SECURITIES AND EXCHANGE COMMISSION

FORM 10 – K

For the Fiscal Year Ended December 31, 2004

For the Transition Period From _______to ________

Commission File Number: 1-13610

PMC COMMERCIAL TRUST

Securities registered pursuant to Section 12(b) of the Act:
Common Shares of beneficial interest, $.01 par value

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES þ NO o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
YES þ NO o

The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Shares of Beneficial Interest on June 30, 2004 as reported on the American Stock Exchange, was approximately $141 million. Common Shares of Beneficial Interest held by each officer and trust manager and by each person who owns 10% or more of the outstanding Common Shares of Beneficial Interest have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 7, 2005, Registrant had outstanding 10,876,961 Common Shares of Beneficial Interest.

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to the Annual Meeting of Shareholders are incorporated by reference into Part III.

PMC COMMERCIAL TRUST

Form 10-K
For the Year Ended December 31, 2004

___________________________________________________________

TABLE OF CONTENTS

1

Forward-Looking Statements

     This Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created thereby. These statements include the plans and objectives of management for future operations, including plans and objectives relating to future growth of our loans receivable and availability of funds. Such forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “believe,” “anticipate,” “estimate,” or “continue,” or the negative thereof or other variations or similar words or phrases. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties identified in this Form 10-K, including, without limitation, the risks identified under the caption “Item 1. Business – Risk Factors.” Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-K will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. Readers are cautioned not to place undue reliance on forward-looking statements. Forward-looking statements speak only as of the date they are made. We do not undertake to update them to reflect changes that occur after the date they are made.

PART I

Item 1. BUSINESS

INTRODUCTION

     PMC Commercial Trust (“PMC Commercial” and together with its wholly-owned subsidiaries, the “Company,” “our” or “we”) is a real estate investment trust (“REIT”) that primarily originates loans to small businesses collateralized by first liens on the real estate of the related business. Our loans are primarily to borrowers in the limited service hospitality industry. We also originate loans for commercial real estate primarily in the service, retail, multi-family and manufacturing industries. In addition, our investments include the ownership of commercial properties in the hospitality industry. Our common shares are traded on the American Stock Exchange under the symbol “PCC.”

     On February 29, 2004, PMC Capital, Inc. (“PMC Capital”), our affiliate through common management, merged with and into PMC Commercial. Primarily as a result of the merger, beneficiaries’ equity increased from approximately $92.1 million at December 31, 2003 to approximately $161.3 million at December 31, 2004 and total assets increased from approximately $131.7 million at December 31, 2003 to approximately $253.8 million at December 31, 2004. We believe that the merger has provided, and will continue to provide, more stability in income available for distribution through the larger, more diversified asset base. The merger resulted in a substantial increase in revenues and expenses. Revenues increased as a result of the income generated by the assets acquired from PMC Capital. Prior to the merger, we had no employees and most of our overhead was paid through an advisory relationship with PMC Capital. Subsequent to the merger, we are internally managed, have 43 employees and overhead of the combined larger entity is now our responsibility.

     We generate revenue from the yield earned on our investments, rental income from property ownership and other fee income from our lending activities. Our operations are centralized in Dallas, Texas and include originating, servicing and selling commercial loans and oversight of our property ownership. During the years ended December 31, 2004 and 2003, our total revenues were approximately $25.4 million and $14.1 million, respectively, and our net income was approximately $24.8 million and $8.2 million, respectively. Our 2004 net income includes an extraordinary gain of approximately $11.6 million from negative goodwill resulting from the merger.

     A substantial part of PMC Capital’s activities were undertaken by its wholly-owned subsidiaries: First Western SBLC, Inc. (“First Western”), PMC Investment Corporation (“PMCIC”) and Western Financial Capital Corporation (“Western Financial”). PMCIC and Western Financial are small business investment companies (“SBICs”). Each of these subsidiaries is now wholly-owned by PMC Commercial.

2

     As a result of the acquisition of First Western, we are now able to originate loans under the Small Business Administration’s (“SBA”) 7(a) Guaranteed Loan Program. First Western is currently a “Preferred Lender,” as designated by the SBA, in Dallas, Texas and originates, sells and services small business loans throughout the continental United States. As a non-bank SBA 7(a) Guaranteed Loan Program lender, First Western is able to originate loans on which a substantial portion of the loan (generally 75%) is guaranteed as to payment of principal and interest by the SBA. A market exists for the sale of the guaranteed portion of First Western’s loans and we receive premiums at the time of sale that approximate up to 10% of the principal amount of the loan sold. To the extent we were to increase our volume of loans originated by First Western, there should be a corresponding increase in premiums received. In addition, due to the existence of the SBA guarantee, we are able to originate loans in industries that we would typically not lend to due to the profitability of the loan including the premium received. See “Lending Activities – SBA Programs.”

     We seek to maximize shareholder value through long-term growth in dividends paid to our shareholders. As a REIT, we must distribute at least 90% of our REIT taxable income to shareholders. See “Tax Status.” We pay dividends from the cash flow generated from our operations.

     Our ability to generate interest income, as well as other loan related fees, is dependent upon economic, regulatory and competitive factors that influence interest rates and loan originations, and our ability to source financing for our investment activities. The amount of other income earned will vary based on volume of loans funded, the timing and amount of financings, the volume of loans receivable which prepay and the resultant applicable prepayment fees, if any, the mix of loans (construction versus non-construction), the rate on loans originated as well as the general level of interest rates.

     Generally, in order to fund new loans or real estate investments, we need to issue new equity, borrow funds or sell loans. Since 1996, our primary source of funds has been structured loan transactions. In a structured loan transaction, we contribute loans receivable to a special purpose entity (“SPE”) in exchange for a subordinate financial interest in that entity. We account for structured loan sale transactions as sales of our loans receivable and the SPE meets the definition of a qualifying special purpose entity (“QSPE”); as a result, neither the loans receivable contributed to the QSPE nor the notes payable issued by the QSPE are included in our consolidated financial statements. See “Structured Loan Transactions.”

     We operate in two reportable segments: (i) the lending division, which originates loans to small businesses primarily in the hospitality industry and (ii) the property division, which owns hotel properties. See detailed financial information regarding our segments in “Item 8. Consolidated Financial Statements and Supplementary Data.”

LENDING ACTIVITIES

Overview

     Our lending division originates loans to small businesses, primarily in the hospitality industry. For the year ended December 31, 2004, total revenues and income from continuing operations for our lending division were approximately $19.9 million (78% of our total revenues) and $10.5 million (86% of our total income from continuing operations), respectively. Total assets allocated to the lending division were approximately $214.2 million (84% of our total assets) at December 31, 2004.

     We are a national lender that focuses our lending activities on businesses in the southeast and southwest regions of the United States. We primarily originate small business loans in the limited service sector of the hospitality industry. With the addition of the lending operations of PMC Capital, we expect to increase our loan originations to the convenience store and gas station, restaurant, service, retail and commercial real estate industries. In addition to first liens on real estate of the related business, our loans are generally personally guaranteed by the principals of the entities obligated on the loans. In addition to our historical underwriting criteria, as a result of the merger, we are now originating loans using PMC Capital’s underwriting criteria which generally has higher loan-to-value ratios than we had prior to the merger. See “Risk Factors.”

     We identify loan origination opportunities through personal contacts, internet referrals, attendance at trade shows and meetings, correspondence with local chambers of commerce, direct mailings, advertisements in trade publications and other marketing methods. In addition, we have generated most of our loans through referrals from lawyers, accountants, real estate and loan brokers and existing borrowers. We may make payments to non-affiliated

3

individuals who assist in generating loan applications, with such payments generally not exceeding 1% of the principal amount of the originated loan.

Limited Service Hospitality Industry

     Our loans in the hospitality industry are generally collateralized by first liens on limited service hospitality properties and are generally made to owner-operated facilities operating under national franchises. We believe that franchise operations offer attractive lending opportunities because such businesses generally employ proven business concepts, have national reservation systems, have consistent product quality, are screened and monitored by franchisors and generally have a higher rate of success when compared to other independently operated hospitality businesses.

     The prevailing lodging industry perception for 2005 is more optimistic than 2004. Lodging demand in the United States appears to correlate to changes in the United States Gross Domestic Product (“U.S. GDP”) growth, with typically a two to three quarter lag. Therefore, given the relatively strong U.S. GDP growth in the past year and the positive projections for the remainder of 2005, an improvement in 2005 and 2006 lodging demand is predicted by industry analysts. Such improvement will be dependent upon several factors including: the strength of the economy, the correlation of hotel demand to new hotel supply and the impact of global or domestic events on travel and the hotel industry. Industry analysts with PricewaterhouseCoopers LLP have published reports that predict the industry’s results will improve in 2005 and 2006.

     Another factor which affects the limited service sector of the hospitality industry is a significant rise in gasoline prices within a short period of time. Most of the limited service hospitality properties collateralizing our loans are located on interstate highways. As seen in the past, when gas prices sharply increase, occupancy rates decrease for properties located on interstate highways.

     While occupancy increased slightly for the overall hospitality industry, average room rates showed a slight decline in 2004 based on published industry statistics. We anticipate that lodging demand will increase in 2005 and 2006 as the lodging industry follows the economy. We believe improving economic trends in the lodging industry will generate an increase in competition among lenders, especially those lenders offering alternatives such as fixed-rate and “mini-perm” loans.

Loan Originations and Underwriting

     We originate mortgage loans to small businesses primarily collateralized by commercial real estate. We believe that we successfully compete in the commercial real estate finance market due to our understanding of our borrowers’ businesses, the flexible loan terms that we offer and our responsive customer service. Our approach to assessing new commercial mortgage loans requires an analysis of the replacement cost of the collateral, its liquidation value and an analysis of local market conditions.

     We also consider the underlying cash flow of the tenant or owner-occupant as well as more traditional real estate underwriting criteria such as:

     Upon receipt of a completed loan application, our credit department conducts: (i) a detailed analysis of the loan, which typically includes an appraisal and a valuation by our credit department of the property that will collateralize the loan to ensure compliance with loan-to-value percentages, (ii) a site inspection for real estate collateralized loans, (iii) a review of the borrower’s business experience, (iv) a review of the borrower’s credit history, and (v) an analysis of the borrower’s debt-service-coverage and debt-to-equity ratios. All appraisals must be performed by an approved, licensed third party appraiser and based on the market value, replacement cost and cash flow value approaches. We generally utilize nationwide independent appraisal firms and seek local market economic information to the extent available.

4

     Our typical loan is distinguished from those of some of our competitors by the following characteristics:

     We are currently originating primarily variable-rate loans. Our variable-rate loans are based on LIBOR, or the prime rate (primarily SBA 7(a) lending). While we have originated fixed-rate loans, we do not expect to originate a significant amount of additional fixed-rate loans in the near future since our sources of funds are primarily variable-rate and due to competitors with a lower cost of funds. Management continually evaluates potential sources of capital with a fixed-rate cost to determine if a fixed-rate loan product would be feasible. Due to the current level of interest rates for smaller companies like ours, it does not appear that a significant amount of capital with a fixed interest cost is available to us that would allow us to generate appropriate spreads to compensate us for the commensurate risk of the loans that would be originated. We will continue to monitor the leverage market for possible fixed-rate sources of capital and to the extent we identify an appropriate source, we may establish a fixed-rate lending product. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Current Operating Overview and Economic Factors – Lending Division.”

     General information on our loans receivable, net, was as follows:

     Our variable-rate loans receivable generally require monthly payments of principal and interest, reset on a quarterly basis, to amortize the principal over ten to 20 years. Fixed-rate loans receivable generally require level monthly payments of principal and interest calculated to amortize the principal over ten to 25 years.

5

Loan Activity

     The following table details our loan activity for the years indicated:

Quarterly Loan Originations

     The following table is a breakdown of loans originated on a quarterly basis during the years indicated:

6

Loan Portfolio Statistics

     Information on our loans receivable, loans which have been sold and on which we have retained interests (the “Sold Loans”) and our loans receivable combined with our Sold Loans (the “Aggregate Portfolio”) was as follows:

Industry Concentration

     The distribution of our loan portfolio by industry was as follows at December 31, 2004:

7

SBA Programs

General

     We participate as a private lender in the SBA 504 Program which allows us to originate first mortgage loans with lower loan-to-value ratios. In addition, the businesses acquired from PMC Capital operate under several licenses from the SBA. First Western is a licensed small business lending company (“SBLC”) that originates loans through the SBA’s 7(a) Guaranteed Loan Program (“SBA 7(a) Loan Program”). PMCIC is a licensed specialized small business investment company (“SSBIC”) under the Small Business Investment Act of 1958, as amended (“SBIA”). PMCIC uses long-term funds provided by the SBA, together with its own capital, to provide long-term collateralized loans to eligible small businesses owned by “disadvantaged” persons, as defined under SBA regulations. Western Financial is a licensed SBIC under the SBIA that provides loans to borrowers whether or not they qualify as “disadvantaged.”

     First Western, PMCIC and Western Financial are periodically examined and audited by the SBA to determine compliance with SBA regulations.

Section 504

     The SBA 504 Program assists small businesses in obtaining subordinated, long-term financing by guaranteeing debentures available through certified development companies for the purpose of acquiring land, building, machinery and equipment and for modernizing, renovating or restoring existing facilities and sites. A typical finance structure for an SBA 504 Program project would include a first mortgage covering 50% of the project cost from a private lender, a second mortgage obtained through the SBA 504 Program covering up to 40% of the project cost and a contribution of at least 10% of the project cost by the principals of the small businesses being assisted. We typically require at least 20% of the equity in a project to be contributed by the principals of the borrower. The SBA does not guarantee the first mortgage. Although the total sizes of projects utilizing the SBA 504 Program guarantees are unlimited, currently the maximum amount of subordinated debt in any individual project generally is $1.5 million (or $2 million for certain projects). Typical project costs range in size from $500,000 to $4 million.

SBA 7(a) Loan Program

     First Western is licensed to operate as an SBLC. The SBA guarantees 75% of qualified loans over $150,000 with such individual guarantees not exceeding $1.5 million. While the eligibility requirements of the SBA 7(a) Loan Program vary by the industry of the borrower and other factors, the general eligibility requirements are that: (i) gross sales of the borrower cannot presently exceed $6 million, (ii) liquid assets of the borrower and affiliates cannot exceed specified limits, and (iii) the maximum aggregate SBA loan guarantees to a borrower cannot exceed $1.5 million. Maximum maturities for SBA 7(a) loans are 25 years for real estate and between seven and 15 years for the purchase of machinery, furniture, fixtures and/or equipment. In order to operate as an SBLC, a licensee is required to maintain a minimum net worth (as defined by SBA regulations) of the greater of (i) 10% of the outstanding loans receivable of First Western or (ii) $1.0 million, as well as certain other regulatory restrictions such as change in control provisions. See “Risk Factors.”

SBIC Program

     SBICs are intended to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a net worth not exceeding $18 million and have average annual fully taxable net income not exceeding $6 million for the most recent two fiscal years. According to SBA regulations, SBICs may make long-term loans to small businesses and invest in the equity securities of such businesses. Under SBA regulations, an SBIC can issue debentures whose principal and interest is guaranteed to be paid in the event of non-payment by the SBIC. As a result, the debentures’ costs of funds are usually advantageous compared to alternative fixed-rate sources of funds available to us.

