 months, 6.2 months, 5.9 months, and 5.4 months, respectively. A 6-month supply of inventory is considered a balanced market with more than 6 months of inventory generally being considered a buyer’s market and less than 6 months of inventory generally being considered a seller’s market. As of December 2008, the number of existing homes sold year-to-date in (a) Austin is 22,393, down 20.1% year-on-year; (b) San Antonio is 19,313, down 19.4% year-on-year; (c) Houston is 65,072, down 16.2% year-on-year, (d) Dallas is 50,477, down 15.4% year-on-year, (e) Fort Worth is 9,679, down 16.1% year-on-year, and (f) Lubbock is 3,245, down 6.9% year-on-year.
The OFHEO reports that Texas had healthy existing home price appreciation between the fourth quarter of 2007 and the fourth quarter of 2008 of 2.09%. That same report provides that existing home price appreciation between the fourth quarter of 2007 and the fourth quarter of 2008 for (a) Austin is 4.44%, (b) Houston is 3.72%, (c) Dallas is 1.86%, (d) Fort Worth is 1.21%, and (e) Lubbock is 4.55%. The city of San Antonio experienced a fourth quarter year-over-year price decline of 1.62%. The OFHEO tracks average house price changes in repeat sales or refinancings of the same single-family properties utilizing conventional, conforming mortgage transactions.
In managing and understanding the markets and submarkets in which we make loans, we monitor the fundamentals of supply and demand. We monitor the economic fundamentals in each of the markets in which we make loans, analyzing demographics, household formation, population growth, job growth, migration, immigration and housing affordability. We also monitor movements in home prices and the presence of market disruption activity, such as investor or speculator activity that can create false demand and an oversupply of homes in a market. Further, we study new home starts, new home closings, finished home inventories, finished lot inventories, existing home sales, existing home prices, foreclosures, absorption, prices with respect to new and existing home sales, finished lots and land, and the presence of sales incentives, discounts, or both, in a market.
The residential homebuilding industry is cyclical and is highly sensitive to changes in general economic conditions, such as levels of employment, consumer confidence and income, availability of financing for acquisition, construction and permanent mortgages, interest rate levels and demand for housing. Sales of new homes are also affected by the condition of the resale market for used homes, including foreclosed homes. Housing demand is, in general, adversely affected by increases in interest rates, housing costs and unemployment, by decreases in the availability of mortgage financing, and by a decrease in consumer confidence, which can occur for numerous reasons including increases in energy costs, interest rates, housing costs and unemployment.
We face a risk of loss resulting from deterioration in the value of the land purchased by the developer with the proceeds of loans from us, a diminution of the site improvement and similar reimbursements used to repay loans made by us, and a decrease in the sales price of the single-family residential lots developed with the proceeds of loans from us. Deterioration in the value of the land, a diminution of the site improvement and similar reimbursements, and a decrease in the sales price of the residential lots can occur in cases where the developer pays too much for the land to be developed, the developer is unable or unwilling to develop the land in accordance with the assumptions required to generate sufficient income to repay the loans made by us, or is unable to sell the residential lots to homebuilders at a price that allows the developer to generate sufficient income to repay the loans made by us. Our general partner actively monitors the markets and submarkets in which we make loans, including mortgage markets, homebuilding economies, the supply and demand for homes, finished lots and land and housing affordability to mitigate such risks. Our general partner also actively manages our loan portfolio in the context of events occurring with respect to the loan and in the market and submarket in which we made the loan. We anticipate that there may be defaults on development loans made by us and that we will take action with respect to such defaults at any such time that we determine it prudent to do so, including such time as we determine it prudent to maintain and protect the value of the collateral securing such loans, and, that we may originate another development loan to another developer with respect to the same project to maintain and protect the value of the collateral securing our initial loan.
We face a risk of loss resulting from adverse changes in interest rates. Changes in interest rates may impact both demand for our real estate finance products and the rate of interest on the loans we make. In most instances, the loans we make will be junior in the right of repayment to senior lenders, who will provide loans representing 70% to 80% of total project costs. As senior lender interest rates available to our borrowers increase, demand for our mortgage loans may decrease, and vice versa.
Developers to whom we make mortgage loans use the proceeds of such loans to develop raw real estate into residential home lots. The developers obtain the money to repay these development loans by selling the residential home lots to home builders or individuals who will build single-family residences on the lots, receiving qualifying site improvement reimbursements, and by obtaining replacement financing from other lenders. If interest rates increase, the demand for single-family residences may decrease. Also, if mortgage financing underwriting criteria become more strict, demand for single-family residences may decrease. In such an interest rate and/or mortgage financing climate, developers may be unable to generate sufficient income from the resale of single-family residential lots to repay loans from us, and developers’ costs of funds obtained from lenders in addition to us may increase, as well. If credit markets deteriorate, developers may not be able to obtain replacement financing from other lenders. Accordingly, increases in single-family mortgage interest rates, decreases in the availability of mortgage financing, or decreases in the availability of replacement financing could increase the number of defaults on development loans made by us.
Our general partner is not aware of any material trends or uncertainties, favorable or unfavorable, other than national economic conditions affecting real estate and interest rates generally, that it reasonably anticipates to have a material impact on either the income to be derived from our investments in mortgage loans, or entities that make mortgage loans, other than those referred to in this Annual Report on Form 10-K. The disruption of mortgage markets, in combination with a significant amount of negative national press discussing chaos in mortgage markets and the poor condition of the national housing industry, including declining home prices, have made potential new home purchasers and real estate lenders very cautious. The economic turmoil that continues to take place, is highlighted by the failure of highly respected financial institutions and a significant decline in equity markets around the world, and marked by unprecedented administrative and legislative actions in the United States and actions by central banks around the globe to stabilize our economy, have further caused many prospective home purchasers in our markets to postpone their purchases. In addition, we believe there is a general lack of urgency to purchase homes in these times of economic uncertainty. We believe that this has resulted in an additional slowing of the sales of new homes and believe this has resulted and anticipate that this will result in a slowing of the sales of finished lots developed by our clients in certain markets; however, we continue to believe that the prices of those lots should not change materially. We also anticipate that the decrease in the availability of replacement financing may increase the number of defaults on development loans made by us or extend the time period anticipated for the repayment of our loans.
Off-Balance Sheet Arrangements
In October 2006, we entered into a limited guaranty effective as of September 1, 2006 for the benefit of UMT or its permitted successors and assigns (the “UDF III Guarantee”), and entered into a letter agreement with UDF I, with respect to a credit enhancement fee related to the UDF III Guarantee (the “UDF III Credit Enhancement Fee Agreement”). Pursuant to the UDF III Guarantee, the Partnership guaranteed the repayment of an amount up to $30 million with respect to that certain Second Amended and Restated Secured Line of Credit Promissory Note between UMT and UDF I. In exchange for that guarantee, and pursuant to the UDF III Credit Enhancement Fee Agreement, UDF I paid UDF III each month in arrears an amount equal to 0.25% of the maximum liability amount, which is included in credit enhancement fees - related party income. As of December 31, 2007, the exposure under the UDF III Guarantee was approximately $15.9 million, and we had recognized as “Credit enhancement fees - related party” revenue of approximately $596,000. In April 2008, UDF I negotiated the release of the UDF III Guarantee. This limited guaranty was terminated and our contingent repayment obligation relieved effective January 1, 2008.
An affiliate of Land Development serves as the advisor to UMT and UDF IV.
Contractual Obligations
As of December 31, 2008, we had originated 49 loans, including 14 loans that have been repaid in full by the respective borrower, totaling approximately $386 million. We have approximately $56.4 million of commitments to be funded under the terms of mortgage notes receivable, including approximately $18.6 million of commitments for mortgage notes receivable - related party and $6.7 million for participation interest - related party.
As of December 31, 2007, we had funded 32 loans, including five loans that have been repaid in full by the respective borrower, totaling approximately $132 million. We had approximately $75.7 million of commitments to be funded under the terms of mortgage notes receivable, including $65.8 million of mortgage notes receivable - related party.
The Partnership has no other outstanding debt or contingent payment obligations, other than certain loan guaranties or letters of credit that we may make to or for the benefit of third-party lenders.
Subsequent Events
We have the right to reallocate the units of limited partnership interest we are offering between the primary offering and our DRIP, and pursuant to Supplement No. 11 to our prospectus regarding the Offering, which was filed with the Securities and Exchange Commission on March 6, 2009, we reallocated the units we are offering such that 16,500,000 units are being offered pursuant to the primary offering and 1,000,000 units are being offered pursuant to the DRIP.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Market risk is the exposure to loss resulting from adverse changes in market prices, interest rates, foreign currency exchange rates, commodity prices and equity prices. A significant market risk to which we are exposed is interest rate risk, which is sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. Changes in interest rates may impact both demand for our real estate finance products and the rate of interest on the loans we make. Another significant market risk is the market price of finished lots. The market price of finished lots is driven by the demand for new single-family homes and the supply of unsold homes and finished lots in a market. The change in one or both of these factors can have a material impact on the cash realized by our borrowers and resulting collectability of our loans and interest.
Demand for our mortgage loans and the amount of interest we collect with respect to such loans depends on the ability of borrowers of real estate development loans to sell single-family lots acquired with the proceeds of the loans to homebuilders.
The single-family lot and residential homebuilding market is highly sensitive to changes in interest rate levels. As interest rates available to borrowers increase, demand for mortgage loans decreases, and vice versa. Housing demand is also adversely affected by increases in housing prices and unemployment and by decreases in the availability of mortgage financing. In addition, from time to time, there are various proposals for changes in the federal income tax laws, some of which would remove or limit the deduction for home mortgage interest. If effective mortgage interest rates increase and/or the ability or willingness of prospective buyers to purchase new homes is adversely affected, the demand for new homes may also be negatively affected. As a consequence, demand for and the performance of our real estate finance products may also be adversely impacted.
As of December 31, 2008 and 2007, our mortgage notes receivable of approximately $169.8 million and $76.9 million, respectively, mortgage notes receivable - related party of approximately $43.3 million and $23.2 million, respectively, and participation interest - related party of approximately $39.3 and $0, respectively, were all at fixed interest rates, and thus, such mortgage notes receivable are not subject to change in future earnings, fair values or cash flows.
We seek to mitigate our single-family lot and residential homebuilding market risk by closely monitoring economic, project market, and homebuilding fundamentals. We review a variety of data and forecast sources, including public reports of homebuilders, mortgage originators and real estate finance companies; financial statements of developers; project appraisals; proprietary reports on primary and secondary housing market data, including land, finished lot, and new home inventory and prices and concessions, if any; and information provided by government agencies, the Federal Reserve Bank, the National Association of Home Builders, the National Association of Realtors, public and private universities, corporate debt rating agencies, and institutional investment banks regarding the homebuilding industry and the prices of and supply and demand for single-family residential homes.
In addition, we further seek to mitigate our single-family lot and residential homebuilding market risk by assigning an asset manager to each mortgage note. This asset manager is responsible for monitoring the progress and performance of the developer and the project as well as assessing the status of the marketplace and value of our collateral securing repayment of our mortgage loan.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The information required by this Item 8 is hereby incorporated by reference to our Financial Statements beginning on page of this Annual Report on Form 10-K.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A(T).
