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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549** **FORM 10-K**(Mark One)   þ **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934****For the fiscal year ended December 31, 2005****OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****For the transition period from                      to                     ****Commission File Number 001-13487** **NATIONAL HEALTH REALTY, INC.**(Exact name of registrant as specified in its charter)   **Maryland** **52-2059888**(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification Number)   **100 Vine Street, Suite 1402, Murfreesboro, Tennessee** **37130**(Address of principal executive offices) (Zip Code)Registrant’s telephone number, including area code: **(615) 890-2020** Securities registered pursuant to Section 12(b) of the Act:   Title of Each Class Name of Each Exchange on Which Registered**Common Stock** **American Stock Exchange** Securities registered pursuant to Section 21(g) of the Act: **Same**      Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes þ No o     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.Yes o No þ     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required tofile 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 willnot be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. o     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (asdefined in Rule 12b-2 of the Act). Large accelerated filer o Accelerated filer þ Non-accelerated filer o     Indicate by check mark whether the registrant is a shell company (as is defined in Rule 12b-2 of the Exchange Act).Yes o No þ     The aggregate market value of Common Stock held by non-affiliates on June 30, 2005 (based on the closing price of such shares on the American Stock Exchange) was approximately $117 million. For purposes of the foregoing calculation only, alldirectors, named executive officers and persons known to the Registrant to be holders of 5% or more of the Registrant’sCommon Stock have been deemed affiliates of the Registrant. The number of shares of Common Stock outstanding as of February 28,2006 was 9,939,463.**Documents Incorporated by Reference**     The following documents are incorporated by reference into Part III, Items 10, 11, 12, 13, and 14 of this Form 10-K:The Registrant’s definitive proxy statement for its 2006 shareholder’s meeting.  
 

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PART 1Item 1. BusinessItem 1A. Risk FactorsItem 1B. Unresolved Staff CommentsItem 2. PropertiesItem 3. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security Holders PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesItem 6. Selected Financial DataItem 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsItem 7A. Quantitative and Qualitative Disclosures about Market RiskItem 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 9B. Other Information PART III Item 10. Directors and Executive Officers of Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions Item 14. Principal Accountant Fees and Services PART IV Item 15. Exhibits and Financial Statement Schedules SIGNATURES EXHIBIT INDEXEX-10.2  AMENDMENT NO.1 TO MASTER OPERATING LEASEEX-10.3  AMENDMENT NO. 2 TO MASTER OPERATING LEASEEX-10.4  AMENDMENT NO. 3 TO MASTER OPERATING LEASEEX-10.6  RESTATED ADVISORY, ADMINISTRATIVE SERVICES AND FACILITIES AGREEMENTEX-13  FINANCIAL STATEMENT SCHEDULESEX-21  SUBSIDIARIES OF THE REGISTRANTEX-23.1  CONSENT OF BDO SEIDMAN, LLPEX-23.2  CONSENT OF ERNST & YOUNG LLPEX-31.1  SECTION 302 CERTIFICATION OF THE CEO & CFOEX-31.2  SECTION 302 CERTIFICATION OF THE CEO & CFOEX-32  SECTION 906 CERTIFICATION OF THE CEO & CFO

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**PART 1****Item 1. Business****General**     National Health Realty, Inc. (NHR) is a Maryland corporation formed during 1997 and inoperation since January 1, 1998. NHR, through its subsidiary NHR/OP, L.P. (the OperatingPartnership) currently owns 16 licensed skilled nursing facilities, six assisted living facilitiesand one independent living center (the Healthcare Facilities). We additionally own first mortgagesecured promissory notes with an outstanding balance of $13.2 million (the Notes). The HealthcareFacilities and the Notes were originally acquired on December 31, 1997 from our then sole ownerNational HealthCare Corporation (NHC), (formerly National HealthCare L.P.). NHR leases theHealthcare Facilities pursuant to certain lease agreements. Fourteen of the Healthcare Facilitiesare leased to NHC and nine are leased to nine separate Florida corporations. These leases coveringthe Healthcare Facilities are “triple net” leases, meaning the tenant shall pay allcharges and expenses in connection with the leased property throughout the term of the lease. TheNotes are secured by nursing facilities and separate makers and guarantors. NHR’s revenues andsources of cash are derived primarily from the interest and principal payments on the Notes andfrom rent payments, primarily from NHC, under the leases.     During 2005, NHC extended its lease from NHR of the fourteen Healthcare Facilities through2017, with additional options to renew at fair market value through 2027. Also during 2005, theleases to nine separate Florida corporations were extended through 2010. NHC continues toguarantee the lease payments on the nine Florida Healthcare Facilities through NHC’s extendedlease term.     During 2005, 2004 and 2003, rental income was 87.8%, 85.5%, and 69.7%, respectively, ofrevenues and mortgage interest income was 12.2%, 14.0%, and 25.6% of revenues.     At our formation, we entered into an Advisory, Administrative Services and FacilitiesAgreement with NHC pursuant to which NHC, through a subsidiary, Tennessee HealthCare Advisors, LLC,provides us with investment advice, office space and personnel. Certain limitations on ourinvestment opportunities provided by the original agreement have been removed effective November 1,2004. See “Investment and Other Policies of NHR” below.**Investment and Other Policies of NHR**     *General*. Our investment objectives are: (i) to provide current income for distribution tostockholders, (ii) to provide the opportunity for additional returns to investors by participatingin any increase in the operating revenues of our leased properties; (iii) to provide theopportunity to realize capital growth resulting from appreciation, if any, in the value of ourportfolio properties, and (iv) to preserve and protect stockholder’s capital. We can offer noassurance that these objectives will be realized.     *Advisory Agreement.*We have contracted for our management with a wholly-owned subsidiary ofNHC. For its services, NHC is entitled to annual compensation of the greater of 2.5% of our grossconsolidated revenues or $500,000. The amount accrued for advisory services in 2005 was $508,000.Either party may terminate the Advisory Agreement on 90 days notice.     *Objectives and Policies*. We were organized to own the Healthcare Facilities and Notes.Because our objective is to maintain payment of our dividends and because of our currently limitedcapital resources, we do not presently intend to seek further outside health care-relatedinvestment opportunities or to provide lease or mortgage financing for such investments. We expectto continue to engage in transactions with NHC for expansions or improvements of our existingproperties, or the construction of new properties which are to be operated by NHC. The Board ofDirectors may alter our investment policies if they determine that such a change is in the bestinterests of the Company and our stockholders. Themethods of implementing our investment policiesmay vary as new investment and financing techniques are developed or for other reasons.