PROPERTY OWNERSHIP

     During the year ended December 31, 2004, total revenues and income from continuing operations for our property division were approximately $5.5 million (22% of our total revenues) and $1.7 million (14% of our total income from continuing operations), respectively. Total assets allocated to the property division were approximately $39.6 million (16% of total assets) at December 31, 2004.

8

     At December 31, 2004, we owned 19 limited service hospitality properties (the “Hotel Properties”) that we purchased in 1998 and 1999 through a sale/leaseback agreement with Arlington Hospitality, Inc. (“Arlington”). Arlington, through its wholly-owned subsidiary, is the operator of our properties through an amended master lease agreement that provides for base rent (currently $3.9 million per year) and percentage rent equal to 4% of the gross room revenues generated by the Hotel Properties. The master lease agreement, as amended, and the underlying individual property leases, as amended, expire in June 2008, but each can be extended by either Arlington or us for one five-year period, and thereafter by Arlington for a five-year period and a subsequent two-year period. If fully extended, the term of the master lease agreement, as amended, would continue until September 2020. Arlington operates our Hotel Properties as “Amerihost Inns” which is a brand name franchised by Cendant Corporation, the largest franchisor of limited service hospitality properties.

     Effective October 1, 2004, we amended the master lease agreement (the “Master Lease Agreement”) and the individual lease agreements to provide incentive for, among other things, the disposition of the Hotel Properties prior to October 1, 2008. Also, the current base rent was reduced from approximately 10.5% to 8.5% of the Stated Value established for the Hotel Properties. The Stated Value of each Hotel Property (currently an aggregate of $46.1 million) is the value attributed to each Hotel Property at inception of the lease agreement for purposes of determining the lease payment. The Master Lease Agreement stipulates increases in base rent to approximately 10.5% or 15% unless, on a cumulative basis, at least five of the Hotel Properties are sold over each of the next four years.

     To the extent we approve sales of our Hotel Properties, certain of our Hotel Properties could be deemed impaired and impairment losses that result, if any, could be material. Our Hotel Properties are reviewed for impairment whenever events or circumstances indicate that the carrying amount of the Hotel Property may not be recoverable, but in no event less than on a quarterly basis. Based on the Master Lease Agreement, if impairment losses were to occur, we would receive shortfall notes receivable from Arlington. See “Item 7. Management’s Discussion and Analysis – Current Operating Overview and Economic Factors – Property Division.”

STRUCTURED LOAN TRANSACTIONS

General

     Structured loan transactions have historically been our primary method of obtaining funds for new loan originations. In a structured loan transaction, we contribute loans receivable to an SPE in exchange for a subordinate financial interest in that entity and obtain an opinion of counsel that the contribution of the loans receivable to the SPE constitutes a “true sale” of the loans receivable. The SPE issues notes payable (usually through a private placement) to third parties and then distributes a portion of the notes payable proceeds to us. The notes payable are collateralized solely by the assets of the SPE. We account for structured loan sale transactions as sales of our loans receivable and the SPE meets the definition of a QSPE; as a result, neither the loans receivable contributed to the QSPE nor the notes payable issued by the QSPE are included in our consolidated financial statements. The terms of the notes payable issued by the QSPEs provide that the partners of these QSPEs are not liable for any payment on the notes. Accordingly, if the QSPEs fail to pay the principal or interest due on the notes, the sole recourse of the holders of the notes is against the assets of the QSPEs. We have no obligation to pay the notes, nor do the holders of the notes have any recourse against our assets. We are the servicer of the loans pursuant to the transaction documents and are paid a fee of 30 basis points per year based on the principal outstanding.

     When a structured loan sale transaction is completed: (1) our ownership interests in the QSPEs are accounted for as retained interests in transferred assets (“Retained Interests”) and are recorded at the present value of the estimated future cash flows to be received from the QSPE and (2) the difference between (i) the carrying value of the loans receivable sold and (ii) the sum of (a) the cash received and (b) the relative fair value of our Retained Interests, constitutes the gain or loss on sale. Gains or losses on these sales may represent a material portion of our net income in the period in which the transactions occur.

     A structured loan financing is similar to a structured loan sale, with the exception that the transaction is not treated as a sale for financial reporting purposes. Therefore, the loans receivable contributed to the SPE and the notes payable issued by the SPE are included in our consolidated financial statements and as a result, the ownership interest in the SPE is not accounted for as a retained interest. Even though the loans receivable and the notes payable are included on our balance sheets from the structured loan financing transaction completed by PMC Commercial in 1998, PMC Commercial has no obligation to pay the notes, nor do the holders of the notes have any recourse against PMC Commercial’s assets. The terms of the notes payable issued by the SPE provide that PMC

9

Commercial is not liable for payment on the notes. Accordingly, even though the loans receivable and the notes payable of the SPE are included in our consolidated financial statements, if the SPE fails to pay the principal or interest on the notes, the sole recourse of the holders of the notes is against the loans receivable and any other assets of the SPE.

     Our structured loan sale transactions and structured loan financing transactions receive opinions from outside counsel that opine to the legal sale of the loans to the legal entity formed in connection with the securitization. Each of our completed securitization transactions (both structured loan sale transactions and structured loan financing transactions) provides a clean-up call. A clean-up call is an option allowed by the transaction documents to repurchase the transferred assets when the amount of the outstanding assets (or corresponding notes payable outstanding) falls to a level at which the cost of servicing those assets becomes burdensome. The clean-up call option regarding a loan in a QSPE or SPE is exercised by the party that contributed the loan to the QSPE or SPE. As a result of the characteristics underlying the structured loan transaction not satisfying the requirements of off-balance sheet accounting treatment, the 1998 securitization originated by PMC Commercial was considered a structured loan financing transaction.

     Since we have historically relied on structured loan transactions as our primary source of operating capital to fund new loan originations, any adverse changes in our ability to complete this type of transaction, including any negative impact on the asset-backed securities market for the type of product we generate, could have a detrimental effect on our ability to generate funds to originate loans. See “Risk Factors.”

Structured Loan Sale Transactions

General

     As of December 31, 2004, the QSPEs consisted of:

     As a result of the merger, we acquired PMC Capital’s subordinate interests in the Joint Ventures and 100% of the subordinate interests in the 1998 Partnership and the 1999 Partnership (collectively, the “Acquired Structured Loan Sale Transactions”). The remaining subordinate interests of the Joint Ventures were 32% of the 2000 Joint Venture, 58% of the 2001 Joint Venture, 61% of the 2002 Joint Venture and 56% of the 2003 Joint Venture . We previously owned the remaining subordinate interests in the Joint Ventures (the “Originated Structured Loan Sale Transactions”).

     Even though we now own 100% of the subordinate interest in each of the Joint Ventures, since a portion was obtained through acquisition (via merger with PMC Capital), we have recorded these investments separately. At the date of acquisition, the fair value of the Acquired Structured Loan Sale Transactions became our cost.

     In addition, First Western has Retained Interests related to the sale of loans originated pursuant to the SBA 7(a) Loan Program. First Western sold the unguaranteed portion of its loans through a private placement in 1997 (“First Western 1997”) and has retained the right to service these loans. We acquired 100% of First Western 1997 in the merger.

2002 and 2003 Structured Loan Sale Transactions

     On October 7, 2003, we completed a structured loan sale transaction of a pool of variable-rate loans receivable. PMC Commercial and PMC Capital contributed loans receivable of $45.4 million and $57.8 million, respectively, to the 2003 Joint Venture. The 2003 Joint Venture issued, through a private placement, approximately $92.9 million of its 2003 Loan-Backed Floating Rate Notes (the “2003 L.P. Notes”) of which approximately $40.9 million was allocated to us based on our ownership percentage in the 2003 Joint Venture. The 2003 L.P. Notes, issued at par, have a stated maturity in 2023, bear interest, reset on a quarterly basis, at the 90-day LIBOR plus 1.25%, and are collateralized by the loans receivable contributed by us and PMC Capital to the 2003 Joint Venture. We accounted for this transaction as a sale, recorded a gain of $711,000 and recorded our Retained Interests at an

10

initial amount of $8,698,000 during 2003. At inception of the 2003 Joint Venture, we had a subordinate interest of 44% in the limited partnership based on our share of the capital.

     On April 12, 2002, we completed a structured loan sale transaction of a pool of primarily fixed-rate loans receivable. PMC Commercial and PMC Capital contributed loans receivable of $27.3 million and $43.2 million, respectively, to the 2002 Joint Venture. The 2002 Joint Venture issued, through a private placement, approximately $63.5 million of its 2002 Loan-Backed Fixed Rate Notes (the “2002 L.P. Notes”) of which approximately $24.6 million was allocated to us based on our ownership percentage in the 2002 Joint Venture. The 2002 L.P. Notes, issued at par, have a stated maturity in 2023, bear interest at 6.67% and are collateralized by the loans receivable contributed by us and PMC Capital to the 2002 Joint Venture. We accounted for this transaction as a sale, recorded a gain of $562,000 and recorded our Retained Interests at an initial amount of $5,293,000 during 2002. At inception of the 2002 Joint Venture, we had a subordinate interest of 39% in the limited partnership based on our share of the capital.

     The terms of the notes issued in conjunction with the 2000 Joint Venture, the 2001 Joint Venture, the 2002 Joint Venture and the 2003 Joint Venture (collectively the “JV Notes”) provide that the partners of the respective Joint Ventures are not liable for any payments on the JV Notes. Accordingly, if the Joint Ventures fail to pay the JV Notes, the sole recourse of the holders of the JV Notes is against the assets of the respective Joint Venture. Accordingly, we have no obligation to pay the JV Notes, nor do the holders of the JV Notes have any recourse against our assets.

Information on Originated Structured Loan Sale Transactions

     Information relating to our Originated Structured Loan Sale Transactions was as follows:

11

Information on Acquired Structured Loan Sale Transactions and First Western 1997

     Information relating to our Acquired Structured Loan Sale Transactions and First Western 1997 (purchased on February 29, 2004) was as follows:

Retained Interests

     Retained Interests represent our residual interest in the loans sold to the QSPE. When we securitize loans, we are required to recognize Retained Interests, which represent our right to receive net future cash flows, at their fair value. Our Retained Interests consist of (i) the required overcollateralization, which is the retention of a portion of each of the Sold Loans, (ii) the reserve fund, which represents the required cash balance owned by the QSPE and (iii) the interest-only strip receivable, which represents the future excess funds to be generated by the QSPE after payment of all obligations of the QSPE. Our Retained Interests are subject to credit, prepayment and interest rate risks. The estimated fair value of our Retained Interests is determined based on the present value of estimated future cash flows that we will receive from the QSPEs. The estimated future cash flows are calculated based on assumptions concerning, among other things, loan losses and prepayment speeds. On a quarterly basis, we measure the fair value of, and record income relating to, the Retained Interests based upon the future anticipated cash flows discounted based on an estimate of market interest rates for investments of this type. Any appreciation of the Retained Interests is included in our balance sheet in beneficiaries’ equity. Any depreciation of Retained Interests is either included in our statement of income as either a realized loss (if there is a reduction in expected future cash flows) or on the balance sheet in beneficiaries’ equity as an unrealized loss.

12

     We retain a portion of the default and prepayment risk associated with the underlying loans of our Retained Interests. Actual defaults and prepayments, with respect to estimating future cash flows for purposes of valuing our Retained Interests will vary from our assumptions, possibly to a material degree, and slower (faster) than anticipated prepayments of principal or lower (higher) than anticipated loan losses will increase (decrease) the fair value of our Retained Interests and related cash flows. We regularly measure our loan loss, prepayment and other assumptions against the actual performance of the loans sold. Although we believe that assumptions made as to the future cash flows are reasonable, actual rates of loss or prepayments will vary from those assumed and the assumptions may be revised based upon changes in facts or circumstances. See “Risk Factors – There is volatility in the valuation of our Retained Interests.”

TAX STATUS

     PMC Commercial has elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, PMC Commercial is generally not subject to Federal income tax (including any applicable alternative minimum tax) to the extent that it distributes at least 90% of its REIT taxable income to shareholders. First Western and PMCIC have elected to be treated as taxable REIT subsidiaries; thus, their earnings are subject to U.S. Federal income tax. To the extent our taxable REIT subsidiaries retain their earnings and profits, these earnings and profits will be unavailable for distribution to our shareholders.

     PMC Commercial may, however, be subject to certain Federal excise taxes and state and local taxes on its income and property. If PMC Commercial fails to qualify as a REIT in any taxable year, it will be subject to Federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and will not be able to qualify as a REIT for four subsequent taxable years. REITs are subject to a number of organizational and operational requirements under the Code. See “Risk Factors” for additional tax status information.

RISK FACTORS

     Management has identified the following important factors that could cause actual results to differ materially from those reflected in forward-looking statements or from our historical results. These factors, which are not all-inclusive, could have a material impact on our asset valuations, results of operations or financial condition. In addition, these factors could impair our ability to maintain dividend distributions at current levels.

We have a concentration of investments in the hospitality industry and in certain states, which may negatively impact the market price of our shares.

     Substantially all of our revenue is generated from lending to hospitality properties and the ownership of Hotel Properties. Our loans receivable were approximately 95% concentrated in the hospitality industry at December 31, 2004. In addition, approximately 90% of the loans receivable underlying our Retained Interests were concentrated in the hospitality industry as of December 31, 2004. Any economic factors that negatively impact the hospitality industry, including terrorism, travel restrictions, bankruptcies or other political or geopolitical events, could have a material adverse effect on our financial condition and results of operations.

     At December 31, 2004, approximately 14% of our loans receivable were collateralized by properties in Texas and approximately 12% were collateralized by properties in Virginia. Approximately 29% of the loans receivable underlying our Retained Interests were collateralized by properties in Texas. No other state had a concentration of 10% or greater of our loans receivable, Sold Loans or Aggregate Portfolio at December 31, 2004. See “Properties” in Item 2 of this Form 10-K for information on state concentrations related to our Hotel Properties. A decline in economic conditions in any state in which we have a concentration of investments could have a material adverse effect on our financial condition and results of operations.

We are dependent on third party management for the operation and sale of our Hotel Properties.

     We are currently dependent upon Arlington to operate and manage our Hotel Properties under the Master Lease Agreement. The operating results of our Hotel Properties are subject to a variety of risks which could negatively impact the cash flow from our Hotel Properties to support the payment obligations under the Master Lease Agreement. Arlington announced in its Annual Report on Form 10-K for the year ended December 31, 2003, that the aggregate cash flow from the operations in 2003 of the Hotel Properties that we own and lease to one of Arlington’s subsidiaries was not sufficient to pay the lease obligations and ongoing capital expenditures related to these Hotel Properties as required by the amended individual lease agreements. To the extent the cash flows from

13

our Hotel Properties are less than the lease payments, the shortfall is paid by Arlington from its other operations since Arlington has guaranteed the lease payments.

     Per the Master Lease Agreement, Arlington is responsible for identifying and marketing our Hotel Properties for sale. There can be no assurance that the Hotel Properties will be sold at the best price or that buyers will be identified for our Hotel Properties. The Master Lease Agreement provides for incentives to sell the Hotel Properties in specific time frames. Arlington’s ability to meet those deadlines will allow the continuation of the reduced base rent.

     In the event Arlington defaults on the Master Lease Agreement, there can be no assurance that we would be able to find a new operator for our Hotel Properties, negotiate to receive the same amount of lease income or that we would be able to collect on the guarantee of Arlington. In addition, in the event Arlington defaults, we would incur costs including holding costs, legal fees and costs to re-franchise the properties.

