NOTE 1 - NATURE OF BUSINESS

Korth Direct Mortgage, Inc. (the “Company” or “KDM”) is incorporated in the State of Florida. The Company was created to originate mortgages and fund those mortgages with Notes secured by mortgage loans. J.W. Korth & Company Limited Partnership (“J.W. Korth”) is a wholly owned subsidiary of KDM.

J.W. Korth is a securities broker dealer registered with the Securities Exchange Commission and the states of Michigan, Florida, and various other states and an SEC registered investment adviser under the Investment Advisers Act of 1940. J.W. Korth is a licensed member of the Financial Industry Regulatory Authority (FINRA), the Securities Investor Protection Corporation, as well as a Municipal Securities Rulemaking Board (MSRB) registrant.

On July 28, 2022, KDM created a new wholly owned subsidiary, KDM Funding I LLC (“KDMF”), which will be an additional issuer of MSNs. KDM is servicer of the loans, and all revenue and expenses are passed through to the Company and consolidated within these financial statements, although the deal history will be broken out by issuer, there are no independent financial statements. Please see the current report Form 8-K filed with the Commission on August 5, 2022, for more information.

The Company operates various pass-through entities typically organized as limited liability companies in order to own real estate and issue additional securities. These entities are consolidated into these financial statements and Notes.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Tax benefits from an uncertain tax position are only recognized if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the unaudited consolidated financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. Interest and penalties related to unrecognized tax benefits are recorded as incurred as a component of income tax expense.

NOTE 3 – CONTINGENT LIABILITY

As part of the acquisition of J. W. Korth, the Company agreed to pay (i) the Preferred Capital Interest partners of J.W. Korth accrued and unpaid dividends of 6% per annum through July 31, 2020; (ii) the J. W. Korth Preferred Capital Interest Partners quarterly dividends concurrently with its payment of the Company’s Series A Preferred Stock dividends at least annually; and (iii) in such years as it pays Series A Preferred dividends, redeem 25% annually of the J. W. Korth Preferred Capital Interest partners through a capital contribution to J. W. Korth.

NOTE 4 – MORTGAGE SECURED NOTES PAYABLE

As stated above in Note 2, the Company funds mortgage loans that it makes by issuing MSNs, which are secured by those same mortgages. As of September 30, 2022 and December 31, 2021, the Company has outstanding loans securing MSNs totaling $442,476,958 and $326,312,345, respectively, and issued MSNs secured by those loans in the amount of $431,916,958 and 326,212,364, respectively. The MSNs have been funded in multiple ways, including private placements, loan participations, SEC registered deals, and 144A offerings, exempt from registration.

The MSNs are typically five-year interest-only notes with the principal balance due at maturity, but terms can vary. Interest rates on the senior MSNs range from 4.25% to 7.50% and mature at various dates from September 2023 to September 2037. The MSNs are non-recourse to KDM and are payable to the extent that the Company receives payment from the borrower of the mortgage loans. Payments are received from the borrowers and passed through to the MSN noteholders.

NOTE 5 - RESTRICTED CASH

The Company maintains multiple segregated accounts in trust for borrowers and investors. The value of these accounts is carried under the asset “Restricted Cash.”

The “In Trust for 1” account holds the monthly tax and insurance payments collected from borrowers and distributes payments annually, on behalf of borrowers, to the appropriate tax authorities and insurance companies. This account corresponds to the Escrow Payable liability. As of September 30, 2022 and December 31, 2021, this account has a balance of $14,306,857 and $9,519,859, respectively.

The “In Trust for 2” account receives payments from borrowers, distributes payments to investors, and pays the servicing fees to the Company. This account corresponds to the Due to Investors liability, which is included in other liabilities and payables. As of September 30, 2022, and December 31, 2021, this account had a balance of $1,406,355 and $421,286, respectively.

The Company also maintains multiple lockbox accounts that collect rental payments directly from tenants on the borrowers’ behalf. These accounts typically net out funds monthly. The lockbox account balances as of September 30, 2022 and December 31, 2021, were $100,179 and $93,775, respectively. This account is included as part of the Escrow Payable liability account.

The Company maintains an account for payment of quarterly Preferred Series B dividends that has a balance of $308,750 as of September 30, 2022 and December 31, 2021, respectively.

The Company maintains an account restricted per the warehouse line agreement that has a balance of $1,000,000 as of September 30, 2022.

Subsequent to September 30, 2022 the Company has opened a cash management account at J. W. Korth & Company that will hold a portion of the restricted cash which will be swept there on a regular basis.