Item 9A(T). Controls and Procedures.
Evaluation of Disclosure Controls and Procedure
As required by Rule 13a-15(b) and Rule 15d-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the management of UMTH Land Development, L.P., our general partner, including its principal executive officer and principal financial officer, evaluated, as of December 31, 2008, the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e) and Rule 15d-15(e). Based on that evaluation, the principal executive officer and the principal financial officer of our general partner concluded that our disclosure controls and procedures, as of December 31, 2008, were effective for the purpose of ensuring that information required to be disclosed by us in this report is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the Exchange Act and is accumulated and communicated to management, including the principal executive officer and the principal financial officer of our general partner, as appropriate to allow timely decisions regarding required disclosures.
We believe, however, that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls systems are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud or error, if any, within a partnership have been detected.
Management’s Annual Report on Internal Control Over Financial Reporting
The management of Land Development 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)). The management of Land Development, including its principal executive officer and principal financial officer, evaluated as of December 31, 2008 the effectiveness of our internal control over financial reporting using the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, the principal executive officer and principal financial officer of Land Development concluded that our internal controls, as of December 31, 2008, were effective in providing reasonable assurance regarding reliability of financial reporting.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Partnership’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Partnership to provide only management’s report in this annual report.
Changes in Internal Controls over Financial Reporting
There have been no changes in our internal controls over financial reporting that occurred during the quarter ended December 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Our General Partner
We operate under the direction of our general partner, Land Development, a Delaware limited partnership formed in March 2003 that is responsible for the management and control of our affairs. The executive offices of our general partner are located at 1301 Municipal Way, Suite 100, Grapevine, Texas 76051. UMT Holdings holds 99.9% of the limited partnership interests in our general partner. UMT Services serves as the general partner of our general partner. Todd F. Etter and Hollis M. Greenlaw together own 100% of UMT Services. Our general partner is assisted by the employees of UMTH General Services, L.P., an affiliate of our general partner. We do not employ our own management personnel. Instead, we pay fees to our general partner for its services to us.
Our general partner is responsible for our direction and management, including identifying prospective loans, evaluating, underwriting and negotiating the acquisition and disposal of loans and overseeing the performance of our loans.
A change in our management may be accomplished by removal of our general partner or the designation of a successor or additional general partner, in each case in accordance with the provisions of our Partnership Agreement. Our Partnership Agreement provides that a general partner may be removed and a new general partner elected upon the written consent or affirmative vote of limited partners owning more than 50% of the limited partnership interests. Our Partnership Agreement further provides that a general partner may designate a successor or additional general partner with the consent of the general partner and limited partners holding more than 50% of the limited partnership interests. Generally, except in connection with such a designation, the general partner shall not have the right to retire or withdraw voluntarily from us or to sell, transfer or assign its interest without the consent of the limited partners holding more than 50% of the limited partnership interests.
Key Personnel
We are managed by the key personnel of our general partner, Land Development. Our general partner provides certain services to us, including identifying prospective loans and investments, evaluating, underwriting and negotiating the acquisition and disposal of loans and investments and overseeing the performance of our loans. The following key personnel hold the positions noted below with our general partner and its affiliates:
Name
Age
Position with Our General Partner
Todd F. Etter
Executive Vice President of our general partner and Director and Chairman of UMT Services, its general partner
Hollis M. Greenlaw
President and Chief Executive Officer of our general partner and President, Chief Executive Officer and Director of UMT Services, its general partner
Michael K. Wilson
Director of UMT Services, its general partner
Ben Wissink
Chief Operating Officer
Cara D. Obert
Chief Financial Officer
Mr. Etter and Mr. Greenlaw are directors, officers and shareholders of UMT Services and UMT Holdings. Mr. Etter, Mr. Greenlaw, Mr. Wilson, Mr. Wissink and Ms. Obert are partners of UMT Holdings. Mr. Wilson is a director of UMT Services. Mr. Etter and Mr. Greenlaw are shareholders of the general partner of UDF I and are also shareholders and officers of the general partner of UDF II. Mr. Wissink and Ms. Obert are officers of the general partner of UDF I, officers of the general partner of UDF II and are officers of UMT Services. Mr. Etter, Mr. Greenlaw, Mr. Wilson, Mr. Wissink and Ms. Obert are limited partners of UDF I. Mr. Greenlaw is Chief Executive Officer and Chairman of the Board of Trustees for UDF IV. Ms. Obert is Chief Financial Officer and Treasurer of UDF IV. Land Development owns a 100% interest in the general partner of the general partner for UDF LOF. Land Development also owns all of the limited partnership interests in the general partner of UDF LOF.
Theodore “Todd” F. Etter, Jr. Mr. Etter serves as the Executive Vice President of Land Development and has served as a director, partner and Chairman of UMT Services, the general partner of UMT Holdings and Land Development, since March 2003. UMT Holdings originates, purchases, sells and services interim loans for the purchase and renovation of single-family homes and land development loans through its subsidiaries UMTH Lending Company, L.P. and Land Development, and it provides real estate-related corporate finance services through its subsidiaries. UMTH GS, a subsidiary of UMT Holdings, has served as the advisor to UMT since August 1, 2006. Mr. Etter serves as Chairman of the general partner of UDF I and UDF II, each of which are limited partnerships formed to originate, purchase, sell and service land development loans and/or equity participations. Since 2000, Mr. Etter has been the Chairman of UMT Advisors, Inc., which served as the advisor to UMT from 2000 through July 31, 2006, and since 1996, he has been Chairman of Mortgage Trust Advisors, Inc., which served as the advisor to UMT from 1996 to 2000. Subsequent to the completion of the terms of their advisory agreements with UMT, neither UMT Advisors, Inc. nor Mortgage Trust Advisors, Inc. has been engaged in providing advisory services. Mr. Etter has overseen the growth of UMT from its inception in 1997 to over $150 million in capital. Since 1998, Mr. Etter has been a 50% owner of and has served as a director of Capital Reserve Corp. Since 2002, he has served as an owner and director of Ready America Funding Corp. Both Capital Reserve Corp. and Ready America Funding Corp. are Texas corporations that originate, sell and service mortgage loans for the purchase, renovation and construction of single-family homes. In 1992, Mr. Etter formed, and since that date has served as President of, South Central Mortgage, Inc. (“SCMI”), a Dallas, Texas-based mortgage banking firm. In July 2003, Mr. Etter consolidated his business interests in Capital Reserve Corp., Ready America Funding Corp. and SCMI into UMT Holdings. From 1980 through 1987, Mr. Etter served as a Principal of South Central Securities, an NASD member firm. In 1985, he formed South Central Financial Group, Inc., a Dallas, Texas-based investment banking firm, and he continues to serve as its President; however, since 1992, South Central Financial Group, Inc. has not actively engaged in investment banking activities. From 1974 through 1981, he was Vice President of Crawford, Etter and Associates, a residential development, marketing, finance and construction company. Since February 2004, Mr. Etter has served as an Advisory Director of American Bank of Commerce, Plano, Texas. Mr. Etter received a Bachelor of Arts degree from Michigan State University in 1972.
Hollis M. Greenlaw. Mr. Greenlaw has served as President and Chief Executive Officer of our general partner since March 2003. He also has served as a partner, President and Chief Executive Officer of UMT Holdings, and as President, Chief Executive Officer and a director of UMT Services since March 2003. Mr. Greenlaw also serves as Chief Executive Officer and Chairman of the Board of Trustees for UDF IV. From March 2003 through December 2008, Mr. Greenlaw directed the funding of over approximately $359 million in loans and land banking transactions and over $54 million of equity investments for UDF I, UDF II and UDF LOF. During that same period, UDF I, UDF II and UDF LOF received over approximately $219 million in loan repayments and over $22 million in equity investment distributions. Since May 1997, Mr. Greenlaw has been a partner of The Hartnett Group, Ltd., a closely-held private investment company managing over $40 million in assets. The Hartnett Group, Ltd. and its affiliated companies engage in securities and futures trading; acquire, develop, and sell real estate, including single-family housing developments, commercial office buildings, retail buildings and apartment homes; own several restaurant concepts throughout the United States; and make venture capital investments. From March 1997 until June 2003, Mr. Greenlaw served as Chairman, President and CEO of a multi-family real estate development and management company owned primarily by The Hartnett Group, Ltd. and developed seven multi-family communities in Arizona, Texas and Louisiana with a portfolio value exceeding $80 million. Prior to joining The Hartnett Group, Ltd., from 1992 until 1997, Mr. Greenlaw was an attorney with the Washington, D.C. law firm of Williams & Connolly, where he practiced business and tax law. Mr. Greenlaw received a Bachelor of Arts degree from Bowdoin College in 1986, where he was a James Bowdoin Scholar and elected to Phi Beta Kappa, and received a Juris Doctorate from the Columbia University School of Law in 1990. Mr. Greenlaw is a member of the Maine, District of Columbia and Texas bars.
Michael K. Wilson. Mr. Wilson has served as President of UMTH Funding Services, L.P. (“UMTH Funding”) and as Executive Vice President and Director of UMT Services since August 2005 and has been a partner of UMT Holdings since January 2007. Mr. Wilson is currently responsible for directing the corporate finance function of UMT Holdings, including Sales, Marketing and Investor Relations, and from August 2005 through December 2008 directed the capital raise of approximately $315 million in securities through independent FINRA-member broker-dealers. From January 2004 through July 2005, Mr. Wilson served as Senior Vice President of Marketing for UMT Holdings. From January 2003 through January 2004, Mr. Wilson served as Senior Vice President of Operations of Interelate, Inc., a marketing services business process outsourcing firm. From September 2001 to December 2002, Mr. Wilson was the sole principal of Applied Focus, LLC, an independent management consulting company that provided management consulting services to executives of private technology companies. Mr. Wilson continues to serve as a consultant for Applied Focus, LLC. From April 1998 to September 2001, Mr. Wilson served as Senior Director and Vice President of Matchlogic, an innovative internet advertising company where he directed outsourced ad management and database marketing services for Global 500 clients including General Motors and Procter & Gamble. From July 1985 to April 1998, Mr. Wilson was employed with Electronic Data Systems in Detroit, Michigan where he led several multi-million dollar IT services engagements, including GM OnStar. Mr. Wilson, who holds FINRA Series 7 and 63 licenses, graduated from Oakland University in 1985 with a Bachelor of Science degree in Management Information Systems and earned a Master of Business Administration degree from Wayne State University in 1992. Mr. Wilson also attended the Thunderbird School of Global Management executive development program.
Ben L. Wissink. Mr. Wissink, a partner of UMT Holdings, joined our general partner as an Asset Manager in September 2005 and subsequently became the Chief Operating Officer in March 2007. Mr. Wissink directs the management of over approximately $199 million in loans and investments for UDF I, UDF II and UDF LOF. From June 2003 through August 2005, Mr. Wissink served as the Controller for the Dallas/Fort Worth land division for the national homebuilding company Lennar Corporation. During that time, Mr. Wissink also served as an analyst for the Texas region. While at Lennar, Mr. Wissink assisted in the underwriting, execution and management of off-balance sheet transactions, including two acquisition and development funds between Lennar Corporation and UDF I. Mr. Wissink graduated from the University of Iowa in 2003 with a Bachelor of Business Administration degree in finance.