     We will continue to need capital to fund loans. Our long-term ability to continue to grow depends, to a large extent, on our ability to sell our asset-backed securities through structured loan transactions. In certain economic markets the availability of funds may be diminished or the “spread” charged for funds may increase causing us to delay a structured loan transaction. In addition, terrorist attacks or political or geopolitical events could impact the availability and cost of our capital.

     A number of factors could impair our ability, or alter our decision, to complete a structured loan transaction. These factors include, but are not limited to:

     Significant changes in any of these criteria may result in us temporarily suspending our use of structured loan transactions and we may seek other sources of financing. A reduction in the availability or an increased cost of this source of funds could have a material adverse effect on our financial condition and results of operations since working capital may not be available or available at acceptable “spreads” to fund our future loan originations or to acquire real estate.

Economic slowdowns, negative political events and changes in the competitive environment could adversely affect operating results.

     Several factors may impact the hospitality industry. Many of the businesses to which we have made, or will make, loans and Arlington may be susceptible to economic slowdowns or recessions. Terrorism, bankruptcies or other political or geopolitical events could affect our borrowers. Our non-performing assets are likely to increase during these periods. These conditions could lead to losses in our portfolio and a decrease in our interest income, net income and assets. During economic downturns, there may be reductions in business travel and consumers generally take fewer vacations. Another factor which affects the limited service sector of the hospitality industry is a significant rise in gasoline prices within a short period of time. Most of the limited service hospitality properties collateralizing our loans are located on interstate highways. As seen in the past, when gas prices sharply increase, occupancy rates for properties located on interstate highways decrease. These factors may cause a reduction in revenue per available room (“RevPAR”). If RevPAR for the limited service sector of the hospitality industry were to experience significant sustained reductions, the ability of our borrowers to meet their obligations could be impaired and loan losses could increase and the ability of Arlington to meet its obligations could be impaired.

14

     Many of our competitors have greater financial and managerial resources than us and are able to provide services we are not able to provide (i.e., depository services). As a result of these competitors’ greater financial resources, they may be better able to withstand the impact of economic downturns than we are.

As a result of the merger with PMC Capital, we now originate riskier loans and loan losses could increase.

     As a result of the merger with PMC Capital, we acquired loans that either were impaired loans at the time of the merger or have become impaired loans subsequent to the merger. In addition, the loan origination platform that we acquired from PMC Capital (including lending through the SBA 7(a) Loan Program) generally is for loans which are more susceptible to loss and which may have higher loan-to-value ratios than we had previously originated. As a result, our loans may incur losses in future periods in greater amounts than had historically been realized.

Our operating results could be negatively impacted by our inability to access certain financial markets.

     We rely upon access to capital markets as a source of liquidity to satisfy our working capital needs, grow and invest in loans. Although we believe that we maintain sufficient access to these financial markets, adverse changes in the economy, the overall health of the limited service hospitality industry and increased loan losses could limit access to these markets and restrict us from continuing our current operating strategy or implementing new operating strategies.

Competition might prevent us from originating loans at favorable yields, which would harm our results of operations and our ability to continue paying dividends at current levels.

     Our net income depends on our ability to originate loans at favorable spreads over our borrowing costs. In originating loans, we compete with other specialty commercial lenders, banks, other REITs, savings and loan associations, insurance companies and other entities that originate loans, many of which have greater financial resources than us. As a result, we may not be able to originate sufficient mortgage loans at favorable spreads over our borrowing costs, which would harm our results of operations and consequently, our ability to continue paying dividends at current levels.

There is volatility in the valuation of our Retained Interests.

     Due to the limited number of entities that conduct transactions with similar assets, the relatively small size of our Retained Interests and the limited number of buyers for such assets, no readily ascertainable market exists for our Retained Interests. Therefore, our estimate of the fair value may vary significantly from what a willing buyer would pay for these assets. If we were forced to immediately liquidate some or all of our Retained Interests, the proceeds of such liquidation may be significantly less than the current estimated fair value of such Retained Interests.

     The estimated fair value of our Retained Interests is determined based on certain assumptions including, but not limited to, anticipated defaults, prepayment speeds and discount rates. We retain a portion of the default and prepayment risk associated with the underlying transferred loans of our Retained Interests. As more fully described below, actual defaults and prepayments with respect to estimating future cash flows for purposes of valuing the Retained Interests may vary from our assumptions, possibly to a material degree, and slower (faster) than anticipated prepayments of principal or lower (higher) than anticipated loan losses will increase (decrease) the fair value of our Retained Interests and the related estimated cash flows. The discount rates utilized are determined for each of the assets comprising the Retained Interests based upon an estimate of the inherent risks associated with each asset.

15

     The following is a sensitivity analysis of our Retained Interests as of December 31, 2004 to highlight the volatility that results when prepayments, loan losses and discount rates are different than our assumptions:

     These sensitivities are hypothetical and should be used with caution. Values based on changes in these assumptions generally cannot be extrapolated since the relationship of the change in assumptions to the change in value may not be linear. The effect of a variation in a particular assumption on the estimated fair value of our Retained Interests is calculated without changing any other assumption. In reality, changes in one factor are not isolated from changes in another which might magnify or counteract the sensitivities.

     Changes in any of these assumptions or actual results which deviate from assumptions will affect the estimated fair value of our Retained Interests, possibly to a material degree. There can be no assurance as to the accuracy of these estimates.

We are leveraged.

     We have borrowed funds and intend to obtain additional funds through advances under our revolving credit facility and conduit warehouse facility, completion of junior subordinated debt and/or preferred stock or SBA debentures, if available. As a result, we use leverage to fund our capital needs. Private lenders and the SBA have fixed dollar claims on our assets superior to the claims of the holders of our common shares. Leverage magnifies the effect that rising or falling interest rates have on our earnings. Any increase in the interest rate earned by us on investments in excess of the interest rate on the funds obtained from borrowings would cause our net income and earnings per share to increase more than they would without leverage, while any decrease in the interest rate earned by us on investments would cause net income and earnings per share to decline by a greater amount than they would without leverage. Leverage is thus generally considered a speculative investment technique. In order for us to repay indebtedness on a timely basis, we may be required to dispose of assets when we would not otherwise do so and at prices which may be below the net book value of such assets. Dispositions of assets could have a material adverse effect on our financial condition and results of operations.

There are significant risks in lending to small businesses.

     Our loans receivable consist primarily of loans to small, privately-owned businesses. There is no publicly available information about these businesses; therefore, we must rely on our own due diligence to obtain information in connection with our investment decisions. Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by banks. A borrower’s ability to repay its loan may be adversely impacted by numerous factors, including a downturn in its industry or other negative economic conditions. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in the collateral for the loan. In addition, small businesses typically depend on the management talents and efforts of one person or a small group of people for their success. The loss of services of one or more of these persons could have an adverse impact on the operations of the small business. Small companies are typically more vulnerable to customer preferences, market conditions and economic downturns and often need additional capital to expand or compete. These factors may have an impact on the ultimate recovery of our loans receivable from such businesses. Loans to small businesses,

16

therefore, involve a high degree of business and financial risk, which can result in substantial losses and accordingly should be considered speculative.

There is volatility in the valuation of our loans receivable.

     There is typically no public market or established trading market for the loans we originate. The illiquid nature of our loans may adversely affect our ability to dispose of such loans at times when it may be advantageous for us to liquidate such investments.

     To the extent one or several of our borrowers experience significant operating difficulties and we are forced to liquidate the loan, future losses may be substantial. The determination of whether significant doubt exists and whether a loan loss reserve is necessary for each loan requires judgment and consideration of the facts and circumstances existing at the evaluation date. Changes to the facts and circumstances of the borrower and/or the physical condition of the collateral underlying the loan, the hospitality industry and the economy may require the establishment of significant additional loan loss reserves.

We have an ongoing need for additional capital since earnings are required to be paid as dividends.

     We will continue to need capital to fund loans. Historically, we have sold loans receivable as part of structured loan transactions, borrowed from financial institutions and issued equity securities to raise capital. A reduction in the availability of funds from financial institutions or the asset-backed securities market could have a material adverse effect on our financial condition and our results of operations. We must distribute at least 90% of our REIT taxable income to our shareholders to maintain our REIT status under the Code. As a result, that income will not be available to fund loan originations or acquire real estate. We expect to be able to borrow from financial institutions and sell loans receivable in the asset-backed securities market in the future.

We are subject to prepayment risk on our Retained Interests and loans receivable which could result in losses or reduced earnings and negatively affect our cash available for distribution to shareholders.

     Prepayments of fixed-rate loans generally increase during times of declining interest rates. Conversely, prepayments of variable-rate loans may increase during times of increasing interest rates and are more susceptible to prepayment as a result of lower prepayment fees. The proceeds from the prepayments we receive are either used to repay debt or invested initially in temporary investments and for prepayments of our fixed-rate loans have generally been re-loaned or committed to be re-loaned at lower interest rates than the prepaid loans receivable. The lower interest rates we receive on these new loans receivable have had an adverse effect on our results of operations and depending upon the rate of future prepayments may further impact our results of operations. The impact of the lower lending rates on our net income may be partially offset by the reduced cost of our variable-rate borrowings in a lower interest rate environment. In addition, when loans receivable are repaid prior to their maturity, we often receive prepayment fees.

     Prepayments of loans of the QSPEs may have a negative impact on our financial condition or results of operations. Prepayments of loans receivable with higher interest rates negatively impact the fair value of our Retained Interests to a greater extent than prepayments of loans receivable with lower interest rates. Prepayments in excess of assumptions will cause a decline in the fair value of our Retained Interests primarily relating to a reduction in the excess funds (our interest-only strip receivable) expected from our structured loan sale transactions. For example, if a $1.0 million loan with an interest rate of 10% prepays and the “all-in cost” of that QSPE’s structured notes was 7%, we would lose the 3% spread we had expected to receive on that loan in future periods. Our “all-in costs” include interest, servicing, trustee and other ongoing costs. The “spread” that is lost may be offset in part or in whole by the prepayment fee that we collect.

     First Western, our SBA guaranteed lending company, sells the guaranteed portion of most of its originated loans through private placements (“Secondary Market Sales”). These sales are especially sensitive to prepayments. Our Retained Interests in these loan sales consists only of the spread between the interest First Western collects from the borrower and the interest paid to the purchaser of the guaranteed portion of the loan. Therefore, to the extent the prepayments of these loans exceed estimates, there is a significant impact on the estimated fair value of the associated Retained Interests.

Changes in interest rates could negatively affect lending operations, which could result in reduced earnings.

     The net income of our lending operations is materially dependent upon the “spread” between the rate at

17

which we borrow funds (historically either short-term at variable rates or longer term at fixed rates) and the rate at which we loan these funds. During periods of changing interest rates, interest rate mismatches could negatively impact our net income, dividend yield, and the market price of our common shares.

     At the present time, we primarily originate variable-rate loans and have debt which is long-term and at fixed interest rates and preferred stock which is long-term with a fixed dividend yield. If the yield on loans originated with funds obtained from fixed-rate borrowings or preferred stock fails to cover the cost of such funds, our cash flow will be reduced.

     As a result of our dependence on variable-rate loans (all of our current commitments are for variable-rate loans), our interest income has been reduced (excluding the impact of loans acquired in the merger) during this low interest rate environment. In addition, to the extent that rates remain at these historically low levels, or if LIBOR or the prime rate decreases from current levels, interest income on our currently outstanding loans receivable will decline.

     Changes in interest rates do not have an immediate impact on the interest income of our fixed-rate loans receivable. Our interest rate risk on our fixed-rate loans receivable is primarily due to loan prepayments and maturities. The average maturity of our loan portfolio is less than their average contractual terms because of prepayments. The average life of mortgage loans receivable tends to increase when the current mortgage rates are substantially higher than rates on existing mortgage loans receivable and, conversely, decrease when the current mortgage rates are substantially lower than rates on existing mortgage loans receivable (due to refinancings of fixed-rate loans receivable at lower rates).

Our Board of Trust Managers may change operating policies and strategies without shareholder approval or prior notice and such change could harm our business and results of operations and the value of our stock.

     Our Board of Trust Managers has the authority to modify or waive our current operating policies and strategies, including PMC Commercial’s election to operate as a REIT, without prior notice and without shareholder approval. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, operating results and value of our stock; however, the effect could be adverse.

We depend on the accuracy and completeness of information about potential borrowers and guarantors.

     In deciding whether or not to extend credit or enter into transactions with potential borrowers and/or their guarantors, we may rely on information furnished to us by or on behalf of potential borrowers and/or guarantors, including financial statements, construction invoices and other financial information. We may also rely on representations of potential borrowers and/or guarantors as to the accuracy and completeness of that information. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that are materially misleading.

There may be significant fluctuations in our quarterly results.

Our quarterly operating results fluctuate based on a number of factors, including, among others:

     As a result of the above factors, quarterly results should not be relied upon as being indicative of performance in future quarters.

     To the extent a structured loan sale transaction is completed, (i) our interest income on loans receivable in future periods will be reduced until the proceeds received are reinvested in new loan originations, (ii) interest expense will be reduced if we repay outstanding debt with the proceeds and (iii) we will earn income from our ownership of a Retained Interest in the loans sold. Until the proceeds are fully reinvested, the net impact of a structured loan sale transaction on future operating periods should be a reduction in interest income, net of interest expense.

18

We depend on our key personnel, and the loss of any of our key personnel could adversely affect our operations.

     We depend on the diligence, experience and skill of our key personnel (executive officers) who provide management services to us for the selection, acquisition, structuring, monitoring and sale of our portfolio assets and the borrowings used to acquire these assets. We have entered into employment agreements with the majority of our executive officers who devote all of their business time to our business. The loss of any executive officer could harm our business, financial condition, cash flow and results of operations.

Failure to qualify as a REIT would subject us to U.S. Federal income tax.

     If a company meets certain income and asset diversification and income distribution requirements under the Code, it can qualify as a REIT and be entitled to pass-through tax treatment. We would cease to qualify for pass-through tax treatment if we were unable to comply with these requirements. PMC Commercial is also subject to a non-deductible 4% excise tax (and, in certain cases, corporate level income tax) if we fail to make certain distributions. Failure to qualify as a REIT would subject us to Federal income tax as if we were an ordinary corporation, resulting in a substantial reduction in both our net assets and the amount of income available for distribution to our shareholders.

     We believe that we have operated in a manner that allows us to qualify as a REIT under the Code and intend to continue to so operate. Although we believe that we are organized and operate as a REIT, no assurance can be given that we will continue to remain qualified as a REIT. Qualification as a REIT involves the application of technical and complex provisions of the Code for which there are limited judicial or administrative interpretations and involves the determination of various factual matters and circumstances not entirely within our control. In addition, no assurance can be given that new legislation, regulations, administrative interpretations or court decisions will not significantly change the tax laws with respect to qualification as a REIT or the Federal income tax consequences of such qualification.

If the combined company fails to qualify as a REIT, we may, among other things:

     As a result of these factors, our failure to qualify as a REIT also could impair our ability to expand our business and raise capital, substantially reduce the funds available for distribution to our shareholders and may reduce the market price of our common shares.

Ownership limitation may restrict change of control or business combination opportunities.

     In order for us to qualify as a REIT, no more than 50% in value of our outstanding capital shares may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year. “Individuals” include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts.

