NOTE 1 - NATURE OF BUSINESS

Korth Direct Mortgage Inc. (the “Company”) is incorporated in the State of Florida. The Company was created to originate mortgages and fund those mortgages with notes secured by mortgage loans. On July 31, 2020, the Company acquired substantially all of the equity of J.W. Korth & Company Limited Partnership, a Michigan limited partnership (“J.W. Korth”), and its general partner, J.W. Korth, LLC, a Florida limited liability company. J.W. Korth is an SEC and FINRA registered securities broker dealer. The financials of J. W. Korth were integrated into the financials of the Company as of August 1, 2020.

Certain information and note disclosures normally included in the Company’s annual financial statements prepared in accordance with US generally accepted accounting principles (“GAAP”) have been condensed or omitted. These unaudited financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s 2020 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NOTE 3 – ACQUISITION OF RELATED PARTY AFFILIATE

On  i July 31, 2020, the Company acquired substantially all of the equity of J.W. Korth, a Michigan limited partnership, and its general partner, J.W. Korth, LLC, a Florida limited liability company. The Company’s acquisitions of J.W. Korth and J.W. Korth, LLC are together referred to as the “Acquisitions.”

The Company was founded by J.W. Korth with James W. Korth, its Chairman and Chief Executive Officer, and his daughter, Holly MacDonald-Korth, the Company’s President and Chief Financial Officer. Mr. Korth is the Managing Partner of J.W. Korth and Ms. MacDonald-Korth is J.W. Korth’s Managing Director and Chief Financial Officer. J.W. Korth is registered with the Securities and Exchange Commission as a broker-dealer and investment advisor, and with the Financial Industry Regulatory Authority (“FINRA”) as a broker-dealer. Together, prior to closing of the Acquisitions Mr. Korth and Ms. MacDonald-Korth together owned approximately 80% of J.W. Korth’s partnership interests and controlled the business and operations of J.W. Korth. J.W. Korth funded the organization and operation of the Company pursuant to a support agreement with the Company from inception until April 2019, at which time the Company became self-sustaining and J.W. Korth forgave a receivable owed to it by the Company. Until the closing of the Acquisitions, the Company was controlled by J.W. Korth, which owned all of its voting common stock.

The Company originates, funds and services loans which it makes to commercial borrowers. The loans are held by the Company as lender. The Company funds its loans directly in the capital markets through issuance of Mortgage Secured Notes (“MSNs” or “Notes”), which are sold through J.W. Korth as underwriter or placement agent through exemptions from registration available under Rule 144A, Regulation D, and other exemptions from registration. The Company and J.W. Korth determined that the Company could operate more efficiently if J.W. Korth became a wholly-owned subsidiary of the Company. J.W. Korth submitted its then-proposed sale to FINRA, as required by FINRA rules, and FINRA advised J.W. Korth that it could proceed with the closing.

Pursuant to the Purchase Agreement, as a condition of closing J.W. Korth agreed to distribute all of its  i 5,000,000 shares of common stock in the Company to its partners ratably in accordance with their partnership interests in J.W. Korth pursuant to exemptions from registration available under Section 4(a)(2) of the Securities Act of 1933, as amended, and Rule 506 promulgated under the Securities Act.

Prior to the closing, J. W. Korth LLC owned  i 73.6% of the Common Capital interest of J.W. Korth and at closing received  i 3,680,000 shares of the Company. Simultaneously J W Korth LLC distributed the Company shares it received from J.W. Korth to its members James Korth and Holly MacDonald-Korth according to their membership interests which were  i 80% and  i 20% respectively.

At closing, after the distribution to its members of the Company shares distributed to J W Korth LLC,  i the Company acquired all of the membership interests in JW Korth LLC from Mr. Korth and Ms. MacDonald-Korth for consideration of the payment to (i) the Preferred Capital Interest partners of J.W. Korth of accrued and unpaid 6% dividends through July 31, 2020, and (ii) James Korth of $150,000 in payment of the value of his JW Korth LLC’s Common Capital Interest account.

As post-closing commitments the Company agreed to  i (i) retain Mr. Korth as the managing partner of J.W. Korth, Ms. MacDonald-Korth as J.W. Korth’s chief financial officer, and all other employees of JW Korth who were employed at closing of the Transactions; (ii) operate J.W. Korth as an SEC registered broker-dealer and investment advisor; (iii) pay the JW Korth Preferred Capital Interest Partners quarterly dividends concurrently with its payment of the Company’s Series A Preferred Stock dividends at least annually; (iv) in such years as it pays Series A Preferred dividends, redeem 25% annually of the JW Korth Preferred Capital Interest partners through a capital contribution to JW Korth; and (v) make a discretionary redemption of all accounts of the limited partners of J.W. Korth under the J.W. Korth partnership agreement. Upon redemption of the limited partners’ accounts and the payment of the other consideration to described above to the JW Korth partners, KDM will own 100% of the voting interests in JW Korth.

Since the acquisition was between related parties, the transaction was recorded at net book value as of the closing date. The difference of $ i 490,345 between the consideration paid and the net book value of the assets and liabilities acquired was recorded as an offset to equity, specifically to Additional Paid-in Capital. Disclosure of supplemental pro forma information for revenue and earnings related to the acquisition, assuming the acquisition was made at the beginning of the earliest period presented, has not been disclosed since the effects of the acquisition would not have been material to the results of operation for the periods presented.

NOTE 4 – CONTINGENT LIABILITY

As part of the acquisition of related party affiliate discussed above in Note 3, the Company agreed to pay (i) the Preferred Capital Interest partners of J.W. Korth accrued and unpaid dividends of  i 6% per annum through  i July 31, 2020; (ii) the JW 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  i 25% annually of the JW Korth Preferred Capital Interest partners through a capital contribution to JW Korth.

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 authority and insurance companies. This account corresponds to the Escrow Payable liability. As of June 30, 2021, this account has a balance of $ i 9,642,629.

The “In Trust for 2” account receives payments from borrowers, distributes payments to investors, and pays the servicing fee to the Company. This account corresponds to the Due to Investors liability. As of June 30, 2021, this account has a balance of $ i 8,992,316, which consists of borrower early payments and commitments and also a balance of $ i 9,405,000 pending closing of one loan. This account corresponds to the Due to Investors liability.

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 June 30, 2021 were $ i 116,101. There is an additional account that consists of reserves for one borrower in the amount of $ i 2,029,492.

NOTE 6 - COMMITMENTS

Prior to the acquisition of J.W. Korth in July 2020, the Company relied entirely on J.W. Korth to provide office space, internet connectivity, phone service, and incidentals. In November 2020, the Company signed a lease for new 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 periods 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 periods.

On January 13, 2021, J.W. Korth negotiated a five-month early termination of its lease for its Miami office and will rely entirely on its parent for office space at the Coral Gables location. The J. W. Korth Michigan office has renegotiated a new lease which began in May 2021.

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 Consolidated Statement 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 June 30, 2021 was $ i 148,977, which includes additional expenses for common area, direct operating expense, utilities, parking, and taxes.

As of June 30, 2021, the net present value of the future lease liabilities, using the weighted-average discount rate of  i 4.24%, which is commensurate with the Company’s secured borrowing rate, over the weighted-average remaining life of 4.6 years was $ i 1,081,288.

PPP Loan

In April 2020, J. W. Korth, at that time the parent company of KDM, availed itself of a Paycheck Protection Program loan (“PPP Loan”) in the amount of $ i 161,600, which was forgiven in April 2021.

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 arrangements and has not recorded any contingent liability in the financial statements for these indemnifications.

NOTE 8 - CUSTOMERS

As of June 30, 2021, the Company had  i forty-six customers. The Company defines customers as borrowers that have an active loan with the Company, or are in the midst of the underwriting process and have a commitment fee on deposit with the Company. We do not have any over concentration with a  i single borrower or location other than three large loans in the states of Ohio, Virginia, and California for a total of approximately 109,000,000.

NOTE 9 – RELATED PARTY TRANSACTIONS

As of December 31, 2020, the intercompany transactions and balances between the Company and J.W. Korth have been eliminated upon consolidation as a result of the acquisition.

In March 2020, the Company purchased an MSN in the amount of $ i 100,000 included on the statement of financial condition as Securities.

On April 1, 2020, the Company closed a first lien and corresponding MSN,  i along with a second lien loan of $500,000 on the same property. The funding for the second lien was provided by 110 Capital LLC, an entity controlled by a KDM director and employee. KDM services both notes.

On May 13, 2020, the Company executed a preferred partner subscription agreement with J.W. Korth in the amount of $ i 250,000, which was eliminated upon consolidation as a result of the acquisition of J.W. Korth in July 2020 (see Note 4 above).

As of June 30, 2021, the Company paid underwriting fees of $ i 152,267 to J.W. Korth in 2021.

On February 12, 2021, the Company closed a first lien and corresponding MSN,  i along with a second lien loan of $200,000 on the same property. The funding for the second lien was provided by 110 Capital LLC, an entity controlled by a KDM director and employee. KDM services both notes.

NOTE 10 – 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 Statement of Financial Condition.

NOTE 11 – 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  i 1,000,000 shares of the Company’s unissued, or reacquired, common stock, $ i 0.001 par value. The Plan will be administered by the Board of Directors or a committee appointed by the Board.

For the six months ended June 30, 2021, the Company recorded $ i 12,906 of stock-based compensation expense. As of June 30, 2021, there was $ i 25,816 in total unrecognized compensation expense related to non-vested employee stock options granted under the Incentive Plan, which is expected to be recognized over 1.0 year.

NOTE 12 – PREFERRED EQUITY

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

On June 29, 2021, the Company issued  i 19,000 shares of its Series B 6.50% Cumulative Non-Voting Redeemable Secured Preferred Stock, with a liquidation preference of $ i 1,000 per share, for net proceeds of $ i 18,302,500. The Company paid $ i 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  i 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 $ i 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 Series B preferred stock is redeemable at the Company’s option,  i in whole or in part, on or after June 29, 2026, at a redemption price per share equal to $ i 1,000.00 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 $ i 1,000.00 per share, plus accrued and unpaid dividends, as follows:

The Company’s obligations to redeem the Series B preferred stock will be 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 be subject to a thirty (30)-day grace period.

NOTE 13 – 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 Statement of Financial Condition as “Mortgage Servicing Rights, at Fair Value.”

Mortgage Secured Notes Receivable:

From time to time the Company may buy-back mortgage secured notes previously issued to investors. These securities are available for sale, but may be held until maturity. These securities are recorded at fair value each quarter with the change in fair value recognized as an unrealized gain or loss each reporting period. The fair value estimate 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.

Securities

J. W. Korth holds $ i 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 small amount 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