NOTE 6 - COMMITMENTS

In November 2020, the Company signed a lease for office space in Miami, Florida, for a term of sixty-two months with the right to extend the term of the lease for two additional, successive terms of two years upon the same terms and conditions as the initial term. In December 2020, the Company entered into a Sublease Agreement to sublet a portion of the office space described above. The subtenant has agreed to cover the proportionate amount of the lease costs associated with the office space based on essentially the same terms as the lease described above, including the rights to extend for two successive two-year terms.

The Company also maintains an office in Lansing, Michigan for J.W. Korth.

The net present value of future lease payments pursuant to the operating lease agreements are included in the ROU Leased Asset and the Lease Liability accounts on the unaudited consolidated statements of financial condition. The ROU Leased Asset represents the right to use an underlying asset for the remaining lease term. The Lease Liability represents the obligation to make lease payments pursuant to the terms of the lease agreements.

Rental expense for the quarter ended September 30, 2022, was $191,137 compared to $211,393 for the year ended September 30, 2021, which includes additional expenses for common area, direct operating expense, utilities, parking, and taxes.

As of September 30, 2022, the net present value of the future lease liabilities, using the weighted-average discount rate of 4.24%, which is commensurate with the Company’s secured borrowing rate, over the weighted-average remaining life of 3.3 years was $823,155.

NOTE 7 - INDEMNIFICATIONS

The Company provides representations and warranties to counterparties in connection with a variety of commercial transactions and occasionally indemnifies them against potential losses caused by the breach of those representations and warranties. These indemnifications generally are standard contractual terms and are entered into in the normal course of business. The maximum potential amount of future payments that the Company could be required to make under these indemnifications cannot be estimated. However, the Company believes that it is unlikely it will have to make material payments under these indemnification arrangements and has not recorded any contingent liability in the unaudited consolidated financial statements for these indemnifications.

NOTE 8 – RELATED PARTY TRANSACTIONS

From time to time, the Company purchases MSNs and holds them in its brokerage account. These MSNs are included on the unaudited consolidated statements of financial condition as mortgages owned. Also, from time to time, second lien or balance sheet loans may be all or partially funded by entities controlled by KDM directors or employees; such loans are serviced by KDM. In some circumstances, in the event a foreclosure becomes necessary, KDM may acquire properties where MSNs are in default as a deed in lieu of foreclosure, KDM may create single purpose entities to take title to such properties and liquidate them to satisfy any debts due under an MSN or keep such properties and repay the MSN from its own funds.

NOTE 9 – DEFERRED REVENUE, NET

Loan origination fees are deferred and recognized as revenue over the life of the respective loan. The associated loan origination costs are also deferred and recognized as expense over the life of the loan. The deferred portion of the loan origination fees is netted against the deferred portion of the loan origination costs and reported as a net deferred revenue liability on the Company’s unaudited consolidated statements of financial condition.

NOTE 10 – EMPLOYEE AND DIRECTOR STOCK OPTIONS

On June 28, 2019, the Company’s Board of Directors adopted the 2019 Stock Option Plan (the “Incentive Plan”). The Incentive Plan provides for the grant of both incentive and non-statutory stock options to key employees, directors or other persons having a service relationship with the Company for the purchase of up to an aggregate of 1,000,000 shares of the Company’s unissued, or reacquired, common stock, $0.001 par value. The Plan is administered by the Board of Directors.

In June 2019, the Company issued options to purchase 835,000 shares of the Company’s common stock at an exercise price of $1.00 per share. The weighted-average grant date fair values of options granted was $0.1855 per share. The fair values of the stock-based awards granted were calculated with the following weighted-average assumptions:

For the nine months ended September 30, 2022 and September 30, 2021, the Company recorded $12,906 and $19,359, respectively of stock-based compensation expense. Stock options vest 50% at issuance and then ratably over the remaining three years vesting period until they are fully vested. As of September 30, 2022, there was $0 in total unrecognized compensation expense related to non-vested employee stock options granted under the Incentive Plan.

NOTE 11 – PREFERRED EQUITY

On September 27, 2019, the Company issued 200,000 shares of its Series A 6% Cumulative Perpetual Convertible Preferred Stock for net proceeds of $4,750,000. The Company paid $250,000 in expenses related to the preferred stock issuance to J. W. Korth as underwriter and distributor. Each share was sold for $25 and is convertible into common stock at a ratio of 5 shares of common stock for each share of Series A Preferred Stock. On September 15, 2021, and June 28, 2022, the Company sold an additional 100,000 and 480,000 shares, respectively of its Series A 6% Cumulative Perpetual Convertible Preferred Stock for net proceeds of $2,375,000 and $11,856,480.