     In order to preserve our REIT status, our declaration of trust generally prohibits any shareholder from directly or indirectly owning more than 9.8% of any class or series of our outstanding common shares or preferred shares. The ownership limitation could have the effect of discouraging a takeover or other transaction in which holders of our common shares might receive a premium for their shares over the then prevailing market price or which holders might believe to be otherwise in their best interests.

U.S. Federal income tax requirements may restrict our operations which could restrict our ability to take advantage of attractive investment opportunities.

     We believe we have operated, and will continue to operate, in a manner that is intended to qualify as a REIT for U.S. Federal income tax purposes. However, the U.S. Federal income tax laws governing REITs are extremely complex, and interpretations of the U.S. Federal income tax laws governing qualification as a REIT are

19

limited. Qualifying as a REIT will require us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding shares and the amount of distributions we make on an ongoing basis.

     At any time, new laws, interpretations, or court decisions may change the federal tax laws regarding, or the U.S. Federal income tax consequences of, qualification as a REIT. In addition, compliance with the REIT qualification tests could restrict our ability to take advantage of attractive investment opportunities in non-qualifying assets, which would negatively affect the cash available for distribution to our shareholders.

Failure to make required distributions would subject us to tax.

     In order to qualify as a REIT, an entity generally must distribute to its shareholders, each taxable year, at least 90% of its taxable income, other than any net capital gain and excluding the non-distributed taxable income of taxable REIT subsidiaries. As a result, our shareholders receive periodic distributions from us. Such distributions are taxable as ordinary income to the extent that they are made out of current or accumulated earnings and profits. To the extent that a REIT satisfies the 90% distribution requirement, but distributes less than 100% of its taxable income, it will be subject to federal corporate income tax on its undistributed income. In addition, the REIT will incur a 4% nondeductible excise tax on the amount, if any, by which its distributions in any calendar year are less than the sum of:

     We have paid out, and intend to continue to pay out, our REIT taxable income to our shareholders in a manner intended to satisfy the 90% distribution requirement and to avoid both Federal corporate income tax and the 4% excise tax.

     Our taxable income may substantially exceed our net income as determined based on generally accepted accounting principles (“GAAP”) because, for example, capital losses will be deducted in determining GAAP income, but may not be deductible in computing taxable income. In addition, we may invest in assets that generate taxable income in excess of economic income or in advance of the corresponding cash flow from the assets, referred to as excess non-cash income. Although some types of non-cash income are excluded in determining the 90% distribution requirement, we will incur federal corporate income tax and the 4% excise tax with respect to any non-cash income items if we do not distribute those items on an annual basis. As a result of the foregoing, we may generate less cash flow than taxable income in a particular year. In that event, we may be required to use cash reserves, incur debt, or liquidate non-cash assets at rates or times that we regard as unfavorable in order to satisfy the distribution requirement and to avoid federal corporate income tax and the 4% excise tax in that year.

Our ownership of and relation with our taxable REIT subsidiaries will be limited, and a failure to comply with the limits would jeopardize our REIT status and may result in the application of a 100% excise tax.

     Subject to certain restrictions, a REIT may own up to 100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT subsidiary may earn income that would not be qualifying income if earned directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a taxable REIT subsidiary. A corporation of which a taxable REIT subsidiary directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a taxable REIT subsidiary. Overall, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more taxable REIT subsidiaries. A taxable REIT subsidiary generally will pay income tax at regular corporate rates on any taxable income that it earns. In addition, the taxable REIT subsidiary rules limit the deductibility of interest paid or accrued by a taxable REIT subsidiary to its parent REIT to assure that the taxable REIT subsidiary is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s-length basis.

     Our taxable REIT subsidiaries are PMCIC, First Western and PMC Funding Corp. PMC Funding Corp. holds assets on our behalf. Our taxable REIT subsidiaries are subject to normal corporate income taxes. We will monitor at all times the value of our investments in taxable REIT subsidiaries for the purpose of ensuring compliance with the rule that no more than 20% of the value of our assets may consist of taxable REIT subsidiary stock and securities (which is applied at the end of each calendar quarter). The aggregate value of our taxable REIT subsidiary stock and securities is less than 20% of the value of our total assets (including our taxable REIT subsidiary stock and securities). In addition, we will scrutinize all of our transactions with our taxable REIT

20

subsidiaries for the purpose of ensuring that they are entered into on arm’s-length terms in order to avoid incurring the 100% excise tax described above. There are no distribution requirements applicable to the taxable REIT subsidiaries and after-tax earnings may be retained. There can be no assurance, however, that we will be able to comply with the 20% limitation on ownership of taxable REIT subsidiary stock and securities on an ongoing basis so as to maintain REIT status or to avoid application of the 100% excise tax imposed on certain non-arm’s-length transactions.

We operate in a highly regulated environment.

     Changes in the laws or regulations governing REITs may significantly affect our business. As a company whose common shares are publicly traded, we are subject to the rules and regulations of the Securities and Exchange Commission. In addition, we are regulated by the SBA. Changes in laws that govern our entities may significantly affect our business. Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations are also subject to change. Any change in the laws or regulations governing our business could have a material impact on our financial condition or results of operations.

     At any time, U.S. Federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. Any of those new laws or interpretations thereof may take effect retroactively and could adversely affect us. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rate on both dividends and long-term capital gains for most non-corporate taxpayers to 15% until 2008. This reduced maximum tax rate generally does not apply to ordinary REIT dividends, which continue to be subject to tax at the higher tax rates applicable to ordinary income (a maximum rate of 35%). However, the 15% maximum tax rate does apply to certain REIT distributions. This legislation may cause shares in non-REIT corporations to be a more attractive investment to individual investors than shares in REITs and may adversely affect the market price of our common shares.

     To the extent a loan becomes a problem loan, we will deliver a default notice and begin foreclosure and liquidation proceedings when we determine that pursuit of these remedies is the most appropriate course of action. Foreclosure and bankruptcy are complex processes that are subject to federal and state laws and regulations, as well as various guidelines imposed by mortgage investors.

     In conjunction with the operations of our assets acquired in liquidation, we are subject to numerous Federal, state and local laws and government regulations including environmental, occupational health and safety, state and local taxes and laws relating to access for disabled persons.

     Under various Federal, state and local laws, ordinances and regulations, a current or former owner or operator of real estate may be considered liable for the costs of remediating or removing hazardous substances found on its property, regardless of whether or not the property owner or operator was responsible for its presence. Such liability may be imposed by the Environmental Protection Agency or any state or local government authority regardless of fault. The ultimate costs under environmental laws and the timing of these costs are difficult to predict, and the liability under some environmental laws related to contaminated sites can be imposed retroactively, may be on a joint and several basis and could be material to our financial statements or results of operations.

We are subject to the Americans with Disabilities Act.

     The Americans with Disabilities Act of 1990 (“ADA”) requires all public accommodations and commercial facilities to meet federal requirements related to access and use by disabled persons. Compliance with the ADA requirements could require removal of access barriers, and noncompliance could result in imposition of fines by the U.S. Government or an award of damages to private litigants. Although we believe that the properties that we own or finance are substantially in compliance with these requirements, a determination that the properties are not in compliance with the ADA could result in the imposition of fines or an award of damages to private litigants. Pursuant to the Master Lease Agreement relating to the Hotel Properties, costs and fines associated with the ADA are the responsibility of the tenant. However, a substantial expense may affect the borrowers’ or tenants’ ability to pay their obligations, and consequently, our cash flow and the amounts available for distributions to shareholders may be adversely affected.

EMPLOYEES

     We employed 43 individuals including marketing professionals, investment professionals, operations professionals and administrative staff as of December 31, 2004. In addition, we have employment agreements with

21

the majority of our executive officers. Annual base salary during the terms of the contracts does not exceed $350,000 for any one individual. Our operations are conducted from our Dallas, Texas office. Management believes the relationship with its employees is good.

COMPETITION

     Our primary competition for lending opportunities has come from banks, financial institutions and other lending companies. Many of these competitors have greater financial and managerial resources than us and are able to provide services we are not able to provide (i.e., depository services). As a result of these competitors’ greater financial resources, they may be better able to withstand the impact of economic downturns than we are.

     Our net income primarily depends on our ability to originate loans at favorable spreads over our borrowing costs. In originating loans we compete with other specialty commercial lenders, banks, other REITs, savings and loan associations, insurance companies and other entities that originate loans, many of which have greater financial resources than us. As a result, we may not be able to originate sufficient mortgage loans at favorable spreads over our borrowing costs, which would harm our results of operations and consequently, our ability to continue paying dividends at current levels.

     In conjunction with our variable-rate loan product, we believe we compete effectively on the basis of interest rates, our long-term maturities and payment schedules, the quality of our service, our reputation as a lender, timely credit analysis and greater responsiveness to renewal and refinancing requests from borrowers. In addition, the variety and flexibility of our variable-rate lending programs enhances our ability to react to current market conditions.

     While we have originated fixed-rate loans, we do not expect to originate a significant amount of additional fixed-rate loans in the near future since our sources of funds are primarily variable-rate and due to competitors with a lower cost of funds.

CUSTOMERS

     In relation to our lending division, we are not dependent upon a single borrower, or a few borrowers, whose loss would have a material adverse effect on us. In addition, we have not loaned more than 10% of our assets to any single borrower.

     Our property division is currently dependent upon Arlington to operate the Hotel Properties. Lease income from Arlington represents 100% of the revenue in this segment. The loss of Arlington as operator of our properties could have a material adverse effect on us. As a REIT, we would be required to find another operator for our Hotel Properties and lease payments could be substantially less than we currently receive. Until such time as a new lease could be entered into, we would incur holding costs, legal fees and costs to re-franchise the properties.

AVAILABLE INFORMATION

     We file annual, quarterly, current and special reports and other information with the Securities and Exchange Commission (the “SEC”). All documents may be located at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549 or you may obtain information on the operation of the Public Reference Room by calling 1-800-SEC-0330. Our SEC filings are also available to the public, free of charge, at our internet site www.pmctrust.com, as soon as reasonably practicable after the reports are filed with, or furnished to, the SEC or at the SEC’s internet site at www.sec.gov.

22

Item 2. PROPERTIES

     We lease office space for our corporate headquarters in Dallas, Texas under an operating lease which expires in October of 2011.

     At December 31, 2004, we owned 19 Hotel Properties. The Hotel Properties are leased to a wholly-owned subsidiary of Arlington pursuant to individual property leases, as amended, which are subject to the terms of a Master Lease Agreement. The Master Lease Agreement and the underlying individual property leases, as amended, expire in June 2008, but each can be extended by either Arlington or us for one five-year period, and thereafter by Arlington for a five-year period and a subsequent two-year period. If fully extended, the term of the Master Lease Agreement would continue until September 2020. Arlington guarantees the payment of the rent due under the terms of the Master Lease Agreement and the amended individual property leases. If Arlington defaults under the Master Lease Agreement, we have the right to, among other things, terminate the Master Lease Agreement and litigate to receive damages pursuant to the guarantee as a result of the default. Lease income represented approximately 22% of our total revenues during 2004. See “Property Ownership.”

     The following table describes the location, number of rooms, year built and annual current base rent for 2005 relating to our Hotel Properties:

Item 3. LEGAL PROCEEDINGS

     In the normal course of business, including our assets acquired in liquidation and the QSPEs, we are periodically party to certain legal actions and proceedings involving matters that are generally incidental to our business (i.e., collection of loans receivable). In management’s opinion, the resolution of these legal actions and proceedings will not have a material adverse effect on our consolidated financial statements.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     There were no matters submitted to a vote of security holders during the fourth quarter of 2004.

23

PART II

Item 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

     The Common Shares are traded on the American Stock Exchange (the “AMEX”) under the symbol “PCC.” The following table sets forth, for the periods indicated, the high and low sales prices as reported on the AMEX and the regular and special dividends per share declared by us for each such period.

     On March 7, 2005, there were approximately 1380 holders of record of Common Shares and the last reported sales price of the Common Shares was $15.38.

     Our shareholders are entitled to receive dividends when and as declared by our Board of Trust Managers (the “Board”). Our Board considers many factors including, but not limited to, expectations for future earnings, REIT taxable income, the interest rate environment, competition, our ability to obtain leverage and our loan portfolio activity in determining dividend policy. The Board also uses REIT taxable income plus tax depreciation, less the collection of percentage rents set aside for future capital expenditures in determining the amount of dividends declared. In addition, as a REIT we are required to pay out 90% of taxable income. Consequently, the dividend rate on a quarterly basis will not necessarily correlate directly to any single factor such as REIT taxable income or earnings expectations.

     We have certain covenants within our debt facilities that limit our ability to pay out returns of capital as part of our dividends. These restrictions have not historically limited the amount of dividends we have paid and management does not believe that they will restrict future dividend payments. Additional information concerning dividends may be found in “Selected Financial Data” in Item 6 and in Item 8.

     See Item 12 for information regarding our equity compensation plans.

24

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

     The following is a summary of our Selected Consolidated Financial Data as of and for the five years in the period ended December 31, 2004. The following data should be read in conjunction with our consolidated financial statements and the notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Form 10-K. The selected financial data presented below has been derived from our consolidated financial statements.

25

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document.

BUSINESS

     Our mission is to derive income primarily from the origination of collateralized loans and from ownership in income producing real estate. Through conservative underwriting and exceptional service, we strive to provide our shareholders with the highest dividend, consistent with the focus on preservation of investment capital. We are committed to remain one of the nation’s leading lenders to the limited service hospitality industry.

     We are primarily a commercial lender that originates loans to small businesses that are principally collateralized by first liens on the real estate of the related business. We then sell certain of our loans receivable through privately-placed structured loan sale transactions. Historically, we have retained residual interests in all loans receivable sold through our subordinate financial interest in the related qualifying special purpose entities (“QSPEs”).

     Our revenues include the following:

     Our ability to generate interest income, as well as other revenue sources, is dependent on economic, regulatory and competitive factors that influence interest rates and loan originations, and our ability to secure financing for our investment activities. The amount of other income earned will vary based on volume of loans funded, the timing and amount of financings, the volume of loans receivable which prepay, the mix of loans (construction versus non-construction), the rate and type of loans originated (whether fixed or variable) as well as the general level of interest rates. For a more detailed description of the risks affecting our financial condition and results of operations, see “Risk Factors” in Item 1 of this Form 10-K.

RECENT DEVELOPMENTS

Conduit Warehouse Facility

     On February 7, 2005, we entered into a $100.0 million conduit warehouse facility (the “Conduit Facility”) with a concurrent reduction in our revolving credit facility from $40.0 million at December 31, 2004 to $20.0 million. In conjunction with the Conduit Facility, we created a new subsidiary, PMC Conduit, L.P., which will hold the assets and liabilities of the Conduit Facility.

     The Conduit Facility operates as a revolving line of credit, collateralized by loans originated by us, which have been or will be sold and/or contributed to PMC Conduit, L.P. While PMC Commercial has not guaranteed the repayment of the Conduit Facility, PMC Commercial must repurchase the loans securing the Conduit Facility if certain of the representations and warranties made by PMC Commercial in connection with the Conduit Facility are breached. Approximately $24.4 million of our loans were contributed to PMC Conduit, L.P. who immediately advanced $15.0 million under the Conduit Facility which was used to repay a portion of the balance outstanding on our revolving credit facility at February 7, 2005. Interest payments on the advances are payable by PMC Conduit, L.P., on a monthly basis, and PMC Conduit L.P.’s principal repayment obligations are expected to be financed through future securitizations of the loans collateralizing advances under the Conduit Facility. We anticipate that future advances under the Conduit Facility will be used to further invest in loans. The Conduit Facility allows for advances based on the amount of eligible collateral contributed to the Conduit Facility and has several financial covenants, the most restrictive of which are maximum delinquency ratios for our contributed loans and serviced portfolio, as defined in the transaction documents. The ability to make advances under the Conduit Facility expires February 6, 2008.