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**NHC Master Agreement to Lease**     Leases Extended — On August 1, 2005, NHC elected to exercise its option to extend the term ofits leases of properties from us for two additional five year terms until December 31, 2017. Theleases are for the real estate of seven long-term care centers, six assisted living centers and oneindependent living center. The currently running initial term of the leases expires on December31, 2007. The leases were further amended to grant NHC an option to renew the leases at fairmarketvalue for a second extended term of ten years until December 31, 2027, assuming no defaultsand on an “all or nothing” basis. We account for the leases as operating leases.     Under the terms of the master lease, NHC continues to guarantee to us the lease payments ofnine Florida long-term care facilities, as discussed below. This requirement is unchanged from ouroriginal lease as amended.     The lease payments for the extended ten-year term of the leases that begin on January 1, 2008are the same lease payments that were required in the initial term of the lease, including anannual inflator for percentage rent as described below. The lease payments for the second extendedten-year term that begins on January 1, 2018, if renewed, will be at fair market value asdetermined at the time of the lease renewal.     During the remaining initial term and the extended renewal term, NHC is obligated to pay NHRannual base rent on the facilities. In addition to base rent, in each quarter of each year after1999, NHC is obligated to pay percentage rent to NHR equal to 3% of the amount by which grossrevenues of each NHR leased health care facility in such later quarter exceed the gross revenues ofsuch health care facility in the applicable quarter of 1999. During 2005, 2004 and 2003, werecognized $1,363,000, $1,295,000, and $1,128,000 of percentage rent from NHC. Total rental incomefrom NHC (including the nine Florida healthcare facilities referred to below) was $17,359,000,$17,255,000, and $17,088,000 during 2005, 2004, and 2003, respectively. During 2005, 2004 and2003, rent derived from the nine Florida facilities totaled $6,178,000, $6,069,000 and $6,069,000,respectively.     On October 1, 2000, NHC terminated, with our consent, its individual leases on nine Floridalong term care facilities. However, NHC, under its master lease agreement, guarantees the leasepayments to NHR on the nine Florida long term care facilities. Also effective October 1, 2000, thefacilities were leased by NHR under a five year term to nine separate limited liabilitycorporations, none of which are owned or operated by NHC. In 2005, the leases have been extendedthrough December 31, 2010. Lease payments to NHR from the new lessees offset NHC’s leaseobligations pursuant to the master operating lease. Since October 1, 2000, the nine separatelimited liability corporations have made all required lease payments to NHR, and NHC has not beenrequired to make any lease payments with respect to those nine properties.     NHC has a right of first refusal with us to purchase any of the properties transferred fromNHC should we receive an offer from an unrelated party during the term of the lease or up to 180days after termination of the related lease.     At December 31, 2005, the approximate future minimum base rent commitments (which excludepercentage rents and expansion rent) to be received by us on non-cancelable operating leases aredescribed in the following table. Base rent on the nine Florida healthcare facilities of$6,505,000 per year is included because NHC guarantees the related lease payments through 2017.     2006 $15,960,000 2007  15,960,000 2008  15,960,000 2009  15,960,000 2010  15,960,000 Thereafter  111,720,000      The leases have also been amended during 2005 to provide that if NHC pays for theconstruction of a bed addition, then the existing annual rent for that center will be increased by .75% of the cost paid by NHC for the
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construction of the addition. Total expansion rent incomefrom NHC totaled $36,000 in 2005. Revenues produced within the addition shall be excluded from anypercentage rent calculation. At such time as NHC is no longer a tenant by virtue of leaseterminations, then NHR shall reimburse to NHC the fair market value of the additional bedsconstructed by NHC. The fair market value shall be calculated as the lesser of (1) the appraisedvalue of the addition or (2) the construction cost incurred by NHC plus 50% of any appraised valueincrease over cost. In addition, NHC agrees at NHR’s request to finance NHR’s purchaseof the addition with a floating rate, interest only note at the prime rate of interest for a periodof up to two years. NHC has submitted a listing of five NHR owned properties which are to beexpanded by NHC for which the construction cost is expected to totalapproximately $26,225,000. NHC has reported to us that at December 31, 2005, expansion iscompleted at one center ($4,000,000) and is underway at two centers (expected cost $10,700,000;incurred $2,243,000).     The Master Agreement to Lease with NHC regarding the Healthcare Facilities (the “MasterAgreement”) sets forth terms and conditions applicable to all leases entered into by and betweenNHC and the Company (the “Leases”). The Leases, which were extended during 2005, provided for aninitial term expiring on December 31, 2007. In 2005, 68.8% of our net revenues were derived fromleases with NHC.     The Master Agreement is a “triple net lease”, under which NHC is responsible for payment ofall taxes, utilities, insurance premium costs, repairs (including structural portions of thebuildings, and other charges relating to the ownership and operation of the HealthcareFacilities). NHC is also obligated to indemnify and hold harmless NHR from all claims resultingfrom the use and occupancy of each Health Care Facility by NHC or persons claiming under NHC andrelated activities, as well as to indemnify us against all costs related to any release, discovery,cleanup and removal of hazardous substances or materials or other environmental responsibility withrespect to the Healthcare Facilities.**Indiana Properties**     During 2000, we obtained title by foreclosure to four properties on which we previously hadmortgage notes receivable. We immediately entered into new leases for three of the facilities, butthe fourth facility was closed. Effective January 1, 2001 the three facilities were sold to HealthServices Management of Indiana, LLC (HSMI). The principal officer of the entity that currentlyowns the three properties was also the principal officer of the company which owned the propertiesprior to the foreclosure.     We accounted for the sale of the three facilities under the deposit method in accordance withthe provisions of Statement of Financial Accounting Standards (“SFAS”) No. 66.Consistent with the deposit method, we initially did not record the sale of the assets andcontinued to record depreciation expense each period. Any cash received from the buyer (whichtotaled $3,092,000 as of October 31, 2003) was reported as a deposit on real estate properties soldawaiting the time the down payment and continuing investment criteria of SFAS 66 were met.     Effective November 1, 2003, the criteria of SFAS 66 were met. Therefore, the sale of the realestate properties was recorded resulting in a gain on sale of real estate of approximately$1,149,000. Sale proceeds received in 2004 resulted in an additional gain on sale of real estateof approximately $105,000. The sale of the assets resulted in recording mortgage notes receivableof approximately $3,875,000. All payments required on the note receivable were current at December31, 2005 and the maturity was extended until March 31, 2007.**Advisory Agreement**     At our inception we entered into an agreement with NHC as “Advisor” under which NHC,through a wholly-owned subsidiary, provides management and advisory services to us during the termof the Advisory Agreement. We believe the Advisory Agreement benefits us by providing us access toNHC’s extensive experience in the ownership and management of long-term care facilities andindependent living centers. Under the Advisory Agreement, we engaged NHC to use its best efforts(a) to present to us a continuing and suitable investment program consistent with our investmentpolicies adopted by the Board of Directors from time to time; (b) to manage our day-to-day affairsand
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operations; and (c) to provide administrative services and facilities appropriate for suchmanagement. In performing its obligations under the Advisory Agreement, NHC is subject to thesupervision of and policies established by our Board of Directors.     The Advisory Agreement is for a stated term which expired December 31, 2003 and thereafterfrom year to year unless earlier terminated. Either party may terminate the Advisory Agreement atany time on 90 days written notice, and we may terminate the Advisory Agreement for cause at anytime.     On August 1, 2005, concurrent with the lease extensions described above, the AdvisoryAgreement was revised to provide that beginning for the year 2005 for its services under theAdvisory Agreement, NHC is entitled to annual compensation equal to the greater of (1) 2.5% of ourgross consolidated revenues or (2) $500,000. It was also clarified that we (and not NHC) are tobear certain corporate costs, such as directors’ and officers’ insurance, audit fees,etc.     Prior to the August 1, 2005 revision, the Advisory Agreement had provided that for itsservices under the Advisory Agreement, the Advisor was entitled to annual compensation of thegreater of 2% of NHR’s gross consolidated revenues or the actual expense incurred by NHC. Theactual amounts accrued to NHC in 2005, 2004 and 2003 were $508,000, $411,000, and $476,000,respectively.     Pursuant to the Advisory Agreement, NHC manages our day-to-day affairs and provides all suchservices through its personnel. The Advisory Agreement provides that without regard to the amountof compensation received by NHC under the Advisory Agreement, NHC shall pay all expenses inperforming its obligations including the employment expenses of the officers and directors andpersonnel of NHC providing services to us. The Advisory Agreement further provides that we shallpay the expenses incurred with respect to and allocable to the prudent operation and business ofNHR including any fees, salaries, and other employment costs, taxes and expenses paid to ourdirectors, officers and employees who are not also employees of NHC. Currently, other than thedirectors who are not employees of NHC, we do not have any officers or employees who are not alsoemployees of NHC. Of our executive officers at December 31, 2005, Mr. Robert G. Adams, Ms.Charlotte A. Swafford, Mr. Donald K. Daniel and Mr. Kenneth D. DenBesten are employees of NHC; Mr.Richard F. LaRoche, Jr. was an employee until his retirement from management responsibilities inMay 2002, but remains a non-compensated corporate secretary for us. All of their renumeration andemployment costs other than stock options, if any, are paid by NHC, although a portion may beallocated for their services to NHR.**Federal Income Tax**     We believe that we have operated our business so as to qualify as a REIT under Sections 856through 860 of the Internal Revenue Code of 1986, as amended (the Code) and we intend to continueto operate in such a manner. REITs are subject to highly complex rules governing ownership andrelationships with tenants which can be inadvertently transgressed; thus no assurance can be giventhat we will be able to qualify at all times. If we qualify as a REIT, we will generally not besubject to federal corporate income taxes on our net income that is currently distributed to ourstockholders. This treatment substantially eliminates the “double taxation” (at thecorporate and stockholder levels) that typically applies to corporate dividends.**Requirement to Pay Dividends as a REIT**     The REIT provisions of the Code require that a REIT distribute annually 90% of its taxableincome, without regard to any capital gains or dividends paid deduction, to its shareholders.Because NHR intends to qualify as a REIT, the majority of our net income will be distributed toshareholders annually. There can be no assurance that we will be able to meet this requirement atall times.
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**Investor Information**     We maintain a worldwide web site at www.nationalhealthrealty.com. We publish to this web siteour annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, andpress releases. We do not necessarily have these filed the same day as they are filed with the SECor released to the public, but rather have a policy of placing these on the web site within two (2)business days of public release or SEC filing.     We also maintain the following documents on the web site: **•** The NHR Code of Ethics and Standards of Conduct. This has been adopted for allemployees of our Administrative Services Contractor, officers and directors of theCompany. The website will also disclose whether there have been any amendments orwaivers to the Code of Ethics and Standards of conduct. To date there have been none.  **•** Information on our “NHR Valuesline”, which allows our staff andinvestors unrestricted access to our Corporate Compliance Officer, executive officersand directors. The toll free number is 800-526-4064 and the communications may beincognito, if desired.  **•** The NHR Restated Audit Committee Charter.  **•** The NHR Compensation Committee Charter.  **•** The NHR Nomination and Corporate Governance Committee Charter     We will furnish, free of charge, a copy of any of the above documents to any interestedinvestor upon receipt of a written request.**Item 1A. Risk Factors**     *We depend on the operating success of our tenants, who operate in the skilled nursing andassisted living industry for collection of our rent revenues.*Our skilled nursing facilityoperators’ revenues are primarily driven by occupancy, Medicare and Medicaid reimbursementand private pay rates. Our assisted living facility operators’ revenues are primarily drivenby occupancy and private pay rates. Expenses for these facility types are driven by the costs oflabor, food, utilities, taxes, insurance and rent or debt service. Revenues from governmentreimbursement have, and may continue, to come under pressure due to reimbursement cuts and federaland state budget shortfalls. Liability insurance and staffing costs continue to increase for ouroperators. To the extend that any decrease in revenues and/or any increase in operating expensesresult in a facility not generating enough cash to make payments to us, the credit of our operatorand the value of other collateral would have to be relied upon.     *We are exposed to the risk that our operators may not be able to meet the rent, principal andinterest or other payments due us, which may result in an operator bankruptcy or insolvency, orthat an operator might become subject to bankruptcy or insolvency proceedings for other reasons.*Although our operating lease agreements provide us the right to evict an operator, demand immediatepayment of rent and exercise other remedies, and our mortgage loans provide us the right toterminate any funding obligations, demand immediate repayment of principal and unpaid interest,foreclose on the collateral and exercise other remedies, the bankruptcy laws afford certain rightsto a party that has filed for bankruptcy or reorganization. An operator in bankruptcy may be ableto limit or delay our ability to collect unpaid rent in the case of a lease or to receive unpaidprincipal and/or interest in the case of a mortgage loan, and to exercise other rights andremedies.     We may be required to fund certain expenses (e.g., real estate taxes, maintenance andcapital improvements) to preserve the value of a facility, avoid the imposition of liens on afacility and/or transition a facility to a new operator. In some instances, we have terminated ourlease with an operator and relet the facility to another operator. In some of
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those situations,we provided working capital loans to and limited indemnification of the new operator. If wecannot transition a leased facility to a new operator, we may take possession of that facility,which may expose us to certain successor liabilities. Should such events occur, our revenue andoperating cash flow may be adversely affected.     *We are exposed to risk as a result of approximately two-thirds of our revenue (66.8% in 2005)is being generated from a lease with NHC.*Additionally, 14 of our 23 owned properties are leasedto NHC. In the event NHC experiences a decline in profitability from their operations, NHC’sability to pay our rent could be adversely affected. If NHC defaults in its obligation to pay ourrent timely, such event would have a material adverse effect on our financial results, carryingvalue of our assets and on our ability to pay dividends.     *We are exposed to risks related to government regulations and the effect they have on ouroperators’ business.*Our operators’ businesses are affected by governmentreimbursement and private payor rates. To the extend that any skilled nursing facility receives asignificant portion of its revenues from governmental payors, primarily Medicare and Medicaid, suchrevenues may be subject to statutory and regulatory changes, retroactive rate adjustments, recoveryof program overpayments or set-offs, administrative rulings, policy interpretations, payment orother delays by fiscal intermediaries, government funding restrictions (at a program level or withrespect to specific facilities) and interruption or delays in payments due to any ongoinggovernmental investigations and audits at such facility. In recent years, governmental payors havefrozen or reduced payments to health care providers due to budgetary pressures. Changes in healthcare reimbursement will likely continue to be of paramount importance to federal and stateauthorities. We cannot make any assessment as to the ultimate timing or effect any futurelegislative reforms may have on the financial condition of the health care industry. There can beno assurance that adequate reimbursement levels will continue to be available for services providedby any facility operator, whether the facility receives reimbursement from Medicare, Medicaid orprivate payors. Significant limits on the scope of services reimbursed and on reimbursement ratesand fees could have a material adverse effect on an operator’s liquidity, financial conditionand results of operations, which could adversely affect the ability of an operator to meet itsobligations to us. In addition, the replacement of an operator that has defaulted on its lease orloan could be delayed by the approval process of any federal, state or local agency necessary forthe transfer of the facility or the replacement of the operator licensed to manage the facility.     *We are exposed to the risk that the cash flows of our tenants and mortgages will be affectedby increased liability claims and increased general and professional liability insurance costs.*Long-term care facility operators (assisted living and skilled nursing facilities) have experiencedsubstantial increases in both the number and size of patient care liability claims in recent years,particularly in the state of Florida. As a result, general and professional liability costs haveincreased and may continue to increase. Nationwide, long-term care liability insurance rates areincreasing because of large jury awards in states like Texas and Florida. Over the past two years,both Texas and Florida have adopted skilled nursing facility liability laws that modify or limittort damages. Despite some of these reforms, the long-term care industry overall continues toexperience very high general and professional liability costs. Insurance companies have respondedto this claims crisis by severely restricting their capacity to write long-term care general andprofessional liability policies. No assurances can be given that the climate for long-term caregeneral and professional liability insurance will improve in any of the foregoing states or anyother states where the facility operators conduct business. Insurance companies may continue toreduce or stop writing general and professional liability policies for assisted living and skillednursing facilities. Thus, general professional liability insurance coverage may be restricted,very costly, or not available, which may adversely affect the facility operators’ futureoperations, cash flows and financial condition, and may have a material adverse effect on thefacility operators’ ability to meet their obligations to us.     *We depend on the success of future acquisitions.*We could encounter unanticipateddifficulties and expenditures relating to any acquired properties, including contingentliabilities, and newly acquired properties might require significant management attention thatwould otherwise be devoted to our ongoing business. If we agree to provide construction funding toan operator and the project is not completed, we may need to take steps to ensure completion of theproject or we could lose the property. Moreover, if we issue equity securities or incur additionaldebt, or both, to finance future acquisitions, it may reduce our per share financial results.These costs may negatively affect our results of operations.
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     *We are exposed to risks related to environmental laws and the costs associated with theliability related to hazardous substances.*Under various federal and state laws, owners oroperators of real property may be required to respond to the release of hazardous substances on theproperty and may be held liable for property damage, personal injuries or penalties that resultfrom environmental contamination. These laws also expose us to the possibility that we may becomeliable to reimburse the government for damages and costs it incurs in connection with thecontamination. Generally, such liability attaches to a person based on the person’srelationship to the property. Our tenants or borrowers are primarily responsible for the conditionof the property and since we are a passive landlord, we do not “participate in themanagement” of any property in which we have an interest. Moreover, we review environmentalsite assessment of the properties that we own or encumber prior to taking an interest in them.Those assessments are designed to meet the “all appropriate inquiry” standard, whichqualifies us for the innocent purchaser defense if environmental liabilities arise. Based uponsuch assessments, we do not believe that any of our properties are subject to materialenvironmental contamination. However, environmental liabilities, including mold, may be present inour properties and we may incur costs to remediate contamination, which could have a materialadverse effect on our business or financial condition.     *We depend on the ability to reinvest cash from our operating, investing and financingactivities in a timely manner and on acceptable terms.*From time to time, we will have cashavailable from (1) the proceeds of sales of our securities, (2) principal payments on our loansreceivable, and (3) the sale of properties, including non-elective dispositions, under the terms ofmaster leases or similar financial support arrangements. We must re-invest these proceeds, on atimely basis, in health care investments or in qualified short-term investments. We compete forreal estate investments with a broad variety of potential investors. This competition forattractive investments may negatively affect our ability to make timely investments on termsacceptable to us. Delays in acquiring properties may negatively impact revenues and perhaps ourability to make distributions to stockholders.     *We depend on the ability to qualify or remain qualified as a REIT.*We intend to operate as aREIT under the Internal Revenue Code and believe we have and will continue to operate in such amanner. Since REIT qualification requires us to meet a number of complex requirements, it ispossible that we may fail to fulfill them, and if we do, our earnings will be reduced by the amountof federal taxes owed. A reduction in our earnings would affect the amount we could distribute toour stockholders. Also, if we were not a REIT, we would not be required to make distributions tostockholders since a non-REIT is not required to pay dividends to stockholders amounting to atleast 90% of its annual taxable income.     *We are subject to risks associated with our obligation to purchase leasehold improvements andadditions made by NHC as tenant to our real estate properties.*Our lease of fourteen properties toNHC has currently been extended until December 31, 2017. Under the terms of the lease, at suchtime as NHC is no longer a tenant by virtue of lease terminations, then NHR shall purchase the bedadditions paid for by NHC but unreimbursed by NHR for the lesser of (1) the appraised value of theaddition or (2) the construction cost incurred by NHC plus 50% of any appraised value increase overcost. Also under the terms of the lease, NHC agrees at NHR’s request to finance NHR’spurchase of the addition with a floating rate interest only note at the prime rate of interest fora period of up to two years. NHC has submitted a listing of certain NHR owned properties expectedto be expanded by NHC for which the construction cost is expected to total approximately$26,225,000. Therefore, we would be required at that time of termination of our leases with NHC(or, if NHC financing is utilized, within two years after termination of our leases with NHC) toobtain financing or to use our own capital resources to purchase these bed additions. The terms ofsuch financing or the availability of our own capital at the time of such lease terminations cannotbe determined at this time.     *We are dependent upon NHC for services related to investment activities and day-to-daymanagement.*Processes such as accounting, monitoring of investments, finance activities, etc. areperformed for us by NHC under an advisory agreement that may be cancelled upon 90 days notice orupon demand in some circumstances. The cancellation of this agreement would, at least temporarily,have a material adverse impact on our business activities and upon our ability to comply withgovernment regulations.
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**Item 1B. Unresolved Staff Comments**     None**Item 2. Properties***Healthcare Facilities*     The following table includes certain information regarding Healthcare Facilities which areowned by us and leased to others:                       Net Book  Base Name of Facility   No. of  Value at  Annual Long-Term Care Location Beds  Dec. 31, 2005  Rent (1) The Aristocrat Naples, FL  60  $3,674,291  $96,000 NHC HealthCare, Clinton Clinton, SC  131   2,144,848   690,991 The Health Center at Coconut Creek Coconut Creek, FL  120   7,171,332   775,000 The Health Center of Daytona Beach Daytona Beach, FL  73   4,318,549   380,000 NHC HealthCare, Farragut Farragut, TN  60   5,171,738   669,414 NHC HealthCare, Garden City Murrells Inlet, SC  88   3,780,035   670,928 NHC HealthCare, Greenville Greenville, SC  176   3,409,782   1,239,689 NHC HealthCare, Lexington Lexington, SC  120   4,497,065   867,828 NHC HealthCare, Mauldin Mauldin, SC  120   5,575,957   524,005 AdamsPlace Murfreesboro, TN  90   3,881,325   564,755 The Imperial Health Care Center Naples, FL  113   4,388,559   570,000 NHC HealthCare, North Augusta North Augusta, SC  132   3,155,996   1,081,625 The Health Center of Windermere Orlando, FL  120   5,409,776   535,000 NHC HealthCare, Parklane Columbia, SC  120   5,289,273   787,808 Charlotte Harbor Health Care Center Port Charlotte, FL  180   5,764,958   1,010,000 NHC HealthCare, West Plains West Plains, MO  118   2,346,599   669,901                Assisted Living              The Place at Vero Beach Vero Beach, FL  120   7,128,479   1,187,000 NHC Place/Anniston Anniston, AL  68   3,434,449   344,147 AdamsPlace Murfreesboro, TN  83   4,050,193   56,349 The Place at Merritt Island Merritt Island, FL  84   5,213,645   765,000 The Place at Stuart Stuart, FL  84   4,592,364   751,000 NHC Place/Farragut Farragut, TN  84   6,413,559   225,965                Independent Living              AdamsPlace Murfreesboro, TN  93   13,097,777   1,497,540  (1) Additional rent equal to three percent (3%) of the increase in gross revenues(calculated and paid on a quarterly basis) of the Healthcare Facilities commenced in 2000. Allleases are triple net leases.*Mortgage Notes*     We own approximately seven mortgage notes representing approximately $13,207,000 loaned to theowners of approximately five nursing homes. The loans were utilized by the initial owners toacquire land, then construct and equip thenursing homes, acquire existing nursing homes, or to provide working capital. The mortgagenotes are secured by mortgages on each of the facilities.
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     In February 2004, we received prepayment of the balance (approximately $30,384,000) of10.25% Florida Convalescent Centers, Inc. notes. The notes had been scheduled to mature on October31, 2004.**Item 3. Legal Proceedings**     We are not subject to any significant pending litigation. The HealthCare Facilities aresubject to claims and lawsuits in the ordinary course of business. Our lessees and mortgagees haveindemnified us against all liabilities arising from the operation of the Healthcare Facilities,and also indemnify us against environmental or title problems affecting the real estate underlyingsuch facilities. While there are lawsuits pending against certain of the mortgagees and/or lesseesof the Healthcare Facilities, management believes that the ultimate resolution of all pendingproceedings will have no material adverse effect on our financial position or results ofoperations.**Item 4. Submission of Matters to a Vote of Security Holders**     The annual meeting of the shareholders was held on May 3, 2005, and the results were includedin the March 31, 2005, Form 10-Q filed with the SEC on May 10, 2005.**PART II****Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities**     Our common shares are listed on the American Stock Exchange (AMEX) under the symbol“NHR”. On March 6, 2006 the last reported sale price for the Common Stock on the AMEXwas $19.30. As of December 31, 2005, we had approximately 4,500 shareholders, of whichapproximately 1,600 are holders of record with the balance indicated by security listing positions.     We received notice on January 20, 2005 from the American Stock Exchange (AMEX) that theCompany was currently not in compliance with the AMEX board of directors composition requirementsas set forth in Section 121A of the AMEX Company Guide. Specifically, the Company did notcurrently have a majority of independent directors serving on its board. The warning letter gaveus until May 31, 2005 to regain compliance with the AMEX requirements. This instance ofnoncompliance was corrected when the Board of Directors announced that at the Board Meeting on May9, 2005, after the Annual Meeting of Shareholders held on May 3, 2005, the Board found that newlyelected Director Richard F. LaRoche, Jr. met the American Stock Exchange requirements of“Independence” due to the expiration of three years since his employment as anexecutive officer of NHC, the Investment Advisor to NHR. The Board had previously determinedDirectors J. Paul Abernathy, Joseph M. Swanson and Joel Jobe were independent; therefore, with Mr.LaRoche elected to the NHR board, four out of seven directors are independent.     High and low stock prices and dividends for 2005 and 2004 were as follows:                           2005  2004           Cash          Cash   Sales Price  Dividends  Sales Price  Dividends Quarter Ended High  Low  Declared  High  Low  Declared March 31 $21.000  $17.770  $.3325  $18.770  $18.500  $.3325 June 30  20.100   18.200   .3325   17.420   16.150   .3325 September 30  20.230   18.450   .3325   19.090   18.910   .3325 December 31  20.980   18.000   .4325   20.040   20.010   .4125 
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*Dividends*     In order to qualify for the beneficial tax treatment accorded to a REIT, we must makequarterly distributions to holders of our common stock equal on an annual basis to at least 90% ofour REIT taxable income (excluding net capital gains), as defined in the Code. Cash available fordistribution to our stockholders is primarily derived from interest payments received on itsmortgages and from rental payments received under our leases. All distributions will be made by usat the discretion of the Board of Directors and will depend on our cash flow and earnings, ourfinancial condition, bank covenants and such other factors as the Board of Directors deemsrelevant. Our REIT taxable income is calculated without reference to our cash flow. Therefore,under certain circumstances, we may not have received cash sufficient to pay our requireddistributions.*No Equity Purchase Plans*     We did not purchase any of our equity securities in 2005, nor do we have any publicallyannounced plans or programs to do so.**Item 6. Selected Financial Data***(dollars in thousands, except share and per share amounts)*                       Year Ended December 31   2005  2004  2003  2002  2001 Net revenues $19,772  $20,191  $24,508  $24,549  $24,561 Net income  11,277   11,435   11,845   8,498   8,877 Net income per share                    Basic  1.14   1.19   1.24   .89   .93 Diluted  1.14   1.16   1.21   .87   .92 Mortgages and other notes receivable  13,207   13,553   44,595(a)  65,562(a)  79,518 Real estate properties, net  115,054   120,926   126,931   138,963   150,036 Total assets  142,755   150,032   182,878   214,941   234,987 Long term debt  10,450   16,150   47,820(a)  79,488(a)  96,314 Total stockholders’ equity  112,390   113,998   114,242   114,476   118,571                      Common shares outstanding  9,939,463   9,699,108   9,590,588   9,570,323   9,570,323                      Weighted average common shares                    Basic  9,853,490   9,594,852   9,575,546   9,570,323   9,570,323 Diluted  9,881,484   9,822,823   9,757,238   9,770,730   9,697,116                      Common dividends declared per share $1.43  $1.41  $1.49  $1.33  $1.33  (a) Approximately $21,982,000 and $30,384,000 of 10.25% notes receivable were prepaid to us in November 2003and February 2004, respectively. We used the proceeds of the prepayments to pay down our long-term debt.**Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations**OVERVIEW     National Health Realty, Inc. (NHR or the Company) is a real estate investment trust(REIT) that began operations on January 1, 1998. Currently NHR, through its subsidiary NHR/OP, L.P.(the Operating Partnership), owns the real estate of 23 healthcare facilities, including 16licensed skilled nursing facilities, six assisted living facilities and
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one independent livingcenter (the Healthcare Facilities), and owns seven first promissory notes with principal balancestotaling $13,207,000 (the Notes) at December 31, 2005 and secured by the real property ofhealthcare facilities. Our revenues are derived primarily from rent and interest income from thesereal estate properties and mortgages receivable. Our primary lessee is National HealthCareCorporation (NHC) which leases 14 of our 23 lease properties and guarantees the lease payments onthe remaining nine lease properties.*Relationship With National HealthCare Corporation*     We have an advisory services agreement with National HealthCare Corporation (NHC) pursuant towhich a subsidiary of NHC will provide us with investment advice, office space and personnel. NHCowns or manages a total of 74 long-term healthcare facilities with 9,177 beds in 10 states. NHC isNHR’s primary tenant, operating ten of our licensed skilled nursing facilities, three assistedliving facilities and one independent living center, the real estate of which facilities is ownedby NHR.     NHC, in its role as Advisor, is subject to the supervision of and policies established by ourBoard of Directors. The Advisory Agreement expired December 31, 2003 and thereafter is renewedfrom year to year unless earlier terminated. Either party may terminate the Advisory Agreement atany time on 90 days written notice, and we may terminate the Advisory Agreement for cause at anytime.*Investment Restriction Removed*     Prior to an announcement by NHC on November 1, 2004 that it is no longer the advisor toNational Health Investors, Inc. (NHI), without the prior approval of NHI, we were precluded frombeing actively or passively engaged in the pursuit of additional investment opportunities. BecauseNHC is no longer the advisor to NHI, the restriction on NHR’s investment activities is removed.*Areas of Focus*     Management is currently focusing upon our capacities as landlord and note holder. Ourobjectives are to (1) provide current income for distribution to stockholders, (2) to provide theopportunity for additional returns to investors by participating in any increase in the operatingrevenues of our leased properties; (3) to provide the opportunity to realize capital growthresulting from appreciation, if any, in the value of our portfolio properties, and (4) to preserveand protect stockholder’s capital. We can offer no assurance that these objectives will berealized.CRITICAL ACCOUNTING ESTIMATES     The preparation of financial statements in conformity with accounting principles generallyaccepted in the United States requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assets and liabilities atthe date of the financial statements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates and cause our reported netincome to vary significantly from period to period.     Our significant accounting policies and the associated estimates and the issues which impactthese estimates are as follows:*Revenue Recognition — Mortgage Interest and Rental Income*     We collect interest and rent from our customers. Generally our policy is to recognizerevenues on an accrual basis as earned. However, we may in the future determine that, based oninsufficient historical collections and the lack of expected future collections, revenue forinterest or rent is not realizable. For any such nonperforming investments,our policy is to recognize interest or rental income only in the period when payments are received. If conclusionsas to the realizibility of revenue change, our revenues could vary significantly from period toperiod.
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*Valuations of and Impairments to Our Investment*s     Decisions about valuations and impairments of our investments require significant judgementsand estimates on the part of management. We monitor the liquidity and credit worthiness of ourtenants and borrowers on an on-going basis. For real estate properties, the need to recognize animpairment is evaluated on a property by property basis in accordance with Statement of FinancialAccounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”(SFAS 144). Recognition of an impairment is based upon estimated future cash flows from a propertycompared to the carrying value of the property. For notes receivable, impairment recognition isbased upon an evaluation of the estimated collectibility of loan payments on a specific loan basisin accordance with Statement of Financial Accounting Standards No. 114, “Accounting by Creditorsfor Impairment of a Loan — An Amendment of FASB Statements No. 5 and 15”. While we believe thatthe carrying amounts of our properties and notes receivable are realizable, it is possible thatfuture events could require us to make significant adjustments or revisions to these estimates.*REIT Status and Taxes*     We believe that we have operated our business so as to qualify as a REIT under Sections 856through 860 of the Internal Revenue Code of 1986, as amended (the “Code”) and we intend to continueto operate in such a manner, but no assurance can be given that we will be able to qualify at alltimes. If we qualify as a REIT, we will generally not be subject to federal corporate income taxeson our net income that is currently distributed to its stockholders. This treatment substantiallyeliminates the “double taxation” (at the corporate and stockholder levels) that typically appliesto corporate dividends. Our failure to continue to qualify under the applicable REIT qualificationrules and regulations would cause us to owe state and federal income taxes and would have amaterial adverse impact on our financial position, results of operations and cash flows.CAPITAL RESOURCES AND LIQUIDITY     At year end, our ratio of debt to capitalization was 8.5%. Our debt consists of a bank termloan in the amount of $10,450,000 which matures on May 14, 2007. The bank term loan requiresquarterly payments of $425,000 and bears interest at the variable rate of 30 day LIBOR plus 1.5%(5.8% at December 31, 2005). On November 18, 2005, we prepaid $4,000,000 in addition to therequired amortization. The loan agreements require that we maintain specified operating ratios andstockholders’ equity. We believe that our operating cash flows and borrowing capacity will beadequate to finance this obligation.*Leases*     We lease our 23 healthcare facilities to various lessees: 14 properties are leased to NHC, andnine properties that were previously leased to NHC prior to October 1, 2000 are leased to nineseparate lessees not related to NHC. With respect to these nine properties, NHC remains obligatedunder its master lease agreement and continues to remain obligated to make the lease payments tous. Lease payments made to us from the new lessees are credited against NHC’s overall rentobligation. At December 31, 2005, all payments are current.*Leases Extended and Amended*     On August 1, 2005, NHC elected to exercise its option to extend the term of its leases ofproperties from us for two additional five year terms until December 31, 2017. The currentlyrunning initial term of the leases expires on December 31, 2007. The leases were also amended togrant NHC an option to renew the leases at fair market value for a second extended term of tenyears until December 31, 2027, assuming no defaults.     The lease payments for the extended ten-year term of the leases that begin on January1, 2008 are the same lease payments that were required in the initial term of the lease, includingan annual inflator for percentage rent. The lease
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payments for the second extended ten-year termthat begins on January 1, 2018, if renewed, will be at fair market value as determined at the timeof the lease renewal.     The leases have also been amended to provide that if NHC pays for the construction of a bedaddition, then the existing annual rent for that center will be increased by .75% of the cost paidby NHC for the construction of the addition. Revenues produced within the addition shall beexcluded from any percentage rent calculation. At such time as NHC is no longer a tenant by virtueof lease terminations then NHR shall purchase the bed additions paid for by NHC but un-reimbursedby NHR for the lesser of (1) the appraised value of the addition or (2) the construction costincurred by NHC plus 50% of any appraised value increase over cost. In addition, NHC agrees atNHR’s request to finance NHR’s purchase of the addition with a floating rate interest only note atthe prime rate of interest for a period of up to two years. NHC has submitted a listing of certainNHR owned properties expected to be expanded by NHC for which the construction cost is expected tototal approximately $26,225,000. See the discussion of commitments below.*FCC Notes and Bank Credit Facility Prepayments*     On February 27, 2004, we received prepayment of the balance (approximately $30,384,000) of our10.25% notes receivable from Florida Convalescent Centers, Inc. or affiliates (FCC) of Sarasota,Florida. The notes were scheduled to mature on October 31, 2004.     The proceeds of the prepayments plus cash on hand were used to pay 100% (approximately$31,175,000) of the then outstanding credit facility debt, which had a current interest rate of3.10%.*HSMI Sale*     On November 1, 2003, after the initial and continuing investment criteria of SFAS 66 were met,we recorded the sale of three long-term health care centers. Recording of the sale resulted in again on the sale of real estate of approximately $1,149,000 and mortgage notes receivable ofapproximately $3,740,000. Additional sale proceeds received in 2004 resulted in an additional gainon sale of real estate of approximately $105,000. All payments required on the notes receivablewere current at December 31, 2005, and the maturity was extended until March 31, 2007.*Sources and Uses of Funds*     Our leasing and mortgage services generated net cash from operating activities during 2005 inthe amount of $18,716,000 compared to $19,000,000 in the prior period. Net cash from operatingactivities generally includes net income plus non-cash expenses, such as depreciation andamortization and provisions for realty and loan losses, if any, and non-cash gains on sales of realestate, if any, adjusted by working capital changes.     Our investing activities provided $346,000 of cash flows in 2005 compared to $31,253,000 in2004. Collections of mortgage notes receivable totaled $346,000 in 2005 compared to $31,042,000 in2004. Collections in 2004 included the prepayment of $30,348,000 of our notes receivable.     Net cash used in financing activities totaled $19,277,000 in 2005 compared to $46,851,000 in2004. Included in these amounts, we made no new borrowings in 2005 compared to $17,000,000 in newborrowings in 2004. The new borrowings in 2004 were used to refinance existing debt that hadhigher rates of interest.     Payments on debt in 2005 were $5,700,000 including $4,000,000 of voluntary prepayments fromcash flows from operating activities. Payments on debt in 2004 were $48,670,000 including$46,097,000 of prepayments. The prepayments in 2004 were primarily made form the proceeds of earlypayments of $30,348,000 of our notes receivable and from $17,000,000 of new borrowings.     Net cash used in financing activities also includes $13,873,000 to pay dividends toshareholders ($14,293,000 in 2004) and $1,714,000 to pay cash distributions to minority partners ofour operating partnership ($1,813,000 in 2004).
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Offsetting in part these amounts used in financingactivities, cash provided from financing activities includes $2,010,000 from the exercise of stockoptions ($925,000 in 2004).*Off Balance Sheet Arrangements*     We currently have no outstanding guarantees or letters of credit. We may or may not elect touse financial derivative instruments to hedge interest rate exposure. At December 31, 2005, we didnot participate in any such financial instruments.*Commitments*     At such time as our lease with NHC is terminated for any reason, we are committed to purchasefrom NHC at fair market value building additions constructed by them at centers owned by us. Ourlease with NHC currently expires on December 31, 2017, with an option to extend the lease for anadditional ten years at fair market value.     The fair market value of any additions shall be calculated as the lesser of (1) the appraisedvalue of the addition or (2) the construction cost incurred by NHC plus 50% of any appraised valueincrease over cost. In addition, NHC agrees, at NHR’s request, to finance NHR’s purchase of theaddition with a floating rate, interest only note at the prime rate of interest for a period of upto two years. Additions at five centers costing approximately $26,225,000 are currently planned.At December 31, 2005, NHC has reported to us that expansion construction is completed at one center(cost $4,000,000) and is underway at two centers (expected total cost of $10,700,000, $2,243,000incurred). Construction is expected to begin in 2006 at two additional centers (expected cost,$11,025,000). The cost of this potential commitment, if any, cannot be determined at this time.     We intend to pay quarterly distributions to our stockholders in an amount at least sufficientto satisfy the distribution requirements of a real estate investment trust. Such requirementsnecessitate that at least 90% of our taxable income be distributed annually. The primary source fordistributions will be rental and interest income we earn on the real property and mortgage notesreceivable. Regular dividends in the amount of $1.33 per common share and a special dividend inthe amount of $.10 per common share were declared for payment for 2005.     Our contractual cash obligations for periods subsequent to December 31, 2005 are as follows:                           Less than          (in thousands) Total  1 Year  2-3 Years  4-5 Years  After 5 Years Long-term debt $10,450  $1,700  $8,750  $—  $— Advisory Agreement  500   500   —   —   —                 Total Contractual Cash Obligations $10,950  $2,200  $8,750  $—  $—                      The potential commitments of up to $26,225,000 have been excluded from the above table becausethe amounts are not estimable and are dependent on events that have not yet occurred.     Future cash obligations for interest expense have not been included in the above table becausefuture floating rates of interest are not known. In 2005, our cash payments for interest were$722,000.     We expect that current cash on hand, marketable securities, short-term notes receivable,operating cash flows, and as needed, our borrowing capacity will be adequate to finance ouroperating and financing requirements for 2006 and 2007.
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RESULTS OF OPERATIONS*Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004*     Net income for the year ended December 31, 2005 is $11,277,000 versus $11,435,000 for the sameperiod in 2004, a decrease of 1.4%. Diluted net income per common share decreased two cents or 1.7%to $1.14 in 2005 from $1.16 in 2004.     Total revenues for the year ended December 31, 2005 decreased $419,000 or 2.1% to $19,772,000from $20,191,000 for the year ended December 31, 2004. Revenues from rental income increased$104,000 or 0.6% when compared to the same period in 2004. Revenues from mortgage interestdecreased $418,000 or 14.8% in 2005 as compared to the same period in 2004. Gain on sale of realestate decreased $105,000.     The increase in rental income is due primarily to the recognition of $1,363,000 of percentagerent compared to $1,295,000 in the prior year and $36,000 of rent for additions to our propertycompared to -0- in the prior year. Percentage rent is calculated as 3% of the amount by whichgross revenues of each leased health care facility in each quarter of each year after 1999 exceedthe gross revenues of such health care facility in the applicable quarter of 1999. Rent foradditions, which is due when the costs of certain construction additions are funded by the tenant,is .75% of the construction costs incurred for additions to one of our properties.     The decrease in mortgage interest income is primarily the result of prepayments on mortgagesreceivable totaling $30,384,000 in February 2004. The gain on sale of real estate in 2004 was theresult of receiving additional proceeds related to the sale of Indiana properties originallyrecorded in November, 2003.     Total expenses for the year ended December 31, 2005 decreased $94,000 or 1.2% to $7,688,000from $7,782,000 for the year ended December 31, 2004. Interest expense decreased $60,000 or 7.7% in2005 as compared to the 2004 period. Depreciation of real estate decreased $94,000 or 1.6%. Generaland administrative costs increased $68,000 or 6.6%.     Interest expense declined due primarily to principal pay downs of our debt. We prepaid$31,175,000 of our credit facility debt in the first quarter of 2004 and an additional $4,000,000on our bank term loan in the fourth quarter of 2005. Furthermore, our bank term loan is amortizingby $425,000 per quarter.     General and administrative expenses increased primarily due to increases in advisory fees,indemnification insurance, audit fees and expenses related to the cashless exercise of directors’stock options in the current year. Prior year general and administrative expenses included thewriteoff of $252,000 previously capitalized costs for a transaction that did not materialize.     Non-operating income which is composed of net revenues from investment and interest incomeincreased $113,000 or 24.8% for 2005 compared to 2004. The increase is due primarily to increasedinterest rates in investments compared to the prior year.*Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003*     Net income for the year ended December 31, 2004 is $11,435,000 versus $11,845,000 for the sameperiod in 2003, a decrease of 3.5%. Diluted net income per common share decreased five cents or4.1% to $1.16 in 2004 from $1.21 in 2003.     Total revenues for the year ended December 31, 2004 decreased $4,317,000 or 17.6% to$20,191,000 from $24,508,000 for the year ended December 31, 2003. Revenues from rental incomeincreased $167,000 or 1.0% when compared to the same period in 2003. Revenues from mortgageinterest decreased $3,440,000 or 54.9% in 2004 as compared to the same period in 2003. Gain onsale of real estate decreased $1,044,000.     The increase in rental income is due primarily to the recognition of $167,000 ofadditional percentage rent. Percentage rent is calculated as 3% of the amount by which grossrevenues of each leased health care facility in each quarter of each year after 1999 exceed thegross revenues of such health care facility in the applicable quarter of 1999.
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     The decrease in mortgage interest income is the result of lower balances of notes receivable.We received prepayments on mortgages receivable totaling $30,384,000 in February 2004 and totaling$21,982,000 in November 2003. Mortgage interest income decreased also because of reductions in theprincipal of the mortgage notes receivable due to regular monthly amortization. The gain on saleof real estate is the result of receiving additional proceeds related to the sale of Indianaproperties originally recorded in November, 2003.     Total expenses for the year ended December 31, 2004 decreased $3,830,000 or 33.0% to$7,782,000 from $11,612,000 for the year ended December 31, 2003. Interest expense decreased$3,212,000 or 80.4% in 2004 as compared to the 2003 period. Depreciation of real estate decreased$356,000 or 5.6%. General and administrative costs increased $203,000 or 24.6% due primarily to awriteoff of $252,000 of previously capitalized costs for a transaction that did not materialize.     Interest expense decreased due primarily to principal paydowns in the fourth quarter of 2003($22,000,000) and the first quarter of 2004 ($31,175,000) on the credit facility. In addition,interest expense decreased due to the decreased rate effective December 31, 2003 and May 14, 2004on approximately $14,922,000 of debt.FUNDS FROM OPERATIONS     We have adopted the definition of Funds From Operations (“FFO”) prescribed by the NationalAssociation of Real Estate Investment Trusts (“NAREIT”) October 1999 White Paper as amended April1, 2002. Accordingly, FFO is defined as net income applicable to common stockholders (computed inaccordance with generally accepted accounting principles “GAAP”) excluding gains (or losses) fromsales of property, plus depreciation of real property and after investments for unconsolidatedentities in which a REIT holds an interest. FFO should not be considered as an alternative to netincome or any other GAAP measurement of performance as an indicator of operating performance or asan alternative to cash flows from operations, investing or financing activities as a measure ofliquidity. We view FFO as a measure of operating performance and believe that FFO is helpful inevaluating a real estate investment portfolio’s overall performance considering the fact thathistorical cost accounting implicitly assumes that the value of real estate assets diminishespredictably over time.     Our funds from operations for the twelve months ended December 31, 2005, on a diluted basiswas $16,509,000, a decrease of $134,000 as compared to $16,643,000 for the same period in 2004.FFO represents net earnings available to common stockholders, excluding the effects of assetdispositions, plus depreciation associated with real estate investments. Diluted FFO assumes, ifdilutive, the conversion of convertible subordinated debentures, the conversion of cumulativeconvertible preferred stock and the exercise of stock options using the treasury stock method.     We believe that funds from operations is an important supplemental measure of operatingperformance for a real estate investment trust. Because the historical cost accounting conventionused for real estate assets requires straight-linedepreciation (except on land), such accounting presentation implies that the value of realestate assets diminishes predictably over time. Since real estate values instead have historicallyrisen and fallen with market conditions, presentations of operating results for a real estateinvestment trust that use historical cost accounting for depreciation could be less informative,and should be supplemented with a measure such as FFO. The term FFO was designed by the realestate investment trust industry to address this issue. Our measure may not be comparable tosimilarly titled measures used by other REITs. Consequently, our funds from operations may notprovide a meaningful measure of our performance as compared to that of other REITs. Since otherREITs may not use our definition of FFO, caution should be exercised when comparing our Company’sFFO to that of other REITs. Funds from operations in and of itself does not represent cashgenerated from operating activities in accordance with GAAP (funds from operations does not includechanges in operating assets and liabilities) and, therefore, should not be considered analternative to net earnings as an indication of operating performance, or to net cash flow fromoperating activities as determined by GAAP in the United States, as a measure of liquidity and isnot necessarily indicative of cash available to fund cash needs.
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     The following table reconciles net income applicable to common stockholders to funds fromoperations applicable to common stockholders:*(in thousands, except share and per share amounts)*             Year Ended December 31, 2005  2004  2003 Net income $11,277  $11,435  $11,845 Adjustments:            Real estate depreciation  5,872   5,966   6,322 Gain on sale of real estate  —   (105)  (1,149)Minority interest in NHR/OP, L.P.’s share of addback for real estate related depreciation andgain on sale of real estate  (640)  (653)  (581)          Funds from operations applicable to common stockholders $16,509  $16,643  $16,437                        Basic funds from operations per share $1.68  $1.73  $1.72           Diluted funds from operations per share $1.67  $1.69  $1.68                        Weighted average shares:            Basic  9,853,490   9,594,852   9,575,546 Diluted  9,881,484   9,822,823   9,757,238 FUTURE RENTAL AND MORTGAGE INTEREST INCOME UNCERTAINTIES     Our rental and mortgage interest income revenues are believed by management to be secure.However, the majority of the income of our lessees and borrowers is derived from the lessees’participation in the Medicare and Medicaid programs. Adverse changes in these programs or theinability of our lessees and borrowers to participate in these programs would have a materialadverse impact on the financial position, results of operations and cash flows of our lessees andborrowers and their resultant ability to service their obligations to us.     None of our lessees or borrowers are in bankruptcy.INCOME TAXES     We intend at all times to qualify as a REIT under Sections 856 through 860 of the InternalRevenue Code of 1986, as amended. Therefore, we will not be subject to federal income tax providedwe distribute at least 90% of our annual REIT taxable income to our stockholders and meet otherrequirements to continue to qualify as a REIT. Accordingly, no provision for federal income taxeshas been made in the consolidated financial statements. Our failure to continue to qualify underthe applicable REIT qualification rules and regulations would have a material adverse impact on ourfinancial position, results of operations and cash flows.
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NEW ACCOUNTING PRONOUNCEMENTS     In May 2003 the FASB issued Statement of Financial Accounting Standards No. 150,“Accounting for Certain Financial Instruments with Characteristics of both Liabilities andEquity.” SFAS 150 establishes standards for classifying and measuring as liabilities certainfinancial instruments that embody obligations of the issuer and have characteristics of bothliabilities and equity. SFAS 150 is generally effective for NHR July 1, 2003. As originallyissued, SFAS 150 would have required NHR to measure the minority interests in NHR/OP, L.P. on theconsolidated balance sheet at estimated fair value at the balance sheet date, with a charge orcredit to income (specifically, interest expense) for the change in carrying value during theperiod. In November 2003, the FASB deferred for an indefinite period the application of theclassification and measurement guidance in SFAS 150 to noncontrolling interests in limited-lifesubsidiaries (such as NHR/OP, L.P.). Measurement of the minority interests in NHR/OP, L.P. atestimated fair value at each balance sheet date, if and when required, would result in significantvolatility in NHR’s financial position and results of operations.     In December 2004, the FASB issued FASB Statement No. 153, *Exchanges of Nonmonetary Assets-AnAmendment of APB Opinion No. 29*(“Statement 153”). Statement 153 amends APB OpinionNo. 29, *Accounting for Non-monetary Transactions*, that was issued in 1973. The amendments made byStatement 153 are based on the principle that exchanges of non-monetary assets should be measuredbased on the fair value of the assets exchanged. Further, the amendments eliminate the narrowexception for non-monetary exchanges of similar productive assets and replace it with a broaderexception for exchanges of non-monetary assets that do not have “commercial substance”.Previously, Opinion 29 required that the accounting for an exchange of a productive asset for asimilar productive asset or an equivalent interest in the same or similar productive asset shouldbe based on the recorded amount of the asset relinquished. The provisions in Statement 153 areeffective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15,2005. Early application is permitted and companies must apply the standard prospectively. TheCompany has adopted Statement 153 effective July 1, 2005. The future effect of Statement 153 onthe Company’s financial statements will depend on whether the Company enters into certainnon-monetary transactions. The Company, however, does not expect the adoption of Statement 153 tohave a significant impact on its financial statements.     In December 2004, the FASB issued SFAS No. 123(R), *Share-Based Payment.*SFAS No. 123(R)replaces SFAS No. 123, *Accounting for Stock-Based Compensation*, and supersedes APB Opinion No. 25,*Accounting for Stock Issued to Employees*. SFAS No. 123(R) requires compensation costs related toshare-based payment transactions to be recognized in the financial statements over the period thatan employee provides service in exchange for the award. SFAS No. 123(R) is effective for Companybeginning January 1, 2006. The Company does not expect the adoption of this pronouncement to havea significant impact on the Company’s financial statements.     In May 2005, the FASB issued FASB Statement No. 154, *Accounting for Changes and ErrorCorrections*. This new standard replaces APB Opinion No. 20, *Accounting Changes*and FASB StatementNo. 3, *Reporting Accounting Changes in Interim Financial Statements*. Statement 154 requires that avoluntary change in accounting principle be applied retrospectively with all prior period financialstatements presented on the new accounting principle, unless it is impracticable to do so.Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-livednonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by achange in accounting principle, and (2) correction of errors in previously issued financialstatements should be termed a “restatement”. The new standard is effective foraccounting changes and correction of errors made in fiscal years beginning after December 15, 2005.The Company does not expect the adoption of this pronouncement to have a significant impact on theCompany’s financial statements.IMPACT OF INFLATION     During the past three years, inflation has not significantly affected our earnings because ofrelatively moderate inflation rates. Inflation may affect us in the future by changing theunderlying value of our real estate or by impacting our cost of financing its operations.
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     Our revenues are generated primarily from long-term investments with fixed rates ofreturn. These investments are financed through a combination of equity, long-term borrowings, and,as needed, line of credit arrangements. During periods of rising interest rates, our ability togrow may be adversely affected because yields on new investments may increase more slowly than newborrowing costs. Certain of our leases offer some degree of inflation protection by requiringincreases in rental income based upon increases in the revenues of the tenants.**Item 7A. Quantitative and Qualitative Disclosures about Market Risk**Interest Rate Risk     Our cash and cash equivalents consist of highly liquid investments with a maturity of lessthan three months. Substantially all of our mortgage and other notes receivable bear interest atfixed interest rates. As a result of the short-term nature of our cash instruments and because theinterest rates on our investment in notes receivable are fixed, a hypothetical 10% change ininterest rates has no impact on our future earnings and cash flows related to these instruments.     As of December 31, 2005, all of our long-term debt ($10,450,000) bears interest at floatinginterest rates. Because the interest rates of these instruments are variable, a hypothetical 10%increase in interest rates would result in additional annual interest expense of $61,000 and a 10%reduction in interest rates would result in annual interest expense declining $61,000.     We currently do not use any derivative instruments to hedge interest rate or other risks. Wedo not use derivative instruments for trading purposes. The future use of such instruments wouldbe subject to strict approvals by our senior officers. Therefore, our exposure related to suchderivative instruments is not material to our financial position, results of operations or cashflows.Equity Price Risk     We consider our investments in marketable securities as available for sale securities andunrealized gains and losses are recorded in stockholders’ equity in accordance with Statementof Financial Accounting Standards No. 115. The investments in marketable securities are recordedat their fair market value based on quoted market prices. Thus, there is exposure to equity pricerisk, which is the potential change in fair value due to a change in quoted market prices.Hypothetically, a 10% increase in quoted market prices would result in a related 10% increase inthe fair value of our investments in marketable securities of approximately $584,000 and 10%reduction in quoted market prices would result in a related 10% decrease in the fair value of ourinvestments in marketable securities of approximately $584,000.
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**Item 8. Financial Statements and Supplementary Data****REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**Board of Directors and Stockholders