On August 12, 2022, the Company repurchased and retired 480,000 shares of its Series A 6% Cumulative Perpetual Convertible Preferred Stock at a price of $25.25 per share, for a total of $12,120,480. The Company paid $640,000 in interest expense.

On June 29, 2021, the Company issued 19,000 shares of its Series B 6.50% Cumulative Non-Voting Redeemable Secured Preferred Stock, with a liquidation preference of $1,000 per share, for net proceeds of $18,302,500. The Company paid $697,500 in expenses related to the preferred stock issuance to its financial advisor and placement agent.

The Series B preferred stock is non-convertible and will pay cumulative dividends, if and when declared by the Company’s Board of Directors, at a rate of 6.50% per annum. Dividends declared will be payable quarterly in arrears on the 15th day of January, April, July and October of each year. The Series B preferred stock ranks senior to KDM’s outstanding Series A 6% Cumulative Perpetual Convertible Preferred Stock, par value $0.001 per share, or Series A preferred stock, and all of KDM’s common stock, and will rank pari passu with, or senior to, all future issuances of preferred stock of KDM.

The Company is required to use commercially reasonable efforts to maintain a nationally recognized statistical ratings organization, or NRSRO, rating for so long as any shares of Series B preferred stock remain outstanding. If the Company fails to maintain an NRSRO rating for the Series B preferred stock of at least BBB (or the equivalent thereof), the dividend rate applicable to the Series B preferred stock will be increased by 25 basis points, and in the event the Company fails to maintain an NRSRO rating of at least BBB- (or the equivalent thereof), the dividend rate applicable to the Series B preferred stock will be increased by an additional 25 basis points. The Company’s current corporate rating is BBB+.

The Series B preferred stock is redeemable at the Company’s option, in whole or in part, on or after June 29, 2026, at a redemption price per share equal to $1,000 per share, plus accrued and unpaid dividends, if any. Subject to applicable law, the Company is required to redeem the Series B preferred stock, in each case at a redemption price equal to $1,000 per share, plus accrued and unpaid dividends, as follows:

The Company’s obligations to redeem the Series B preferred stock are secured by a security interest on servicing fees, as specified in each mortgage secured note issued by the Company, which is the difference between the interest payable pursuant to the mortgage secured note and the interest receivable pursuant to the related commercial real estate mortgage loan. The requisite holders of Series B preferred stock will be entitled to exercise rights and remedies pursuant to such security interest in the event that the Company does not pay the relevant mandatory redemption price (inclusive of any accrued and unpaid dividends) within thirty (30) days of the applicable redemption date, except with respect to the final redemption date, which is not subject to a thirty (30)-day grace period.

NOTE 12 – FAIR VALUE

FASB ASC 820, Fair Value Measurements and Disclosures (“ASC 820”), defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not assumptions specific to the entity.

ASC 820 establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial assets and liabilities at fair value. GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below:

Level I—Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

Level II—Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

Level III—Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

ASC 820 requires the use of observable market data, when available, in making fair value measurements. When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurements. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.

Valuation Process

Cash and cash equivalents: 

The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

Mortgages Owned and Mortgage Secured Notes Payable:

Mortgage loans for which the Company has the intention and ability to hold for the foreseeable future, or until maturity or payoff, are reported at their outstanding principal balances, net of any unearned income, premiums or discounts. If a decline in fair value below the carrying balance is other-than-temporary, an unrealized impairment loss is recorded, and the loan is recorded at the lower fair value at each reporting period. To date, the Company has not recorded any impairment losses related to the mortgage loans.

Due to the fact that the Company issues notes secured directly by underlying loans, our assets and liabilities in this category have identical values and assets have offsetting balances.

Mortgage Servicing: 

The net present value of the servicing income is recognized at the time the mortgage is initiated as an unrealized gain. This value uses several inputs that are highly subjective including: discount rate, constant prepayment rate, the current interest rate environment, and default rate assumptions. Since the Company has limited operating history and a small amount of loans outstanding, we have a limited basis to predict prepayment rates and default rates, but have engaged a third party, MIAC Analytics, to assist us in our valuation of this asset. The amount is included on the Unaudited Consolidated Statements of Financial Condition as “Mortgage Servicing Rights, at Fair Value.”

Securities

J. W. Korth holds $225,000 of defaulted Banco Cruzeiro del Sur bonds which it reasonably believes it will receive par value for from the receiver handling the liquidation in Brazil. Local counsel has informed us that the bank has sufficient cash to pay off our bonds. We therefore carry them at par value.

KDM also holds a some of its own MSNs in an account which it may buy from time to time to provide liquidity to clients of J.W. Korth. These bonds are carried at the published statement values.