     The Conduit Facility is a short-term capital source that is an intermediary to our long-term source of capital which is currently the securitization of our loan portfolio. The Conduit Facility should allow us to build a larger pool of loans which will then be sold as part of a securitization.

Junior Subordinated Debt

     On March 15, 2005, PMC Commercial issued notes payable (the “Junior Subordinated Notes”) of approximately $27.1 million due March 15, 2035 to a special purpose subsidiary, PMC Preferred Capital Trust-A, a Delaware statutory trust (the “Preferred Trust”). The Junior Subordinated Notes are subordinated to PMC Commercial’s existing debt. The Preferred Trust issued shares of its preferred beneficial interest (the “Preferred Securities”) to an unaffiliated party in exchange for approximately $26.3 million and issued shares of common beneficial interest to PMC Commercial for $820,000. The Junior Subordinated Notes and the Preferred Securities each bear interest at a floating rate which resets on a quarterly basis at the 90-day LIBOR plus 3.25% (approximately 6.25% as of March 15, 2005) and generally may not be redeemed prior to March 15, 2010. After payment of costs associated with the issuance of approximately $800,000, the proceeds from the sale of the Preferred Securities were approximately $25.5 million. The net proceeds were used to prepay, without penalty, the $20 million of uncollateralized notes payable and the remainder was used to repay a portion of the outstanding balance on our Conduit Facility.

26

CURRENT OPERATING OVERVIEW AND ECONOMIC FACTORS

     The following provides a summary of our current operating overview and significant economic factors that may have an impact on our financial condition and results of operations. The factors described below could impact the volume of loan originations, the income we earn on our assets, our ability to complete a securitization, the performance of our loans, the operations of our properties and/or the performance of the QSPEs.

General

     We completed the merger with PMC Capital on February 29, 2004. Primarily as a result of the merger, beneficiaries’ equity increased from approximately $92.1 million at December 31, 2003 to approximately $161.3 million at December 31, 2004, and total assets increased from approximately $131.7 million at December 31, 2003 to approximately $253.8 million at December 31, 2004. We believe that the merger has provided, and will continue to provide, more stability in income available for distribution through the larger, more diversified asset base. The merger resulted in a substantial increase in revenues and expenses. Revenues increased as a result of the income generated by the assets acquired from PMC Capital. Prior to the merger, we had no employees and most of our overhead was paid through an advisory relationship with PMC Capital. Subsequent to the merger, we are internally managed and overhead of the combined larger entity is now our responsibility. Our overhead also increased due to costs associated with the Sarbanes-Oxley Act of 2002 (the “Act”). We incurred consulting fees and costs related to external consultants and our external auditors’ performance of procedures relating to the Act. These costs are significant, totaling approximately $400,000 during 2004. Significant costs related to the Act are expected to continue in future periods.

     The increased equity provided by the merger has assisted us in restructuring our leverage. In addition to the $100.0 million Conduit Facility, which provided us with increased availability of funds, we completed the issuance of the Junior Subordinated Notes.

Lending Division

     Loans originated during 2004 were $53.7 million which is greater than the $31.3 million of loans we originated during 2003. On a pro forma basis with PMC Capital, loans originated would have been $68.1 million during 2003. We currently anticipate loan originations to be between $60 million and $80 million during 2005. Several key concerns have caused us to re-evaluate our estimates of loan originations as detailed below:

     In order to effectively compete for variable-rate loans, we are currently reducing the interest rate spreads that we historically charged by approximately 25 basis points. We believe that the spread reduction will still provide us with appropriate rewards for the risk related to the types of loans that we are originating but such loans will not be as profitable as in prior years.

     At December 31, 2004 and 2003, our outstanding commitments to fund new loans were approximately $30.3 million and $7.7 million, respectively. Our pipeline has increased but not to the level we had at December 31, 2002 of approximately $40.9 million. However, we have seen an increase in activity as the economic expansion gains traction and our renewed marketing efforts gain momentum.

     Prior to 2003, we had primarily been a fixed-rate lender. During 2002, with interest rates falling and short-term rates at historical lows, borrowers were looking to take advantage of the market by either entering into “mini-perm” fixed-rate loans with banks or variable-rate loans. We could not effectively compete with the low fixed interest rates offered through the “mini-perm” products of the banks due to the relatively higher cost of our capital. Therefore, we introduced a variable-rate loan product based on LIBOR. With the continued low interest rate environment in 2003 and 2004, we became solely dependent on variable-rate loans.

     Now that the market is changing so that borrowers are looking for fixed-rate loans, we are still constrained by the local bank competition that offers a five-year fixed-rate loan whose rate is well below the interest rate of the long-term interest rate that we can offer. Historically, the rate for our fixed-rate product needed to be around 4%

27

over the 10-year treasury in order to provide us with what management believed was a reasonable spread. With the 10-year treasury at approximately 4.3%, the rate we needed to obtain is approximately 8.3% for a quality loan with a 20-year amortization and maturity. The local banks offer a five-year maturity, 20-year amortization loan at approximately 3% over 5-year treasuries (currently approximately 4.0%) which provides for an interest rate of approximately 7.0%. Management believes that the difference between the bank’s rate and ours is causing borrowers to take on the refinancing risk that rates won’t rise by more than 1.3% in the next five years and they are therefore taking the “mini-perm” bank loan.

     Even if we were to originate fixed-rate loans, the securitization market cost of funds may cause us to have a lower spread than we historically have achieved on our fixed-rate securitizations. In addition, during the period between when we make loans with fixed interest rates and when we complete a fixed-rate structured loan transaction, if rates were to rise, our spreads would narrow. Therefore, until interest rate markets and competition revert back to conditions in 2002 and prior, we expect continued strong competition and therefore limited originations of fixed-rate loans.

     Our net interest margin is dependent upon the difference between the cost of our borrowed funds and the rate at which we invest these funds (the “net interest spread”). A significant reduction in net interest spread may have a material adverse effect on our results of operations and may cause us to re-evaluate our lending focus. Over the past few years the spread has been reduced causing decreased income from continuing operations (excluding the increase from loans acquired in the merger) and there can be no assurance that it will not continue to decrease. We believe that our LIBOR-based loan program allows us to compete more effectively with variable-rate products of our competitors, provides us with a more attractive securitization product and provides us with a net interest spread that is less susceptible to interest rate fluctuations than our fixed-rate loan programs.

     Most of our loans are to borrowers operating properties in the limited service sector of the hospitality industry. The limited service sector of the hospitality industry, as a subset of the hospitality industry, does not always react to economic conditions in the same manner as the rest of the hospitality industry. Economic conditions that impact the limited service sector of the hospitality industry and, to a lesser degree, the hospitality industry in general, have a significant impact on our loans to, and investments in, hospitality properties, and our future lending operations.

Property Division

     We own 19 limited service hospitality properties. As a REIT, we cannot operate these properties. As a result, we are dependent upon Arlington to operate and manage our Hotel Properties. Arlington’s operating results, including the operations of our Hotel Properties, are subject to a variety of risks which could affect Arlington’s ability to generate sufficient cash flow to support the payment obligations under the amended master lease agreement (the “Master Lease Agreement”). In the event Arlington defaults on the Master Lease Agreement, there is no assurance that we would be able to find a new operator for our hotel properties, negotiate to receive the same amount of lease income or collect on the guarantee of Arlington. In addition, in the event Arlington defaults, we may incur costs, including holding costs, legal fees and costs to re-franchise the properties.

     Effective October 1, 2004, the Master Lease Agreement with Arlington provides incentive for, among other things, the disposition of all Hotel Properties prior to October 1, 2008. Also, the current base rent was reduced through September 30, 2006 from approximately 10.5% to 8.5% of the Stated Value established for the Hotel Properties. The Stated Value of each Hotel Property (currently an aggregate of $46.1 million) is the value attributed to each Hotel Property at the inception of the lease agreement for purposes of determining the lease payment. The continuation of the reduced base rent will continue unless, on a cumulative basis, at least five of the Hotel Properties are not sold over each of the next four years.

     While current payments for rent have been reduced, these rent payment reductions will cease and increased rent payments will occur if Arlington does not either purchase from us, or have a third party purchase from us, the Hotel Properties at their Stated Value. The aggregate Stated Value of the properties of $46.1 million is greater than our book value of $38.1 million. In addition, based on discussions with Arlington and real estate brokers in the markets in which our Hotel Properties are located, the market value of the Hotel Properties in aggregate approximates the aggregate book value of the Hotel Properties. As a result, Arlington must provide additional rent over the remaining term of the lease either in shortfall notes at the time of a sale or through increased monthly rent payments. In the event the conditions as stipulated in the Master Lease Agreement are not met, the Master Lease Agreement provides for an increase in base rent to the prior contractual rate (approximately 10.5% of the Stated Value) or 15% of the Stated Value depending on the type of default. Commencing October 1, 2004, we are

28

recognizing straight-line rent based on the estimated future cash flows from Arlington over the remaining term of the Master Lease Agreement.

     In addition, as a result of the lease amendment:

     Effective October 1, 2004, we estimated that our cash received for rent (assuming no properties were sold) would be reduced, on an annual basis, by approximately $1.0 million. Our lease payments will be further reduced as a result of property sales; however, we would earn income on any investments which we acquire with the proceeds from the property sale and/or repayment of any shortfall notes.

     To the extent we approve sales of our Hotel Properties, certain of our Hotel Properties could be deemed impaired and impairment losses that result, if any, could be material. Our Hotel Properties are reviewed for impairment whenever events or circumstances indicate that the carrying amount of the property may not be recoverable, but in no event less than on a quarterly basis. To the extent Hotel Properties are sold, we will receive the net proceeds, after payment of any mortgage debt related to individual properties (currently we have mortgage debt of approximately $14.2 million on eleven of the properties).

Lodging Industry

     The prevailing lodging industry perception for 2005 is more optimistic than 2004. Lodging demand in the United States appears to correlate to changes in U.S. GDP growth, with typically a two to three quarter lag. Therefore, given the relatively strong U.S. GDP growth in the past year and the positive projections for the remainder of 2005, an improvement in 2005 and 2006 lodging demand is predicted by industry analysts. Such improvement will be dependent upon several factors including: the strength of the economy, the correlation of hotel demand to new hotel supply and the impact of global or domestic events on travel and the hotel industry. Industry analysts with PricewaterhouseCoopers LLP have published reports that predict the industry’s results will improve in 2005 and 2006.

     In 2004, occupancy increased slightly for the overall hospitality industry and average room rates showed a slight decline based on published industry statistics. We anticipate that lodging demand will increase in 2005 and 2006 as the lodging industry follows the economy. We believe improving economic trends in the lodging industry will generate an increase in competition among lenders, especially those lenders offering alternatives such as fixed-rate and “mini-perm” loans. We anticipate an improvement in volume but continued net interest spread pressure.

     Another factor which affects the limited service sector of the hospitality industry is a significant rise in gasoline prices within a short period of time. Most of the limited service hospitality properties collateralizing our loans are located on interstate highways. Historically, when gas prices sharply increase, occupancy rates decrease for properties located on interstate highways.

29

PORTFOLIO INFORMATION

Lending Activities

General

     Our lending activities consist primarily of originating loans to borrowers who operate in the hospitality industry. Our net loans receivable were $128.2 million and $50.5 million at December 31, 2004 and 2003, respectively. During 2004 and 2003, we originated loans totaling $53.7 million and $31.3 million and received principal repayments of $31.0 million (of which approximately $13.7 million represented prepayments and $5.3 million represented balloon maturities or repayments of SBA 504 program loans) and $7.6 million (of which approximately $2.6 million represented prepayments and $2.4 million represented balloon maturities), respectively. Loans originated and principal payments during 2004 of $53.7 million and $31.0 million, respectively, include SBA 7(a) guaranteed loans originated of $6.6 million and proceeds from the sale of SBA 7(a) guaranteed loans of $6.2 million.

     When originating a loan, we charge a commitment fee. During 2004 and 2003, we collected commitment fees of $379,000 and $110,000, respectively. The increase during 2004 is primarily due to the merger. Commitment fees are collected when the prospective borrower accepts our proposed terms and are deferred and recognized as an adjustment of yield over the life of the related loan receivable.

     At December 31, 2004, approximately $100.1 million of our loans receivable had a variable interest rate (reset on a quarterly basis) based primarily on the 90-day LIBOR, or the prime rate (primarily related to our SBA 7(a) Guaranteed Loan Program) with a weighted average interest rate of approximately 6.4%. The spread that we charge over LIBOR generally ranges from 3.5% to 4.5% and the spread we charge over the prime rate generally ranges from 1.75% to 2.75%. The LIBOR rate used in determining interest rates during the first quarter of 2005 (set on January 1, 2005) was 2.56%. The prime rate used in determining interest rates to be charged to our borrowers during the first quarter of 2005 (set on January 1, 2005) was 5.25%. To the extent LIBOR or the prime rate changes, we will have changes in interest income from our variable-rate loans receivable. In addition, at December 31, 2004, approximately $28.1 million of our loans receivable had a fixed interest rate with a weighted average interest rate of approximately 9.7%. See Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.”

Prepayment Activity

     Prepayment activity on our fixed-rate loans receivable has remained at high levels as a result of the continued low interest rate environment. We believe that we will continue to see prepayment activity at these higher levels in 2005. Many of our prepayment fees for our fixed-rate loans receivable are based upon a yield maintenance premium which provides for greater prepayment fees as interest rates decrease. In addition, certain loans receivable have prepayment prohibitions of up to five years.

     The timing and volume of our prepayment activity for both our variable and fixed-rate loans receivable fluctuate and are impacted by numerous factors including the following:

     When our loans receivable are repaid prior to their maturity, we generally receive prepayment fees. Prepayment fees result in one-time increases in our income. The proceeds from the prepayments we receive are either used to repay debt or invested initially in temporary investments and for prepayments of our fixed-rate loans have generally been re-loaned or committed to be re-loaned at lower interest rates than the prepaid loans receivable. These lower interest rates have had an adverse effect on our interest income and depending upon the rate of future prepayments may further impact our interest income. It is difficult for us to accurately predict the volume or timing of prepayments since the factors listed above are not all-inclusive and changes in one factor are not isolated from changes in another which might magnify or counteract the rate or volume of prepayment activity.

     Prepayments of loans receivable of the QSPEs will also have an impact on our financial condition and results of operations. Prepayments of Sold Loans with higher interest rates negatively impact the value of our Retained Interests to a greater extent than prepayments of Sold Loans with lower interest rates. Prepayments in excess of our assumptions will cause a decline in the value of our Retained Interests primarily relating to a reduction

30

in the excess funds (our interest-only strip receivable) expected from our structured loan sale transactions. The “spread” that is lost may be offset in part or in whole by the prepayment fee that we collect.

     First Western, our SBA guaranteed lending company, sells the guaranteed portion of most of its originated loans through private placements. These sales are especially sensitive to prepayments. Our Retained Interests in these loan sales consist only of the spread between the interest First Western collects from the borrower and the interest paid to the purchaser of the guaranteed portion of the loan. Therefore, to the extent the prepayments of these loans exceed estimates, there is a significant impact on the value of the associated Retained Interests.