Cara D. Obert. Ms. Obert is a partner of UMT Holdings. Ms. Obert, a Certified Public Accountant, served as the Chief Financial Officer for UMT Holdings from March 2004 until August 2006 and served as Controller for UMT Holdings from October 2003 through March 2004. She has served as the Chief Financial Officer of our general partner since August 2006 and serves as Chief Financial Officer and Treasurer of UDF IV. From 1996 to 2003, she was a self-employed consultant, assisting clients, including Fortune 500 companies, in creating and maintaining financial accounting systems. She served as Controller for Value-Added Communications, Inc., a Nasdaq-listed telecommunications company that provided communications systems for the hotel and prison industries. From 1990 to 1993, she was employed with Arthur Andersen LLP, an international accounting and consulting firm. She graduated from Texas Tech University in 1990 with a Bachelor of Arts degree in accounting.
No Audit Committee; No “Audit Committee Financial Expert”
We do not have a board of directors and, as such, have no board committees such as an audit committee. Because we do not have an audit committee, we do not have an “audit committee financial expert.” Our general partner is responsible for managing the relationship with our Independent Registered Public Accounting Firm.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires each director, officer, and individual beneficially owning more than 10% of a registered security of the Partnership to file with the Securities and Exchange Commission, within specified time frames, initial statements of beneficial ownership (Form 3) and statements of changes in beneficial ownership (Forms 4 and 5) of limited partnership units of the Partnership. These specified time frames require the reporting of changes in ownership within two business days of the transaction giving rise to the reporting obligation. Reporting persons are required to furnish us with copies of all Section 16(a) forms filed with the Securities and Exchange Commission. Based upon our review of the reports furnished to us pursuant to Section 16(a) of the Exchange Act, to the best of our knowledge, all required Section 16(a) filings were timely and correctly made by reporting persons during 2008.
Code of Conduct
Land Development, our general partner, has adopted a Code of Business Conduct that is applicable to all of its officers, key personnel and employees. You may obtain a copy of this document, free of charge, by mailing a written request to: United Development Funding III, L.P., Investor Relations, 1301 Municipal Way, Suite 100, Grapevine, Texas 76051.
Item 11.
Item 11. Executive Compensation.
We operate under the direction of our general partner, which is responsible for the management and control of our affairs. The employees of UMTH General Services, L.P., an affiliated entity, assist our general partner. The employees of UMTH General Services, L.P. do not devote all of their time to managing us, and they do not receive any direct compensation from us for their services. Accordingly, we do not have, and our general partner has not considered, a compensation policy or program for itself, its affiliates, any employees of our general partner or any employees of affiliates of our general partner, and we have not included a Compensation Discussion and Analysis in this Annual Report on Form 10-K. We pay fees to our general partner and its other affiliates. See Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Use of Proceeds from Registered Securities” and Item 13, “Certain Relationships and Related Transactions, and Director Independence” for a description of the fees payable and expenses reimbursed to our affiliates.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
There are no limited partners known by us who beneficially owned more than 5% of our limited partnership units as of March 24, 2009.
We do not have any officers or directors. Our general partner owns all of the general partnership interest. We do not maintain any equity compensation plans, and no arrangements exist that would, upon operation, result in a change in control for us.
The following table sets forth information as of December 31, 2008 regarding the beneficial ownership of our limited partnership interest and general partnership interest by each person known by us to own 5% or more of the outstanding class of partnership interest, each director of our general partner, each executive officer of our general partner, and the directors and executive officers of our general partner and our general partner, as a group. The percentage of beneficial ownership is calculated based on 15,019,292 limited partnership units and contributions from our general partner.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Transactions with Related Persons
Our general partner and certain of its affiliates are paid compensation and fees for services relating to the Offering and the investment and management of our assets.
Our general partner receives 1.5% of the gross offering proceeds (excluding proceeds from our DRIP) for reimbursement of organization and offering expenses. As of December 31, 2008 and 2007, we had paid approximately $2.8 million and $1.4 million, respectively, to our general partner pursuant to such reimbursement, and our general partner has incurred on our behalf approximately $612,000 and $2.6 million, respectively, of expenses relating to the Offering for which it has not received reimbursement.
In addition, we reimburse our general partner up to 0.5% of the gross offering proceeds for bona fide due diligence expenses incurred by unaffiliated selling group members and paid by us through our general partner (except that no such due diligence expenses shall be paid with respect to sales under our DRIP). As of December 31, 2008 and 2007, approximately $930,000 and $477,000, respectively, was paid to our general partner for reimbursement of bona fide due diligence expenses incurred by unaffiliated selling group members. Our general partner or its affiliates determine the amount of expenses owed for organization and offering expenses and bona fide due diligence expenses.
We pay wholesaling fees of up to 1.2% of our gross offering proceeds (excluding proceeds from sales under our DRIP) to IMS Securities, Inc., an unaffiliated third party. From such amount, IMS Securities, Inc. re-allows up to 1% of our gross offering proceeds to wholesalers that are employed by an affiliate of our general partner. We reimburse our general partner for such wholesaling fees paid by our general partner on our behalf. Approximately $257,000 and $213,000 were paid to our general partner as of December 31, 2008 and 2007, respectively, in respect of such wholesaling fees.
UMTH Funding Services, L.P., an affiliate of our general partner, receives 0.8% of the gross offering proceeds (excluding proceeds from sales under our DRIP) as a marketing support fee for marketing and promotional services provided to selling group members. As of December 31, 2008 and 2007, approximately $2.3 million and $1.2 million, respectively, was paid pursuant to such marketing support fee.
Our general partner also is paid 3% of the net amount available for investment in mortgages for fees and expenses associated with the selection and origination of mortgages, including, but not limited to, legal fees and expenses, travel and communications expenses, costs of appraisals, accounting fees and expenses, and title insurance funded by us. As of December 31, 2008 and 2007, Land Development was paid approximately $5.1 million and $2.9 million, respectively, for acquisition and origination expenses.
Our general partner currently receives a promotional interest equal to 10% of cash available for distribution prior to the return to the limited partners of all of their capital contributions plus an 8% annual cumulative (non-compounded) return on their net capital contributions. As of December 31, 2008 and 2007, our general partner was paid approximately $1.8 million and $590,000, respectively, for its unsubordinated promotional interest. After the limited partners receive a return of their net capital contributions and an 8% annual cumulative (non-compounded) return on their net capital contributions, the general partner will receive a subordinated promotional interest of 15% of remaining cash available for distribution (including net proceeds from a capital transaction or pro rata portion thereof).
Our general partner receives a carried interest, which is an equity interest in UDF III to participate in all distributions, other than distributions attributable to our general partner’s promotional interest of cash available for distribution and net proceeds from a capital transaction. If our general partner enters into commitments to investments in mortgages in excess of 82% of the gross offering proceeds, our general partner will be entitled to a carried interest equal to (a) 1% for the first 2.5% of commitments to investments in mortgages above 82% of the gross offering proceeds (or if commitments to investments in mortgages are above 82% but no more than 84.5%, 1% multiplied by the fractional amount of commitments to investments in mortgages above 82%), (b) 1% for the next 2% of additional commitments to investments in mortgages above 84.5% of the gross offering proceeds (or if commitments to investments in mortgages are above 84.5% but no more than 86.5%, 1% multiplied by the fractional amount of commitments to investments in mortgages above 84.5%) and (c) 1% for each additional 1% of additional commitments to investments in mortgages above 86.5% of the gross offering proceeds (or a fractional percentage equal to the fractional amount of any 1% of additional commitments to investments in mortgages). As of December 31, 2008 and 2007, our general partner was paid approximately $267,000 and $87,000, respectively, for its carried interest.
For services rendered in connection with the servicing of our loans, we pay a monthly mortgage servicing fee to our general partner equal to one-twelfth of 0.25% of our aggregate outstanding development mortgage notes receivable balance as of the last day of the month. As of December 31, 2008 and 2007, Land Development was paid approximately $414,000 and $140,000, respectively, in mortgage servicing fees.
We are dependent on our general partner and certain of its affiliates for certain services that are essential to us, including identifying prospective loans, evaluating, underwriting and negotiating the acquisition and disposal of loans and overseeing the performance of our loans. In the event that these companies were unable to provide the respective services to us, we would be required to obtain such services from other sources.
In October 2006, we entered into the UDF III Guarantee effective as of September 1, 2006 for the benefit of UMT, or its permitted successors and assigns, and entered into the UDF III Credit Enhancement Fee Agreement with UDF I with respect to a credit enhancement fee related to the UDF III Guarantee. Pursuant to the UDF III Guarantee, the Partnership guaranteed the repayment of an amount up to $30 million with respect to that certain Second Amended and Restated Secured Line of Credit Promissory Note between UMT and UDF I. In exchange for that guarantee, and pursuant to the UDF III Credit Enhancement Fee Agreement, UDF I paid UDF III each month in arrears an amount equal to 0.25% of the maximum liability amount, which is included in credit enhancement fees - related party income. As of December 31, 2007, the exposure under the UDF III Guarantee was approximately $15.9 million. In April 2008, UDF I negotiated the release of the UDF III Guarantee. This limited guaranty was terminated and our contingent repayment obligation relieved effective January 1, 2008.
In January 2007, we originated a secured promissory note to OU Land Acquisition II, L.P., a Texas limited partnership of which UDF I has a 50% partner interest, in the principal amount of approximately $1.6 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bears interest at a rate of 15% per annum, is collateralized by a second lien deed of trust on approximately 101 acres of land located in Texas and is payable on June 14, 2010. As of December 31, 2008 and 2007, we had recognized approximately $246,000 and $201,000, respectively, of interest income related to this note.
In September 2007, we originated a secured promissory note to UDF PM, LLC, a Texas limited liability company and wholly-owned subsidiary of UDF I, in the principal amount of approximately $6.4 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bears an interest rate of 15% per annum, is collateralized by a second lien deed of trust on approximately 335 finished lots and 15 acres of land located in Texas and is payable on September 4, 2010. As of December 31, 2008 and 2007, we had recognized approximately $699,000 and $290,000, respectively, of interest income related to this note, of which approximately $42,000 is included in accrued interest receivable - related party as of December 31, 2008, and no amount is included in accrued interest receivable - related party as of December 31, 2007.
In November 2007, we originated a secured promissory note to United Development Funding X, L.P. (“UDF X”) a Delaware limited partnership and wholly-owned subsidiary of our general partner, in the principal amount of approximately $70 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. In August 2008, we amended this revolving credit facility to reduce the commitment amount to $25 million. The secured promissory note, which bears an interest rate of 15% per annum, is collateralized by a pledge of 100% of the ownership interests in UDF X and is payable on November 11, 2012. As of December 31, 2008 and 2007, we had recognized approximately $2.4 million and $98,000, respectively of interest income related to this note, of which approximately $81,000 and $3,000 is included in accrued interest receivable - related party.
In December 2007, we originated a secured promissory note to UDF Northpointe, LLC, a Texas limited liability company and wholly-owned subsidiary of UDF I, in the principal amount of approximately $6 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bears an interest rate of 12% per annum, is collateralized by a second lien deed of trust on 255 finished lots and 110 acres of land in Texas and is payable on December 28, 2010. As of December 31, 2008 and 2007, we had recognized approximately $629,000 and $1,600, respectively, of interest income related to this note. In December 2008, UDF Northpointe, LLC was purchased by an unrelated third party, who thus, assumed the secured promissory note.