Fair Value Disclosure

Fair Value Measurements

Changes in Fair Value Measurements for the nine months ended September 30, 2022

The Company’s policy for recording transfers between levels of the fair value hierarchy is to recognize such transfers as of the

financial statement date. For the nine months ended September 30, 2022, there were no transfers between levels.

The Company has established valuation processes and policies for its Level 3 investments to ensure that the methods used are fair and consistent in accordance with ASC 820 – Fair Value Measurements and Disclosures. The Company’s valuation committee performs reviews of the Level 3 investments’ valuations, which include reviewing any significant price changes reported from the prior period. When a Level 3 investment has a significant price change, the valuation committee reviews relevant market data to substantiate the price change.

NOTE 13 – INCOME TAXES

The provision for income taxes was $1,006,274 for the nine months ended September 30, 2022. The effective tax rate was 26.7% of the income before income taxes of $4,191,272, which differs from the federal statutory rate of 21% due to the effect of state income taxes and certain of the Company’s expenses that are not deductible for tax purposes.

The provision for income taxes was $1,028,093 for the nine months ended September 30, 2021. The effective tax rate was 24.3% of the income before income taxes of $4,224,679, which differs from the federal statutory rate of 21% due to state income taxes and certain of the Company’s expenses that are not deductible for tax purposes.

NOTE 14 – PROPERTY AND EQUIPMENT

Depreciation expense for the periods ending September 30, 2022 and September 30, 2021, was $52,500 and $25,474, respectively.

NOTE 15 – WAREHOUSE LINE OF CREDIT

On March 31, 2022, The Company entered into a Master Repurchase Agreement and Securities Contract (the “Agreement”) with Signature Bank (“Signature”), for the provision of an uncommitted warehouse facility up to $100,000,000 (the “Line”). The Agreement provides for approximately a three-year term and may be terminated in accordance therein.

The Agreement provides that from time to time the Company may receive proceeds under the Line to originate first priority lien mortgages on real property. Signature will purchase the first lien commercial real estate mortgage loans (the “Loans”) pursuant to the Agreement. Each of the Loans will be originated in accordance with the underwriting and ratings criteria of the Company as further described in the Agreement. The Company will repurchase the Loans from Signature coincident with securitization or other disposition or pooling of the Loans under the terms and timeframes set forth in more detail in the Agreement.

The Line has a back-up security interest grant secured by collateral specified in the Agreement in the event the Agreement is recharacterized as a secured loan. The Agreement contains financial covenants of the Company, including limitations on the Company’s incurrence of certain debt and requirements that the Company maintain certain financial ratios and minimum net worth. The Company is in compliance with these covenants as of and for the quarter ended September 30, 2022.

The Line is floating rate and both the haircut percentage and SOFR-linked interest rate spread vary according to property type and time on the line. The Line offers up to 75% leverage on investment grade loans and is designed for 30 to 90 day hold periods but can accommodate up to a 12-month holding period, with decreasing leverage as time passes.

In connection with entering into the Line, the Company incurred loans fees of approximately $1,589,783 which is netted against the amount drawn on the line and is included in the warehouse line of credit, net in the accompanying unaudited consolidated statements of financial condition. Loans fees associated with the Line will be amortized on a straight-line basis over the term of the Line.

As of September 30, 2022, the Company had a balance of $4,340,000 on the warehouse line net of the costs associated with the final Agreement which is shown on the unaudited consolidated statements of financial condition as Warehouse line of credit, net. Total amortization expense for the nine months ended September 30, 2022 and recorded as interest expense is $264,964.

NOTE 16 – SUBSEQUENT EVENTS

The Company has evaluated all events or transactions that occurred after September 30, 2022, through the date these unaudited consolidated financial statements, which is the date that the unaudited consolidated financial statements were available to be issued. During this period, there were no material subsequent events requiring disclosure, other than those noted below.

As a result of an uncured maturity default on a $7,500,000 second mortgage held by the Company, the Company received a deed in lieu of foreclosure from the CM Loan Borrower, which was recorded along with an assumption of the first mortgage on November 4, 2022 and transferred to a successor entity controlled by the Company. Monthly debt service on the first mortgage is paid by the collected rents from the property and the Company believes that it will be in a position before the first mortgage matures to liquidate the property for amounts sufficient to cover the first and second mortgages.

In order to take advantage of high money market and US Treasury interest rates, the Company opened a cash management account with its subsidiary, J. W. Korth & Company. This account will act as an additional account for loan reserve funds and is only permitted to invest in US government securities or money market funds. Coincident with the opening of this account, the Company entered into a pledge agreement with Delaware Trust, in order to pledge those funds as additional collateral for the holders of MSNs.