Impaired Loans

     Our policy with respect to loans receivable which are in arrears as to interest payments for a period in excess of 60 days is generally to discontinue the accrual of interest income. To the extent a loan becomes a Problem Loan (as defined below), we will deliver a default notice and begin foreclosure and liquidation proceedings when we determine that pursuit of these remedies is the most appropriate course of action.

     Senior management closely monitors our impaired loans which are classified into two categories: Problem Loans and Special Mention Loans (together, “Impaired Loans”). Our Problem Loans are loans which are not complying with their contractual terms, the collection of the balance of the principal is considered impaired and on which the fair value of the collateral is less than the remaining unamortized principal balance. Our Special Mention Loans are those loans receivable that are either not complying or had previously not complied with their contractual terms but we expect a full recovery of the principal balance through either collection efforts or liquidation of collateral.

     Historically, we have not had a significant amount of Impaired Loans or delinquent loans nor have we had a significant amount of charged-off loans. Our Impaired Loans were as follows:

     Our provision for loan losses (excluding reductions of loan losses during 2004) as a percentage of our weighted average outstanding loans receivable was 0.42% and 0.40% during 2004 and 2003, respectively. During 2004, we reversed $675,000 of previously recorded loan loss reserves due to the reduction in the expected loss on a loan collateralized by a limited service hospitality property due to repayment of all principal on the loan. We recorded loan loss reserves of $422,000 during 2004 primarily related to two limited service hospitality properties on which significant doubt exists as to the ultimate realization of the loan.

31

     At December 31, 2004 and 2003, we had reserves in the amount of $164,000 and $675,000, respectively, against loans receivable that we have deemed to be Impaired Loans. Our aggregate Impaired Loans increased from $3.4 million at December 31, 2003 to $8.2 million at December 31, 2004 primarily as a result of our larger portfolio including the loans acquired in connection with the merger and the change in our underwriting. As a result of the merger, we acquired, and are originating loans which can be considered riskier (i.e., higher loan-to-value ratio) than PMC Commercial originated prior to the merger.

Retained Interests

     At December 31, 2004 and 2003, the estimated fair value of our Retained Interests was $70.5 million and $30.8 million, respectively. We acquired Retained Interests with an estimated value of $43.6 million in connection with the merger. This estimated value became our cost through purchase accounting. Retained Interests represents the subordinate interest in loans receivable that have been contributed to QSPEs and have been recorded as sold. When we securitize loans receivable, we are required to recognize Retained Interests, which represents our right to receive net future cash flows, at their estimated fair value. Our Retained Interests consist of (i) the retention of a portion of each of the Sold Loans (the “required overcollateralization”), (ii) contractually required cash balances owned by the QSPE (the “reserve fund”) and (iii) future excess funds to be generated by the QSPE after payment of all obligations of the QSPE (the “interest-only strip receivable”). Retained Interests are subject to credit, prepayment and interest rate risks.

     The estimated fair value of our Retained Interests is based on estimates of the present value of future cash flows we expect to receive from the QSPEs. Estimated future cash flows are based in part upon estimates of prepayment speeds and loan losses. Prepayment speeds and loan losses are estimated based on the current and anticipated interest rate and competitive environments and our historical experience with these and similar loans receivable. The discount rates utilized are determined for each of the components of Retained Interests as estimates of market rates based on interest rate levels considering the risks inherent in the transaction. Changes in any of our assumptions, or actual results which deviate from our assumptions, may materially affect the value of our Retained Interests.

     The net unrealized appreciation on our Retained Interests at December 31, 2004 and 2003 was approximately $5.1 million and $3.6 million, respectively. Any appreciation of our Retained Interests is included in the accompanying balance sheet in beneficiaries’ equity. Any depreciation of our Retained Interests is either included in the accompanying statement of income as a realized loss (if there is a reduction in expected future cash flows) or on our balance sheet in beneficiaries’ equity as an unrealized loss. Reductions in expected future cash flows generally occur as a result of decreases in expected yields, increases in anticipated loan losses or increases in prepayment speed assumptions. Our acquired Retained Interests are more susceptible to incurring realized losses. When acquired from PMC Capital, the estimated fair value at February 29, 2004 for each of the components of Retained Interests was recorded as our cost. As a result, during any period that (i) the value of any of the components of our Retained Interests is below the cost and (ii) the estimated cash flow from the particular component has been reduced, realized losses would result. Once realized losses occur, we recognize subsequent appreciation of our Retained Interests as income over the estimated remaining life of the Retained Interests through a higher effective yield.

Assets Acquired in Liquidation

     We have not historically had a significant amount of assets acquired in liquidation. However, we anticipate that we will acquire assets through liquidation of the collateral underlying certain of our Problem Loans over the next twelve to eighteen months. Currently, we have $6.9 million in aggregate Problem Loans, including $3.2 million of Problem Loans of the QSPEs which may be repurchased by us if they become “charged-off” loans per the transaction documents.

     With regard to properties acquired through foreclosure, deferred maintenance issues may have to be addressed as part of the operation of the property or it may not be economically justifiable to operate the property prior to its sale. To the extent keeping the property in operation is deemed to assist in attaining a higher value upon sale, we will take steps to do so including hiring third party management companies to operate the property.

     In connection with the sale of our assets acquired in liquidation to third parties, we may finance a portion of the purchase price of the property. These loans will typically bear market rates of interest. While these loans are evaluated using the same methodology as our loans receivable, certain lending criteria may not be able to be achieved.

32

Property Ownership Data

     Our Hotel Properties are operated by Arlington pursuant to our Master Lease Agreement.

     The following table summarizes statistical data regarding the underlying operations of our 19 Hotel Properties (1):

     Our income related to the Hotel Properties is from lease payments and the recording of straight-line rent adjustments. Our lease is a “triple net” lease; therefore, all expenses of operation including insurance and real estate taxes are the obligation of Arlington. The data provided above is for informational purposes only. All revenues and expenses from operation of the properties belong to Arlington.

     A summary of financial information for the lessee of our properties, Arlington, (which has been derived from their latest available public filings as of our filing date) as of September 30, 2004 and December 31, 2003, and for the nine months ended September 30, 2004 and the years ended December 31, 2003 and 2002 is as follows:

ARLINGTON HOSPITALITY, INC.

     Arlington is a public entity that files periodic reports with the SEC. Additional information about Arlington, including December 31, 2004 financial information when available, can be obtained from the SEC’s website at www.sec.gov.

33

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     Our discussion and analysis of our financial condition and our results of operations is based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Our management has discussed the development and selection of these critical accounting policies and estimates with the audit committee of our Board of Trust Managers (the “Board”), and the audit committee has reviewed the disclosures relating to these policies and estimates included in this annual report.

     We believe the following critical accounting considerations and significant accounting policies represent our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Valuation of Loans Receivable

     Loan loss reserves are established based on a determination, through an evaluation of the recoverability of individual loans receivable, that significant doubt exists as to the ultimate realization of the loan receivable. We monitor the loan portfolio on an ongoing basis and evaluate the adequacy of our loan loss reserves. In our analysis, we review various factors, including the value of the collateral securing the loan receivable and the borrower’s payment history. The determination of whether significant doubt exists and whether a loan loss reserve is necessary for each loan requires judgment and consideration of the facts and circumstances existing at the evaluation date. Changes to the facts and circumstances of the borrower, the hospitality industry and the economy may require the establishment of significant additional loan loss reserves. If a determination is made that significant doubt exists as to the ultimate collection of our loans receivable, the effect on our results of operations may be material.

     At December 31, 2004 and 2003, we had reserves in the amount of $164,000 and $675,000, respectively, against loans receivable that we have deemed to be Impaired Loans. Our provision for loan losses (excluding reductions of loan losses during 2004) as a percentage of our weighted average outstanding loans receivable was 0.42% and 0.40% during 2004 and 2003, respectively. During 2004, we reversed $675,000 of previously recorded loan loss reserves due to the reduction in the expected loss on a loan collateralized by a limited service hospitality property due to repayment of all principal on the loan. We recorded loan loss reserves of $422,000 during 2004 primarily related to two limited service hospitality properties on which significant doubt exists as to the ultimate realization of the loan. To the extent one or several of our loans experience significant operating difficulties and we are forced to liquidate the loans, future losses may be substantial.

Valuation of Retained Interests

     Due to the limited number of entities that conduct structured loan sale transactions with similar assets, the relatively small size of our Retained Interests and the limited number of buyers for such assets, no readily ascertainable market exists for our Retained Interests. Therefore, our estimate of fair value may vary significantly from what a willing buyer would pay for these assets.

     The valuation of our Retained Interests is our most volatile critical accounting estimate because the valuation is dependent upon estimates of future cash flows that are dependent upon the performance of the underlying loans receivable and estimates of discount rates. Prepayments or losses in excess of estimates will cause unrealized depreciation and ultimately realized losses. The estimated fair value of our Retained Interests is determined based on the present value of estimated future cash flows from the QSPEs. The estimated future cash flows are calculated based on assumptions including, among other things, prepayment speeds and loan losses. We regularly measure loan loss and prepayment assumptions against the actual performance of the loans receivable sold and to the extent adjustments to our assumptions are deemed necessary, they are made on a quarterly basis. If prepayment speeds occur at a faster rate than anticipated, or future loan losses either occur quicker, or in amounts greater than expected, the fair value of the Retained Interests will decline and total income in future periods would be reduced. For example, if a $1.0 million loan with an interest rate of 10% prepays and the “all-in cost” of that QSPE’s structured notes was 7%, we would lose the 3% spread we had expected to receive on that loan in future periods. The “spread” that is lost may be offset in part or in whole by the prepayment fee that we collect. If prepayments occur slower than anticipated, or future loan losses are either slower than or less than expected, cash flows would exceed estimated amounts, the estimated fair value of our Retained Interests would increase and total income in future periods would be enhanced. Although we believe that assumptions as to the future cash flows of the structured loan sale transactions are reasonable, actual rates of loss or prepayments may vary significantly from those assumed and other assumptions may be revised based upon anticipated future events. These assumptions are

34

updated on a quarterly basis. Over the past three years, there has been no significant change in the methodology employed in valuing these assets. The discount rates utilized in computing the net present value of future cash flows are based on an estimate of the inherent risks associated with each cash flow stream. Purchasers of these types of investments may utilize different discount rates in determining the fair value of the estimated future cash flows.

     As a result of the merger, we acquired PMC Capital’s subordinate interests in the Joint Ventures and 100% of the subordinate interests in the 1998 Partnership and the 1999 Partnership (collectively, the “Acquired Structured Loan Sale Transactions”). The remaining subordinate interests of the Joint Ventures were 32% of the 2000 Joint Venture, 58% of the 2001 Joint Venture, 61% of the 2002 Joint Venture and 56% of the 2003 Joint Venture . We previously owned the remaining subordinate interests in the Joint Ventures (the “Originated Structured Loan Sale Transactions”).

     Significant estimates related to the Originated Structured Loan Sale Transactions were as follows at December 31, 2004:

     Significant estimates related to our Acquired Structured Loan Sale Transactions and First Western 1997 were as follows at December 31, 2004:

     At December 31, 2004, we have identified two sold loans ($3.2 million) that we consider Problem Loans. If we had to liquidate these loans, the losses could exceed estimates and the estimated fair value of our Retained Interests would decline.

35

     The following is a sensitivity analysis of our Retained Interests as of December 31, 2004 to highlight the volatility that results when prepayments, loan losses and discount rates are different than our assumptions:

     These sensitivities are hypothetical and should be used with caution. Values based on changes in these assumptions generally cannot be extrapolated since the relationship of the change in assumptions to the change in value may not be linear. The effect of a variation in a particular assumption on the estimated fair value of our Retained Interests is calculated without changing any other assumption. In reality, changes in one factor are not isolated from changes in another which might magnify or counteract the sensitivities.

Valuation of Real Estate Investments

     In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS No. 144”) our Hotel Properties are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.

     We consider each individual Hotel Property to be an identifiable component of our business. In accordance with SFAS No. 144, we do not consider hotels as “held for sale” until it is probable that the sale will be completed within one year. We consider a Hotel Property as “held for sale” once we have (i) executed a contract for sale, (ii) allowed the potential buyer to substantially complete their due diligence review and (iii) received a substantial non-refundable deposit. In addition, the determination of “held for sale” status is assessed based on all facts and circumstances, including management’s intent and ability to eliminate the cash flows of the property from the Company’s operations and management’s intent and ability not to have significant continuing involvement in the operations of the property.

     We discontinue depreciation on Hotel Properties if they are classified as “held for sale.” Upon designation of a Hotel Property as “held for sale,” we compare the carrying value of the Hotel Property to its estimated fair value, less costs to sell. We will reclassify the Hotel Property to real estate investment held for sale in our consolidated balance sheet at the lesser of its carrying value or its estimated fair value, less costs to sell. Any adjustment to the carrying value of a Hotel Property classified as “held for sale” is reflected in discontinued operations in our consolidated statements of income. In addition, the operating results of those properties classified as “held for sale” or that have been sold are included in discontinued operations.

     For assets to be held and used, we perform a recoverability test to determine if the future undiscounted cash flows over our expected holding period for the property exceed the carrying amount of the property. If the recoverability test is not met, estimated fair value is determined by comparing the carrying value of the property to its future undiscounted cash flows using a risk-adjusted discount rate. Future cash flows are based on estimated future rent payments to be received on the Hotel Properties.

36

Revenue Recognition Policies

Interest Income

     Interest income includes interest earned on loans and our short-term investments and includes the amortization of net loan origination fees and discounts. Interest income on loans is accrued as earned with the accrual of interest generally suspended when the related loan becomes a non-accrual loan. A loan receivable is generally classified as non-accrual (a “Non-Accrual Loan”) if (i) it is past due as to payment of principal or interest for a period of more than 60 days, (ii) any portion of the loan is classified as doubtful or is charged-off or (iii) if the repayment in full of the principal and/or interest is in doubt. Generally, loans are charged off when management determines that we will be unable to collect any remaining amounts due under the loan agreement, either through liquidation of collateral or other means. Interest income on a Non-Accrual Loan is recognized on either the cash basis or the cost recovery basis.

     When originating a loan receivable, we charge a commitment fee. These fees, net of costs, are deferred and recognized as an adjustment of yield over the life of the related loan receivable using a method which approximates the interest method.

     For purchased loans, we may have discounts representing the difference between the unamortized principal balance of the loan and its estimated fair value at the date of purchase. These discounts are recognized as an adjustment of yield over the life of the related loan receivable using a method which approximates the interest method.

     For loans originated under the SBA 7(a) Loan Program, when we sell the SBA guaranteed portion of the loans, a portion of the sale proceeds representing the difference in the face amount of the unguaranteed portion of the loans and the value of the loans (the “Retained Loan Discount”) is recorded as a reduction in basis of the retained portion of the loan rather than premium income. The Retained Loan Discount is amortized to interest income over the life of the underlying loan using the interest method unless the underlying loan receivable is prepaid or sold.

Income from Retained Interests

     The income from our Retained Interests represents the accretion (recognized using the interest method) on our Retained Interests which is determined based on estimates of future cash flows and includes any fees collected (i.e., late fees, prepayment fees, etc.) by the QSPEs in excess of anticipated fees. We update our cash flow assumptions on a quarterly basis and any changes to cash flow assumptions impact the yield on our Retained Interests.