In May 2008, a secured promissory note originated in March 2007 to Buffington JV Fund II, Ltd. (“Buff JV”), a Texas limited partnership of which UDF I has a 50% partner interest, in the principal amount of approximately $5.3 million was paid in full. In connection with the origination therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bore an interest rate of 13% per annum and was to be payable on June 30, 2009, was collateralized by a pledge of the 1% ownership interests from Buffington JV Fund Management, LLC, a Texas limited liability company and the general partner of Buff JV, and a pledge of the 49% ownership interests from Buffington Asset Group, Ltd., a Texas limited partnership and a limited partner of Buff JV. As of December 31, 2008 and 2007, we had recognized approximately $473,000 and $451,000, respectively, of interest income related to this note.
In August 2008, we originated a secured revolving line of credit to UDF LOF, in the principal amount of up to $25 million, pursuant to a Secured Line of Credit Promissory Note (the “UDF LOF Note”). Land Development is the asset manager for, and an affiliate of, UDF LOF. The UDF LOF Note, which bears interest at a base rate equal to 15% per annum, is secured by a lien of all of UDF LOF’s existing and future acquired assets and is payable on August 20, 2011. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the UDF LOF Note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. As of December 31, 2008, we had recognized approximately $178,000 of interest income related to this note, of which approximately $7,000 is included in accrued interest receivable - related party as of December 31, 2008.
In August 2008, we originated a secured promissory note with Buffington Capital Homes, Ltd., a Texas limited partnership (“Buffington Capital”), in the principal amount of $2.5 million. Land Development has a minority partner interest in Buffington Capital. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the Buffington Capital note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. The secured note, which bears interest at 14% per annum, is secured by a first lien on finished lot inventory that is owned and controlled by Buffington Capital. Buffington Capital’s payment and performance is guaranteed by Buffington Land, Ltd., a Texas limited partnership, and is payable on August 12, 2010. As of December 31, 2008, we had recognized approximately $104,000 of interest income related to this note, of which approximately $40,000 is included in accrued interest receivable - related party as of December 31, 2008.
In August 2008, we originated a secured promissory note with Buffington Texas Classic Homes, Ltd., a Texas limited partnership (“Buffington Classic”), in the principal amount of $2 million. Land Development has a minority partner interest in Buffington Classic. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the Buffington Classic note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. The secured note, which bears interest at 14% per annum, is secured by a first lien on finished lot inventory that is owned and controlled by Buffington Classic. Buffington Classic’s payment and performance is guaranteed by Buffington Land, Ltd., a Texas limited partnership, and is payable on August 21, 2010. As of December 31, 2008, we had recognized approximately $29,000 of interest income related to this note, of which approximately $5,000 is included in accrued interest receivable - related party as of December 31, 2008.
In August 2008, we originated a secured line of credit to UDF I in the principal amount of up to $45 million pursuant to a Secured Line of Credit Promissory Note (the “UDF Note”). In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the UDF Note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. We agreed in principal to subordinate the UDF Note to a loan from UDF I’s senior lender. We entered into an intercreditor agreement with UMT, another lender that has made a $45 million line of credit loan to UDF I. The UMT and UDF III liens, and the priority of payment from UDF I to UMT and UDF III, respectively, are of equal rank and priority. The UMT loan is subordinate to the loan from UDF I’s senior lender. The UDF Note, which bears interest at 14% per annum, is collateralized by a lien against all of UDF I’s existing and future acquired assets, including the loans and investments owned by UDF I, pursuant to a security agreement executed by UDF I in favor of the Partnership (the “UDF Security Agreement”) and is payable on December 31, 2009. As of December 31, 2008, we had recognized approximately $13,000 of interest income related to this note. The UDF Note was terminated effective September 19, 2008 in order to allow us to enter into the Economic Interest Participation Agreement discussed below.
In September 2008, we originated an additional secured promissory note with Buffington Classic, in the principal amount of approximately $290,000. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the Buffington Classic note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. We provided a letter of credit on behalf of Buffington Classic in the amount of approximately $290,000. If the letter of credit is drawn upon, then an amount equal to the drawn amount will be automatically advanced under the secured promissory note. The secured note bears interest at 14% per annum and represents a 12-month note period with two 12-month renewal options. As of December 31, 2008, no amount had been drawn upon this note; thus, no interest income had been recognized during 2008.
In September 2008, we entered into an Economic Interest Participation Agreement with UMT pursuant to which UDF III purchased (i) an economic interest in a $45 million revolving credit facility (the “UMT Loan”) from UMT to UDF I and (ii) a purchase option to acquire a full ownership participation interest in the UMT Loan (the “Option”). The UMT Loan is a $45 million revolving line of credit facility evidenced by a Second Amended and Restated Secured Line of Credit Promissory Note dated as of June 20, 2006, as modified by an amendment effective September 1, 2006 (as amended, the “UMT Note”). The UMT Loan is secured by a security interest in the assets of UDF I including UDF I’s land development loans and equity investments pursuant to the First Amended and Restated Security Agreement dated as of September 30, 2004, executed by UDF I in favor of UMT (the “Security Agreement”).
Pursuant to the Economic Interest Participation Agreement, each time UDF I requests an advance of principal under the UMT Note, we will fund the required amount to UMT and our economic interest in the UMT Loan increases proportionately. Our economic interest in the UMT Loan gives us the right to receive payment from UMT of principal and accrued interest relating to amounts funded by us to UMT which are applied towards UMT’s funding obligations to UDF I under the UMT Loan. We may abate our funding obligations under the Economic Interest Participation Agreement at any time for a period of up to twelve months by giving UMT notice of the abatement.
The Option gives us the right to convert our economic interest into a full ownership participation interest in the UMT Loan at any time by giving written notice to UMT and paying an exercise price of $100. The participation interest includes all rights incidental to ownership of the UMT Note and the Security Agreement, including participation in the management and control of the UMT Loan. UMT will continue to manage and control the UMT Loan while we own an economic interest in the UMT Loan. If we exercise our Option and acquire a participation interest in the UMT Loan, UMT will serve as the loan administrator but both UMT and us will participate in the control and management of the UMT Loan. The UMT Note matures on December 31, 2009. The purpose of the UMT Loan is to finance UDF I’s investments in real estate development projects. The UMT Loan interest rate is the lower of 14% or the highest rate allowed by law. UDF I may use the UMT Loan proceeds to finance indebtedness associated with the acquisition of any assets and to seek income that qualifies under the Real Estate Investment Trust provisions of the Internal Revenue Code to the extent such indebtedness, including indebtedness financed by funds advanced under the UMT Loan and indebtedness financed by funds advanced from any other source, including senior debt, is no less than 68% of the appraised value of all subordinate loans and equity interests for land development and/or land acquisition owned by UDF I and 75% for first lien secured loans for land development and/or acquisitions owned by UDF I. As of December 31, 2008, we had recognized approximately $1.2 million of interest income related to this note, of which approximately $508,000 is included in accrued interest receivable - related party.
The UMT Loan is subordinate to UDF I’s senior debt, which includes a line of credit provided by Textron Financial Corporation in the amount of $30 million, and all other indebtedness of UDF I to any national or state chartered banking association or other institutional lender that is approved by UMT in writing. As of December 31, 2008, approximately $38.3 million of the Economic Interest Participation Agreement is included in participation interest - related party.
Effective December 2008, the Partnership modified a secured promissory note in the principal amount of approximately $8.1 million that it had originated with UDF I in December 2006 in the principal amount of approximately $6.9 million. In connection with the origination of the promissory note, and as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. UDF I’s obligations under the note are secured by a first lien deed of trust filed on 190 developed single-family home lots located in Thornton, Colorado. The note bears interest at a base rate equal to 12% per annum and interest payments are due monthly. The note matures on June 30, 2009. As of December 31, 2008 and 2007, UDF III had recognized $890,000 and $750,000, respectively, of interest income related to this note, of which approximately $628,000 is included in accrued interest receivable - related party as of December 31, 2007, and no amount is included in accrued interest receivable - related party as of December 31, 2008.
Policies and Procedures for Transactions with Related Persons
The agreements and arrangements among us, our general partner and its affiliates have been established by our general partner, and our general partner believes the amounts to be paid thereunder to be reasonable and customary under the circumstances. In an effort to establish standards for minimizing and resolving these potential conflicts, our general partner has agreed to the guidelines and limitations set forth in our Partnership Agreement. Among other things, these provisions:
·
set forth the specific conditions under which we may own mortgages jointly or in a partnership with an affiliate of the general partner;
·
prohibit us from purchasing mortgages or leasing investment properties from our general partner or its affiliates except under certain limited circumstances;
·
prohibit the commingling of partnership funds (except in the case of making capital contributions to joint ventures and to the limited extent permissible under the NASAA Mortgage Program Guidelines); and
·
require us to obtain an independent appraisal of the property securing each mortgage loan that we purchase.
In addition, our general partner has a fiduciary obligation to act in the best interests of both our limited partners and the investors in other affiliated programs and will use its best efforts to assure that we will be treated at least as favorably as any other affiliated program.
Item 14.
Item 14. Principal Accountant Fees and Services.
Because we do not have a board of directors or any board committees, including an audit committee, our general partner pre-approves all auditing and permissible non-auditing services provided by our independent registered public accounting firm. The independent public accountants may not be retained to perform the non-auditing services specified in Section 10A(g) of the Exchange Act.
Fees Paid to Independent Registered Public Accounting Firm
The following table presents fees for professional audit services rendered by Whitley Penn LLP for the audit of our annual financial statements for the years ended December 31, and 2007 and fees billed for other services rendered by our independent public registered accounting firm during that period:
___________
(1)
Audit fees consisted of professional services performed in connection with the audit of our financial statements and review of our financial statements included in our Forms 10-Q, our Form 10-K and our Registration Statement on Form S-11.
(2)
Fees related to consultations concerning financial accounting and reporting standards.
(3)
Tax fees consisted principally of assistance with matters relating to tax preparation and tax advice.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)
List of Documents Filed.
1.
Financial Statements.
The list of the financial statements filed as part of this Annual Report on Form 10-K is set forth on page herein.
2.
Financial Statement Schedules.
None.
3.
Exhibits.
The list of exhibits filed as part of this Annual Report on Form 10-K is submitted in the Exhibit Index following the financial statements in response to Item 601 of Regulation S-K.
(b)
Exhibits.
The exhibits filed in response to Item 601 of Regulation S-K are listed in the Exhibit Index attached hereto.
(c)
Financial Statement Schedules.
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
United Development Funding III, L.P.
March 31, 2009 By: /s/ Hollis M. Greenlaw
Hollis M. Greenlaw
President and Chief Executive Officer of UMTH Land Development, L.P., sole general partner of the Registrant and President and Chief Executive Officer of UMT Services, Inc., sole general partner of UMTH Land Development, L.P.
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.
March 31, 2009 By: /s/ Hollis M. Greenlaw
Hollis M. Greenlaw
President and Chief Executive Officer of UMTH Land Development, L.P., sole general partner of the Registrant and President and Chief Executive Officer of UMT Services, Inc., sole general partner of UMTH Land Development, L.P.
(Principal Executive Officer)
March 31, 2009 By: /s/ Cara D. Obert
Cara D. Obert
Chief Financial Officer of UMTH Land Development, L.P., sole general partner of the Registrant
(Principal Financial Officer and Principal Accounting Officer)
March 31, 2009 By: /s/ Theodore F. Etter
Theodore F. Etter
Chairman of the Board of UMT Services, Inc., sole general partner of UMTH Land Development, L.P., sole general partner of the Registrant
Report of Independent Registered Public Accounting Firm
Audited Financial Statements:
Balance Sheets
Statements of Operations
Statements of Changes in Partners’ Capital
Statements of Cash Flows
Notes to Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Partners of
United Development Funding III, L.P.
We have audited the accompanying balance sheets of United Development Funding III, L.P. (the “Partnership”) as of December 31, 2008 and 2007 and the related statements of operations, changes in partners’ capital and cash flows for the years ended December 31, 2008, 2007 and 2006. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Partnership is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of United Development Funding III, L.P. as of December 31, 2008 and 2007 and the results of its operations and its cash flows for the years ended December 31, 2008, 2007 and 2006 in conformity with accounting principles generally accepted in the United States of America.
/s/ Whitley Penn LLP
Dallas, Texas
March 31,
UNITED DEVELOPMENT FUNDING III, L.P.
BALANCE SHEETS
See accompanying notes to financial statements.
UNITED DEVELOPMENT FUNDING III, L.P.
STATEMENTS OF OPERATIONS
See accompanying notes to financial statements.
See accompanying notes to financial statements.
UNITED DEVELOPMENT FUNDING III, L.P.
STATEMENTS OF CASH FLOWS
See accompanying notes to financial statements.
UNITED DEVELOPMENT FUNDING III, L.P.
NOTES TO FINANCIAL STATEMENTS
December 31, 2008 and 2007
A. Nature of Business
United Development Funding III, L.P. (which may be referred to as the “Partnership,” “we,” “us,” “our” or “UDF III”) was organized on June 13, 2005 as a Delaware limited partnership. Our principal business purpose is to originate, acquire, service, and otherwise manage, either alone or in association with others, a diversified portfolio of mortgage loans that are secured by real property or equity interests in entities that hold real property already subject to other mortgages (including mortgage loans that are not first in priority and participation interests in mortgage loans) and participation interests in mortgage loans, and to issue or acquire an interest in credit enhancements to borrowers, such as guaranties or letters of credit. Our offices are located in Grapevine, Texas.
Our general partner is UMTH Land Development, L.P., a Delaware limited partnership (“Land Development”) that is responsible for our overall management, conduct, and operation. Our general partner has authority to act on our behalf in all matters respecting us, our business and our property. Our limited partners shall take no part in the management of our business or transact any business for us and shall have no power to sign for or bind us; provided, however, that the limited partners, by a majority vote and without the concurrence of the general partner, have the right to: (a) amend the Agreement of Limited Partnership, as amended (the “Partnership Agreement”), governing the Partnership, (b) dissolve the Partnership, (c) remove the general partner or any successor general partner, (d) elect a new general partner, and (e) approve or disapprove a transaction entailing the sale of all or substantially all of the real properties acquired by the Partnership.
B. Summary of Significant Accounting Policies
A summary of our significant accounting policies consistently applied in the preparation of the accompanying financial statements follows:
Basis of Accounting
The accounts are maintained and the financial statements have been prepared using the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts in the financial statements and accompanying notes. Actual results could differ from these estimates and assumptions.
Cash and Cash Equivalents
We consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. At December 31, 2008 and 2007, there were no such amounts included in cash and cash equivalents.
Restricted Cash
Restricted cash includes monies held in escrow with respect to subscriptions for limited partnership units.
Mortgage Notes Receivable and Mortgage Notes Receivable - Related Party
Mortgage notes receivable and mortgage notes receivable - related party are recorded at the lower of cost or estimated net realizable value. The mortgage investments are collateralized by land and related improvements to residential property owned by the borrowers and/or ownership interests of the borrower. Currently, mortgage notes receivable have terms ranging from two to 51 months. None of such mortgages are insured or guarantied by a federally owned or guarantied mortgage agency. We originate and/or acquire all mortgage notes receivable and intend to hold the mortgage notes receivable for the life of the notes.
Participation Interest - Related Party
Participation interest - related party represents an Economic Interest Participation Agreement with UMT, pursuant to which we purchased (i) an economic interest in a $45 million revolving credit facility from UMT to UDF I and (ii) a purchase option to acquire a full ownership participation interest in the revolving credit facility from UMT to UDF I. See Note K, “Related Party Transactions” for further details.
Allowance for Loan Losses
The allowance for loan losses is our estimate of incurred losses in our portfolio of mortgage notes receivable, mortgage notes receivable - related party and profit participation - related party. We periodically perform a detailed review of our portfolio of mortgage notes and other loans to determine if impairment has occurred and to assess the adequacy of the allowance for loan losses. We charge additions to the allowance for loan losses to current period earnings through a provision for loan losses. Amounts determined to be uncollectible are charged directly against (and decrease) the allowance for loan losses (“charged off”), while amounts recovered on previously charged off accounts increase the allowance. The following table summarizes the changes in the reserve for loan losses during the years ended December 31, 2008 and 2007:
Revenue Recognition
Interest income on mortgage notes receivable and profit participation interest - related party is recognized over the life of the loan and recorded on the accrual basis. Income recognition is suspended for loans at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. As of December 31, 2008 and 2007, we were accruing interest on all mortgage notes receivable.
Credit enhancement fee - related party income is generated by a limited guaranty on behalf of an affiliate. Such income is recognized on a monthly basis as collectability is deemed probable. As of December 31, 2007, we were recognizing all credit enhancement fee income on our limited guaranty. In April 2008, UDF I negotiated the release of the limited guaranty. The limited guaranty was terminated and our contingent repayment obligation relieved effective January 1, 2008, which is further discussed in Note I.
We generate mortgage and transaction service revenues by originating and acquiring mortgage notes receivable and other loans. In accordance with Statement of Financial Accounting Standards (“SFAS”) 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, we defer recognition of income from nonrefundable commitment fees paid by the borrowers and recognize such amount on a straight-line basis over the expected life of such notes. The Partnership also expenses a 3% acquisition and origination fee (“placement fee”) paid to the general partner to provide for processing and origination costs associated with mortgage notes receivable or profit participation interest held by the Partnership on a straight-line basis over the expected life of such notes. As of December 31, 2008 and 2007, approximately $2.5 million and $346,000, respectively, of such net deferred fees have been offset against mortgage notes receivable. Approximately $188,000 and $291,000 of net deferred fees have been offset against mortgage notes receivable - related party as of December 31, 2008 and 2007, respectively. As of December 31, 2008, approximately $937,000 of net deferred fees have been offset against profit participation - related party, which was entered into in September 2008. Accordingly, there were no offsets to profit participation - related party during 2007. See Note K, “Related Party Transactions” for further details.
Organization Costs and Offering Costs
In accordance with Statement of Position 98-5, Reporting on the Costs of Start-up Activities, the Partnership expenses organization costs as incurred. Offering costs related to raising capital from debt will be capitalized and amortized over the term of such debt. Offering costs related to raising capital from equity will be offset as a reduction of capital raised in partners’ capital. Certain offering costs are currently being paid by the general partner. As noted in Note K, these costs will be reimbursed to our general partner by the Partnership.
Cash Flow Distributions
Cash available for distributions represents the funds received by the Partnership from operations (other than proceeds from a capital transaction or a liquidating distribution), less cash used by the Partnership to pay our expenses, debt payments, and amounts set aside to create a retained earnings reserve (currently at 9.5% of net income; the retained earnings reserve is intended to recover some of the organization and offering expenses incurred in connection with our Registration Statement on Form S-11, covering a public offering of our units of limited partnership interest (the “Offering”)). Our general partner receives a monthly distribution for promotional and carried interest (see Note G) from the cash available for distributions. Monthly distributions are currently paid to the limited partners at a 9.75% annualized return on a pro rata basis based on the number of days the limited partner has been invested in the Partnership. Retained earnings would contain a surplus if the cash available for distributions less the 9.5% reserve exceeded the monthly distribution to the general partner and limited partners. Retained earnings would contain a deficit if cash available for distributions less the 9.5% reserve is less than the monthly distribution to the general partner and limited partners. It is the intent of management to monitor and distribute any surplus on an annual basis. As of December 31, 2008, a deficit of retained earnings of $2.2 million is included in the limited partners’ capital account. As of December 31, 2007, a surplus of retained earnings of $188,600 is included in the limited partners’ capital account.
Income Taxes
The Partnership is organized as a limited partnership for federal income tax purposes. As a result, income or losses are taxable or deductible to the partners rather than at the partnership level; accordingly, no provision has been made for federal income taxes in the accompanying financial statements.
Fair Value of Financial Instruments
In accordance with the reporting requirements of SFAS No. 107, Disclosures About Fair Value of Financial Instruments, we calculate the fair value of our assets and liabilities which qualify as financial instruments under this statement and include this additional information in the notes to the financial statements when the fair value is different than the carrying value of those financial instruments. The estimated fair value of cash equivalents, restricted cash, accrued interest receivable, accounts payable, accrued liabilities, and line-of-credit approximates the carrying amounts due to the relatively short maturity of these instruments. The estimated fair value of mortgage notes receivable approximates the carrying amount since they bear interest at the market rate.
Impact of Recently Issued Accounting Standards
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a market-based framework or hierarchy for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures; however the application of this statement may change current practice. The requirements of SFAS 157 are first effective for us for the fiscal year beginning January 1, 2008. However, in February 2008, the FASB issued FASB Staff Position (“FSP”) 157-2, Effective Date of FASB Statement No. 157 (“FSP 157-2”). FSP 157-2 delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter 2009. Accordingly, the Partnership’s adoption of this standard on January 1, 2008 is limited to financial assets and liabilities. The Partnership’s adoption of SFAS 157 has not had a material impact on the Partnership’s financial condition or results of operations. However, the Partnership is still in the process of evaluating this standard with respect to its effect on nonfinancial assets and liabilities and therefore has not yet determined the impact that it will have on the Partnership’s financial statements upon full adoption.
In October 2008, the FASB issued FSP 157-3, Determining the Fair Value of a Financial Asset When the Market for that Asset Is Not Active (“FSP 157-3”). FSP 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for the financial asset is not active. FSP 157-3 was effective upon issuance, including prior periods for which financial statements have not been issued. The adoption of FSP 157-3 has not had a material impact on the Company’s financial position or results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 (“SFAS 159”). The fair value option permits entities to choose to measure eligible financial instruments at fair value at specified election dates. The entity will report unrealized gains and losses on the items on which it has elected the fair value option in earnings. The Partnership’s adoption of SFAS 159 has not had a material impact on the Partnership’s results of operations or financial condition.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS 141R”), and SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS 160”). SFAS 141R modifies the accounting and disclosure requirements for business combinations and broadens the scope of the previous standard to apply to all transactions in which one entity obtains control over another business. SFAS 160 establishes new accounting and reporting standards for non-controlling interests in subsidiaries. The Partnership will be required to apply the provisions of the new standards in the first quarter of 2009. Early adoption is not permitted for these new standards. The Partnership is in the process of evaluating the effect that SFAS 141R and SFAS 160 will have on the Partnership.
Reclassifications
Certain prior year amounts have been reclassified to conform to current year presentation.
C. Registration Statement
On May 15, 2006, the Offering was declared effective under the Securities Act of 1933, as amended. The Offering, at the time of such effectiveness, covered up to 12,500,000 units of limited partnership interest at a price of $20 per unit and up to 5,000,000 units of limited partnership interest to be issued pursuant to our distribution reinvestment plan (the “DRIP”) for $20 per unit. We have the right to reallocate the units of limited partnership interest we are offering between the primary offering and our DRIP, and pursuant to Supplement No. 8 to our prospectus regarding the Offering, which was filed with the Securities and Exchange Commission on September 4, 2008, we reallocated the units being offered such that 16,250,000 units are being offered pursuant to the primary offering and 1,250,000 units are being offered pursuant to the DRIP. On July 3, 2006, our initial public subscribers were accepted as limited partners and the subscription proceeds from such initial public subscribers were released to us. As of December 31, 2008, we had issued an aggregate of 15,019,292 units of limited partnership interest in the Offering, consisting of 14,739,257 units that have been issued to our limited partners in exchange for gross proceeds of approximately $294.9 million (approximately $259.6 million, net of costs associated with the Offering) and another 415,660 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $8.3 million, minus 135,625 units of limited partnership interest that have been repurchased pursuant to our unit redemption program for approximately $2.7 million. As of December 31, 2007, we had issued an aggregate of 5,509,316 units of limited partnership interest in the Offering, consisting of 5,429,702 units that have been issued to our limited partners in exchange for gross proceeds of approximately $108.6 million (approximately $95.6 million, net of costs associated with the Offering) and another 79,614 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $1.6 million. No units of limited partnership interest were repurchased as of December 31, 2007.
D. Line-of-Credit
On December 29, 2008, a revolving credit facility (the “Revolving Credit Facility”) that we had entered into in December 2006, with Premier Bank, a Missouri banking association d/b/a Premier Bank of Texas, which permitted us to borrow up to an aggregate outstanding principal amount of $10 million, was terminated. The terminated Revolving Credit Facility was secured by a first priority lien upon all of our existing and future acquired assets. In consideration for the origination of the terminated Revolving Credit Facility, we paid an origination fee in the amount of approximately $113,000, which was amortized over the two-year term of the terminated Revolving Credit Facility. The annual interest rate on the terminated Revolving Credit Facility was equal to the prime rate of interest as quoted in the Wall Street Journal (3.25% at December 29, 2008 and 7.25% at December 31, 2007). As of December 31, 2007, we had approximately $99.1 million in aggregate partners’ equity pursuant to the terminated Revolving Credit Facility.
We utilized the terminated Revolving Credit Facility as transitory indebtedness to provide liquidity and to reduce and avoid the need for large idle cash reserves, including usage to fund identified investments pending receipt of proceeds from the sale of our units. Proceeds from the sale of our units were used to repay the terminated Revolving Credit Facility. We used the terminated Revolving Credit Facility as a portfolio administration tool and not to provide long-term or permanent leverage on our investments. As of December 31, 2007, approximately $2.3 million was outstanding on the terminated Revolving Credit Facility. No balance was outstanding at the time of termination of the Revolving credit facility. Interest expense related to the terminated Revolving Credit Facility was approximately $1,500 and $256,500 for the years ended December 31, 2008 and 2007, respectively.
E. Partners’ Capital
As of December 31, 2008, we had issued an aggregate of 15,019,292 units of limited partnership interest in the Offering, consisting of 14,739,257 units that have been issued to our limited partners in exchange for gross proceeds of approximately $294.9 million (approximately $259.6 million, net of costs associated with the Offering), another 415,660 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $8.3 million, less 135,625 units of limited partnership interest that have been repurchased pursuant to our unit redemption program for approximately $2.7 million. In addition to the monthly DRIP distributions, we also distributed approximately $11.4 million in cash during 2008, for aggregate monthly distributions of approximately $23.1 million. As of December 31, 2007, we had issued an aggregate of 5,509,316 units of limited partnership interest in the Offering, consisting of 5,429,702 units that have been issued to our limited partners in exchange for gross proceeds of approximately $108.6 million (approximately $95.6 million, net of costs associated with the Offering), and another 79,614 units of limited partnership interest issued to limited partners in accordance with our DRIP in exchange for gross proceeds of approximately $1.6 million. In addition to the monthly DRIP distributions, we also distributed approximately $3.3 million in cash during 2007, for total monthly distributions of approximately $5 million. Distributions to our general partner are more fully discussed in Notes G and K.
F. Offering Compensation
Various parties receive compensation as a result of the Offering, including the general partner, affiliates of the general partner and unaffiliated selling group members. See Note K for a description of the Offering reimbursements and compensation of the general partner and its affiliates. Payments to unaffiliated selling group members include selling commissions (7% of gross offering proceeds, except that commissions with respect to sales under the DRIP are reduced to 1% of gross offering proceeds), marketing support fees (up to 1% of gross offering proceeds, except that no marketing support fees are paid with respect to sales under the DRIP) and bona fide due diligence fees for expenses incurred in connection with the due diligence review of the Offering (not to exceed 0.5% of gross offering proceeds, except that no due diligence fees are paid with respect to sales under the DRIP).
G. Operational Compensation
The general partner receives acquisition and origination expenses and fees of 3% of the net amount available for investment in mortgages for fees and expenses associated with the selection and origination of mortgages, including, but not limited to, legal fees and expenses, travel and communications expenses, costs of appraisals, accounting fees and expenses, and title insurance funded by the Partnership. The general partner also receives mortgage servicing fees of 0.25% of the aggregate outstanding loan balance held by the Partnership for services rendered in connection with the servicing of Partnership loans. In addition, the general partner receives a carried interest of 1% of Cash Available for Distribution, as defined below, and net proceeds from a capital transaction (or pro rata portion thereof) if the Partnership invests more than 82% but no more than 84.5% of the gross offering proceeds in mortgage loans; an additional 1% of Cash Available for Distribution and net proceeds from a capital transaction (or pro rata portion thereof) if the Partnership invests more than 84.5% but not more than 86.5% of the gross offering proceeds in mortgage loans; and an additional 1% of Cash Available for Distribution and net proceeds from a capital transaction (or pro rata portion thereof) for each additional 1% of additional investments in mortgages above 86.5% of the gross offering proceeds. Furthermore, prior to the receipt by the limited partners of a return of their net capital contributions and an 8% annual cumulative (non-compounded) return on their net capital contributions, the general partner receives an unsubordinated promotional interest of 10% of Cash Available for Distribution. After the limited partners receive a return of their net capital contributions and an 8% annual cumulative (non-compounded) return on their net capital contributions, the general partner will receive a subordinated promotional interest of 15% of remaining Cash Available for Distribution (including net proceeds from a capital transaction or pro rata portion thereof).
Payments to affiliates of the general partner primarily consist of reimbursements for amounts incurred by UMTH Funding Services, L.P., who assists the general partner in the Partnership’s management.
Cash Available for Distribution is the cash funds received by the Partnership from operations (other than net proceeds from a capital transaction that produces proceeds from (i) the repayment of principal or prepayment of a mortgage to the extent classified as a return of capital for federal income tax purposes, (ii) the foreclosure, sale, exchange, condemnation, eminent domain taking or other disposition of a mortgage loan or of a property subject to a mortgage, or (iii) insurance or a guarantee with respect to a mortgage), including, without limitation, interest, points, revenue participations in property appreciation and interest or dividends from interim investments, less all cash used to pay Partnership expenses and debt payments and amounts set aside for reserves.
H. Unit Redemption Program
Limited partners who have held their units for at least one year may request that the Partnership repurchase their units. A limited partner wishing to have units repurchased must mail or deliver in writing a request to the Partnership indicating such desire. The purchase price of repurchased units, except as described below for redemptions upon the death of a limited partner, will be equal to (i) 92% of the purchase price actually paid for any units held less than two years, (ii) 94% of the purchase price actually paid for any units held for at least two years but less than three years, (iii) 96% of the purchase price actually paid for any units held for at least three years but less than four years, (iv) 98% of the purchase price actually paid for any units held for at least four years but less than five years, and (v) the lesser of the purchase price actually paid for any units held at least five years or the then-current fair market value of the units as determined by the most recent annual valuation of units. The purchase price for units redeemed upon the death of a limited partner will be the lesser of (i) the price the limited partner actually paid for the units or (2) $20 per unit, limited to aggregate annual redemptions not to exceed 1% of units outstanding in the preceding 12-month period.
The Partnership intends to redeem units on a monthly basis and will not redeem in excess of 5% of the weighted average number of units outstanding during the 12-month period immediately prior to the date of redemption. The general partner will determine from time to time whether the Partnership has sufficient excess cash from operations to repurchase units. Generally, the cash available for redemption will be limited to 1% of the operating cash flow from the previous fiscal year, plus any net proceeds from the DRIP. If the funds set aside for the unit redemption program are not sufficient to accommodate all requests, at such time, if any, when sufficient funds become available, pending requests will be honored among all requesting limited partners as follows: first, pro rata as to redemptions upon the death or disability of a limited partner; next, pro rata as to limited partners who demonstrate, in the discretion of the general partner, another involuntary exigent circumstance, such as bankruptcy; and, finally, pro rata as to other redemption requests.
I. Commitments and Contingencies
In October 2006, we entered into a limited guaranty effective as of September 1, 2006 for the benefit of UMT or its permitted successors and assigns (the “UDF III Guarantee”), and entered into a letter agreement with UDF I, a Delaware limited partnership and related party, with respect to a credit enhancement fee related to the UDF III Guarantee (the “UDF III Credit Enhancement Fee Agreement”). Pursuant to the UDF III Guarantee, the Partnership guaranteed the repayment of an amount up to $30 million with respect to that certain Second Amended and Restated Secured Line of Credit Promissory Note between UMT and UDF I. In exchange for that guarantee, and pursuant to the UDF III Credit Enhancement Fee Agreement, UDF I paid UDF III each month in arrears an amount equal to 0.25% of the maximum liability amount, which is included in credit enhancement fees - related party income. As of December 31, 2007, the exposure under the UDF III Guarantee was approximately $15.9 million. In April 2008, UDF I negotiated the release of the UDF III Guarantee. This limited guaranty was terminated and our contingent repayment obligation relieved effective January 1, 2008.
An affiliate of our general partner serves as the advisor to UMT. In addition, our general partner serves as the asset manager for UDF I.
The Partnership has no other outstanding debt or contingent payment obligations, other than certain loan guaranties or letters of credit that we may make to or for the benefit of third-party lenders. There are approximately $56.4 million of commitments to be funded under the terms of mortgage notes receivable as of December 31, 2008. Included in such amount is approximately $18.6 million of commitments for mortgage notes receivable - related party and $6.7 million for participation interest - related party. As of December 31, 2007, there were approximately $75.7 million of commitments to be funded under the terms of mortgage notes receivable. Included in such amount is approximately $65.8 million of commitments for mortgage notes receivable - related party.
J. General and Administrative Expenses
General and administrative expenses of the Partnership are summarized in the following chart:
K. Related Party Transactions
Our general partner and certain of its affiliates receive fees in connection with the Offering and in connection with the acquisition and management of the assets and reimbursement of costs of the Partnership.
Our general partner receives 1.5% of the gross offering proceeds (excluding proceeds from the DRIP) for reimbursement of organization and offering expenses. The Partnership has a related party payable to Land Development of approximately $612,000 and $2.6 million as of December 31, 2008 and 2007, respectively, for organization and offering costs paid by Land Development related to the Offering.
Our general partner is paid 3% of the net amount available for investment in mortgages for fees and expenses associated with the selection and origination of mortgages, including, but not limited to, legal fees and expenses, travel and communications expenses, costs of appraisals, accounting fees and expenses, and title insurance funded by the Partnership. Such costs are amortized into interest income over the life of the mortgage notes receivable.
The Partnership also reimburses its general partner up to 0.5% of the gross offering proceeds for expenses related to bona fide due diligence expenses incurred by unaffiliated selling group members and paid by the Partnership through its general partner (except that no such due diligence expenses shall be paid with respect to sales under the DRIP).
The Partnership pays wholesaling fees of up to 1.2% of the gross offering proceeds (excluding proceeds from sales under the DRIP) to IMS Securities, Inc., an unaffiliated third party. From such amount, IMS Securities, Inc. reallows up to 1% of the gross offering proceeds to wholesalers that are employed by an affiliate of the general partner. The Partnership reimburses the general partner for such wholesaling fees paid on behalf of the Partnership.
Our general partner currently receives a promotional interest equal to 10% of cash available for distribution prior to the return to the limited partners of all of their capital contributions plus an 8% annual cumulative (non-compounded) return on their net capital contributions. After the limited partners receive a return of their net capital contributions and an 8% annual cumulative (non-compounded) return on their net capital contributions, the general partner will receive a subordinated promotional interest of 15% of remaining cash available for distribution (including net proceeds from a capital transaction or pro rata portion thereof).
Our general partner receives a carried interest, which is an equity interest in the Partnership to participate in all distributions, other than distributions attributable to our general partner’s promotional interest of cash available for distribution and net proceeds from a capital transaction. If our general partner enters into commitments to investments in mortgages in excess of 82% of the gross offering proceeds, our general partner will be entitled to a carried interest equal to (a) 1% for the first 2.5% of commitments to investments in mortgages above 82% of the gross offering proceeds (or if commitments to investments in mortgages are above 82% but no more than 84.5%, 1% multiplied by the fractional amount of commitments to investments in mortgages above 82%), (b) 1% for the next 2% of additional commitments to investments in mortgages above 84.5% of the gross offering proceeds (or if commitments to investments in mortgages are above 84.5% but no more than 86.5%, 1% multiplied by the fractional amount of commitments to investments in mortgages above 84.5%) and (c) 1% for each additional 1% of additional commitments to investments in mortgages above 86.5% of the gross offering proceeds (or a fractional percentage equal to the fractional amount of any 1% of additional commitments to investments in mortgages).
For services rendered in connection with the servicing of the Partnership’s loans, the Partnership pays a monthly mortgage servicing fee to our general partner equal to one-twelfth of 0.25% of our aggregate outstanding development mortgage notes receivable balance as of the last day of the month. Such fees are included in general and administrative expenses.
UMTH Funding Services, L.P., an affiliate of our general partner, receives 0.8% of the gross offering proceeds (excluding proceeds from sales under our DRIP) as a marketing support fee for marketing and promotional services provided to selling group members. UMTH Funding Services, L.P. also is reimbursed for operating expenses incurred in assisting the general partner in the Partnership’s management.
The chart below summarizes the payment of related party fees and reimbursements associated with the Offering and origination and management of assets for the years ended December 31, 2008 and 2007:
In January 2007, we originated a secured promissory note to OU Land Acquisition II, L.P., a Texas limited partnership of which UDF I has a 50% partner interest, in the principal amount of approximately $1.6 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bears interest at a rate of 15% per annum, is collateralized by a second lien deed of trust on approximately 101 acres of land located in Texas and is payable on June 14, 2010. During 2008 and 2007, we recognized approximately $246,000 and $201,000, respectively, of interest income related to this note.
In September 2007, we originated a secured promissory note to UDF PM, LLC, a Texas limited liability company and wholly-owned subsidiary of UDF I, in the principal amount of approximately $6.4 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bears an interest rate of 15% per annum, is collateralized by a second lien deed of trust on approximately 335 finished lots and 15 acres of land located in Texas and is payable on September 4, 2010. During 2008 and 2007, we recognized approximately $699,000 and $290,000, respectively, of interest income related to this note, of which approximately $42,000 is included in accrued interest receivable - related party as of December 31, 2008, and no amount is included in accrued interest receivable - related party as of December 31, 2007.
In November 2007, we originated a secured promissory note to United Development Funding X, L.P. (“UDF X”) a Delaware limited partnership and wholly-owned subsidiary of our general partner, in the principal amount of approximately $70 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. In August 2008, we amended this revolving credit facility to reduce the commitment amount to $25 million. The secured promissory note, which bears an interest rate of 15% per annum, is collateralized by a pledge of 100% of the ownership interests in UDF X and is payable on November 11, 2012. During 2008 and 2007, we recognized approximately $2.4 million and $98,000, respectively of interest income related to this note, of which approximately $81,000 and $3,000 is included in accrued interest receivable - related party.
In December 2007, we originated a secured promissory note to UDF Northpointe, LLC, a Texas limited liability company and wholly-owned subsidiary of UDF I, in the principal amount of approximately $6 million, and in connection therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bears an interest rate of 12% per annum, is collateralized by a second lien deed of trust on 255 finished lots and 110 acres of land in Texas and is payable on December 28, 2010. During 2008 and 2007, we recognized approximately $629,000 and $1,600, respectively, of interest income related to this note. In December 2008, UDF Northpointe, LLC was purchased by an unrelated third party, who thus, assumed the secured promissory note.
In May 2008, a secured promissory note originated in March 2007 to Buffington JV Fund II, Ltd. (“Buff JV”), a Texas limited partnership of which UDF I has a 50% partner interest, in the principal amount of approximately $5.3 million was paid in full. In connection with the origination therewith as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. The secured promissory note, which bore an interest rate of 13% per annum and was to be payable on June 30, 2009, was collateralized by a pledge of the 1% ownership interests from Buffington JV Fund Management, LLC, a Texas limited liability company and the general partner of Buff JV, and a pledge of the 49% ownership interests from Buffington Asset Group, Ltd., a Texas limited partnership and a limited partner of Buff JV. During 2008 and 2007, we recognized approximately $473,000 and $451,000, respectively, of interest income related to this note.
In August 2008, we originated a secured revolving line of credit to UDF LOF, in the principal amount of up to $25 million, pursuant to a Secured Line of Credit Promissory Note (the “UDF LOF Note”). Land Development is the asset manager for, and an affiliate of, UDF LOF. The UDF LOF Note, which bears interest at a base rate equal to 15% per annum, is secured by a lien of all of UDF LOF’s existing and future acquired assets and is payable on August 20, 2011. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the UDF LOF Note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. During 2008, we recognized approximately $178,000 of interest income related to this note, of which approximately $7,000 is included in accrued interest receivable - related party as of December 31, 2008.
In August 2008, we originated a secured promissory note with Buffington Capital Homes, Ltd., a Texas limited partnership (“Buffington Capital”), in the principal amount of $2.5 million. Land Development has a minority partner interest in Buffington Capital. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the Buffington Capital note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. The secured note, which bears interest at 14% per annum, is secured by a first lien on finished lot inventory that is owned and controlled by Buffington Capital. Buffington Capital’s payment and performance is guaranteed by Buffington Land, Ltd., a Texas limited partnership, and is payable on August 12, 2010. During 2008, we recognized approximately $104,000 of interest income related to this note, of which approximately $40,000 is included in accrued interest receivable - related party as of December 31, 2008.
In August 2008, we originated a secured promissory note with Buffington Texas Classic Homes, Ltd., a Texas limited partnership (“Buffington Classic”), in the principal amount of $2 million. Land Development has a minority partner interest in Buffington Classic. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the Buffington Classic note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. The secured note, which bears interest at 14% per annum, is secured by a first lien on finished lot inventory that is owned and controlled by Buffington Classic. Buffington Classic’s payment and performance is guaranteed by Buffington Land, Ltd., a Texas limited partnership, and is payable on August 21, 2010. During 2008, we recognized approximately $29,000 of interest income related to this note, of which approximately $5,000 is included in accrued interest receivable - related party as of December 31, 2008.
In August 2008, we originated a secured line of credit to UDF I in the principal amount of up to $45 million pursuant to a Secured Line of Credit Promissory Note (the “UDF Note”). In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the UDF Note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. We agreed in principal to subordinate the UDF Note to a loan from UDF I’s senior lender. We entered into an intercreditor agreement with UMT, another lender that has made a $45 million line of credit loan to UDF I. The UMT and UDF III liens, and the priority of payment from UDF I to UMT and UDF III, respectively, are of equal rank and priority. The UMT loan is subordinate to the loan from UDF I’s senior lender. The UDF Note, which bears interest at 14% per annum, is collateralized by a lien against all of UDF I’s existing and future acquired assets, including the loans and investments owned by UDF I, pursuant to a security agreement executed by UDF I in favor of the Partnership (the “UDF Security Agreement”) and is payable on December 31, 2009. During 2008, we recognized approximately $13,000 of interest income related to this note. The UDF Note was terminated effective September 19, 2008 in order to allow us to enter into the Economic Interest Participation Agreement discussed below.
In September 2008, we originated an additional secured promissory note with Buffington Classic, in the principal amount of approximately $290,000. In connection therewith, as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the Buffington Classic note is fair and at least as reasonable to us as a transaction with an unaffiliated party in similar circumstances. We provided a letter of credit on behalf of Buffington Classic in the amount of approximately $290,000. If the letter of credit is drawn upon, then an amount equal to the drawn amount will be automatically advanced under the secured promissory note. The secured note bears interest at 14% per annum and represents a 12-month note period with two 12-month renewal options. As of December 31, 2008, no amount had been drawn upon this note; thus, no interest income had been recognized during 2008.
In September 2008, we entered into an Economic Interest Participation Agreement with UMT pursuant to which UDF III purchased (i) an economic interest in a $45 million revolving credit facility (the “UMT Loan”) from UMT to UDF I and (ii) a purchase option to acquire a full ownership participation interest in the UMT Loan (the “Option”). The UMT Loan is a $45 million revolving line of credit facility evidenced by a Second Amended and Restated Secured Line of Credit Promissory Note dated as of June 20, 2006, as modified by an amendment effective September 1, 2006 (as amended, the “UMT Note”). The UMT Loan is secured by a security interest in the assets of UDF I including UDF I’s land development loans and equity investments pursuant to the First Amended and Restated Security Agreement dated as of September 30, 2004, executed by UDF I in favor of UMT (the “Security Agreement”).
Pursuant to the Economic Interest Participation Agreement, each time UDF I requests an advance of principal under the UMT Note, we will fund the required amount to UMT and our economic interest in the UMT Loan increases proportionately. Our economic interest in the UMT Loan gives us the right to receive payment from UMT of principal and accrued interest relating to amounts funded by us to UMT which are applied towards UMT’s funding obligations to UDF I under the UMT Loan. We may abate our funding obligations under the Economic Interest Participation Agreement at any time for a period of up to twelve months by giving UMT notice of the abatement.
The Option gives us the right to convert our economic interest into a full ownership participation interest in the UMT Loan at any time by giving written notice to UMT and paying an exercise price of $100. The participation interest includes all rights incidental to ownership of the UMT Note and the Security Agreement, including participation in the management and control of the UMT Loan. UMT will continue to manage and control the UMT Loan while we own an economic interest in the UMT Loan. If we exercise our Option and acquire a participation interest in the UMT Loan, UMT will serve as the loan administrator but both UMT and us will participate in the control and management of the UMT Loan. The UMT Note matures on December 31, 2009. The purpose of the UMT Loan is to finance UDF I’s investments in real estate development projects. The UMT Loan interest rate is the lower of 14% or the highest rate allowed by law. UDF I may use the UMT Loan proceeds to finance indebtedness associated with the acquisition of any assets and to seek income that qualifies under the Real Estate Investment Trust provisions of the Internal Revenue Code to the extent such indebtedness, including indebtedness financed by funds advanced under the UMT Loan and indebtedness financed by funds advanced from any other source, including senior debt, is no less than 68% of the appraised value of all subordinate loans and equity interests for land development and/or land acquisition owned by UDF I and 75% for first lien secured loans for land development and/or acquisitions owned by UDF I. During 2008, we recognized approximately $1.2 million of interest income related to this note, of which approximately $508,000 is included in accrued interest receivable - related party.
The UMT Loan is subordinate to UDF I’s senior debt, which includes a line of credit provided by Textron Financial Corporation in the amount of $30 million, and all other indebtedness of UDF I to any national or state chartered banking association or other institutional lender that is approved by UMT in writing. As of December 31, 2008, approximately $39 million of the Economic Interest Participation Agreement is included in participation interest - related party.
As of December 31, 2007, we had recognized approximately $596,000 as credit enhancement fees - related party. As discussed in Note I, this credit enhancement was released effective January 1, 2008, and thus, no such credit enhancement fees - related party have been recognized during 2008.
Effective December 2008, the Partnership modified a secured promissory note in the principal amount of approximately $8.1 million that it had originated with UDF I in December 2006 in the principal amount of approximately $6.9 million. In connection with the origination of the promissory note, and as required by our Partnership Agreement and the NASAA Mortgage Program Guidelines, we obtained an opinion from an independent advisor stating that the loan is fair and at least as reasonable to us as a loan or credit enhancement to an unaffiliated borrower in similar circumstances. UDF I’s obligations under the note are secured by a first lien deed of trust filed on 190 developed single-family home lots located in Thornton, Colorado. The note bears interest at a base rate equal to 12% per annum and interest payments are due monthly. The note matures on June 30, 2009. During 2008 and 2007, UDF III recognized $890,000 and $750,000, respectively, of interest income related to this note, of which approximately $628,000 is included in accrued interest receivable - related party as of December 31, 2007, and no amount is included in accrued interest receivable - related party as of December 31, 2008.
An affiliate of Land Development serves as the advisor to UMT. Land Development serves as the asset manager of UDF I.
L. Concentration of Credit Risk
Financial instruments that potentially expose the Partnership to concentrations of credit risk are primarily temporary cash equivalents, mortgage notes receivable, mortgage notes receivable - related party and partnership interests - related party. The Partnership maintains deposits in financial institutions that may at times exceed amounts covered by insurance provided by the U.S. Federal Deposit Insurance Corporation (“FDIC”). The Partnership has not experienced any losses related to amounts in excess of FDIC limits.
At December 31, 2008 and 2007, 95% and 91%, respectively, of the Partnership’s mortgage investments were secured by property located in Texas. All of the Partnership’s mortgage investments are in the United States.
M. Subsequent Events
We have the right to reallocate the units of limited partnership interest we are offering between the primary offering and our DRIP, and pursuant to Supplement No. 11 to our prospectus regarding the Offering, which was filed with the Securities and Exchange Commission on March 6, 2009, we reallocated the units we are offering such that 16,500,000 units are being offered pursuant to the primary offering and 1,000,000 units are being offered pursuant to the DRIP.
N. Quarterly Financial Data (Unaudited)
Selected quarterly financial data (unaudited) for the years ended December 31, 2008 and 2007 is set forth below:
Index to Exhibits
Exhibit Number
Description
3.1
Second Amended and Restated Agreement of Limited Partnership of Registrant (previously filed in and incorporated by reference to Exhibit B to prospectus of the Registrant filed pursuant to Rule 424(b)(3) on May 18, 2006)
3.2
Certificate of Limited Partnership of Registrant (previously filed in and incorporated by reference to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on August 26, 2005)
3.3
First Amendment to Second Amended and Restated Agreement of Limited Partnership of Registrant (previously filed in and incorporated by reference to Exhibit B to Supplement No. 6 to prospectus dated May 15, 2006, contained within Post-Effective Amendment No. 3 to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on April 29, 2008)
4.1
Subscription Agreement (previously filed in and incorporated by reference to Exhibit C to Supplement No. 6 to prospectus dated May 15, 2006, contained within Post-Effective Amendment No. 3 to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on April 29, 2008)
10.1
Form of Escrow Agreement between United Development Funding III, L.P. and Coppermark Bank (previously filed in and incorporated by reference to Pre-Effective Amendment No. 4 to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on February 10, 2006)
10.2
Distribution Reinvestment Plan (previously filed in and incorporated by reference to Exhibit D to prospectus of the Registrant filed pursuant to Rule 424(b)(3), filed on May 18, 2006)
10.3
Form of Participation Agreement by and between the Registrant, UMTH Land Development, L.P., United Development Funding, L.P. and United Development Funding II, L.P. (previously filed in and incorporated by reference to Pre-Effective Amendment No. 1 to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on November 18, 2005)
10.4
Form of Marketing Support Agreement (previously filed in and incorporated by reference to Pre-Effective Amendment No. 3 to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on February 1, 2006)
10.5
Limited Guaranty by United Development Funding III, L.P. for the benefit of United Mortgage Trust (previously filed in and incorporated by reference to Form 8-K filed on October 20, 2006)
10.6
Letter agreement with respect to the Limited Guaranty between United Development Funding III, L.P. and United Mortgage Trust for the benefit of United Development Funding, L.P. (previously filed in and incorporated by reference to Form 8-K filed on October 20, 2006)
10.7
Fairness opinion with respect to Limited Guaranty by United Development Funding III, L.P. for the benefit of United Mortgage Trust and letter agreement with respect to the Limited Guaranty between Registrant and United Mortgage Trust for the benefit of United Development Funding, L.P. (previously filed in and incorporated by reference to Form 8-K filed on October 20, 2006)
10.8
Secured Promissory Note by Centurion Acquisitions, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2006)
10.9
Secured Promissory Note by Midlothian Longbranch, L.P. for the benefit of United Development Funding, III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2006)
10.10
Environmental Indemnity Agreement by Midlothian Longbranch, L.P., Centurion Acquisitions, L.P., Pars Investments, Inc. and Mehrdad Moayedi in favor of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2006)
10.11
Secured Promissory Note by Arete Real Estate and Development Company, Modern Modular Home Rental Corp., and Creative Modular Housing Inc. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2006)
10.12
Security Agreement by Arete Real Estate and Development Company, Creative Modular Housing Inc. and Modern Modular Home Rental Corp. in favor of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2006)
10.13
Continuing Unconditional Guaranty by Joe Fogarty, Nancy Fogarty and the Fogarty Family Trust for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2006)
10.14
Secured promissory note by Centurion Acquisitions, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 8-K filed on November 21, 2006)
10.15
Security Agreement by Centurion Acquisitions, L.P. and Pars Investment Inc., for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 8-K filed on November 21, 2006)
10.16
Continuing Unconditional Guaranty by Pars Investment Inc. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 8-K filed on November 21, 2006)
10.17
Loan and Security Agreement between United Development Funding III, L.P., as borrower, and Premier Bank, as lender (previously filed in and incorporated by reference to Form 8-K filed on January 3, 2007)
10.18
Revolving Note from United Development Funding III, L.P. for the benefit of Premier Bank (previously filed in and incorporated by reference to Form 8-K filed on January 3, 2007)
10.19
Secured Promissory Note by United Development Funding, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 8-K filed on January 4, 2007)
10.20
Fairness opinion with respect to Secured Promissory Note by United Development Funding, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 8-K filed on January 4, 2007)
10.21
Secured Promissory Note by Buffington Hidden Lakes, Ltd. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-K filed on April 2, 2007)
10.22
Continuing Unconditional Guaranty by Buffington Hidden Lakes GP, Inc. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-K filed on April 2, 2007)
10.23
Letter of engagement between UMTH Funding Services, L.P. and United Development Funding III, L.P. regarding arrangement of financing and financial advising (previously filed in and incorporated by reference to Post-Effective Amendment No. 1 to Registrant’s Registration Statement on Form S-11, Commission File No. 333-127891, filed on April 30, 2007)
10.24
Note Purchase, Assignment and Assumption Agreement by and between McDougal Family Partnership, Ltd. and United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on May 15, 2007)
10.25
Secured Line of Credit Promissory Note by United Development Funding X, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2007)
10.26
Security Agreement by United Development Funding X, L.P. in favor of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2007)
10.27
Continuing Unconditional Guaranty by UMT Holdings, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2007)
10.28
Fairness opinion with respect to Secured Line of Credit Promissory Note by United Development Funding X, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2007)
10.29
Secured Line of Credit Promissory Note by United Development Funding, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.30
Secured Line of Credit Promissory Note by United Development Funding Land Opportunity Fund, L.P. for the benefit United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.31
Security Agreement by United Development Funding, L.P. in favor of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.32
Security Agreement by United Development Funding Land Opportunity Fund, L.P. in favor of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.33
First Amendment to Secured Line of Credit Promissory Note by United Development Funding X, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.34
Economic Interest Participation Agreement and Purchase Option between United Mortgage Trust and United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.35
Fairness Opinion with respect to Secured Line of Credit Promissory Note by United Development Funding, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.36
Fairness Opinion with respect to Economic Interest Participation Agreement and Purchase Option between United Mortgage Trust and United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.37
Fairness Opinion with respect to First Amendment to Secured Line of Credit Promissory Note by United Development Funding X, L.P. for the benefit of United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
10.38
Fairness Opinion with respect to Secured Line of Credit Promissory Note by United Development Funding Land Opportunity Fund, L.P. for the benefit United Development Funding III, L.P. (previously filed in and incorporated by reference to Form 10-Q filed on November 14, 2008)
31.1 (1)
Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer
31.2 (1)
Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer
32.1 (2)
Section 1350 Certifications
_________________
(1)
Filed herewith.
(2)
Furnished herewith. In accordance with Item 601(b)(32) of Regulation S-K, this Exhibit is not deemed “filed” for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section. Such certifications will not be deemed incorporated by reference into any filing under the Securities Act of 1933, as amended, or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.