Lease Income

     Lease income consists of base and percentage rents on our properties and straight-line rental income adjustments. We record the payments remaining to be paid on the Master Lease Agreement by Arlington to us on a straight-line basis. We receive a fixed percentage of the monthly room revenue of our leased properties which is reported as income when earned.

RESULTS OF OPERATIONS

Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003

Overview

     Income from continuing operations increased by $5,732,000 (88%), to $12,253,000 during 2004 from $6,521,000 during 2003, primarily as a result of the merger. Earnings per share from continuing operations and gain on sales of loans receivable also increased $0.09 (8%), to $1.21 per share during 2004 from $1.12 per share during 2003. Primarily as a result of the merger, net income increased by $16,607,000, to $24,781,000 during 2004 from $8,174,000 during 2003. Earnings per share increased $1.17, to $2.44 per share during 2004 from $1.27 per share during 2003. Net income during 2004 includes an extraordinary gain from negative goodwill of $11,593,000 representing the excess of fair value of the net assets acquired over the cost of the merger with PMC Capital on February 29, 2004.

37

     The increase in income from continuing operations is primarily due to the merger with PMC Capital. As a result of the merger, our assets under management increased resulting in both increased revenues and expenses. Our revenue increases were primarily from (i) our Retained Interests (approximately $5.8 million) due primarily to the acquisition of $43.6 million of Retained Interests in connection with the merger with PMC Capital and the completion in October 2003 of our 2003 structured loan sale transaction, (ii) increased interest income (approximately $2.4 million) due primarily to an increase in our weighted average loans receivable outstanding due to the acquisition of $55.1 million of loans in the merger and (iii) increased other income (approximately $2.1 million) due primarily to increased prepayments resulting in greater prepayment fee income and servicing fees earned subsequent to the merger with PMC Capital.

     Our expense increases were (i) increased overhead (comprised of salaries and related benefits, general and administrative and advisory and servicing fees expense) of approximately $3.4 million (upon merger with PMC Capital, we became a self-managed REIT), (ii) increased interest expense of approximately $1.3 million due to liabilities assumed in the merger with PMC Capital and (iii) realized losses from Retained Interests of approximately $1.2 million primarily due to a reduction in expected future cash flows due to increased anticipated and actual prepayments and anticipated losses on our acquired Retained Interests.

     Significant changes in our revenues and expenses are further described below.

Revenues

     Interest income increased by $2,386,000 (41%), to $8,162,000 during 2004 from $5,776,000 during 2003. Interest income consisted of the following:

     The increase in interest income – loans was primarily attributable to an increase in our weighted average loans receivable outstanding of $23.1 million (30%) to $100.8 million during 2004 from $77.7 million during 2003 primarily as a result of the merger partially offset by a decrease in the weighted average interest rate on our loans receivable from 8.1% at December 31, 2003 to 7.1% at December 31, 2004. In addition, we accreted purchase discounts and received cash payments on certain of our Non-Accrual Loans during 2004. Our idle funds interest income increased due to cash equivalents of our SBICs, acquired in the merger, which are required to be used for future operating commitments of these SBICs.

     Lease income increased $436,000 (9%), to $5,460,000 during 2004 compared to $5,024,000 during 2003. Lease income consists of the following: (i) base rent, (ii) percentage rent and (iii) straight-line rent adjustments. In accordance with the terms of the Master Lease Agreement, we record lease income on a straight-line basis based on all remaining payments due from Arlington over the term of the Master Lease Agreement. Base rent is currently equal to 8.5% of the Stated Value ($46.1 million) for the Hotel Properties. Base rent for our 18 Hotel Properties included in continuing operations was approximately $4.4 million during 2004. Base rent for the 18 Hotel Properties was reduced by approximately $220,000 during 2004 as a result of the lease amendment. In addition to our base rent, we receive percentage rent equal to 4% of the gross room revenues of our Hotel Properties. The Master Lease Agreement provides for rent increases to approximately 10.5% and ultimately 15% unless, on a cumulative basis, at least five of the Hotel Properties are sold over each of the next four years. During the fourth quarter of 2004, we recorded approximately $575,000 of straight-line rent adjustments to lease income for the 18 Hotel Properties included in continuing operations. Assuming no property sales during 2005, we will record a straight-line rent adjustment of approximately $2.1 million; however, base rent would be reduced from approximately $4.4 million to approximately $3.9 million. Our lease payments (base and percentage rent) would be reduced as a result of any additional property sales.

     Income from Retained Interests increased $5,821,000 (198%), to $8,763,000 during 2004 compared to $2,942,000 during 2003. The increase was mainly due to the acquisition of $43.6 million of Retained Interests in

38

the merger and the completion of our 2003 structured loan sale transaction. The weighted average balance of our Retained Interests was $65.9 million during 2004 compared to $24.0 million during 2003. The income generated from the Retained Interests acquired from PMC Capital was $4.2 million during 2004. The income from our Retained Interests consists of the accretion earned on our Retained Interests which is determined based on estimates of future cash flows and includes any fees collected by the QSPEs in excess of anticipated fees. The yield on our Retained Interests, which is comprised of the income earned less realized losses, decreased to 11.5% during 2004 from 12.3% during 2003 primarily due to realized losses incurred.

     Other income increased $2,109,000 (622%), to $2,448,000 during 2004 compared to $339,000 during 2003 primarily due to (i) increased prepayment fees and (ii) servicing fees earned subsequent to the merger with PMC Capital. Prepayment fees increased from $108,000 during 2003 to $656,000 during 2004. Prepayment activity has remained at high levels as a result of the continued low interest rate environment. We believe that we will continue to see prepayment activity at these higher levels during 2005. As a result of the merger with PMC Capital, we now earn fees ($1,142,000 during 2004) for servicing all loans held by the QSPEs and First Western’s loans sold into the secondary market.

Interest Expense

     Interest expense increased by $1,345,000 (42%), to $4,549,000 during 2004 from $3,204,000 during 2003. Interest expense consisted of the following:

     The increase was attributable to interest expense on liabilities assumed from PMC Capital consisting primarily of (i) uncollateralized notes payable with a face value of $35.0 million and a weighted average cost of funds of 3.8% and (ii) debentures payable with a face value of $18.5 million and a cost of funds of 6.0%. During April and July 2004 (at maturity), we repaid $5.0 million and $10.0 million, respectively, of the uncollateralized notes payable with interest rates of LIBOR plus 1.3% and LIBOR plus 1.4%, respectively. This increase was partially offset by (i) a decrease in the principal balance of the structured notes payable from our 1998 structured loan financing ($7.2 million outstanding at December 31, 2004 compared to $18.7 million outstanding at December 31, 2003) due to prepayments of loans and (ii) a reduction in borrowings under our revolving credit facility ($8.0 million weighted average borrowings outstanding during 2004 compared to $17.3 million weighted average borrowings outstanding during 2003). As a result of the rising short-term interest rate environment, our cost of funds for our variable-rate debt, primarily our revolving credit facility and $10.0 million of our uncollateralized notes payable, has been increasing. In addition, interest expense related to our revolving credit facility increased due to unused fees and the amortization of up-front costs.

Other Expenses

     During 2003 and the first two months of 2004, (i) our overhead expense for identifying, originating and servicing our investment portfolio and costs of corporate overhead was covered by an investment advisory agreement with PMC Capital and (ii) other general and administrative costs were limited primarily to professional fees, directors and officers insurance, trust manager fees and shareholder expenses. As a result of the merger, on March 1, 2004, we became a self-managed REIT and our assets under management substantially increased from approximately $244.4 million to approximately $563.9 million. Beginning March 1, 2004, our operating expenses consisted of salaries and related benefits, rent and other general and administrative expenses necessary to service our investment portfolio, identify and originate new investments and provide for our corporate administrative needs.

39

Since our assets under management increased, the increase in our general and administrative expenses is greater than our historical advisory fee expense. We estimate that the net increase in overhead as a result of the merger during 2004 was approximately $3.0 million ($3.6 million annualized). This increase does not include increased overhead resulting from any costs incurred from requirements of the Act or costs of new marketing programs.

     Our combined general and administrative expenses, advisory fee expense and salaries and related benefits during 2004 increased by $3,394,000 (145%), from $2,333,000 during 2003 to $5,727,000 during 2004. This increase was primarily a result of the increased costs related to our larger investment portfolio and corporate structure. In addition, our professional fees, including accounting, legal and consulting services, increased to $880,000 during 2004 from $165,000 during 2003. The increase relates primarily to accounting and consulting fees associated with requirements of the Act and increased accounting and auditing fees resulting from (i) the larger company subsequent to the merger and (ii) tax return compliance and preparation fees. We expect our professional fees to remain at these higher levels during 2005.

     Realized losses on Retained Interests were $1,182,000 during 2004, primarily resulting from a reduction in expected future cash flows due to increased anticipated and actual prepayments and anticipated losses on our acquired Retained Interests. Our acquired Retained Interests are more susceptible to incurring realized losses. When acquired from PMC Capital, the estimated fair value at February 29, 2004 for each of the components of Retained Interests was recorded as our cost. As a result, during any period that (i) the value of any of the components of our Retained Interests is below the cost and (ii) the estimated cash flow from the particular component has been reduced, realized losses will occur. Since our originated Retained Interests were recorded based on the “net realizable value” of the residual interests which established unrealized gains included in our beneficiaries’ equity, realized losses will only be recorded if the unrealized valuation gains are reversed and estimated future cash flows are decreasing. There were no realized losses on our Retained Interests during 2003.

     Our provision for (reduction of) loan losses, net, was ($253,000) during 2004 and $310,000 during 2003. During 2004, we reversed $675,000 of previously recorded loan loss reserves due to the reduction in the expected loss on a loan collateralized by a limited service hospitality property due to repayment of all principal on the loan. We recorded loan loss reserves of $422,000 during 2004 primarily related to two limited service hospitality properties on which significant doubt exists as to the ultimate realization of the loans. During 2003, we increased reserves on the loan which paid off during 2004 due to significant doubt as to the ultimate realization of the loan which existed at the time.

Discontinued operations

     We had a net loss on sales of real estate of $252,000 during 2004 compared to a gain of $283,000 during 2003. The net loss during 2004 was primarily comprised of the sale of a limited service hospitality property acquired through liquidation of a loan and the sale of two Amerihost Inn hotel properties during 2004. The limited service hospitality property was sold for approximately $1.5 million which generated a gain of approximately $205,000. The two Amerihost Inn hotel properties were sold during August 2004 and December 2004 for approximately $1.8 million each resulting in losses of approximately $354,000 and $116,000, respectively. Pursuant to the sale of the Amerihost Inn hotel property in August, we received a lease termination fee from Arlington in the form of a note receivable with an estimated fair value of $624,000 which is included in net earnings from discontinued operations. The property was sold prior to the lease amendment which was effective October 1, 2004. The gain during 2003 was due to the sale of an Amerihost Inn hotel property for approximately $2.2 million.

     Our net earnings from discontinued operations increased by $528,000 (80%), to a net profit of $1,187,000 during 2004 from a net profit of $659,000 during 2003 primary as a result of the lease termination fee income described above. During 2004, the rental income from the Amerihost Inn properties sold during 2004 and the Amerihost Inn property held for sale at December 31, 2004 were included in discontinued operations. In addition to these properties, during 2003 discontinued operations included the Amerihost Inn hotel property which was sold during 2003.

Extraordinary item – negative goodwill

     Our negative goodwill was $11,593,000 during 2004 representing the excess of fair value of the net assets acquired over the cost of the merger with PMC Capital. The cost of the merger was allocated to the assets acquired, liabilities assumed and preferred stock of subsidiary based on estimates of their respective fair values at the date of the merger. The fair value of the net assets acquired exceeded the cost of the merger, resulting in negative goodwill. The amount of negative goodwill was allocated proportionately to reduce the assigned values of the acquired assets

40

excluding current assets, financial assets and assets held for sale. Substantially all of the assets acquired were considered to be financial assets or assets to be disposed of by sale.

Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002

Overview

     Income from continuing operations decreased by $1,382,000 (17%) to $6,521,000 during 2003 from $7,903,000 during 2002. Net income decreased by $1,762,000 (18%), to $8,174,000 during 2003 from $9,936,000 during 2002. Our basic earnings per share decreased $0.27 (18%), to $1.27 per share during 2003 from $1.54 per share during 2002. The decrease in net income is primarily due to:

     Partially offsetting these decreases in net income were:

     Significant changes in revenues and expenses are further described below.

Revenues

     The interest income decrease of $460,000 (7%), to $5,776,000 during 2003 from $6,236,000 during 2002 was primarily attributable to (i) the sale of $45.4 million in loans receivable in a structured loan sale transaction completed in October 2003, (ii) the sale of the majority of our fixed-rate loans receivable in a structured loan sale transaction completed in April 2002, (iii) decreasing variable interest rates and (iv) principal collections including loan maturities and prepayments of our fixed-rate loans which were reinvested in lower yielding variable-rate loans.

     Our lease income increased by $70,000 (1%), to $5,024,000 during 2003 from $4,954,000 during 2002 primarily due to a 2% (CPI) increase in base rent during 2003.

     Income from Retained Interests increased $49,000 (2%), to $2,942,000 during 2003 compared to $2,893,000 during 2002. The income from our Retained Interests consists of the accretion on our Retained Interests which is determined based on estimates of future cash flows and includes any fees collected by the QSPEs in excess of anticipated fees. The increase was primarily the result of an increase in the balance of our Retained Interests due to the completion of our 2003 structured loan sale transaction partially offset by a decrease in the yield on our Retained Interests, which is comprised of the income earned less realized losses, to 12.3% during 2003 from 13.2% during 2002 resulting primarily from better than anticipated cash flows in 2002.

     Other income decreased $825,000 (71%), to $339,000 during 2003 compared to $1,164,000 during 2002 which is primarily attributable to increased prepayment fees received during 2002. Prepayment fees increased sharply in 2002 as a result of the refinancing options at low fixed interest rates made available by mini-perm loans offered by banks. While interest rates remained low and “mini-perm” bank loans were still available in 2003, many of the borrowers that considered refinancing did so during 2002.

41

Interest Expense

     Interest expense decreased by $241,000 (7%), to $3,204,000 during 2003 from $3,445,000 during 2002. Interest expense consisted of the following:

     The decrease was primarily attributable to a decrease in the principal balance of the structured notes payable from our 1998 structured loan financing ($18.7 million outstanding at December 31, 2003 compared to $26.0 million outstanding at December 31, 2002). This decrease was partially offset by an increase in the weighted average borrowings outstanding under our revolving credit facility to $17.3 million during 2003 compared to $4.2 million during 2002. The weighted average interest rate on our revolving credit facility decreased to 3.1% during 2003 from 3.6% during 2002.

Other Expenses

     Fees associated with the advisory agreements with our Investment Manager consisted of the following:

     Our provision for loan losses increased $245,000 (377%), to $310,000 during 2003 from $65,000 during 2002. During 2003, we increased reserves on a loan on which significant doubt exists as to the ultimate realization of the loan.

Discontinued operations

     Our profit from discontinued operations decreased by $529,000 (36%), to a net profit of $942,000 during 2003 from a net profit of $1,471,000 during 2002. The decrease was primarily a result of property sales. Included in discontinued operations are the gains from selling one Amerihost Inn hotel property in 2003 and two Amerihost Inn hotel properties in 2002. The gain recognized in 2003 was $380,000 less than 2002. Results of operations for the two properties sold during 2002, the property sold during 2003, the two properties sold during 2004, and the property held for sale at December 31, 2004 are included in discontinued operations for 2003 and 2002.

42

Gain on sale of assets

     Gain on sale of loans receivable was $711,000 and $562,000 during 2003 and 2002, respectively. The increase in the gain is primarily the result of (i) an increase in the amount of loans sold from $27.3 million in April 2002 to $45.4 million during October 2003 and (ii) an increase in the spread earned at the time the transactions were completed to 2.77% for the structured loan sale transaction completed in October 2003 compared to 2.56% for the structured loan sale transaction completed in April 2002. These increases were partially offset by an increase in costs for the 2003 transaction due primarily to the delay in completing the securitization.

CASH FLOW ANALYSIS

     We generated $12,953,000 and $8,710,000 in cash from operating activities during 2004 and 2003, respectively. The primary source of funds from operating activities is our income from continuing operations which was $12,253,000 during 2004 compared to $6,521,000 during 2003 (an increase of $5,732,000) primarily due to our increased net assets resulting from the merger with PMC Capital.

     Our investing activities reflect a net source of funds of $19,953,000 and $17,534,000 during 2004 and 2003, respectively. The primary source of funds in 2004 resulted from the cash and cash equivalents acquired in connection with the merger of $31,488,000 while during 2003 the primary source of funds was from proceeds from our 2003 structured loan sale transaction, net, of $39,949,000. During 2004 and 2003, our net loans funded were comparable at $20,431,000 in 2004 versus $22,033,000 during 2003. During 2004, we also (i) had significant increases in funds related to our Retained Interests of $6,361,000, (ii) received proceeds from the sales of properties, net, of $3,513,000 and (iii) paid merger related costs of $1,006,000. We anticipate that the principal received on our Retained Interests and proceeds from property sales during 2005 will continue at or exceed the levels experienced during 2004.

     Our financing activities reflect a net use of funds of $24,919,000 and $25,215,000 during 2004 and 2003, respectively. Proceeds from our revolving credit facility increased $21,900,000 during 2004 compared to 2003. We increased borrowing on our revolving credit facility during 2004 due to funding of loans, net of prepayments received. This increase in proceeds was partially offset by increased payment of principal on notes payable of $19,133,000 primarily caused by prepayments of loans in our 1998 structured loan financing transaction and the repayment (at maturity) of $15,000,000 in medium term notes payable acquired in connection with the merger. We increased payment of dividends to $12,872,000 during 2004 from $10,187,000 during 2003. The increased use of funds for dividends relates to the increased shares outstanding resulting primarily from the merger; however, on a per share basis our dividends decreased from $1.54 per share during 2003 to $1.40 per share during 2004.

LIQUIDITY AND CAPITAL RESOURCES

Sources and Uses of Funds

General

     We have $9.1 million of cash and cash equivalents at December 31, 2004. Of this, $8.3 million is available only for future operating commitments of our SBICs. Pursuant to SBA rules and regulations, our SBICs cannot advance funds to us. As a result, we will have to borrow funds on the revolving credit facility or use the Conduit Facility to make investments even though our SBICs have available cash and cash equivalents. Our outstanding commitments to fund new loans were $30.3 million at December 31, 2004, of which (i) $4.9 million represents commitments of our SBICs and (ii) $6.9 million are for loans to be originated by First Western, approximately 75% of which will be sold into the secondary market. Commitments have fixed expiration dates and require payment of a fee to us. Since some commitments expire without the proposed loan closing, total committed amounts do not necessarily represent future cash requirements.

43

     In general, our liquidity requirements include operating costs, origination of new loans, debt principal payment requirements and payment of dividends. We intend to utilize, as deemed appropriate by prevailing market conditions, a combination of the following sources to generate funds:

     We expect that these sources of funds and cash on hand will be sufficient to meet our working capital needs. However, there can be no assurance that we will be able to raise funds through these financing sources. A reduction in the availability of the above sources of funds could have a material adverse effect on our financial condition and results of operations. If these sources are not available, we may have to originate loans at reduced levels or sell assets, potentially on unfavorable terms. Historically, our primary funding source has been the securitization and sale of our loans receivable. See “Structured Loan Transactions.”

     As a REIT we must distribute to our shareholders at least 90% of our REIT taxable income to maintain our tax status under the Code. Accordingly, to the extent the sources above represent taxable income, such amounts have historically been distributed to our shareholders. During 2005, we anticipate that our cash flows from operating activities will be utilized to fund our expected 2005 dividend distributions and generally will not be available to fund portfolio growth or for the repayment of principal due on our debt.

     At December 31, 2004, the SBICs had $7.0 million in available commitments from the SBA expiring in September 2007 to issue future debentures. These debentures will have 10-year maturities, will be charged interest (established on the date of issuance) at a spread over 10-year treasuries and will have semi-annual interest-only payments. To the extent funds are needed to originate loans by our SBICs, these pre-approved debentures can be issued. During March 2005, $4.0 million of these debentures were issued to PMCIC from our available commitments.

     The primary use of our funds is to originate commercial mortgage loans to small businesses in the limited service hospitality industry. During 2005, we anticipate loan originations will range from $60 million to $80 million. See “Lending Division” for information on current market conditions. As a REIT, we also use funds for the payment of dividends to shareholders. While there are timing differences, in aggregate, our dividends will normally approximate 100% of our REIT taxable income. We also use funds for payment of our operating overhead including salaries and other general and administrative expenses and we have payment requirements of principal and interest on our borrowings.

     In addition, we may use funds to repurchase loans from the QSPEs which (i) become “charged-off” as defined in the transaction documents either through delinquency or initiation of foreclosure, (ii) reach maturity or (iii) require modification due to an assumption. During 2004, we repurchased, at a price equal to their aggregate principal balance, approximately $5.5 million of such loans, which are included in loans funded on our consolidated statement of cash flows. We recorded these loans at their estimated fair value at the date of repurchase of approximately $4.4 million based on an analysis of anticipated proceeds either from liquidation of these loans or collections of principal and interest. To the extent additional loans become “charged-off,” reach maturity or require modification, we may repurchase these loans from the QSPEs at prices equal to their outstanding principal balance.

44

Debt

     Information on our Revolver and notes and debentures payable was as follows as of December 31, 2004:

     At December 31, 2004, we had $14.6 million outstanding and availability of $25.4 million under our Revolver which matures December 31, 2005. Under our Revolver, we are charged interest on the balance outstanding at our election of either the prime rate of the lender less 50 basis points or 187.5 basis points over the 30, 60 or 90-day LIBOR. In addition, we are charged an unused fee equal to 37.5 basis points computed based on our daily available balance. The credit facility requires us to meet certain covenants, the most restrictive of which provides for an asset coverage test based on our cash and cash equivalents, loans receivable, Retained Interests and real estate investments as a ratio to our senior debt and limit our ability to pay out returns of capital as part of our dividends. The ratio must exceed 1.25 times. At December 31, 2004, we were in compliance with the covenants of this facility. During February 2005, our Revolver was reduced from $40 million to $20 million upon completion of the Conduit Facility.

     We do not anticipate any use of funds for the maturities on our mortgage notes payable since these mortgages are typically “rolled-over” into new mortgages upon maturity, unless the underlying Hotel Property has been sold.

     During 2004 (at maturity), $3.0 million of fixed-rate mortgages payable with interest rates of 7.5% and 8.0% were “rolled-over” into $3.0 million of variable-rate mortgages payable with interest rates of prime plus 0.5% maturing in 2009. We have a $1.0 million mortgage payable with a fixed interest rate of 5.6% due in December 2005 and anticipate that, if the underlying Hotel Property has not been sold, that this mortgage payable will be “rolled-over” into a new variable-rate mortgage payable.

     In the merger, we assumed PMC Capital’s liabilities including $35.0 million in uncollateralized notes payable with maturities through 2006 (the “Medium Term Notes”). We repaid $5.0 million (at an interest rate of LIBOR plus 1.3%) and $10.0 million (at an interest rate of LIBOR plus 1.4%) of the Medium Term Notes at maturity in April 2004 and July 2004, respectively, using existing cash and our Revolver. The Medium Term Notes require us to meet certain covenants, the most restrictive of which require that (i) net loans receivable must exceed 150% of senior funded debt, (ii) loan losses for any twelve-month period must not exceed 3% of net loans receivable and (iii) consolidated earnings plus interest expense must exceed 150% of interest expense. During March 2005, we prepaid, without penalty, the remaining $20 million of Medium Term Notes.

     In the merger, we assumed $18.5 million in SBA debentures with maturities ranging from 2005 to 2013. At December 31, 2004, we had $7.0 million in SBA debentures due in September 2005. During March 2005, we “rolled-over” $4.0 million of such debentures and repaid the remaining $3.0 million using cash on hand and our Revolver.

45

     On February 7, 2005, we entered into a $100.0 million Conduit Facility with a concurrent reduction in our revolving credit facility from $40.0 million at December 31, 2004 to $20.0 million. The Conduit Facility operates as a revolving line of credit, collateralized by loans originated by us, which have been or will be sold and/or contributed to PMC Conduit, L.P. While PMC Commercial has not guaranteed the repayment of the Conduit Facility, PMC Commercial must repurchase the loans securing the Conduit Facility if certain of the representations and warranties made by PMC Commercial in connection with the Conduit Facility are breached. Approximately $24.4 million of our loans were contributed to PMC Conduit, L.P. who immediately advanced $15.0 million under the Conduit Facility which was used to repay a portion of the balance outstanding on our revolving credit facility at February 7, 2005. Interest payments on the advances are payable by PMC Conduit, L.P., on a monthly basis, and PMC Conduit L.P.’s principal repayment obligations are expected to be financed through future securitizations of the loans collateralizing advances under the Conduit Facility. We anticipate that future advances under the Conduit Facility will be used to further invest in loans. The Conduit Facility allows for advances based on the amount of eligible collateral contributed to the Conduit Facility and has covenants, the most restrictive of which are maximum delinquency ratios for our contributed loans and serviced portfolio, as defined in the transaction documents. The ability to make draws under the Conduit Facility expires February 6, 2008. At the end of each annual period commencing February 6, 2006, the alternate lenders have the option to extend their respective commitments for an additional 364-day period. If the Conduit Facility is not extended, any and all principal amounts outstanding and all accrued and unpaid interest would be immediately due and payable. In connection with the closing of our $100 million Conduit Facility, we incurred approximately $550,000 in costs including a fee to the financial institution of $350,000.

     On March 15, 2005, PMC Commercial issued Junior Subordinated Notes of approximately $27.1 million due March 15, 2035 to the Preferred Trust. The Junior Subordinated Notes are subordinated to PMC Commercial’s existing debt. The Preferred Trust issued the Preferred Securities to an unaffiliated party in exchange for approximately $26.3 million and issued shares of common beneficial interest to PMC Commercial for $820,000. The Junior Subordinated Notes and the Preferred Securities each bear interest at a floating rate which resets on a quarterly basis at the 90-day LIBOR plus 3.25% (approximately 6.25% as of March 15, 2005) and generally may not be redeemed prior to March 15, 2010. After payment of costs associated with the issuance of approximately $800,000, the proceeds from the sale of the Preferred Securities were approximately $25.5 million. The net proceeds were used to prepay, without penalty, the $20 million of Medium Term Notes and the remainder was used to repay a portion of the outstanding balance on our Conduit Facility.

Structured Loan Transactions

     Historically, our primary source of long-term funds has been structured loan sale transactions. We generated net proceeds of $39.9 million, $24.0 million, $29.5 million and $49.2 million from the completion of our 2003, 2002, 2001 and 2000 structured loan sale transactions, respectively. The proceeds from future structured loan sale transactions, if any, are expected to be greater as a result of the merger. Due primarily to decreased loan originations and availability of alternative sources of funds, we do not anticipate completing our next structured loan transaction until the latter half of 2005.

     We account for structured loan sale transactions as sales of our loans receivable and the SPE meets the definition of a QSPE; as a result, neither the loans receivable contributed to the QSPE nor the notes payable issued by the QSPE are included in our consolidated financial statements. When a structured loan sale transaction is completed the subordinate interest in the QSPE is accounted for as a Retained Interest.

     A structured loan financing is similar to a structured loan sale, with the exception that the transaction is not treated as a sale for financial reporting purposes. Therefore, the loans receivable contributed to the SPE and the notes payable issued by the SPE are included in our consolidated financial statements and, as a result, the ownership interest in the SPE is not accounted for as a Retained Interest.

     The transaction documents of the QSPEs contain provisions (the “Credit Enhancement Provisions”) that govern the assets and the inflow and outflow of funds of the QSPE formed as part of the structured loan transactions. The Credit Enhancement Provisions include specified limits on the delinquency, default and loss rates on the loans receivable included in each QSPE. If, at any measurement date, the delinquency, default or loss rate with respect to any QSPE were to exceed the specified limits, the Credit Enhancement Provisions would automatically increase the level of credit enhancement requirements for that QSPE. During the period in which the specified delinquency, default or loss rate was exceeded, excess cash flow from the QSPE, if any, which would otherwise be distributable to us, would be used to fund the increased credit enhancement levels up to the principal amount of such loans and would delay or reduce our distribution. The increased reserve requirement would be discontinued (i) if “charged-off” loans (as defined in the transaction documents) are repurchased by us from the QSPEs thereby releasing the excess cash previously deposited into the reserve accounts, (ii) upon liquidation of the collateral underlying the loan or (iii) if excess cash flow from the QSPE rebuilds the reserve or based on a combination of the above. While management believes that any funds used to build the reserve fund would ultimately be distributed to us, there can

46

be no assurance that future events would not occur to cause amounts to continue to be deferred or never be distributed to us under Credit Enhancement Provisions.

     Since we have historically relied on structured loan transactions as our primary source of operating capital to fund new loan originations, any adverse changes in our ability to complete this type of transaction, including any negative impact on the asset-backed securities market for the type of product we generate, could have a detrimental effect on our ability to sell loans receivable thereby reducing our ability to originate loans. The timing of a structured loan transaction also has significant impact on our financial condition and results of operations.

     A number of factors could impair our ability, or alter our decision, to complete a structured loan transaction. See “Item 1. Business – Risk Factors.”

Seasonality

     Generally, our business is not subject to seasonal trends. However, since we primarily lend to the limited service hospitality industry, loan delinquencies typically rise temporarily during the winter months due primarily to reductions in business travel and consumer vacations.

Impact of Inflation

     To the extent that we originate fixed-rate loans while we borrow funds at variable rates, we have an interest rate mismatch. In an inflationary environment, if variable-rates were to rise significantly and we were originating fixed-rate loans, our net interest margin would be reduced. In general, we have matched our fixed-rate debt with fixed-rate producing assets. Our fixed-rate structured notes are matched with fixed-rate loans receivable and our fixed-rate mortgages are generally matched with our properties with a fixed-rate base rent. We primarily originate variable-rate loans and have $28.3 million in variable-rate debt; therefore, we do not believe inflation will have a significant adverse impact on us in the near future.

     To the extent costs of operations (i.e., utilities, salaries, etc.) rise while economic conditions prevent a matching rise in revenue rates (i.e., room rates, amenities, etc.), our borrowers and Arlington would be negatively impacted and loan losses and lease income could be affected. Accordingly, our borrowers can be impacted by inflation. In addition, in an inflationary environment we may experience pressure to increase our income and dividend yield to maintain our stock price.

47

SUMMARIZED CONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS

     The following summarizes our contractual obligations at December 31, 2004: