**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-K**

** **

**ý****ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

 

**For thefiscal year ended December 31, 2003**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**CommissionFile Number 001-16817**

 

**FIVE STAR QUALITY CARE, INC.**

** **
| **Maryland**                                                     |   | **04-3516029**                    |
|------------------------------------------------------------------|--------|-----------------------------------|
| (State of Incorporation)                                         |   | (IRS Employer Identification No.) |
|                                                             |   |                              |
| **400 Centre Street, Newton, Massachusetts 02458  617-796-8387** |
| 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 to be registered pursuant to Section 12(g)of the Act: **None**

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark if disclosure of delinquentfilers 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 orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.  ý

 

Indicate by checkmark whether the registrant is anaccelerated filer (as defined in Exchange Act Rule 12b-2).

Yes o  No ý

 

The aggregate market value of the voting shares of theregistrant held by non-affiliates was $12.7 million based on the $1.51 closingprice per common share on the American Stock Exchange on June 30, 2003.   For purposes of this calculation, anaggregate of 283,582.6 common shares held by the directors and officers of theregistrant and have been included in the number of shares held by affiliates,which includes 35,000 common shares held by Senior Housing Properties Trust.

 

Number of the registrant’s Common Shares outstandingas of March 24, 2004: 8,514,634.

 

References in this Annual Report on Form 10-K to the“Company,” “Five Star”, “FVE”, “we”, “us” or “our” include Five Star QualityCare, Inc., and its consolidated subsidiaries, unless the context indicatesotherwise.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

** **

Certain informationrequired in Items 10, 11, 12, 13 and 14 of Part III of this Annual Report onForm 10-K is incorporated by reference from our definitive Proxy Statement forthe annual meeting of shareholders currently scheduled for May 11, 2004.

 

 

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**WARNING CONCERNING FORWARD LOOKING STATEMENTS**

 

OURANNUAL REPORT ON FORM 10-K CONTAINS FORWARD LOOKING STATEMENTS WITHIN THEMEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 AND FEDERALSECURITIES LAWS.  THESE STATEMENTSREGARD OUR INTENT, BELIEF OR EXPECTATIONS, OR THE INTENT, BELIEF OREXPECTATIONS OF OUR DIRECTORS AND OFFICERS, BUT THEY ARE NOT GUARANTEED TOOCCUR.  FOR EXAMPLE:

 

•                  THE LARGE RECENT INCREASES IN INSURANCE COSTSAND IN INSURANCE RESERVE CALCULATIONS MAY HAVE A GREATER ADVERSE IMPACT ON OURBUSINESS THAN WE CURRENTLY ANTICIPATE;

•                  WE MAY BE UNABLE TO CARRY OUT OUR BUSINESSPLAN TO EXPAND OUR OPERATIONS OF COMMUNITIES WHERE RESIDENTS PAY FOR SERVICESWITH PRIVATE RESOURCES BECAUSE WE ARE UNABLE TO LOCATE SUCH EXPANSIONOPPORTUNITIES AT PRICES WE ARE WILLING OR ABLE TO PAY;

•                  WE MAY BE UNABLE TO COLLECT ACCOUNTSRECEIVABLE WHICH WE BELIEVE ARE DUE FROM INTEGRATED HEALTH SERVICES, INC., FROMTHE UNITED STATES DEPARTMENT OF HEALTH AND HUMAN SERVICES, OR FROM THE STATE OFCONNECTICUT MEDICAID PROGRAM;

•                  THE SALE OF MARRIOTT SENIOR LIVING SERVICES,INC.  BY MARRIOTT INTERNATIONAL, INC. TOSUNRISE SENIOR LIVING, INC. SEEMS TO HAVE ADVERSELY AFFECTED THE OPERATIONS OFTHE 31 SENIOR LIVING COMMUNITIES WHICH SUNRISE SENIOR LIVING SERVICES, INC. NOWMANAGES FOR OUR ACCOUNT.  SINCE THESALE, THE OPERATING RESULTS AT THESE 31 COMMUNITIES HAVE DECLINED.  THE REVENUES AT THESE COMMUNITIES MAYCONTINUE TO DECLINE, THE EXPENSES AT THESE COMMUNITIES MAY CONTINUE TO INCREASEAND OUR INCOME MAY CONTINUE TO DECLINE; AND

•                  WE MAY BE UNABLE TO COMPLETE OUR PURCHASE OFTHE TWO FACILITIES LOCATED IN MICHIGAN FROM SENIOR HOUSING PROPERTIES TRUST.

 

ALSO,WHENEVER WE USE WORDS SUCH AS “BELIEVE”, “EXPECT”, “ANTICIPATE”, “INTEND”,“PLAN”, “ESTIMATE”, “PREDICT” OR SIMILAR EXPRESSIONS, WE ARE MAKING FORWARDLOOKING STATEMENTS.  ACTUAL RESULTS MAYDIFFER MATERIALLY FROM THOSE CONTAINED IN OR IMPLIED BY THESE FORWARD LOOKINGSTATEMENTS AS A RESULT OF VARIOUS FACTORS. SUCH FACTORS INCLUDE, WITHOUT LIMITATION THOSE DESCRIBED ABOVE AND:

 

•                  CHANGES IN THE ECONOMY AND THE CAPITALMARKETS (INCLUDING PREVAILING INTEREST RATES);

•                  COMPLIANCE WITH AND CHANGES TO REGULATIONSAND PAYMENT POLICIES WITHIN THE SENIOR HOUSING AND HEALTHCARE INDUSTRIES;

•                  CHANGES IN OUR FINANCING TERMS;

•                  COMPETITION WITHIN THE SENIOR HOUSING ANDHEALTHCARE INDUSTRIES; AND

•                  CHANGES IN FEDERAL, STATE AND LOCALLEGISLATION.

 

THESECTION ENTITLED “RISK FACTORS” BEGINNING ON PAGE 2 OF THIS REPORT ON FORM 10-KINCLUDES A LISTING OF OTHER IMPORTANT MATTERS WHICH MAY ADVERSELY AFFECT OURBUSINESS AND FINANCIAL PERFORMANCE MORE THAN WE ANTICIPATE AND MORE THAN MAY BEIMPLIED BY OUR FORWARD LOOKING STATEMENTS.

 

SINCEWE BECAME A PUBLIC COMPANY AT THE BEGINNING OF 2002, WE HAVE BEEN UNABLE TOOPERATE PROFITABLY.  FORWARD LOOKINGSTATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K MAY IMPLY THAT WE EXPECT TOOPERATE PROFITABLY IN THE FUTURE. HOWEVER, WE MAY BE UNABLE TO OPERATE PROFITABLY FOR THE REASONS SETFORTH ABOVE OR FOR OTHER REASONS. ALTHOUGH WE BELIEVE OUR LIQUIDITY AND CAPITAL RESOURCES ARE SUFFICIENTTO MEET OUR BUSINESS NEEDS FOR THE NEXT 12 MONTHS, IN FACT THEY MIGHT NOT BESUFFICIENT FOR US TO CONTINUE IN BUSINESS. AN INVESTMENT IN OUR SECURITIES INVOLVES

 

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AHIGH DEGREE OF RISK OF LOSS, AND INVESTORS SHOULD NOT PLACE UNDUE RELIANCE UPONFORWARD LOOKING STATEMENTS WHICH IMPLY OTHERWISE.

 

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**FIVE STAR QUALITY CARE, INC.**

**2003FORM 10-K ANNUAL REPORT**

**Tableof Contents**

 
| **PART I**   |                                                                                            |
|--------------|-------------------------------------------------------------------------------------------------|
|         |                                                                                            |   |
| Item 1.      | Business                                                                                        |   |
| Item 2.      | Properties                                                                                      |   |
| Item 3.      | Legal Proceedings                                                                               |   |
| Item 4.      | Submission of Matters to a Vote of Security  Holders                                            |   |
|         |                                                                                            |   |
| **PART II**  |                                                                                            |
|         |                                                                                            |
| Item 5.      | Market for the Registrant’s Common Equity  and Related Shareholder Matters                 |   |
| Item 6.      | Selected Financial Data                                                                         |   |
| Item 7.      | Management’s Discussion and Analysis of  Financial Condition and Results of Operations     |   |
| Item 7A.     | Quantitative and Qualitative Disclosures  About Market Risk                                     |   |
| Item 8.      | Financial Statements and Supplementary Data                                                     |   |
| Item 9.      | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure           |   |
| Item 9A.     | Controls and Procedures                                                                         |   |
|         |                                                                                            |   |
| **PART III** |                                                                                            |
|         |                                                                                            |   |
| Item 10.     | Directors and Executive Officers of the  Registrant                                             |   |
| Item 11.     | Executive Compensation *                                                                        |   |
| Item 12.     | Security Ownership of Certain Beneficial  Owners and Management and Related Shareholder Matters |   |
| Item 13.     | Certain Relationships and Related  Transactions *                                               |   |
| Item 14.     | Principal Accountant Fees and Services *                                                        |   |
|         |                                                                                            |   |
| **PART  IV** |                                                                                            |
|         |                                                                                            |   |
| Item 15.     | Exhibits, Financial Statement Schedules and  Reports on Form 8-K                                |   |
|         |                                                                                            |   |
|         |                                                                                                 |   |
|         | *                                                                                               | Incorporated  by reference to our Proxy Statement for the Annual Meeting of Shareholders  scheduled to be held on May 11, 2004, to be filed pursuant to Regulation 14A. |   |
|              |                                                                                                 |  |  |

 

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**PART I**

** **

**Item 1**.  Business

** **

**GENERAL**

** **

We operate senior livingcommunities, including independent living and congregate care communities,assisted living communities and nursing homes. As of March 24, 2004, we operated 101 communities containing 14,035living units, including 48 primarily independent and assisted livingcommunities containing 9,167 units and 53 nursing homes containing 4,868units.  Of our 48 primarily independentand assisted living communities, we lease 45 communities containing 8,774 unitsfrom Senior Housing Properties Trust, or Senior Housing, our former parent,including 31 communities which are directly operated by Sunrise Senior LivingServices, Inc., or SLS, a wholly owned subsidiary of Sunrise Senior Living,Inc., or Sunrise, and own and operate three communities containing 393units.  All of our nursing homes areleased from Senior Housing.  Our101 communities include 4,975 independent living apartments, 2,522assisted living suites, 283 special care beds and 6,255 nursing beds.  Our principal executive offices are locatedat 400 Centre Street, Newton, Massachusetts 02458, and our telephone number is(617) 796-8387.

 

**OURHISTORY**

 

We were created by Senior Housing in April 2000 tooperate nursing homes repossessed or acquired from two former Senior Housingtenants.  We were reincorporated inMaryland on September 17, 2001.  OnDecember 31, 2001, Senior Housing distributed substantially all of ouroutstanding shares to its shareholders and we became a separate publicly ownedcompany listed on the American Stock Exchange. Pursuant to the transactionagreement governing this spin off: Senior Housing capitalized us with$50 million of equity, consisting of cash and working capital, primarilyoperating receivables, net of operating payables; we agreed to lease 31 primarilyindependent and assisted living communities operated by Marriott Senior LivingServices, or MSLS, upon their acquisition by Senior Housing which occurred in2002, as described below; we leased 55 nursing homes from Senior Housing; weassumed one lease from the town of Campbell, NE; and we agreed to acquire FSQ,Inc., or FSQ, the former operating company of the healthcare business we ownedin order to acquire the personnel, systems and assets necessary for ourbusiness.

 

During 2002, we commencedoperations at 51 senior living communities including the 31 communities thenoperated by MSLS and currently operated by SLS and 20 additionalcommunities.  Also during 2002, weceased operations at two of our communities, one of which was previously leasedfrom Senior Housing and one of which was previously leased from the town ofCampbell, NE.

 

During 2003, we commencedoperations at three senior living communities which we lease from SeniorHousing.  Also during 2003, we ceasedoperations at seven of our communities, one of which was previously leased fromSenior Housing and six of which we acquired in 2002.  We also acquired an institutional pharmacy located in Wisconsinthat, as of December 31, 2003, services 10 senior living communities and weacquired an insurance company from Reit Management & Research LLC, or RMR,one of our affiliates.

 

**OUR GROWTH STRATEGY**

 

We believe that the agingof the U.S. population will increase demand for existing senior livingapartments, independent living properties, assisted living communities andnursing homes.  Our growth strategy isto profit from this demand by operating such properties that provide highquality services to residents who pay with private resources.  Throughout 2002 and 2003, we added 48primarily independent and assisted living communities to our business whichgenerate 88% of their revenue from residents’ private resources, rather thanfrom Medicare or Medicaid.

 

Our nursing homes derivea majority of their revenues from Medicare and Medicaid. In the future we maydecide to expand our nursing home operations; however, if we do so, we expectto value such acquisitions at levels which take account of the risks associatedwith Medicare and Medicaid revenues.

 

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**In addition, from time to time,we consider acquisition opportunities in service industries other than seniorcare.**

** **

**RISK FACTORS**

** **

Since we became a public company at the end of 2001,we have been unable to operate profitably. Ownership of our securities involves a high degree of risk. Thefollowing is a summary of the material risks of ownership of our securities:

 

**A small percentage decline in our revenues or increase in ourexpenses can have a large negative percentage impact upon our operatingresults.**

 

Our operating revenues for 2003 were$576.2 million and our expenses were $583.8 million. A small percentagedecline in our revenues or increase in our expenses might have a dramaticnegative impact upon our income or may produce greater losses.

 

**Ourgrowth strategy may not succeed.**

 

Our business planincludes acquiring additional senior living communities, some of which may beowned and some of which may be leased. In addition, we may consider acquisition opportunities in other serviceindustries.  Our acquisition strategyinvolves risks.  For example: we may beunable to locate senior living communities or other service businessesavailable for purchase at acceptable prices; we may be unable to negotiateacceptable lease terms; we may be unable to access the capital to acquire oroperate additional communities or alternative business opportunities; acquiredoperations may bring with them contingent liabilities which mature; to theextent we incur acquisition financing, our leverage may increase; and combiningour present operations with newly acquired operations may be disruptive.  For these reasons and others: our businessplan to grow may not succeed; the benefits which we hope to achieve by growingmay not be achieved; and our existing operations may suffer from a lack ofmanagement attention or financial resources if such attention and resources aredevoted to a failed growth strategy.

 

**The failure of Medicare or Medicaid rates to match increasingcosts or rate reductions could increase our losses.**

 

At some of our communities, we receive operatingrevenues for nursing home services from the Medicare and Medicaid programs. In2003, we derived 39% of our total revenues from these programs, primarily inthe 51 nursing home communities we lease from Senior Housing.  Since 1998, a Medicare prospective paymentsystem has lowered Medicare rates paid to senior living communities includingmany of those that we operate.  InOctober 2002, temporary increases in Medicare payment rates expired.  In October 2003, Medicare rates increased byapproximately 6%.  Our Medicare revenuestotaled $86.1 million and $68.4 million during 2003 and 2002,respectively.  Our Medicaid revenuestotaled $148.6 million and $142.6 million during 2003 and 2002,respectively.  Some of the states inwhich we operate have not raised rates or are expected to reduce Medicaidfunding to address state budget shortfalls; however we cannot estimate themagnitude of the potential combined Medicare and Medicaid rate reductions, butit may be material.  If future Medicareand Medicaid rates do not match our cost increases, our losses willincrease.  Further Medicare and Medicaidrate declines may have a dramatic negative impact on our revenues and mayproduce greater losses.

 

**Nursing home and senior living operators like us are beingsubjected to increased litigation and insurance costs.**

 

There are various federal and state laws prohibitingfraud by healthcare providers, including criminal provisions that prohibitfiling false claims for Medicare and Medicaid payments and laws that governpatient referrals.  State and federalgovernments are devoting increasing resources to anti-fraud initiatives againsthealthcare providers. In some states, advocacy groups monitor the quality ofcare at senior living communities and these groups may bring litigation againstoperators. Also, in several instances private litigation by nursing homepatients has succeeded in winning very large damage awards for alleged abuses.The effect of this litigation and potential

 

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litigation hasbeen to increase materially the costs of monitoring and reporting quality ofcare compliance. In addition, the cost of medical malpractice insurance hasincreased significantly and may continue to increase as long as the presentlitigation environment affecting the operations of nursing homes and othersenior living communities continues.  In2003 and 2002, we experienced significant increases in our professionalliability insurance costs.  In order topartially offset these increases in professional liability insurance, weincreased our levels of self insurance at most of the communities weoperate.  We expect our insurance coststo increase, and we cannot now predict the amount of such increase, or to whatextent, if at all, we may be able to offset any increases through use of higherdeductibles, retention amounts, self insurance or other means.  Increases in costs which are not offset mayhave a dramatic negative impact on our expenses and reserves and may producegreater losses.

 

## **The sale of Marriott Senior LivingServices, Inc. to Sunrise may have adverse consequences to us.**

##  

In March 2003, Marriott International, Inc., orMarriott, sold MSLS to Sunrise and MSLS changed its name to SLS.  SLS is a 100% owned subsidiary ofSunrise.  We believe Sunrise’s and SLS’sfinancial condition and reputation as an operator of senior living communitiesis weaker than the financial condition and reputation of Marriott andMSLS.  The operations and the financial resultswhich we realize from the 31 senior living communities managed for us by SLSmay continue to decline as a result of this sale.

 

**Our community based business requires regular capitalexpenditures.**

 

Physical characteristics of senior living communitiesare mandated by various governmental authorities. Changes in these regulationsmay require us to make significant expenditures. Our leases with Senior Housingrequire us to maintain our communities in compliance with applicable laws. Inthe future, our communities may require significant expenditures to addressongoing required maintenance and to make them attractive to residents. Ouravailable financial resources may be insufficient to fund these expenditures.

 

**If we fail to comply with complex regulations which governour operations we may be subject to sanctions.**

 

State licensing and Medicare and Medicaid laws requireoperators of nursing homes and assisted living communities to comply withextensive standards governing operations. Federal and State agenciesadministering these laws regularly inspect such communities and investigatecomplaints.  During the past severalyears, the Federal Centers for Medicare and Medicaid Services, or CMS, haveincreased their efforts to enforce Medicare and Medicaid standards and overseestate survey agencies which inspect senior living communities and investigatecomplaints. When deficiencies are identified, sanctions and remedies such asdenials of payment for new Medicare and Medicaid admissions, civil moneypenalties, state oversight and loss of Medicare and Medicaid participation orlicenses may be imposed. CMS and the states are increasingly using suchsanctions and remedies when deficiencies, especially those involving findingsof substandard care or repeat violations, are identified. We and Sunrisereceive notices of potential sanctions and remedies from time to time, and suchsanctions have been imposed on some of our nursing homes and assisted livingcommunities from time to time. As of December 31, 2003, none of our communitieswere under sanctions.  If we or SLS areunable to cure deficiencies which have been identified or which are identifiedin the future, such sanctions will be imposed and, if imposed, may have adversefinancial consequences to us.

 

**Receivables fromIntegrated Health Services, the United States Department of Health and HumanResources and the State of Connecticut may not be collected.**

** **

As described in the notes to our financial statements,we have asserted claims for the collection of $1.3 million due to us fromIntegrated Health Services and the Department of Health and Human Services, andanother $1.5 million from the State of Connecticut.  If we are unsuccessful in collecting these amounts, we will incurcharges equal to the uncollected amounts.

 

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**Anti-takeover provisions in our governing documents and inour material agreements may prevent shareholders from receiving a takeoverpremium for their shares.**

 

Our charterplaces restrictions on the ability of any person or group to acquire beneficialownership of more than 9.8% of any class of our equity shares.  Additionally, the terms of our leases withSenior Housing and our shared services agreement with RMR contain provisionswhereby our rights under these agreements may be cancelled by Senior Housingand RMR, respectively, upon the acquisition by any person or group of more than9.8% of our voting stock, and upon other change in control events, as definedin those documents.  If the breach of theseownership limitations causes a lease default, shareholders causing the defaultmay become liable to us or to other shareholders for damages.  Additionally, on March 10, 2004, we enteredinto a rights agreement whereby in the event a person or group of personsacquired or attempts to acquire 10% or more of our outstanding common shares,our shareholders, other than such person or group, will be entitled to purchaseadditional shares or other securities or property at a discount.  The rights agreement and other provisions inour charter and bylaws may increase the difficulty of acquiring control of usby means of a tender offer, open market purchases, a proxy fight or otherwise,if the acquisition is not approved by our board of directors.  Other provisions which may deter takeoverproposals include the following:

 

•                  a staggeredboard of directors with separate terms for each class of directors;

•                  theavailability, without a shareholders’ vote, of additional shares and classes ofshares that our board of directors may authorize and issue on terms that itdetermines;

•                  a 75%shareholder vote required for removal of directors for cause; and

•                  advance noticeprocedures with respect to nominations of directors and shareholder proposals.

 

For all of these reasons, shareholders may be unableto cause a change of control of us or to realize a change of control premiumfor their common shares.

 

**We are subject to possible conflicts of interest.**

 

Our continuing business is subject to possibleconflicts of interest, as follows:

 

•                  Our ChiefExecutive Officer, Evrett W. Benton, and our Chief Financial Officer, Bruce J.Mackey Jr., are also part-time employees of RMR. RMR is the investment managerfor Senior Housing and we purchase various services from RMR pursuant to ashared services agreement.

•                  Our managingdirectors, Barry M. Portnoy and Gerard M. Martin, are also managing trustees ofSenior Housing.  Messrs. Portnoyand Martin also own RMR and another entity that leases office space to us.

 

We do notbelieve that these conflicts have caused our business to be adverselyaffected.  However, future businessdealings between us and Senior Housing, RMR, Messrs. Portnoy and Martinand their affiliates may be on terms less favorable to us than we could achieveon an arm’s length basis.

 

**Our business is highlycompetitive and we may be unable to operate profitably.**

** **

We compete with numerous other companies which providesenior living services, including home healthcare companies and other realestate based service providers. Historically, nursing homes have been somewhatprotected from competition by state laws requiring certificates of need todevelop new communities; however, these barriers are being eliminated in manystates. Also, there are few barriers to competition for home healthcare or forindependent and assisted living services. Growth in the availability of nursinghome alternatives, including assisted living communities, has had and may inthe future have the effect of reducing the occupancy or operating profitabilityat nursing homes including those we operate. Many of our existing competitorsare larger and have greater financial resources than we do. Accordingly, wecannot provide any assurances that we will be able to attract a sufficientnumber of residents to our communities or that we will be able to attractemployees and keep wages and other employee benefits, insurance costs and otheroperating expenses at levels which will allow us to compete successfully or tooperate profitably.

 

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**Our existing contractswith Senior Housing and others may inhibit our ability to grow.**

** **

So long as we maintain our shared services agreementwith RMR or are a tenant under a lease with Senior Housing, we may not acquireor finance any real estate without first giving Senior Housing or any otherpublicly owned real estate investment trust, or REIT, or other entity managedby RMR the opportunity to acquire or finance real estate investments of thetype in which Senior Housing or any other publicly owned REIT or other entitymanaged by RMR, respectively, invest. These agreements may make it difficult, more expensive or impossible forus to invest in other real estate in the future. Also, because of our variousrelationships with Senior Housing and RMR, competitors of those companies maybe unwilling to lease senior living communities to us or conduct business withus. These circumstances may prevent us from realizing some growthopportunities.

 

**Our owned and leasedproperties are subject to real estate risks.**

** **

At December31, 2003, we owned four senior living communities and leased 97 senior livingcommunities from Senior Housing.  Ourleases require that we pay for and indemnify Senior Housing from allliabilities associated with the ownership or operation of the communities welease which arise prior to or during the terms of our leases.  Also, we may acquire or lease additionalreal estate in the future.  Accordingly,our business is subject to risks associated with real estate, including:

 

•                  costs associatedwith uninsured damages, including damagesfor which insurance may be unavailable or unavailable on commerciallyreasonable terms;

•                  costs anddamages caused by eminent domain takings;

•                  costs that maybe required for maintenance and repair; and

•                  the need to makeexpenditures due to changes in laws and other regulations, including theAmericans with Disabilities Act.

 

**Our business exposes usto environmental risks.**

** **

Under various laws in the U.S., operators of realestate may be required to investigate and clean up hazardous substances presentat their properties, including but not limited to medical waste, mishandledpetroleum products and asbestos containing materials, and may be held liablefor property damage or personal injuries that result from such contamination.These laws also expose us to the possibility that we become liable to reimbursethe government for damages and costs it incurs in connection with thecontamination. As the owner of real estate leased to us, Senior Housing may bealso subject to similar liabilities, and we have agreed to indemnify SeniorHousing from costs it incurs at our leased properties related to environmentalhazards which arise prior to or during the terms of our leases. We can give youno assurance that environmental liabilities are not present in our operatedcommunities or that costs we incur to remediate contamination or the presenceof asbestos will not have a material adverse effect on our business andfinancial condition.

 

**TYPES OF SERVICES**

** **

Our present business plancontemplates the ownership, leasing and management of independent livingapartments or congregate care communities, assisted living communities,specialty care suites, nursing homes and senior apartments. Some communitiescombine more than one type of service in a single building or campus.

 

*IndependentLiving Apartments or Congregate Care Communities.*  Independent living properties, or congregatecare communities, provide high levels of privacy to residents and requireresidents to be capable of relatively high degrees of independence. Anindependent living apartment usually bundles several services as part of aregular monthly charge. For example, one or two meals per day in a centraldining room, weekly maid service or a social director may be offered.Additional services are generally available from staff employees on afee-for-service basis. In some independent living properties, separate parts ofthe community are dedicated to assisted living or nursing services.  At December 31, 2003, our business included4,975 independent living apartments in 38 communities. We operate 13 of thesecommunities and SLS operates 25 communities for our account.

 

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*AssistedLiving Communities.*  Assisted living communities are typically comprised of one bedroomunits which include private bathrooms and efficiency kitchens. Services bundledwithin one charge usually include three meals per day in a central dining room,daily housekeeping, laundry, medical reminders and 24 hour availability ofassistance with the activities of daily living such as dressing and bathing.Professional nursing and healthcare services are usually available at thecommunity on call or at regularly scheduled times.  At December 31, 2003, our business included 2,522 assisted livingsuites in 43 communities. We operate 14 of these communities and SLS operates29 communities for our account.

 

*SpecialtyCare Suites*. Specialty care suites offer specialized programs for patients sufferingfrom specific illnesses, usually Alzheimer’s disease.  At December 31, 2003, our business included 283 specialty caresuites in 9 communities all of which SLS operates for our account.

 

*NursingHomes*.  Nursing homesgenerally provide extensive nursing and healthcare services similar to thoseavailable in hospitals, without the high costs associated with operatingtheaters, emergency rooms or intensive care units. A typical purpose builtnursing home includes mostly two-bed units with a separate bathroom in eachunit and shared dining and bathing facilities. Some private rooms are availablefor those residents who can afford to pay higher rates or for residents whosemedical conditions require segregation. Nursing homes are generally staffed bylicensed nursing professionals 24 hours per day.  At December 31, 2003, our business included 6,255 nursing homebeds in 75 communities. We operate 51 of these communities and SLS operates 24communities for our account.

 

*SeniorApartments.*  Seniorapartments are marketed to residents who are generally capable of caring forthemselves. Residence is usually restricted on the basis of age. Purpose builtcommunities may have special function rooms, concierge services, high levels ofsecurity and assistance call systems for emergency use. Residents at thesecommunities who need healthcare or assistance with the activities of dailyliving are expected to contract independently for these services with homehealthcare companies.  Our business atDecember 31, 2003 included no senior apartments.

 

**OPERATING STRUCTURE**

** **

We have six regional offices, which are located inMaryland, Georgia, California, Wisconsin and two in Nebraska.  Each regional office is responsible for upto 15 communities in multiple states. Each region is headed by a regional director of operations withextensive experience in the senior living industry. Each regional office istypically supported by a clinical or wellness director, a rehabilitationdirector, a regional accounts manager, a human resources specialist and a salesand marketing specialist.  Regionalstaff are responsible for: overseeing all aspects of community-basedoperations; marketing and sales; resident care; the hiring of communityexecutives, care managers and other community-based personnel; compliance withapplicable local and state regulatory requirements; and, implementation of ourdevelopment and acquisition plans within their region.

 

We employ about 57 people in our corporateheadquarters.  Corporate staff membersare responsible for: the establishment of company-wide policies and proceduresrelating to resident care; employee hiring, training and employee retention;information technology; state and federal reimbursement assistance; statelicensing and certification maintenance; legal; community design anddevelopment; community operations; and accounting and finance functions,including accounts payable, payroll, general finance and accounting, and taxplanning and compliance.  The centralizationof these activities improves efficiency and permits community staff to focus onthe delivery of services to our residents and other local issues.

 

**INDEPENDENT AND ASSISTEDLIVING COMMUNITY STAFFING**

** **

Each of the independent and assisted livingcommunities we operate for our own account has an executive directorresponsible for the day-to-day operations of the community, including qualityof care, resident services, sales, consulting and marketing, financialperformance and staff supervision. The executive director is supported bydepartment heads, who oversee the care and service of the residents, a wellnessdirector, who is responsible for coordinating the services necessary to meetthe health care needs of our residents and a marketing director, who isresponsible for selling our services. Other key positions include the dining services coordinator, theactivities coordinator and the maintenance coordinator.

 

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**NURSINGHOME STAFFING**

** **

Each of our nursing homes is managed by astate licensed administrator who is supported by other professional personnel,including a director of nursing, activities director, marketing director,social services director, business office manager, and physical, occupationaland speech therapists.  Our directors ofnursing are state licensed nurses who supervise our registered nurses, licensedpractical nurses and nursing assistants. Staff size and composition varydepending on the size and occupancy of each nursing home and on the type ofcare provided by the nursing home. Our nursing homes contract with physicianswho provide medical services.

 

**PHARMACY SERVICES ANDMEDICAL SUPPLIES**

** **

**At our pharmacy we have anexecutive director who is a state licensed pharmacist, who manages the pharmacyand supervises billing.  The executivedirector is responsible for the day to day operations of the business includingsales and marketing, financial performance, monitoring state regulated codesregarding the dispensing of controlled substances and staff supervision.  Other professional personnel, includinglicensed dispensing pharmacists, a director of pharmacy consultation, medicalrecords director, nurse consultant, pharmacy technicians, and billingpersonnel, support the executive director.**

** **

**EMPLOYEES**

** **

As of March 24, 2004, wehad approximately 6,978 employees, including 4,883 full time equivalents.Approximately 709 employees, including 498 full time equivalents, arerepresented under five collective bargaining agreements, all of which haveremaining terms of one to three years. We have no other employment agreements.We believe our relations with our union and non-union employees are good.

 

**GOVERNMENTREGULATION AND REIMBURSEMENT**

 

Our operations mustcomply with numerous federal, state and local statutes and regulations.  Also, the healthcare industry dependssignificantly upon federal and state programs for revenues and, as a result, isvulnerable to the budgetary policies of both the federal and state governments.

 

*Senior Apartments. *Generally,government programs do not pay for housing in senior apartments. Rents are paidfrom the residents’ private resources. Accordingly, the government regulationsthat apply to these types of properties are generally limited to zoning,building and fire codes, Americans with Disabilities Act requirements and otherlife safety type regulations applicable to residential real estate. Governmentrent subsidies and government assisted development financing for low incomesenior housing are exceptions to these general statements. The development andoperation of subsidized senior housing properties are subject to numerousgovernmental regulations.  We do notcurrently own any subsidized senior apartments.

 

*IndependentLiving Communities.*Government benefits generally are notavailable for services at independent living communities and the residentcharges in these communities are paid from private resources. However, a numberof Federal Supplemental Security Income program benefits pay housing costs forelderly or disabled residents to live in these types of residentialcommunities. The Social Security Act requires states to certify that they willestablish and enforce standards for any category of group living arrangement inwhich a significant number of Supplemental Security Income residents reside orare likely to reside. Categories of living arrangements which may be subject tothese state standards include independent living apartments and assisted livingcommunities. Because independent living apartments usually offer common diningfacilities, in many locations they are required to obtain licenses applicableto food service establishments in addition to complying with land use and lifesafety requirements. In many states, independent living apartment communitiesare licensed by state or county health departments, social service agencies oroffices on aging with jurisdiction over group residential communities forseniors. To the extent that independent living apartments include units inwhich assisted living or nursing services are provided, these units are subjectto applicable state licensing regulations, and if the communities receiveMedicaid or Medicare funds, to certification standards. In some states,insurance or consumer protection agencies regulate independent livingapartments in which residents pay entrance fees or prepay for services.  One community

 

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which we acquiredin 2002 includes 32 independent living apartments where rent rates areregulated by the requirement of a tax exempt bond financing.

 

*Assisted Living Communities. *According to the National Academy for StateHealth Policy, a majority of states provide or are approved to provide Medicaidpayments for residents in some assisted living communities under waiversgranted by CMS or under Medicaid state plans, and certain other states areplanning some Medicaid funding by preparing or requesting waivers to fundassisted living demonstration projects. Because rates paid to assisted livingcommunity operators are lower than rates paid to nursing home operators, somestates use Medicaid funding of assisted living as a means of lowering the costof services for residents who may not need the higher intensity of healthrelated services provided in nursing homes. States that administer Medicaidprograms for assisted living communities are responsible for monitoring theservices at, and physical conditions of, the participating communities.Different states apply different standards in these matters, but generally webelieve these monitoring processes are similar to the concerned states’inspection processes for nursing homes.

 

In light of the largenumber of states using Medicaid to purchase services at assisted livingcommunities and the growth of assisted living in recent years, a majority ofstates have adopted licensing standards applicable to assisted livingcommunities. A majority of states have licensing statutes or standardsspecifically using the term “assisted living” and have requirements forfacilities servicing people with Alzheimer’s disease or dementia.  The majority of states have revised theirlicensing regulations recently or are reviewing their policies or drafting orrevising their regulations. State regulatory models vary; there is no nationalconsensus on a definition of assisted living, and no uniform approach by thestates to regulating assisted living communities. Most state licensingstandards apply to assisted living communities whether or not they acceptMedicaid funding. Also, according to the National Academy for State HealthPolicy, a few states require certificates of need from state health planningauthorities before new assisted living communities may be developed.  Based on our analysis of current economicand regulatory trends, we believe that assisted living communities that becomedependent upon Medicaid payments for a majority of their revenues may declinein value because Medicaid rates may fail to keep up with increasing costs. Wealso believe that assisted living communities located in states that adoptcertificate of need requirements or otherwise restrict the development of newassisted living communities may increase in value because these limitationsupon development may help ensure higher occupancy and higher non-governmentalrates.

 

Two federal government studies and a recent report toa senate committee by an assisted living work group provide backgroundinformation and make recommendations regarding the regulation of, and thepossibility of increased governmental funding for, the assisted living industry.The first study, an April 1999 report by the General Accounting Office tothe Senate Special Committee on Aging on assisted living communities in fourstates, found a variety of residential settings serving a wide range ofresident health and care needs. The General Accounting Office found thatconsumers often receive insufficient information to determine whether aparticular community can meet their needs and that state licensing andoversight approaches vary widely. The General Accounting Office anticipatesthat as the states increase the use of Medicaid to pay for assisted living,federal financing will likewise grow, and these trends will focus more publicattention on the place of assisted living in the continuum of long-term careand upon state standards and compliance approaches.  In June 2003, the General Accounting Office recommended that CMSstrengthen its oversight of state Medicaid waiver programs and qualityassurance programs.  The second study, aNational Study of Assisted Living for the Frail Elderly, was funded by the U.S.Department of Health and Human Services Assistant Secretary for Planning andEvaluation and reported on the effects of different service and privacyarrangements on resident satisfaction, aging in place and affordability. In2001, 2002 and 2003, the Senate Special Committee on Aging held hearings onassisted living and its role in the continuum of care and on community-basedalternatives to nursing homes.  In April2003, an assisted living workgroup consisting of almost 50 organizationsinvolved in assisted living, representing providers, consumers, accrediting andstate regulatory organizations and others, provided a report to the SenateSpecial Committee on Aging.  This workgroupcould not agree on a definition for “assisted living” or on model standards,but presented recommendations on subjects ranging from staffing and funding tostate regulatory approaches.  We cannotpredict whether these studies and reports will result in governmental policychanges or new legislation, or what impact any changes may have. Based upon ouranalysis of current economic and regulatory trends, we do not believe that thefederal government is likely to have a material impact upon the currentregulatory environment in which the assisted living industry operates unless italso undertakes expanded funding obligations, and we do not believe amaterially increased financial commitment from the federal government ispresently likely. However, we do anticipate that assisted living

 

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communities willincreasingly be licensed and regulated by the various states, and that, in theabsence of federal standards, the states’ policies will continue to varywidely.

 

*NursingHomes-Reimbursement. *About64% of all nursing home revenues in the U.S. in 2002 came from publicly fundedprograms, including about 49% from Medicaid programs and 13% from the Medicareprogram. Nursing homes are among the most highly regulated businesses in thecountry. The federal and state governments regularly monitor the quality ofcare provided at nursing homes. State health departments conduct surveys ofresident care and inspect the physical condition of nursing home properties.These periodic inspections and occasional changes in life safety and physicalplant requirements sometimes require nursing home operators to make significantcapital improvements. These mandated capital improvements have in the pastusually resulted in Medicare and Medicaid rate adjustments, albeit on the basisof amortization of expenditures over expected useful lives of the improvements.A new Medicare prospective payment system, or PPS, was phased in over threeyears beginning with cost reporting years starting on or after July 1,1998. Under this new Medicare payment system, capital costs are part of theprospective rate and are not community specific. This new Medicare paymentsystem and other recent legislative and regulatory actions with respect tostate Medicaid rates are limiting the reimbursement levels for some nursinghome services.  At the same time federaland state enforcement and oversight of nursing homes are increasing, makinglicensing and certification of these communities more rigorous. These actionshave adversely affected our revenues and increased our expenses.

 

The current Medicare payment system was established bythe Balanced Budget Act of 1997, and was intended to reduce the rate of growthin Medicare payments for skilled nursing communities. Before the currentMedicare payment system, Medicare rates were community specific and cost-based.Under the current Medicare payment system, skilled nursing facilities receive afixed payment for each day of care provided to residents who are Medicarebeneficiaries. Each resident is assigned to one of 44 care groups depending onthat resident’s medical characteristics and service needs. Per diem paymentrates are based on these care groups. Medicare payments cover substantially allservices provided to Medicare residents in skilled nursing communities,including ancillary services such as rehabilitation therapies. The new Medicarepayment system is intended to provide incentives to providers to furnish onlynecessary services and to deliver those services efficiently. During the threeyear phase in period, Medicare rates for skilled nursing communities were basedon a blend of community specific costs and rates established by the newMedicare payment system.  According tothe General Accounting Office, between fiscal year 1998 and fiscal year 1999,the first full year of the new Medicare payment system phase in, the averageMedicare payment per day declined by about 9%.

 

Since November 1999, Congress has provided somerelief from the impact of the Balanced Budget Act of 1997. EffectiveApril 1, 2000, the Medicare, Medicaid and State Children’s HealthInsurance Program Balanced Budget Refinement Act of 1999 temporarily boostedpayments for certain skilled nursing cases by 20% and allowed skilled nursingcommunities to transition more rapidly to the federal payment system. This Actalso increased the new Medicare payment rates by 4% for fiscal years 2001 and2002 and imposed a two-year moratorium on some therapy limitations for skillednursing patients covered under Medicare Part B.  In December 2000, the Medicare, Medicaid and StateChildren’s Health Insurance Program Benefits Improvement and Protection Act of2000 was approved. Effective April 1, 2001 to October 1, 2002, thisAct increased the nursing component of the payment rate for each care group by16.66%. This Act also increased annual inflation adjustments for fiscal year2001, increased rehabilitation care group rates by 6.7%,  maintained the previously temporary 20%increase in the other care group rates established in 1999, and extended themoratorium on some therapy reimbursement rate caps through 2000.  However, as of October 1, 2002, the 4%across the board increase in Medicare payment rates and the 16.66% increase inthe nursing component of the rates expired. Effective October 1, 2003, CMS has increased the annual inflation updateto skilled nursing community rates by 3% per year, and added an additional3.26% for the year beginning October 1, 2003, to account for inflationunderestimates in prior years.  The 20%increase for the skilled nursing care groups and the 6.7% increase inrehabilitation care group rates will expire when the current resourceutilization groups are refined. Effective December 8, 2003, the Medicare Prescription Drug, Improvementand Modernization Act of 2003 set a new moratorium on implementation of sometherapy reimbursement rate caps through 2005.

 

*NursingHomes-Survey And Enforcement.* CMS has undertaken aninitiative to increase the effectiveness of Medicare and Medicaid nursing homesurvey and enforcement activities. CMS’s initiative follows a July 1998General Accounting Office investigation which found inadequate care in asignificant proportion of California

 

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nursing homes andCMS’s July 1998 report to Congress on the effectiveness of the survey andenforcement system. In 1999, the U.S. Department of Health and Human ServicesOffice of Inspector General issued several reports concerning quality of carein nursing homes, and the General Accounting Office issued reports in 1999,2000 and 2003 which recommended that CMS and the states strengthen theircompliance and enforcement practices, including federal oversight of stateactions, to better ensure that nursing homes provide adequate care. Since 1998,the Senate Special Committee on Aging has been holding hearings on theseissues. CMS is taking steps to focus more survey and enforcement efforts onnursing homes with findings of substandard care or repeat violations ofMedicare and Medicaid standards and to identify chain operated communities withpatterns of noncompliance. CMS is also increasing its oversight of state surveyagencies and requiring state agencies to use enforcement sanctions and remediesmore promptly when substandard care or repeat violations are identified, toinvestigate complaints more promptly, and to survey communities moreconsistently. In addition, CMS has adopted regulations expanding federal andstate authority to impose civil money penalties in instances of noncompliance.Medicare survey results and nursing staff hours per resident for each nursinghome are posted on the Medicare website at www.medicare.gov.  When deficiencies under state licensing andMedicare and Medicaid standards are identified, sanctions and remedies such asdenials of payment for new Medicare and Medicaid admissions, civil monetarypenalties, state oversight and loss of Medicare and Medicaid participation orlicensure may be imposed.  We receivenotices of potential sanctions and remedies from time to time, and suchsanctions have been imposed from time to time on us.  If we are unable to cure deficiencies which have been identifiedor that are identified in the future, additional sanctions may be imposed, andif imposed, may adversely affect our ability to meet our financial obligationsand negatively affect our financial condition and results of operations.

 

In 2000 and 2002 CMS issued reports on its studylinking nursing staffing levels with quality of care, and CMS is assessing theimpact that minimum staffing requirements would have on community costs andoperations. In a report presented to Congress in 2002, the Department of Healthand Human Services found that 90% of nursing homes lack the nurse and nurseaide staffing necessary to provide adequate care to residents. The Bushadministration has indicated that it does not intend to impose minimum staffinglevels or to increase Medicare or Medicaid rates to cover the costs ofincreased staff at this time, but CMS is now publishing the nurse staffinglevel at each nursing home on its internet site to increase market pressures onnursing home operators.

 

Federal efforts to target fraud and abuse andviolations of anti-kickback laws and physician referral laws by Medicare andMedicaid providers have also increased. In March 2000, the U.S. Departmentof Health and Human Services Office of Inspector General issued complianceguidelines for nursing communities to assist them in developing voluntarycompliance programs to prevent fraud and abuse. Also, new rules governing theprivacy, use and disclosure of individually identified health informationbecame final in 2001 and took effect in 2003, with civil and criminal sanctionsfor noncompliance. An adverse determination concerning any of our licenses oreligibility for Medicare or Medicaid reimbursement or the costs of requiredcompliance with applicable federal or state regulations could adversely affectour ability to meet our financial obligations and negatively affect ourfinancial condition and results of operations.

 

*NursingHomes-Certificates Of Need.* Most states limit the number ofnursing homes by requiring developers to obtain certificates of need before newcommunities may be built. Also, states such as California and Texas that haveeliminated certificate of need laws often have retained other means of limitingnew nursing home development, such as the use of moratoria, licensing laws orlimitations upon participation in the state Medicaid program. We believe thatthese governmental limitations may make nursing homes more valuable by limitingcompetition.

 

*OtherMatters*.  Under theMedicare Prescription Drug, Improvement and Modernization Act of 2003, Medicarebeneficiaries may receive prescription drug benefits beginning in 2006 byenrolling in private health plans or managed care organizations, or if theyremain in traditional Medicare, by enrolling in stand alone prescription drugplans.  A number of legislativeproposals that would affect major reforms of the healthcare system have beenintroduced in the U.S. Congress and many state governments, such as programsfor national health insurance, the option of block grants for states ratherthan federal matching money for certain state Medicaid services, additionalMedicare and Medicaid reforms and federal and state cost containmentmeasures.  In connection with recentfiscal pressures on state governments, legislation and regulation to reduceMedicaid nursing home payment rates in some states are possible in the future.  We cannot predict whether any of theselegislative or regulatory proposals will be adopted or, if adopted, whateffect, if any, these proposals would have on our business.

 

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**LIABILITY AND WORKER COMPENSATIONINSURANCE**

 

Litigation against seniorliving operators has been increasing during the past few years. Several casesby nursing home patients or their families who have won large monetary awardsfor mistreatment have been widely publicized. The amount of such litigation inFlorida has been particularly significant. As a result, liability insurancecosts are rising and, in some cases, such insurance is not available to somesenior living operators.  We haveliability insurance for the properties which we now operate.  Only one of these communities is located inFlorida and the Florida community has no nursing home beds.  Sunrise is responsible for obtaininginsurance for the senior living communities which SLS manages for us. Thesecommunities include six in Florida (885 independent living apartments, 442assisted living suites and 95 nursing home beds).

 

Our insurance costs forworkers compensation are also increasing at significant rates, particularly inCalifornia.  We operate six communitieswith approximately 575 employees in California.

 

Our current liability andworkers compensation insurance expires in June 2004; we expect ourinsurance costs to increase, and we cannot now predict the amount of any suchincrease, or to what extent, if at all, we may be able to offset any increasethrough use of higher deductibles, retention amounts, self insurance or othermeans.

 

**COMPETITION**

 

The senior livingservices business is highly competitive. We compete with service providersoffering alternate types of services, such as home healthcare services, as wellas other companies providing community based services.  Our management team has been assembledwithin the past four years, and, although we believe it is experienced andhighly talented, it does not have extensive experience working together. Weexpect we may expand our business with Senior Housing; however, Senior Housingis not obligated to provide us with opportunities to lease additionalproperties. As of December 31, 2003, we have debt totaling $10.4 million, andhave large lease obligations and limited financeable assets.  Many of our competitors have greaterfinancial resources than we do. For all of these reasons and others, we cannotprovide any assurance that we will be able to compete successfully for businessin the senior living industry.

 

**ENVIRONMENTALMATTERS**

 

Under variousfederal, state and local laws, owners as well as tenants and operators of realestate may be required to investigate and clean up hazardous substancesreleased or otherwise present at a property, and may be held liable to a governmentalentity or to third parties for property damage or personal injuries and forinvestigation and clean up costs incurred in connection with any such hazardoussubstances. Under our leases, we have also agreed to indemnify Senior Housingfor any such liabilities related to the leased communities. In addition, someenvironmental laws create a lien on a contaminated site in favor of thegovernment for damages and costs it incurs in connection with thecontamination, which lien may be senior in priority to our leases. We havereviewed environmental surveys of our leased and owned communities.   Based upon that review we do not believethat any of these properties are subject to any material environmental contamination.  However, no assurances can be given that aprior owner, operator or occupant of our communities did not create a materialenvironmental condition not known to us which might have been revealed by morein depth study of the properties; or future uses or conditions (including,without limitation, changes in applicable environmental laws and regulations)will not result in the imposition of environmental liability upon us.  The presence or discovery of any materialenvironmental contaminants could have a material adverse impact on us.

 

**INTERNETWEBSITE**

** **

Our internet address iswww.5sqc.com.** **Copies of our governance guidelines, code ofethics and the charters of our audit, quality of care, compensation andnominating and governance committees may be obtained free of charge by writingto our Secretary, Five Star Quality Care, Inc., 400 Centre Street, Newton, MA02458 or at our website www.5sqc.com under the heading “Governance.”  Wemake available, free of charge, through the “SEC Filings” tab under the“Financials” section of our internet website, our annual report on Form 10-K,our quarterly reports on Form 10-Q, our current reports on Form 8-K andamendments to such reports filed or furnished pursuant

 

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toSection 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, assoon as reasonably practicable after such forms are electronically filed withthe Securities and Exchange Commission, or SEC.

 

Anyshareholder or other interested party who desires to communicate with ourindependent directors, individually or as a group, may do so by filling out areport at the “Contact Us” section of our website.  Our board also provides a process for interested persons to sendcommunications to the entire board. Information about the process for sending communications to our boardcan be found at the “Contact Us” section of our website.

 

**Ourwebsite address is included several times in this Annual Report on Form 10-K asa textual reference only.  Theinformation in the website is not incorporated by reference into this AnnualReport on Form 10-K.**

 

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**Item 2**.  Properties

** **

**OUR SENIOR LIVINGCOMMUNITIES**

** **

At March 24, 2004, our business included 101 seniorliving communities: 

 
|                                                             |   | **No. of  Units**                   |   |                         |   |                        |   |              |   |
|------------------------------------------------------------------|--------|-------------------------------------|--------|------------------------------|--------|-----------------------------|--------|-------------------|--------|
| **Ownership**                                                    |   | **Independent  Living  Apartments** |   | **Assisted  Living  Suites** |   | **Specialty  Care  Suites** |   | **Nursing  Beds** |   | **Total** |   | **Annual  Rent** |   | **2003  Revenues** |   |
|                                                             |   |                                |   |                         |   |                        |   |              |   |   |   | **(in 000s)** |   |
| Owned communities (three communities owned  and operated by us)  |   | 250                                 |   | 143                          |   | —                      |   | —            |   | 393 |   | N/A |   | $ | 7,363 |   |
| Senior Housing Lease No. 1 (31  communities managed by SLS) |   | 3,992                               |   | 1,597                        |   | 283                         |   | 1,619             |   | 7,491 |   | $ | 63,674 |   | 294,023 |   |
| Senior Housing Lease No. 2 (67  communities operated by us) |   | 733                                 |   | 782                          |   | —                      |   | 4,636             |   | 6,151 |   | 18,290 |   | 273,750 | (1) |
| Totals:                                                          |   | 4,975                               |   | 2,522                        |   | 283                         |   | 6,255             |   | 14,035 |   | $ | 81,964 |   | $ | 575,136 |   |

 

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(1)          Includes amounts forperiods prior to commencement of our lease.

 

**OWNED COMMUNITIES**

** **

As of March 24,2004, our business included three owned communities containing 393 independent andassisted living units located in three states. The following table providesadditional information about these communities and their operations:

 
|         |                                      | **No. of  Units**     |   | **Year ended  December 31, 2003** |   |
|--------------|-------------------------------------------|-----------------------|--------|-----------------------------------|--------|
| **Location** |                                      | **Ind.  liv.  apts.** |   | **Asst.  liv.  suites**           |   | **Totals** |   | **Occupancy** |   | **Revenues** |   | **Percent  of revenues  from private  pay resources** |   |
|         |                                      |                  |   |                              |   |   |   |   |   | **(in 000s)** |   |   |   |
| 1.           | Florissant,  MO                           |                  | 114    |                              | — |   | 114 |   | 68% |   | $ | 1,756 |   | 100% |   |
| 2.           | Omaha, NE                                 |                  | — |                              | 73     |   | 73 |   | 71% |   | 1,610 |   | 100% |   |
| 3.           | Ft. Myers,  FL                            |                  | 136    |                              | 70     |   | 206 |   | 83% |   | 3,997 |   | 100% |   |
|         | Totals: three communities in three states |                  | 250    |                              | 143    |   | 393 |   | 76% |   | $ | 7,363 |   | 100% |   |

 

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**SENIOR HOUSING LEASE NO.1**

** **

Thirty one senior livingcommunities that are managed for us by SLS are leased from Senior Housing underone lease.  These communities contain7,491 living units and are located in 13 states.  The following table provides additional information about thesecommunities and their current operations as of and for the year ended December31, 2003: 

 
|         |   | **No. of Units**                               |   | **Year ended  December 31, 2003** |   |
|--------------|--------|------------------------------------------------|--------|-----------------------------------|--------|
| **Location** |   | **Ind.  liv.  apts.**                          |   | **Asst.  liv.  suites**           |   | **Spec.  care  beds** |   | **Nursing  beds** |   | **Total** |   | **Occupancy** |   | **Revenues** |   | **Percent  of revenues  from private  pay resources** |   |
|         |   |                                           |   |                              |   |   |   |   |   |   |   |   |   | **(in 000s)** |   |   |   |
| 1.           |   | Peoria, AZ                                     |   | 155                               |   | 79 |   | — |   | 57 |   | 291 |   | 89% |   | $ | 9,611 |   | 95% |   |
| 2.           |   | Scottsdale,  AZ                                |   | 167                               |   | 33 |   | — |   | 96 |   | 296 |   | 83% |   | 10,006 |   | 95% |   |
| 3.           |   | Tucson, AZ                                     |   | 200                               |   | 31 |   | 28 |   | 67 |   | 326 |   | 91% |   | 12,593 |   | 90% |   |
| 4.,5.        |   | San Diego,  CA                                 |   | 246                               |   | 100 |   | — |   | 59 |   | 405 |   | 89% |   | 19,695 |   | 96% |   |
| 6.           |   | Newark, DE                                     |   | 62                                |   | 26 |   | — |   | 110 |   | 198 |   | 96% |   | 10,614 |   | 66% |   |
| 7.           |   | Wilmington,  DE                                |   | 140                               |   | 37 |   | — |   | 66 |   | 243 |   | 97% |   | 12,246 |   | 82% |   |
| 8.           |   | Wilmington,  DE                                |   | 71                                |   | 44 |   | — |   | 46 |   | 161 |   | 97% |   | 7,217 |   | 93% |   |
| 9.           |   | Wilmington,  DE                                |   | 62                                |   | 15 |   | — |   | 82 |   | 159 |   | 92% |   | 8,837 |   | 63% |   |
| 10.          |   | Wilmington, DE                                 |   | —                            |   | 51 |   | 26 |   | 31 |   | 108 |   | 84% |   | 4,190 |   | 100% |   |
| 11.          |   | Coral  Springs, FL                             |   | 184                               |   | 62 |   | — |   | 35 |   | 281 |   | 87% |   | 9,794 |   | 84% |   |
| 12.          |   | Deerfield  Beach, FL                           |   | 198                               |   | 33 |   | — |   | 60 |   | 291 |   | 89% |   | 11,207 |   | 70% |   |
| 13.          |   | Ft.  Lauderdale, FL                            |   | —                            |   | 111 |   | — |   | — |   | 111 |   | 86% |   | 2,028 |   | 100% |   |
| 14.          |   | Ft. Myers,  FL                                 |   | —                            |   | 85 |   | — |   | — |   | 85 |   | 85% |   | 2,219 |   | 100% |   |
| 15.          |   | Palm Harbor,  FL                               |   | 230                               |   | 87 |   | — |   | — |   | 317 |   | 82% |   | 7,688 |   | 100% |   |
| 16.          |   | West Palm  Beach, FL                           |   | 273                               |   | 64 |   | — |   | — |   | 337 |   | 70% |   | 6,797 |   | 100% |   |
| 17.          |   | Indianapolis,  IN                              |   | 117                               |   | — |   | 30 |   | 74 |   | 221 |   | 93% |   | 11,627 |   | 79% |   |
| 18.          |   | Overland  Park, KS                             |   | 117                               |   | 30 |   | — |   | 60 |   | 207 |   | 95% |   | 9,215 |   | 87% |   |
| 19.          |   | Lexington,  KY                                 |   | 140                               |   | 9 |   | — |   | — |   | 149 |   | 96% |   | 4,598 |   | 100% |   |
| 20.          |   | Lexington,  KY                                 |   | —                            |   | 22 |   | — |   | 111 |   | 133 |   | 96% |   | 7,774 |   | 65% |   |
| 21.          |   | Louisville,  KY                                |   | 240                               |   | 24 |   | — |   | 60 |   | 324 |   | 97% |   | 12,088 |   | 85% |   |
| 22.          |   | Winchester,  MA                                |   | —                            |   | 125 |   | — |   | — |   | 125 |   | 97% |   | 6,502 |   | 100% |   |
| 23.          |   | Lakewood, NJ                                   |   | 217                               |   | 108 |   | 31 |   | 60 |   | 416 |   | 67% |   | 13,349 |   | 80% |   |
| 24.          |   | Albuquerque,  NM                               |   | 114                               |   | 35 |   | — |   | 60 |   | 209 |   | 96% |   | 10,273 |   | 94% |   |
| 25.          |   | Columbus, OH                                   |   | 144                               |   | 87 |   | 25 |   | 60 |   | 316 |   | 91% |   | 14,368 |   | 95% |   |
| 26.          |   | Myrtle  Beach, SC                              |   | —                            |   | 60 |   | 36 |   | 68 |   | 164 |   | 78% |   | 5,880 |   | 61% |   |
| 27.          |   | Dallas, TX                                     |   | 190                               |   | 38 |   | — |   | 90 |   | 318 |   | 87% |   | 13,198 |   | 77% |   |
| 28.          |   | El Paso, TX                                    |   | 138                               |   | — |   | — |   | 120 |   | 258 |   | 77% |   | 8,768 |   | 66% |   |
| 29.          |   | Houston, TX                                    |   | 197                               |   | 71 |   | 64 |   | 87 |   | 419 |   | 88% |   | 17,852 |   | 91% |   |
| 30.          |   | San Antonio,  TX                               |   | 151                               |   | 30 |   | 27 |   | 60 |   | 268 |   | 96% |   | 11,988 |   | 94% |   |
| 31.          |   | Woodlands,  TX                                 |   | 239                               |   | 100 |   | 16 |   | — |   | 355 |   | 91% |   | 11,801 |   | 100% |   |
|         |   |                                           |   |                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|         |   | Totals: 31 communities in  13 states |   | 3,992                             |   | 1,597 |   | 283 |   | 1,619 |   | 7,491 |   | 88% |   | $ | 294,023 |   | 86% |   |

 

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**SENIOR HOUSING LEASE NO.2**

** **

During 2003, we had twoadditional leases with Senior Housing, one was for 53 nursing homes and theother was for 13 independent and assisted living communities.  In March 2004, we combined the leasefor the 53 nursing homes and 13 independent and assisted living communitiesinto one lease.  Simultaneously with thelease combination, we sold Senior Housing one independent and assisted livingcommunity located in Maryland with 229 units. The purchase price was $24.1 million, its appraised value.  This property was added to the combinedlease.  All of these properties are operated by us.  The annual rent due under the combined lease for the 67communities is $18.3 million.

 

The following tableprovides additional information about these communities and their operations asof and for the year ended December 31, 2003: 

 
|      |   | **No. of Units**                          |   | **Year ended  December 31, 2003** |   |
|-----------|--------|-------------------------------------------|--------|-----------------------------------|--------|
| **State** |   | **No. of  Communities**                   |   | **Nursing  Beds**                 |   | **Asst  liv.  apts.** |   | **Ind.  liv.  apts.** |   | **Total** |   | **Occupancy** |   | **Revenues** |   | **Percent of  revenues from  Medicaid** |   |
|      |   |                                      |   |                              |   |   |   |   |   |   |   |   |   | **(in 000s)** |   |   |   |
| 1.        |   | Arizona                                   |   | 2                                 |   | 125 |   | 52 |   | — |   | 177 |   | 85% |   | $ | 6,600 |   | 83% |   |
| 2.        |   | California                                |   | 6                                 |   | 397 |   | 165 |   | 84 |   | 646 |   | 95% |   | 27,209 |   | 62% |   |
| 3.        |   | Colorado                                  |   | 7                                 |   | 739 |   | — |   | 64 |   | 803 |   | 89% |   | 38,568 |   | 74% |   |
| 4.        |   | Connecticut                               |   | 2                                 |   | 300 |   | — |   | — |   | 300 |   | 98% |   | 21,971 |   | 95% |   |
| 5.        |   | Georgia                                   |   | 3                                 |   | 338 |   | — |   | — |   | 338 |   | 92% |   | 13,818 |   | 94% |   |
| 6.        |   | Iowa                                      |   | 7                                 |   | 476 |   | — |   | 19 |   | 495 |   | 90% |   | 22,830 |   | 78% |   |
| 7.        |   | Kansas                                    |   | 2                                 |   | 55 |   | — |   | 140 |   | 195 |   | 88% |   | 4,924 |   | 27% |   |
| 8.        |   | Maryland                                  |   | 6                                 |   | — |   | 324 |   | 275 |   | 599 |   | 86% |   | 20,114 |   | — |   |
| 9.        |   | Michigan                                  |   | 2                                 |   | 273 |   | — |   | — |   | 273 |   | 87% |   | 19,801 |   | 86% |   |
| 10.       |   | Missouri                                  |   | 1                                 |   | 75 |   | — |   | — |   | 75 |   | 79% |   | 2,147 |   | 67% |   |
| 11.       |   | Nebraska                                  |   | 14                                |   | 814 |   | — |   | — |   | 814 |   | 89% |   | 33,664 |   | 68% |   |
| 12.       |   | North  Carolina                           |   | 1                                 |   | — |   | 89 |   | 143 |   | 89 |   | 95% |   | 3,478 |   | — |   |
| 13.       |   | Virginia                                  |   | 5                                 |   | — |   | 152 |   | — |   | 295 |   | 83% |   | 6,746 |   | — |   |
| 14.       |   | Wisconsin                                 |   | 7                                 |   | 861 |   | — |   | — |   | 861 |   | 91% |   | 44,240 |   | 77% |   |
| 15.       |   | Wyoming                                   |   | 2                                 |   | 183 |   | — |   | 8 |   | 191 |   | 83% |   | 7,640 |   | 78% |   |
|      |   | Totals: 67  communities in 15 states |   | 67                                |   | 4,636 |   | 782 |   | 733 |   | 6,151 |   | 88% |   | $ | 273,750 |   | 68% |   |

 

**OUR SENIOR HOUSING LEASES**

 

The material terms of ourleases with Senior Housing include the following:

 

*Guaranteed Obligations*. We have guaranteedour subsidiaries’ obligations under these leases.

 

*OperatingCosts*.  Each lease isa so-called “triple-net” lease which requires us to pay all costs incurred inthe operation of the communities, including the costs of personnel, service toresidents, insurance and real estate and personal property taxes.

 

*Minimum Rent. *Asof March 24, 2004, aggregate minimum rent under our leases is$82.0 million per year. Rent for Lease No. 1 is $63.7 million per year andrent for Lease No. 2 is $18.3 million per year.  

*Percentage Rent*.  Beginning in 2006, we will be required to pay additional rentwith respect to each lease.  This rentwill be 4% of the increase in resident revenues at the leased properties overthe 2005 resident revenues.

 

15

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*Term.*  The terms of these leases are as follows:

 
|   |                                                                            | **Initial  Expiration Date** |              | **Renewal  Terms** |
|--------|---------------------------------------------------------------------------------|------------------------------|-------------------|--------------------|
|   |                                                                            |                         |              |               |
| • | Lease No. 1 for 31 independent and assisted  living communities operated by SLS |                         | December 31, 2017 |               | Two renewal options totaling 15 years for  all, but not less than all, 31 communities. |
| • | Lease No. 2 for 67 senior living  communities operated by us                    |                         | December 31, 2020 |               | One 15 year renewal option for all, but not  less than all, 67 communities. |

 

*Rent During Renewal Term.*  Rent during each renewal term is acontinuation of minimum rent and percentage rent payable during the initialterm.

 

*Maintenance and Alterations.* We are required to operate continuously andmaintain, at our expense, the leased communities in good order and repair,including structural and nonstructural components. We may request SeniorHousing to fund amounts needed for repairs and renovations in return for rentadjustments to provide Senior Housing a return on its investment according toformulas set forth in the leases. At the end of each lease term, we arerequired to surrender the leased communities in substantially the samecondition as existed on the commencement date of the lease, subject to anypermitted alterations and subject to ordinary wear and tear.

 

*Assignment and Subletting.*  Senior Housing’s consent is generallyrequired for any direct or indirect assignment or sublease of any of thecommunities. In the event of any assignment or subletting, we will remainliable under the applicable lease.

 

*EnvironmentalMatters.* We arerequired, at our expense, to remove and dispose of any hazardous substance atthe leased communities in compliance with all applicable environmental laws andregulations. We have indemnified Senior Housing for any liability which mayarise as a result of the presence of hazardous substances at any leasedcommunities and from any violation or alleged violation of any applicableenvironmental laws.

 

*Indemnification and Insurance.*  With limited exceptions, we are required toindemnify Senior Housing from all liabilities which may arise from theownership or operation of the communities. We generally are required tomaintain commercially reasonable insurance, including:

 

•                  “all-risk”property insurance, in an amount equal to 100% of the full replacement cost ofthe communities ;

•                  businessinterruption insurance;

•                  comprehensivegeneral liability insurance, including bodily injury and property damage, inamounts as are generally maintained by companies providing senior livingservices;

•                  flood insuranceif any community is located in whole or in part in a flood plain;

•                  workerscompensation insurance if required by law; and

•                  such additionalinsurance as may be generally maintained by companies providing senior livingservices including professional and general liability insurance.

 

Each leaserequires that Senior Housing be named as an additional insured under thesepolicies.

 

*Damage, Destruction or Condemnation.*  If any of the leased communities is damagedby fire or other casualty or taken for a public use, we are generally obligatedto rebuild unless the community cannot be restored. If the community cannot berestored, Senior Housing will generally receive all insurance or takingproceeds and we are liable to Senior Housing for the amount of any deductibleor deficiency between the replacement cost and the insurance proceeds, and ourrent is adjusted pro rata.

 

*Non Economic Circumstances.*  If we determine that continued operations ofone or more communities is not economically practical, we may negotiate withSenior Housing to include a substitute property under the leases

 

16

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or close or sellthat community, including Senior Housing’s ownership in the property.  In the event of such a sale, Senior Housingreceives the net proceeds and our rent for the remaining communities in theaffected lease is reduced according to a formula set forth in the lease.

 

*Events of Default.* Events of default under each lease includethe following:

 

•                  any person orgroup acquiring ownership of 9.8% of our outstanding voting stock;

•                  any change inour control or sale of a material portion of our assets without SeniorHousing’s consent;

•                  our failure topay rent or any other sum when due;

•                  our failure tomaintain the insurance required under such lease;

•                  the occurrenceof certain events with respect to our insolvency;

•                  the institutionof a proceeding for our dissolution;

•                  our defaultunder any indebtedness which gives the holder the right to accelerate;

•                  our being declaredineligible to receive reimbursement under Medicare or Medicaid programs for anyof the leased communities;

•                  our failure toperform any terms, covenants or agreements of the leases and the continuancethereof for a specified period of time after written notice; and

•                  the revocationof any material license required for our operations.

 

*Remedies.*  Upon the occurrence of any event of default,each lease provides that, among other things, Senior Housing may, to the extentlegally permitted:

 

•                  accelerate therent;

•                  terminate theleases in whole or in part;

•                  enter theproperty and take possession of any and all our personal property and retain orsell the same at a public or private sale;

•                  make any paymentor perform any act required to be performed by us under the leases;

•                  terminate our rights to occupy and use theleased property; and

•                  rent the property and recover from us thedifference between the amount of rent which would have been due under the leaseand the rent received from the re-letting.

 

We are obligatedto reimburse Senior Housing for all costs and expenses incurred in connectionwith any exercise of the foregoing remedies.

 

*Management.*  We may not enter into any new management agreement or amend ormodify any management agreement with SLS affecting any leased community withoutthe prior written consent of Senior Housing.

 

*Lease Subordination.* Our leases may be subordinated to anymortgages of the leased properties by Senior Housing described above. 

 

*Financing Limitations; Security*.  We may not incur debt secured by ourinvestments in our tenant subsidiaries. Further, our tenant subsidiaries are prohibited from incurringliabilities other than operating liabilities incurred in the ordinary course ofbusiness, liabilities secured by our accounts receivables or purchase moneydebt.  We are required to pledge 100% ofthe equity interests of our tenant subsidiaries to Senior Housing or itslenders, and we may pledge equity interests to our leases only if consented toby Senior Housing.

 

*FF&EReserves.* We arerequired under our lease for the 31 communities managed by SLS to make depositsinto accounts that we own for replacements and improvements.  Senior Housing has a security and remainderinterest in these accounts and in all property purchased with funding fromthese accounts.

 

17

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**SUNRISE SENIOR LIVING SERVICES, INC.MANAGEMENT AGREEMENTS**

 

The following is adescription of the material terms of our management agreements with SLS:

 

*Term. *Generallyeach of the management agreements has an initial term expiring in 2027, withone five-year renewal term at SLS’s option.

 

*Community Services.* Our contract with SLS delegates to SLS theresponsibility for operations of the managed communities, including obtainingand maintaining all insurance, establishing resident care policies andprocedures, carrying out and supervising all necessary repairs and maintenance,procuring food, supplies, equipment, furniture and fixtures, and establishingprices, rates and charges for services provided. SLS also recruits, employs anddirects all community based employees.

 

*Central Services. *SLSalso furnishes certain central administrative services, which are provided on acentral or regional basis to all senior living communities managed by SLS. Suchservices include: (1) marketing and public relations; (2) humanresources program development; (3) information systems development andsupport; and (4) centralized computer payroll and accounting.

 

*FF&E Reserves and Capital Improvements. *SLS has established areserve account under each management agreement, referred to as an FF&EReserve, to cover the expected recurring cost of replacements and renewals tothe furniture, furnishings, fixtures, soft goods, case goods, vehicles andequipment, and for building repairs and maintenance which are normallycapitalized. The FF&E Reserve accounts are funded from the operatingrevenues of the managed communities. The amount of this funding varies somewhatamong the managed communities; however, for most communities it is currentlyset at 2.85% of gross revenues and is expected to gradually increase to3.5%.  In 2003 we deposited $8.1 millioninto these accounts.  In the event majorcapital improvements are required, or if the amounts set aside in the FF&EReserve accounts are inadequate for required repairs, we may be required toseparately fund such repairs and improvements. Any such separate funding whichwe provide increases the amount of our owner’s priority, described below.  The amount of FF&E Reserve fundingrequired under our SLS management agreements is the same as the fundingrequired by our Senior Housing lease for these communities.  Also, under our lease we have the option torequest Senior Housing to provide any required separate funding in return forrent adjustments to provide Senior Housing a return on its investment accordingto a formula set forth in the lease.

 

*Fees. *Forits management services, SLS receives a base fee generally equal to 5% of themanaged communities’ gross revenues, plus an incentive fee generally equal to20% of operating cash flows in excess of owner’s priority amounts, as definedin the agreements. For its central services, SLS receives a fee generally equalto 2% of gross revenues. Generally, through the earlier of (1) the end ofJune 2004 or (2) the date on which certain performance criteria have beenmet, payment of up to one half of this central services fee (i.e., 1% of grossrevenues) is conditional, and is waived if specified annual profit targets arenot achieved. During 2003 and 2002 management and central services fees paid toSLS and SLS’s predecessor, MSLS, totaled $17.4 and $16.6 million,respectively.

 

*Owner’s Priority. *Wereceive the profits of the SLS managed communities on a priority basis beforeSLS receives any incentive fees for community services or any conditionalcentral services fees. The amount of the owner’s priority for each managedcommunity is established based upon a specified rate of return on historicalcapital investments in these communities, including capital improvements duringthe term of the management agreements which are funded by us or Senior Housingin addition to the FF&E Reserve. For fiscal years 2003 and 2002, theaggregate amount of owner’s priority for all 31 communities was $69.4 millionand $69.3 million, respectively.

 

*Pooling*. Twenty-nine of the communitiesare subject to pooling arrangements whereby the calculation and payment ofFF&E Reserves, fees payable to SLS and owner’s priority for several groupsof these 29 communities are combined.

 

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*Defaultsand Termination*.  TheSLS management agreements contain various default and terminationprovisions.  Our right to exercisetermination options under the SLS management agreements is subject to approvalby Senior Housing under the terms of the lease for these 31 SLS communities.

 

**Item 3**.    Legal Proceedings

** **

During 2002, about the timeMarriott determined to sell MSLS to Sunrise, we and Senior Housing becameinvolved in litigation with Marriott International and MSLS which has beenpreviously described in our 2002 Annual Report on Form 10-K and our quarterlyreports on Form 10-Q for the quarters ended March 31, 2003, June 30, 2003 andSeptember 30, 2003.  On January 7, 2004,we and Senior Housing settled our pending litigation with Marriott andMSLS.  Under the terms of the settlementwe and Senior Housing, and Marriott and MSLS, agreed to dismiss all claims andcounterclaims asserted in the litigation. Also under the terms of the settlement, Marriott paid to us and SeniorHousing $1.25 million each.  Thesettlement was a compromise of the parties’ disputes entered into to avoid theexpense and inconvenience of litigation and neither we or Senior Housing, nor Marriottor MSLS, has admitted any liability, violation of law or wrongdoing inconnection with the matters in the litigation. We believe the settlement settles all of our litigation with Marriott.This settlement does not affect our or Senior Housing’s rights vis-à-visSunrise or SLS which arise by reason of events after Sunrise purchased MSLS.

 

In the ordinary course of business we are involved inother litigation incidental to our business; however, we are not aware of anyother material pending legal proceeding affecting us for which we might becomeliable or the outcome of which we expect to have a material impact on us.

 

**Item 4**.  Submission of Matters to a Vote of SecurityHolders

** **

**None.**

 

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**PART II**

** **

**Item 5**.  Market for the Registrant’s Common Equityand Related Shareholder Matters

** **

Our common shares are traded on the American StockExchange under the symbol “FVE”. The following table sets forth for the periodsindicated the high and low closing price for our common shares as reported bythe American Stock Exchange: 

 
|           |   | **Low** |   | **High** |   |
|----------------|--------|---------|--------|----------|--------|
| 2002           |   |    |   |     |   |
| First Quarter  |   | $       | 6.97   |     | $      | 8.75 |   |
| Second Quarter |   | 5.35    |   | 7.35     |   |
| Third Quarter  |   | 1.07    |   | 5.50     |   |
| Fourth Quarter |   | 0.96    |   | 2.09     |   |
|           |   |    |   |     |   |
| 2003           |   |    |   |     |   |
| First Quarter  |   | $       | 1.11   |     | $      | 1.75 |   |
| Second Quarter |   | 1.07    |   | 1.75     |   |
| Third Quarter  |   | 1.45    |   | 2.46     |   |
| Fourth Quarter |   | 2.06    |   | 4.45     |   |

 

The closing price of ourcommon shares on the American Stock Exchange on March 24, 2004, was $4.43 pershare.

 

As of March 18, 2004, there were 4,057 shareholders ofrecord of our common shares, and we estimate that as of such date there wereapproximately 60,500 beneficial owners of our common shares.

 

We have not paid any dividends in the past and do notexpect to pay dividends in the foreseeable future.

 

On January 14, 2004, pursuant to our stock option andstock incentive plan, Barbara D. Gilmore, a newly elected trustee, received agrant of 1,000 common shares, par value $0.01 per share, valued at $5.49 pershare, the closing price of our common shares on the American Stock Exchange onJanuary 14, 2004.  This grant was made pursuant to an exemptionfrom registration contained in section 4(2) of the Securities Act of 1933, asamended.

 

20

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**Item 6****.    Selected Financial Data**

 

The following table presents selected financial datawhich has been derived from our historical financial statements for the periodfrom April 27, 2000 (the date we commenced operations) throughDecember 31, 2003. Prior to December 31, 2001, we were owned by SeniorHousing.  The following data should beread in conjunction with, and is qualified in its entirety by reference to, ourfinancial statements and the notes thereto included elsewhere in this AnnualReport on Form 10-K.  As discussed under“Management’s Discussion and Analysis of Financial Condition and Results ofOperations”, we are a relatively new company and our historical financialinformation before January 1, 2002 is not fully reflective of our currentoperations.  Accordingly, you should notplace undue reliance on our historical financial information before January 1,2002.

 
|                                            |   | **Year ended  December 31,**                 |    |     |   |
|-------------------------------------------------|--------|----------------------------------------------|---------|----------|--------|
|                                            |   | **2003**                                     |    | **2002** |   | **2001** |   | **Period  from April  27, 2000 through  December 31, 2000** |   |
|                                            |   | **(in thousands, except per share amounts)** |    |
| Total revenues                                  |   | $                                            | 576,215 |     | $      | 519,403 |   | $ | 219,834 |   | $ | 2,222 |   |
| Net income (loss) from continuing  operations   |   | (7,567                                       | )       | (10,259  | )      | 1,473 |   | (1,614 | ) |
| Net income (loss) from discontinued  operations |   | (372                                         | )       | (2,915   | )      | (946 | ) | 298 |   |
| Net income (loss)                               |   | $                                            | (7,939  | )        | $      | (13,174 | ) | $ | 527 |   | $ | (1,316 | ) |
| Per common share data:                          |   |                                         |    |     |   |   |   |   |   |
| Income (loss) from continuing operations        |   | $                                            | (0.89   | )        | $      | (1.36 | ) | $ | 0.34 |   | $ | (0.37 | ) |
| Income (loss) from discontinued operations      |   | (0.05                                        | )       | (0.38    | )      | (0.22 | ) | 0.07 |   |
| Net income   (loss)                        |   | $                                            | (0.94   | )        | $      | (1.74 | ) | $ | 0.12 |   | (0.30 | ) |
| Balance sheet data (as of December 31):         |   |                                         |    |     |   |   |   |   |   |
| Total assets                                    |   | $                                            | 147,370 |     | $      | 133,197 |   | $ | 68,043 |   | $ | 54,788 |   |
| Total indebtedness                              |   | 10,435                                       |    | 16,123   |   | — |   | 100 |   |
| Other long term obligations                     |   | 18,417                                       |    | 17,723   |   | — |   | — |   |
| Total shareholders’ equity                 |   | $                                            | 64,427  |     | $      | 65,047 |   | $ | 50,233 |   | $ | 54,688 |   |

 

The following tablepresents selected financial data from 1999 and 2000 derived from historicalfinancial statements of our two predecessors, Integrated Health Services, Inc.and Mariner Post-Acute Network, Inc., prior to their acquisition by SeniorHousing.

** **
|                                    |   | **Year ended  December 31,** |    |
|-----------------------------------------|--------|------------------------------|---------|
|                                    |   | **2000**                     |    | **1999** |   |
|                                    |   | **(in thousands)**           |    |
| **Integrated Health  Services, Inc.**   |   |                         |    |   |   |
| Operating data:                         |   |                         |    |   |   |
| Operating revenues                      |   | $                            | 135,378 |   | $ | 130,333 |   |
| Net loss                                |   | (25,252                      | )       | (126,939 | ) |
| Total assets                            |   | $                            | 34,942  |   | $ | 61,274 |   |
| Long term liabilities                   |   | —                       |    | 17,500 |   |
| **Mariner Post-Acute Network, Inc.**    |   |                         |    |   |   |
| Operating data:                         |   |                         |    |   |   |
| Operating revenues                      |   | $                            | 85,325  |   | $ | 86,945 |   |
| Net loss                                |   | (7,421                       | )       | (43,804 | ) |
| Balance sheet data (as of December 31): |   |                         |    |   |   |
| Total assets                            |   | $                            | 23,052  |   | $ | 17,433 |   |
| Long term liabilities                   |   | 32,091                       |    | 28,603 |   |

 

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**Item 7**.    Management’s Discussion and Analysis of Financial Condition andResults of Operations

** **

**OVERVIEW**

** **

We were incorporated inDelaware in April 2000 and reincorporated in Maryland inSeptember 2001. We were formed as a 100% owned subsidiary of SeniorHousing. Effective July 1, 2000, we assumed the operations of healthcarecommunities from two bankrupt former tenants of Senior Housing. Pursuant to taxlaws applicable to REITs, Senior Housing engaged FSQ, Inc., an independentoperating company formed by our managing directors, to manage thesecommunities.  At the time we assumedoperations of these communities, we had not received substantially all of therequired licenses for these communities. As a result, for the period fromJuly 1, 2000 through December 31, 2000, we accounted for theoperations of these communities using the equity method of accounting and weonly recorded the net income from these operations.  Thereafter, we obtained all necessary licenses to operate thesecommunities, and on January 1, 2001, we began to consolidate the resultsof operations of these communities. On December 31, 2001, Senior Housingdistributed substantially all of our shares to its shareholders in a spin offtransaction and we became a separately traded public company. On January 2,2002, in order to acquire the personnel, systems and assets necessary tooperate these communities, we acquired FSQ, Inc. by merger.

 

Since we succeeded tosubstantially all of the business formerly conducted by subsidiaries or unitsof two former tenants of Senior Housing, these subsidiaries and units areconsidered to be our predecessors. See “Item 6. Selected Financial Data” for adiscussion of financial data of our predecessors.

 

Our revenues consistprimarily of payments for services provided to residents at our communities.The payments are either made by the residents, their families or insurers,referred to as private pay revenues, or by the Medicare and Medicaidprograms.  For the year endedDecember 31, 2003, private pay revenues represented 61% of our totalrevenues.  Our expenses consistprimarily of rent, wages and benefits of personnel, food, supplies, insuranceand other resident care costs, as well as taxes, and other property relatedcosts.

 

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**OUR HISTORICAL RESULTS OFOPERATIONS**

** **

As described above, untilcompletion of the spin off, we operated as a subsidiary of Senior Housing. Ourpast operations as Senior Housing’s subsidiary prior to 2002 differ from our2002, 2003 and current operations as an independent public company.  Specifically, in 2000 and 2001, we operatedonly 56 communities for Senior Housing, which owned the real estate as well asthe operations.  Effective December 31,2001, we began to lease these 56 communities (now 53 communities) from SeniorHousing which continued to own the real estate.  In January 2002, we leased from Senior Housing an additional 31communities that are currently managed by SLS. Since Sunrise acquired SLS, the financial results of these 31communities have declined and this decline has had a material and adverseimpact on our financial results.  We arehaving discussions with SLS concerning possible improvements in the financialresults of these operations.  In April2002, we acquired and began to operate five additional senior livingcommunities.  In October 2002, we beganto operate 15 additional owned or leased senior living communities.  In May 2003, we began to operate threeadditional leased senior living communities. During 2002 and 2003, we also disposed of six senior livingcommunities.  Our principal source offinancing as a subsidiary of Senior Housing prior to 2002 was intercompanyadvances from Senior Housing, an entity with financial resources substantiallyin excess of ours. Because of these differences, we believe that our historicalresults of operations for periods prior to 2002 described below are notcomparable to our 2003 or 2002 operations or our expected futureoperations.  The following tablespresent an overview of our operations for the years ended December 31, 2003 and2002.

 

**Yearended December 31, 2003 versus year ended December 31, 2002**

 

The following tablespresent an overview of our portfolio for the years ended December 31, 2003 and2002:

 
|                                            |   | **2003** |    | **2002** |   | **Change** |   |
|-------------------------------------------------|--------|----------|---------|----------|--------|------------|--------|
| Revenues from residents (in 000s)               |   | $        | 575,986 |     | $      | 519,106    |   | +11 | % |
| Community expenses (in 000s)                    |   | $        | 466,628 |     | $      | 417,301    |   | +12 | % |
| Total expenses (in 000s)                        |   | $        | 583,782 |     | $      | 529,662    |   | +10 | % |
| No. of communities (end of period)              |   | 101      |    | 105      |   | -4         |   |
| No. of living units (end of period)             |   | 14,035   |    | 13,962   |   | +73        |   |
| Occupancy                                       |   | 88       | %       | 89       | %      | -1         | %pt    |
| Average daily rate                              |   | $        | 126     |     | $      | 114        |   | +11 | % |
| Revenue per day per available unit              |   | $        | 112     |     | $      | 102        |   | +10 | % |
| Percent of revenues from Medicare and  Medicaid |   | 39       | %       | 39       | %      | —     |   |
| Percent of revenues from private and other      |   | 61       | %       | 61       | %      | —     |   |

 

“Same Store” Communities (communities that weoperated continuously since 1/1/02):

 
|                                            |   | **2003** |    | **2002** |   | **Change** |   |
|-------------------------------------------------|--------|----------|---------|----------|--------|------------|--------|
| Revenues from residents (in 000s)               |   | $        | 236,667 |     | $      | 227,446    |   | +4 | % |
| Community expenses (in 000s)                    |   | $        | 215,793 |     | $      | 210,645    |   | +2 | % |
| No. of communities (end of period)              |   | 53       |    | 53       |   | —     |   |
| No. of living units (end of period)             |   | 4,868    |    | 4,868    |   | —     |   |
| Occupancy                                       |   | 90       | %       | 89       | %      | +1         | %pt    |
| Average daily rate                              |   | $        | 148     |     | $      | 144        |   | +3 | % |
| Revenue per day per available unit              |   | $        | 133     |     | $      | 128        |   | +4 | % |
| Percent of revenues from Medicare and  Medicaid |   | 79       | %       | 78       | %      | +1         | %pt    |
| Percent of revenues from private and other      |   | 21       | %       | 22       | %      | -1         | %pt    |

 

Revenues from residents for 2003 were$576.0 million, an increase of 11% over revenues from residents of $519.1million for 2002. This increase is attributable primarily to our beginningoperations at 15 communities on October 25, 2002, and at three communities onMay 30, 2003.  Revenues from residentsat the communities we operated throughout 2003 and 2002 were $236.7 million and$227.4 million, respectively, an increase of 4%.  This increase is due primarily to higher per diem charges toresidents and higher occupancy.  About39% of our revenues from residents in 2003 and 2002 were received from Medicareand Medicaid.

 

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Interest and other income decreased by $68,000 in 2003to $229,000 compared to $297,000 in 2002 due to lower cash balances and lowerinterest rates in 2003 partially offset by interest earned on mortgage notesreceivable.

 

 Expenses for2003 were $583.8 million, an increase of 10% over expenses of $529.7 millionfor 2002. Our wages and benefits costs increased from $274.2 million to $315.6million, or 15%, primarily due to expenses at the 18 communities we began tooperate since October 2002 as well as increases in workers compensation andemployee health insurance costs.  Otheroperating expenses, which include utilities, housekeeping, dietary,maintenance, insurance and community level administrative costs, increased from$143.1 million to $151.0 million, or 6%, again primarily due to expenses at the18 communities we began to operate since October 2002, as well as higherprofessional and general liability insurance costs.  Management fees related to the 31 communities managed for us bySLS for 2003 and 2002, were $17.4 million and $16.6 million, respectively.  This increase is primarily because thesearrangements commenced on January 11, 2002, and, therefore, the 2003 periodincludes 11 more days than the 2002 period. Rent expense to Senior Housing increased from $75.2 million to $77.3million, or 3%, primarily due to rents for communities we began to lease sinceOctober 2002, and rent increases which accompanied Senior Housing’s purchase ofimprovements at leased communities, partially offset by a lease modificationentered into on October 1, 2002 which changed the ownership of certain FF&Ereserve escrows.  Community leveloperating expenses related to the communities we operated throughout 2003 and2002, were $215.8 million and $210.6 million, respectively, an increase of2%.  This increase is primarily due toincreases in employee health, workers compensation and professional and generalliability insurance costs.

 

Our general and administrative expenses for 2003 were$17.7 million, an increase of 15% over 2002 of $15.4 million, primarily due tocosts resulting from our increased operations and to legal costs incurred inconnection with our litigation with Marriott and MSLS, which was settled inJanuary 2004.

 

Depreciation expense in 2003 was $3.6 million, anincrease of 95% over depreciation expense of $1.8 million in 2002.  The increase is attributable to our purchaseof seven communities in the second half of 2002 as well as capitalizedimprovements to some of our communities which increased our depreciable assets.

 

Loss from discontinued operations for 2003 was$372,000, a decrease of $2.5 million over the loss in 2002.  This decrease is attributable to ourdispositions of these operations as well as the recovery of some accountsreceivable that were previously written off.

 

**As a result of the factors describedabove, our net loss for 2003 was $7.9 million, compared to a loss of $13.2million in 2002.  Our net loss per sharein 2003 was $0.94 compared to a loss per share of $1.74 in 2002.**

 

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**Year ended December 31,2002 versus year ended December 31, 2001**

 

The following tablespresent an overview of our portfolio for the years ended December 31, 2002 and2001:

 
|                                            |   | **2002** |    | **2001** |   | **Change** |   |
|-------------------------------------------------|--------|----------|---------|----------|--------|------------|--------|
| Revenues from residents (in 000s)               |   | $        | 519,106 |     | $      | 219,742    |   | +136 | % |
| Community expenses (in 000s)                    |   | $        | 417,301 |     | $      | 201,447    |   | +107 | % |
| Total expenses (in 000s)                        |   | $        | 529,662 |     | $      | 218,361    |   | +142 | % |
| No. of communities (end of period)              |   | 105      |    | 56       |   | 49         |   |
| No. of living units (end of period)             |   | 13,962   |    | 5,211    |   | 8,751      |   |
| Occupancy                                       |   | 89       | %       | 90       | %      | -1         | %pt    |
| Average daily rate                              |   | $        | 114     |     | $      | 130        |   | -12 | % |
| Revenue per day per available unit              |   | $        | 102     |     | $      | 116        |   | -12 | % |
| Percent of revenues from Medicare and  Medicaid |   | 39       | %       | 78       | %      | -39        | %pts   |
| Percent of revenues from private and other      |   | 61       | %       | 22       | %      | +39        | %pts   |

 

“Same Store” Communities (communities that weoperated continuously since 1/1/01):

 
|                                            |   | **2002** |    | **2001** |   | **Change** |   |
|-------------------------------------------------|--------|----------|---------|----------|--------|------------|--------|
| Revenues from residents (in 000s)               |   | $        | 227,446 |     | $      | 219,742    |   | +4 | % |
| Community expenses (in 000s)                    |   | $        | 210,645 |     | $      | 201,447    |   | +5 | % |
| No. of communities (end of period)              |   | 53       |    | 53       |   | —     |   |
| No. of living units (end of period)             |   | 4,868    |    | 4,868    |   | —     |   |
| Occupancy                                       |   | 89       | %       | 89       | %      | —     |   |
| Average daily rate                              |   | $        | 144     |     | $      | 139        |   | +4 | % |
| Revenue per day per available unit              |   | $        | 128     |     | $      | 124        |   | +3 | % |
| Percent of revenues from Medicare and  Medicaid |   | 78       | %       | 78       | %      | —     |   |
| Percent of revenues from private and other      |   | 22       | %       | 22       | %      | —     |   |

 

Revenues from residents for 2002 were$519.1 million, an increase of 136% over revenues from residents of  $219.7 million for 2001. This increase isattributable primarily to our lease of 31 communities on January 11, 2002, ouracquisition of five communities on April 1, 2002, and the 15 communities webegan to operate in October 2002. Revenues from residents at the communities we operated throughout 2002and 2001 were $227.4 million and $219.7 million, respectively, an increase of4%.  This increase is due primarily tohigher per diem charges to residents. About 39% of our revenues from residents in 2002 were received fromMedicare and Medicaid, compared to 78% in 2001.  This decrease is due largely to the 31 SLS communities and othercommunities we leased or acquired during 2002, all of which are focused onservices to residents who pay with private resources.

 

Interest income increased by $205,000 in 2002 from$297,000 compared to $92,000 in 2001 due to earnings on higher cash balances inthe 2002 period.

 

Expenses for 2002 were $529.6 million, an increase of142% over expenses of $218.4 million for 2001. Our wages and benefits costsincreased from $153.4 million to $274.2 million, or 78%, primarily due toexpenses at the 51 communities we leased or acquired in 2002.  Other operating expenses, which includeutilities, housekeeping, dietary, maintenance, insurance and community leveladministrative costs, rose from $48.0 million to $143.1 million or 198%, againprimarily due to expenses at the 51 communities we leased or acquired in2002.  During 2001, MSLS did not manageany communities for us and we were a subsidiary of Senior Housing that did notlease any communities.  As a result, wedid not incur management fees to MSLS or rent expense in 2001.  Community level operating expenses relatedto the communities we operated throughout 2002 and 2001, were $210.6 millionand $201.5 million, respectively, an increase of 5%.  This increase is principally attributable to higher insurancepremiums, an increase in reserves for the self funded portion of our insuranceprograms and higher wage and benefit costs, which were partially offset by adecrease in expenses from our reduced use of higher cost, third party staffing.

 

Our general and administrative expenses for 2002 were$15.4 million, a decrease of 1% over 2001, primarily due to operational startup costs incurred during 2001 which we did not incur in 2002 and which wereonly

 

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partially offsetby increased costs in 2002 associated with operating as a separate, publiclyowned company and the legal and other costs incurred in connection with ourlitigation with Marriott and MSLS.

 

Depreciation expense in 2002 was $1.8 million, anincrease of 38% over depreciation expense of $1.3 million in 2001.  The increase is attributable to our purchaseof 11 communities in 2002.

 

Loss from discontinued operations for 2002 was $2.9million, an increase of $2.0 million over the loss in 2001.  This increase was the result of reservesrecorded for Medicaid receivables due from the State of Connecticut related tocommunity closure costs and an asset impairment charge related to a closedcommunity.

 

As a result of the factors described above, our netloss for 2002 was $13.2 million, compared to a profit of $527,000 in 2001.  Our net loss per share in 2002 was$1.74.  Assuming the shares outstandingas of December 31, 2001 were outstanding for all of 2001, our earnings per sharewould have been $0.12 for 2001.

 

**LIQUIDITY AND CAPITALRESOURCES**

** **

Our total current assets at December 31, 2003, were$59.7 million compared to $48.3 million at December 31, 2002.  At December 31, 2003, we had cash andequivalents of $21.2 million.

 

Our total current liabilities were $58.1 million atDecember 31, 2003 compared to $34.4 million at December 31, 2002.  This increase was due to severalfactors.  At December 31, 2003, we had$4.0 million outstanding under our revolving credit facility and there were nosuch outstanding amounts at December 31, 2002. In March 2004, we prepaid the amounts outstanding under our revolvingcredit facility.  At December 31, 2003,we owed Senior Housing $6.6 million primarily related to our lease obligationsand there were no such outstanding amounts at December 31, 2002.  This amount was paid in January 2004.  In addition, our accounts payable andaccrued expenses and our accrued compensation and benefits increased primarilydue to a change in the timing of certain current liabilities at the SLS managedcommunities as well as increases in our insurance reserves.  Finally, the increase in amounts due to SLSwas primarily due to SLS’s not transferring cash amounts due to them on atimely basis.

 

As described in Note 1 to our financial statements, in2003, information became available to us which resulted in $7.2 million ofadditional paid in capital.  This amountwas the result of our having received more working capital assets and havingassumed fewer liabilities than we had previously recorded.

 

Currently, we lease 98communities from Senior Housing under two leases.  Our leases with Senior Housing require us to pay a total of  $82.0 million of minimum rent annually.  Percentage rent on the leases begins in2006.  At March 24, 2004, we believe weare in compliance with the terms of these leases.

 

Our primary source of cash to fund operating expenses,including rent, principal and interest payments on our mortgage debt androutine capital expenditures, is our revenues from services to residents at ourcommunities. At some of our communities, operating revenues for nursing homeservices are received from the Medicare and Medicaid programs. In 2003, 39% ofour total revenues were derived from these programs.  Medicare and Medicaid revenues in 2003 were earned primarily bythe 51 nursing home communities we lease from Senior Housing.  Since 1998, a Medicare prospective paymentsystem has generally lowered Medicare rates paid to senior living communitiesincluding many of those that we operate. In October 2002, temporary increases in Medicare payment ratesexpired.  In October 2003, Medicarerates increased by approximately 6%. Our Medicare revenues totaled $86.1 million and $68.4 million during2003 and 2002, respectively.  OurMedicaid revenues totaled $148.6 million and $142.6 million during 2003 and2002, respectively.  Some of the statesin which we operate have not raised rates or are expected to reduce Medicaidfunding.  The magnitude of the potentialcombined Medicare and Medicaid rate reductions cannot currently be estimated,but it may be material and may affect our future results of operations.  Further Medicare and Medicaid rates declinesmay have a dramatic negative impact on our revenues and may produce greaterlosses.

 

We expect recent increases in the costs of insurance,especially tort liability insurance, workers compensation and employee healthinsurance, which are affecting the senior living industry, will continue tohave a material adverse impact upon our future results of operations.  As discussed in Note 15 to our financialstatements, a failure by Integrated Health Services, Inc., the United StatesDepartment of Health and Human Services or the State of Connecticut to makepayments that we believe are due to us would have a material adverse impactupon our future results.  Also, webelieve Marriott’s sale of MSLS to Sunrise has had, and may continue to have,an adverse impact on our financial results and increase our working capitalrequirements.

 

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Our revolving credit facility limits our ability toincur debt as more fully described below. The terms of our leases with SeniorHousing contain provisions whereby our rights under these agreements may becancelled by Senior Housing upon the acquisition by any person or group of morethan 9.8% of our voting stock, and upon other change of control events.  These leases also limit our ability tocreate, incur, assume or guarantee indebtedness.

 

In August2003, we sold a community in Seabury, Connecticut for $3.5 million, $3.15million of which was in the form of a promissory note from the purchaser.  This note is payable in monthly installmentsof $8,750 of principal, plus interest which accrues on the unpaid principalbalance at a rate of 8%.  This notematures on August 31, 2009, but we have the right to require prepayment as ofAugust 31, 2008.

 

In December2003, we sold a set of group homes in Maryland for $3.55 million, $3.11 millionof which was in the form of a promissory note from the purchaser.  This note is payable in monthly installmentsof $1,700 of principal, plus interest which accrues on the unpaid principalbalance at a rate of 9%.  This notematures November 30, 2018, but we have the right to require prepayment earlierby giving notice after November 30, 2009.

 

As described in Note 12 to our financial statements,we have an agreement to purchase two properties from Senior Housing.  We have also sold one property to SeniorHousing.  We expect to finance thistransaction with proceeds we receive from new United States Department ofHousing and Urban Development, or HUD, insured mortgages, sales proceeds and byborrowings under our revolving credit facility.

 

Despite the commitments, contingencies and limitationsdescribed above, we believe that a combination of our efforts to increaserevenues and contain costs, our ability to borrow on our revolving creditfacility, our ability to sell to Senior Housing certain capital improvementsmade to communities leased from Senior Housing and the possibility of sales orfinancings of our owned communities will be sufficient to meet our workingcapital needs, operating expenses, rent payments to Senior Housing, debtservice and capital expenditures for the next 12 months and the foreseeablefuture.

 

As of December 31, 2003,our contractual obligations were as follows (dollars in thousands):

 
|                                                                       |   | **Payment  due by period** |      |
|----------------------------------------------------------------------------|--------|----------------------------|-----------|
| **Contractual Obligations**                                                |   | **Total**                  |      | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
|                                                                       |   |                       |      |   |   |   |   |   |   |   |   |
| Long-Term Debt Obligations (1)                                             |   | $                          | 6,381     |   | $ | 6,381 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating Lease Obligations (2)                                            |   | 1,184,083                  |      | 81,964 |   | 163,928 |   | 163,928 |   | 774,263 |   |
| Purchase Obligations (3)                                                   |   | 10,500                     |      | 10,500 |   | — |   | — |   | — |   |
| Other Long-Term Liabilities Reflected on  our Balance Sheet under GAAP (4) |   | 18,417                     |      | 4,124 |   | 6,460 |   | 5,179 |   | 2,654 |   |
| Total                                                                      |   | $                          | 1,219,381 |   | $ | 102,969 |   | $ | 170,388 |   | $ | 169,107 |   | $ | 776,917 |   |

 

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(1)                                                    Thisamount represents amounts due under a HUD insured mortgage.  This amount was paid in March 2004.

(2)                                                    Theseamounts represent minimum lease payments due to Senior Housing under two leasesthrough 2020.

(3)                                                    Thisamount represents two properties we agreed to purchase from SeniorHousing.  We expect to finance thistransaction with proceeds we receive from new HUD insured mortgages and byborrowings under our revolving credit facility.

(4)                                                    Theseamounts include liabilities for continuing care contracts which requireresidents to make advance payments some of which are refundable andcontinuously carried as liabilities and some of which or not refundable and arecarried as liabilities until they are recognized as revenues over the periodsduring which we expect to provide the service. These amounts also include insurance reserves related to workers compensationand professional liability insurance as well as deferred gains related toproperty and fixed asset sales.

 

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**Debt Instruments andCovenants**

** **

In October 2002, we entered into a revolving creditfacility.  The interest rate onborrowings on this facility is LIBOR plus a spread.  The maximum amount available under this facility is $12.5million, and is subject to limitations based upon qualifying collateral. Theborrower under this facility is a subsidiary that we organized with theintention that it be “bankruptcy-remote”. Certain of our other subsidiaries sell or contribute their accountsreceivable to the borrower on a true sale basis and make certain representationsand other undertakings in favor of the borrower in connection with eachsale.  The seller subsidiaries havegranted security interests in their assets to secure their obligations to theborrower.  We guarantee the obligationsof the seller subsidiaries obligations to the borrower subsidiary and havepledged the stock or membership interests in each of the seller subsidiaries tothe borrower. The borrower has in turn collaterally assigned theseundertakings, guarantees and collateral to the revolving credit facilitylenders, and has granted a security interest in the purchased receivables andall of its other assets to secure its obligations under the facility. Thefacility is available for acquisitions, working capital and general businesspurposes.  The facility containscovenants and events of default requiring the maintenance of collateral,minimum net worth and certain other financial ratios, and places limits on ourability to incur or assume debt or create liens with respect to certain of ourproperties, and other customary provisions. The accounts receivable collateralizing the facility totaled $19.1million, net of allowances of $1.0 million, as of December 31, 2003.  In certain circumstances and subject toavailable collateral and lender approvals the maximum amounts which we may drawunder this credit agreement may be increased to $25.0 million. The terminationdate of the facility is October 24, 2005. As of December 31, 2003, $4.0 millionwas outstanding under the facility.  AtMarch 24, 2004, we believe we are in compliance with all applicable covenantsunder this revolving credit agreement and no amounts were outstanding under thefacility.

 

In connection with our October 2002 acquisition of acommunity, we assumed two HUD insured mortgages totaling approximately $15.7million.  In December 2003, we prepaidone  $9.3 million mortgage. In March2004, the second $6.4 million mortgage was prepaid.

 

**Related PartyTransactions**

** **

On December 31, 2001, Senior Housing distributed substantially allof its ownership of our shares to its shareholders of record onDecember 17, 2001. In order to effect this spin off and to governrelations after the spin off, we entered into agreements with Senior Housing,pursuant to which it was agreed that:

 

•                                          solong as Senior Housing remains a REIT, we may not waive the share ownershiprestrictions in our charter on the ability of any person or group to acquiremore than 9.8% of any class of our equity shares without, among otherrequirements, the consent of Senior Housing and our determination that the exceptionto the ownership limitations would not cause a default under any of our leases;

 

•                                          solong as we are a tenant of Senior Housing, we will neither permit any person orgroup to acquire more than 9.8% of any class of our voting stock or permit theoccurrence of other change in control events, as defined, nor will we take anyaction that, in the reasonable judgment of Senior Housing or HRPT PropertiesTrust, or HRPT, might jeopardize the tax status of Senior Housing or HRPT as aREIT;

 

•                                          SeniorHousing has the option, upon the acquisition by a person or group of more than9.8% of our voting stock and upon other change in control events, as defined,to cancel all of our rights under the leases we have with Senior Housing; and

 

•                                          solong as we maintain our shared services agreement with RMR or are a tenantunder a lease with Senior Housing then we will not acquire or finance any realestate without first giving Senior Housing, HRPT, Hospitality Properties Trust,or HPT, or any other publicly owned REIT or other entity managed by RMR theopportunity to acquire or finance real estate investments of the type in whichSenior Housing, HRPT, HPT or any other publicly owned REIT or other entitymanaged by RMR, respectively, invest.

 

At the time of our spin off from Senior Housing, all of the personsserving as our directors were trustees of Senior Housing. Two of our currentdirectors, Messrs. Martin and Portnoy, are current trustees of SeniorHousing.

 

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As of March 24, 2004, we lease 98 senior living communities from SeniorHousing for total annual minimum rent of $82.0 million.

 

During 2003, we and Senior Housing were jointly involved in litigationwith Marriott and MSLS, the operator of 31 of the senior living communitieswhich we leased from Senior Housing. We and Senior Housing equally shared thecosts of this litigation.  Thislitigation was settled in January 2004.

 

Since January 1, 2003, we have entered or agreed to enter into severaltransactions with Senior Housing, including the following:

 

•                                          During2003, pursuant to the terms of our leases with Senior Housing, Senior Housingpurchased $11.4 million of improvements to its properties leased by us, and theannual rent payable to Senior Housing was increased by 10% of the amountsinvested, or $1.1 million.

 

•                                          InMarch 2003, one of Senior Housing’s private company tenants defaulted on itslease for a nursing home in Missouri. Senior Housing terminated this lease and engaged us to manage thisproperty for Senior Housing’s account. Currently this property is listed for sale or lease.  We are paid a management fee of 5% of thegross revenues at this nursing home, totaling $135,000 through December 31,2003.

 

•                                          InMay 2003, Senior Housing purchased from an unrelated third party three assistedliving properties with 143 living units located in Virginia for $6.5million.  In September 2003, we sold Senior Housing one independent livingproperty with 164 units in California for $12.3 million, its appraised value. Thesefour properties were added to an existing lease with Senior Housing for nineother independent and assisted living properties.  The minimum rent forthe properties included in this lease was increased by $1.9 million peryear.  All other terms of the lease remained unchanged.

 

•                                          InJuly 2003, we agreed to buy two nursing homes in Michigan that we leased fromSenior Housing.  The purchase price is$10.5 million, the appraised value of the properties. These two properties areleased on a combined basis with other nursing home properties. Under the termsof our lease with Senior Housing, upon consummation of the sale, the annualrent payable under the combined lease will be reduced by 10% of the netproceeds that Senior Housing received from the sale.  We expect this purchase to occur during the first half of 2004.However, this sale is contingent upon our obtaining Department of Housing andUrban Development insured financing for this purchase, and this sale may notclose because of a failure of this condition or for some other reason.

 

•                                          OnMarch 1, 2004, Senior Housing purchased from us one independent and assistedliving community with 229 units located in Maryland.  The purchase price was $24.1 million, the appraised value of theproperty.  Simultaneous with thispurchase, our existing leases with Senior Housing were modified as follows:

 

•   the lease for 53 nursinghomes and the lease for 13 independent and assisted living communities werecombined into one lease and the property acquired on March 1, 2004 was added tothis combined lease;

 

• the combined lease maturity date was changed to December 31, 2020 fromDecember 31, 2018 and 2019 for the separate leases;

 

• our minimum rent for the combined lease of 53 nursing homes and 14independent living communities was increased by $2.4 million per year;

 

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• for all of our leases with Senior Housing, the amount of additional rentto be paid to Senior Housing was changed to 4% of the increase in revenues atthe leased properties beginning in 2006. Prior to the lease combination,the percentage and the beginning time period for the nursing home lease and theindependent and assisted living community lease was 3% and 2004 and 4% and2005, respectively; and

 

• all other lease terms remain substantially unchanged.

 

We obtained aworkers compensation insurance policy for the year beginning June 15,2003, from a third-party insurer.  This third-party insurer ceded aportion of the premiums we paid to a Bermuda based company, AffiliatesInsurers, Limited, or Affiliates, which was owned by RMR.  Affiliates wasorganized by RMR to assist us in creating a partial self insurance program onan expedited basis. On December 8, 2003, we acquired Affiliates from RMR for anamount equal to RMR’s cost of organizing and capitalizing that company,approximately $1.3 million.

 

Our Chief Executive Officer and Chief Financial Officer are alsoofficers and employees of RMR. These officers devote a substantial majority oftheir business time to our affairs and the remainder to RMR’s business which isseparate from our business. We believe the compensation we pay to theseofficers reasonably reflects their division of business time; however,periodically, these individuals may divide their business time differently thanthey do currently and their compensation from us may become disproportionate tothis division.

 

RMR providesinvestment, management and administrative services to us under a sharedservices agreement which is subject to renewal annually.  RMR is compensated at an annual rate equalto 0.6% of our total revenues. Aggregate fees earned by RMR for services during 2003 were$3.4 million.  The fact that RMRhas responsibilities to other entities, including our landlord, Senior Housing,could create conflicts; and in the event of such conflicts between SeniorHousing and us, the shared services agreement allows RMR to act on behalf ofSenior Housing rather than on our behalf. RMR is owned by Messrs. Martinand Portnoy who are our managing directors. Messrs. Martin and Portnoyeach have material interests in the transactions between us and RMR describedabove.  All transactions between us andRMR are approved by our independent directors. Our independent directors have approved the renewal of the sharedservices agreement for its current term which will end December 31, 2004.

 

Messrs. Martin and Portnoy own the building in which ourheadquarters is located. Our lease for space was originally executed byFSQ, Inc. This lease expires in 2011. During 2003, we paid rent under thislease of $569,000.

 

Until March 31, 1997, Mr. Portnoy was a partner ofSullivan & Worcester LLP, our counsel and counsel to Senior Housing,RMR and affiliates of each of the foregoing, and he received payments from thatfirm during 2003 in respect of his retirement.

 

**Critical AccountingPolicies**

** **

Our critical accounting policies concern revenuerecognition, our assessment of the net realizable value of our accountsreceivable, the realizable value of long term assets, accounting for long termcare contracts, accounting for business combinations and our assessment ofreserves related to our self insurance programs.

 

Our revenue recognition policies involve judgmentsabout Medicare and Medicaid rate calculation methodologies.  These judgments are based principally uponour experience with these programs and our knowledge and familiarity with thecurrent rules and regulations of these programs.  We recognize revenues when services are provided and theseamounts are reported at their estimated net realizable amounts.  Some Medicare and Medicaid revenues aresubject to audit and retroactive adjustment.

 

Our policies for valuing accounts receivable involvesignificant judgments based upon our experience, including consideration of theage of the receivable, the terms of the agreements with our residents or theirthird party payors, the resident or payors stated intent to pay, the residentor payors financial capacity and other factors which may include litigation orappeal proceedings.

 

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We monitor our long-term assets to determine whetherany impairment of these assets may have occurred.  If the facts and circumstances indicate that an impairment mayhave occurred, we evaluate the asset’s carrying value to determine whether animpairment charge is required.  Thisprocess includes a review of historical and projected future financial resultsrealized or to be realized from the affected assets, market conditionsaffecting the sale of similar assets and the like.  This process requires that estimates be made and errors in ourjudgments or estimates could have a material effect on our financialstatements.

 

At certain of our facilities, we offer long-term carecontracts under which residents pay a one-time deposit in exchange for reducedcharges during their stay.  The one-timedeposits may be refundable or non-refundable, or partially refundable andpartially non-refundable.  We recordsuch deposits as a long-term obligation and amortize the non-refundable portionof such deposits into revenue over our estimate of the periods during whichfuture services will be provided.  Webase these estimates on our experience and actuarial information.

 

During 2003 and 2002, we began to lease or acquire 54senior living communities and as of March 24 2004, we lease or own a total of101 communities.  We accounted for eachof these transactions as a purchase business combination in accordance withStatement of Financial Accounting Standards No. 141.  Purchase accounting requires that we make certain judgments andestimates based on our experience, including determining the fair value anduseful lives of assets acquired and the fair value of liabilities assumed.  Some of our judgments and estimates are alsobased upon published industry statistics.

 

Our critical accounting policies for determiningreserves for the self funded part of our insurance programs and for our selfinsurance programs involve significant judgments based upon our experience,including projected settlements for pending claims, known incidents which weexpect may result in claims, estimates of incurred but not yet reported claimsand incidents, claims experience, estimated litigation costs and other factors.  We also periodically receive and rely uponrecommendations from professional consultants in establishing these reserves.

 

In the future we may need to revise the judgments,estimates and assessments we use to formulate our critical accounting policiesto incorporate information which is not now known.  We cannot predict the effect changes to these premises underlyingour critical accounting policies may have on our future results of operations,although such changes could be material and adverse.

 

**Inflation and Deflation**

** **

Inflation in the past several years in the U.S. hasbeen modest. Future inflation might have both positive or negative impacts onour business. Rising price levels may allow us to increase occupancy charges toresidents, but may also cause our operating costs, including our percentagerent, to increase.  Also our ability toincrease rates paid by Medicare and Medicaid will be limited despite inflation.

 

Deflation would likelyhave a negative impact upon us. A large component of our expenses consist ofminimum rental obligations to Senior Housing. Accordingly we believe that ageneral decline in price levels which could cause our charges to residents todecline would likely not be fully offset by a decline in our expenses.

 

**Seasonality**

 

Our business is subject to modest effects ofseasonality. During the calendar fourth quarter holiday periods nursing homeand assisted living residents are sometimes discharged to join familycelebrations and admission decisions are often deferred. The first quarter ofeach calendar year usually coincides with increased illness among nursing homeand assisted living residents which can result in increased costs or dischargesto hospitals. As a result of these factors, nursing home and assisted livingoperations sometimes produce greater earnings in the second and third quartersof a calendar year and lesser earnings in the first and fourth quarters. We donot believe that this seasonality will cause fluctuations in our revenues oroperating cash flow to such an extent that we will have difficulty paying ourexpenses, including rent, which do not fluctuate seasonally.

 

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**Item 7A**.  Quantitative and Qualitative DisclosuresAbout Market Risk

** **

We are exposed to risks associated with market changesin interest rates.  We manage ourexposure to this market risk through our monitoring of available financingalternatives.  Our strategy to manageexposure to changes in interest rates is unchanged since December 31,2002.  Other than as described below wedo not now anticipate any significant changes in our exposure to fluctuationsin interest rates or in how we manage this risk in the future.

 

Changes in market interest rates also affect the fairvalue of our debt obligations; increases in market interest rates decrease thefair value of our fixed rate debt, while decreases in market interest ratesincrease the fair value of our fixed rate debt.   For example: based upon discounted cash flow analysis, if prevailinginterest rates were to decline by 10% and other credit market considerationsremained unchanged, the market value of our $6.4 million mortgage debtoutstanding on December 31, 2003, would increase by about $596,000; and,similarly, if prevailing interest rates were to increase by 10%, the marketvalue of our $6.4 million mortgage debt would decline by about $510,000.

 

Our revolving creditfacility bears interest at floating rates and matures in October 2005.  As of December 31, 2003, we had $4.0 millionoutstanding under this revolving credit facility.  We borrow in U.S. dollars and borrowings under our revolvingcredit facility are subject to interest at LIBOR plus a spread.  Accordingly, we are vulnerable to changes inU.S. dollar based short term rates, specifically LIBOR.  A change in interest rates would not affectthe value of any outstanding floating rate debt but would affect our operatingresults.  For example, if the maximumamount of our credit facility of $12.5 million were drawn and interest ratesdecrease or increase by 1% per annum, our interest expense would decrease orincrease by $125,000 per year, or $0.02 per share, respectively.  If interest rates were to change graduallyover time, the impact would be spread over time.

 

Our exposure tofluctuations in interest rates may increase in the future if we incur debt tofund acquisitions or otherwise.

 

As of March 24, 2004, wehave no commercial paper, derivatives, swaps, hedges, joint ventures orpartnerships.

 

**Item 8**. Financial Statements andSupplementary Data

** **

The information requiredby this Item is included in Item 15 of this Annual Report on Form 10-K.

 

**Item 9**. Changes in andDisagreements with Accountants on Accounting and Financial Disclosure

** **

We have had no changes inor disagreements with our accountants on accounting and financial disclosure.

 

**Item 9A**.  Controls and Procedures

** **

As of the end of theperiod covered by this report, our management carried out an evaluation, underthe supervision and with the participation of our President and Chief ExecutiveOfficer and our Treasurer and Chief Financial Officer, of the effectiveness ofour disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 ofthe Securities Exchange Act of 1934. Based upon that evaluation, our President and Chief Executive Officerand our Treasurer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective.

 

There have been nosignificant changes in our internal controls over financial reporting duringthe quarter ended December 31, 2003 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting, including any corrective actions with regard to significantdeficiencies and material weaknesses.  

 

32

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**PART III**

 

**Item10****.  Directorsand Executive Officers of the Registrant**

 

**Code of Ethics**

 

In March 2004, we adopteda Code of Business Conduct and Ethics that applies to all our representatives,including our officers, directors and employees, and to the employees of RMRwith respect to matters relating to us. Our Code of Business Conduct and Ethics is posted on our website,www.5sqc.com, under the heading “Governance”. A printed copy of our Code of Business Conduct and Ethics is alsoavailable free of charge to any shareholder who requests a copy.

 

The remainder ofinformation required by Item 10 is incorporated by reference to our definitiveProxy Statement, which will be filed not later than 120 days after the end ofour fiscal year.

 

**Item11****.  ExecutiveCompensation**

 

The information requiredby Item 11 is incorporated by reference to our definitive Proxy Statement,which will be filed not later than 120 days after the end of our fiscal year.

 

**Item12****.  SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters**

 

Equity Compensation PlanInformation.  We maygrant options and common shares to our officers, directors, employees and otherindividuals who render services to us, subject to vesting requirements underour 2001 Stock Option and Stock Incentive Plan.  In addition, our directors receive 1,000 shares per year each aspart of their annual compensation for serving as our directors and such sharesmay be awarded under these plans.  Theterms of grants made under these plans are determined by our compensationcommittee at the time of the grant.  Thefollowing table provides a summary as of December 31, 2003, of our 2001 StockOption and Stock Incentive Plan.

 
|                                                        |   | **Number of  securities  to be issued upon  exercise of  outstanding options,  warrants and rights** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights** |   | **Number of  securities  remaining available for future  issuance under equity  compensation plans (excluding  securities reflected in the first  column)** |   |
|-------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                        |   |                                                                                                 |   |                                                                               |   |                                                                                                                                                        |   |
| Equity compensation plans approved by  security holders     |   | None                                                                                                 |   | None                                                                               |   | 583,000                                                                                                                                                     | (1)    |
| Equity compensation plans not approved by  security holders |   | None                                                                                                 |   | None                                                                               |   | None                                                                                                                                                        |   |
| Total                                                       |   | None                                                                                                 |   | None                                                                               |   | 583,000                                                                                                                                                     |   |

 

----

(1) Pursuant tothe terms of our 2001 Stock Option and Stock Incentive Plan, in no event shallthe number of shares issued exceed 650,000.

 

The remainder of theinformation required by Item 12 is incorporated by reference to our definitiveProxy Statement, which will be filed not later than 120 days after the end ofour fiscal year.

 

**Item13****.  CertainRelationships and Related Transactions**

 

The information requiredby Item 13 is incorporated by reference to our definitive Proxy Statement,which will be filed not later than 120 days after the end of our fiscal year.

 

33

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**Item 14****.  PrincipalAccountant Fees and Schedules**

 

The informationrequired by Item 14 is incorporated by reference to our definitive ProxyStatement, which will be filed not later than 120 days after the end of ourfiscal year.

 

**Item 15****.  Exhibits, Financial Statement Schedules andReports on Form 8-K.**

 

(a)  Index toFinancial Statements and Financial Statement Schedules

 
| **Consolidated  Financial Statements of Five Star Quality Care, Inc.**                                         |   |
|----------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                           |   |
| Report of Independent Auditors                                                                                 |   |
|                                                                                                           |   |
| Consolidated Balance Sheet at December 31, 2003 and 2002                                                  |   |
|                                                                                                           |   |
| Consolidated Statement of Operations for  the years ended December 31, 2003, 2002 and 2001                |   |
|                                                                                                           |   |
| Consolidated Statement of Shareholders’  Equity for the years ended December 31, 2003, 2002 and 2001 |   |
|                                                                                                           |   |
| Consolidated Statement of Cash Flows for  the year ended December 31, 2003, 2002 and 2001                 |   |
|                                                                                                           |   |
| Notes to Consolidated Financial Statements                                                                     |   |

 

All financial statement schedules are not requiredunder the related instructions or are inapplicable and have therefore beenomitted.

 

(b)  Reports onForm 8-K

 

During the fourth quarter of 2003, we furnished aCurrent Report on Form 8-K dated November 13, 2003, furnishing our pressrelease containing our results of operations and financial condition for thequarter ended September 30, 2003 (Items 7 and 12).

 

(b)         Exhibits

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|-----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1             |   | Transaction Agreement, dated December 7, 2001, by and among  Senior Housing Properties Trust, certain subsidiaries of Senior Housing  Properties Trust party thereto, the Registrant, certain subsidiaries of the  Registrant party thereto, FSQ, Inc., Hospitality Properties Trust, HRPT  Properties Trust and Reit Management & Research LLC. (*Incorporated by reference to Senior Housing  Properties Trust’s Current Report on Form 8-K dated December 13,  2001.*)                                                                                                                                                                                               |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 2.2             |   | Sale-Purchase Agreement by and among ILM II Senior  Living, Inc. and ILM II Holding, Inc. and the Registrant,  dated January 23, 2002, as amended by First Amendment to Sale-Purchase  Agreement by and among ILM II Senior Living, Inc., ILM II  Holding, Inc. and Five Star Quality Care, Inc., dated  February 22, 2002 and Second Amendment to Sale-Purchase Agreement among  ILM II Senior Living, Inc., ILM II Holding, Inc., and  Five Star Quality Care, Inc., dated March 1, 2002.  (*Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-83648*.) |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 2.3             |   | Purchase and  Sale Agreement, dated as of August 26, 2002, by and among Constellation  Health Services, Inc. and certain of its subsidiaries, as Seller, and  Constellation Real Estate Group, Inc., as Guarantor, and Senior Housing  Properties Trust, as Buyer, as amended by First Amendment to Purchase and  Sale Agreement, dated as of October 25, 2002, by and among Constellation  Health Services, Inc. and certain of its subsidiaries, as Seller, and Senior  Housing Properties Trust and the Registrant, collectively as Buyer.  (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated October 25,  2002*.)                                                   |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 3.1             |   | Articles of Amendment and Restatement of the Registrant.  (*Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-69846, as amended on December 5, 2001*.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

34

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| 3.2         |   | Composite copy of Amended and Restated Bylaws of the Registrant.  (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10, 2004*.)                                                                                                                                                                                                                                                                               |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 3.3         |   | Articles Supplementary.  *(Incorporated by reference to the Company’s Form 8A  dated March 19, 2004.)*                                                                                                                                                                                                                                                                                                                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.1         |   | Specimen Certificate for shares of common stock of the  Registrant.  (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-69846, as amended  on November 8, 2001*.)                                                                                                                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.2         |   | Description of Capital Stock of the Registrant. *(Contained in Exhibits 3.1 and 3.2.)*                                                                                                                                                                                                                                                                                                                                                                     |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.3         |   | Rights Agreement, dated as of March 10, 2004, by and between the  Company and Equiserve Trust Company, N.A. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10,  2004.)*                                                                                                                                                                                                                                         |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.1        |   | Deed of Trust Note, dated May 22, 1986, by and between the Company  (successor in interest to The Heartlands Retirement Community - Ellicott City  I, Inc., successor in interest to Health Park Housing Limited Partnership)  and The Bank of New York (successor in interest to Mercantile-Safe Deposit  and Trust Company).  (*Incorporated by reference to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2002*.) |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.2        |   | Second Deed of Trust Note, dated July 31, 1997, by and between the  Company (successor in interest to The Heartlands Retirement Community – Ellicott  City I, Inc.) and Mercantile Mortgage Corporation.  (*Incorporated by reference  to the Company’s Annual Report on Form 10-K for the year ended December 31,  2002*.)                                                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.3        |   | Stock Purchase Agreement, dated August 9, 2001, by and among Senior  Housing Properties Trust, SNH/CSL Properties Trust, Crestline Capital  Corporation and CSL Group, Inc.  (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-69846*.)                                                                                                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.4        |   | Amendment to Stock Purchase Agreement, dated November 5, 2001, by and  among Senior Housing Properties Trust, SNH/CSL Properties Trust, Crestline  Capital Corporation and CSL Group, Inc.   (*Incorporated by reference to  Senior Housing Properties Trust’s Current Report on Form 8-K dated November  5, 2001*.)                                                                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.5†  |   | 2001 Stock Option and Stock Incentive Plan of the Registrant.  (*Incorporated  by reference to the Company’s Registration Statement on Form S-1, File No.  333-69846, as amended on December 5, 2001.*)                                                                                                                                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.6†# |   | Form of Restricted Share Agreement.   *(Incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003.)*                                                                                                                                                                                                                                                                                         |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.7#       |   | Representative Form of Composite Copy of Operating Agreement, as  amended through December 13, 2001 by and among subsidiaries of the Registrant  and Marriott Senior Living Services, Inc.  (*Incorporated by reference  to the Company’s Registration Statement on Form S-1, File No. 333-83648, as  amended on December 5, 2001*.)                                                                                                   |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.8#       |   | Representative Form of Pooling Agreement by and  among certain subsidiaries of the Registrant and Marriott Senior Living  Services, Inc.  (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-69846, as amended on  December 5, 2001*.)                                                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.9        |   | Master Lease Agreement, dated December 31, 2001, by and among  certain affiliates of Senior Housing Properties Trust, as Landlord, and Five  Star Quality Care Trust, as Tenant.  (*Incorporated by reference to Senior Housing  Properties Trust’s Current Report on Form 8-K dated December 31, 2001*.)                                                                                                                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.10       |   | Amended Master Lease Agreement, dated January 11, 2002, by and  among certain affiliates of Senior Housing Properties Trust, as Landlord, and  FS Tenant Holding Company Trust and FS Tenant Pool III Trust, as Tenant.  (*Incorporated  by reference to Senior Housing Properties Trust’s Current Report on  Form 8-K dated December 31, 2001*.)                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.11       |   | First Amendment to Amended Master Lease Agreement, dated October 1,  2002, by and among certain affiliates of Senior Housing Properties Trust, as  Landlord, and FS Tenant Holding Company Trust and FS Tenant Pool III Trust,  as Tenant. (*Incorporated by reference to  the Company’s Annual Report on*                                                                                                                                            |

 

35

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|   |   | *Form 10-K for the year ended December 31,  2002*.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.12  |   | Second Amendment to Amended Master Lease Agreement, dated March 1,  2004, by and among certain affiliates of Senior Housing Properties Trust, as  Landlord, and FS Tenant Holding Company Trust and FS Tenant Pool III Trust,  collectively as Tenant.  *(Filed herewith.)*                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.13  |   | Amended and Restated Lease Agreement, dated March 1, 2004, by and  among certain affiliates of Senior Housing Properties Trust, as Landlord, and  Five Star Quality Care Trust, as Tenant.   (*Incorporated by reference to the  Company’s Current Report on Form 8-K dated March 1, 2004*.)                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.14  |   | Guaranty  Agreement, dated December 31, 2001, made by the Registrant, as  Guarantor, for the benefit of the Landlord under the Master Lease Agreement,  dated December 31, 2001, by and among certain affiliates of Senior  Housing Properties Trust, as Landlord, and Five Star Quality Care Trust, as  Tenant.  (*Incorporated by reference to Senior Housing Properties Trust’s  Current Report on Form 8-K dated December 31, 2001*.)                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.15  |   | Pledge of Shares of Beneficial Interest Agreement, dated  December 31, 2001, made by the Registrant for the benefit of the  Landlord under the Master Lease Agreement, dated December 31, 2001, by  and among certain affiliates of Senior Housing Properties Trust, as Landlord,  and Five Star Quality Care Trust, as Tenant.   (*Incorporated by reference to the  Company’s Registration Statement on Form S-1, File No. 333-83648, as amended  on December 5, 2001*.)                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.16  |   | Security Agreement, dated December 31, 2001, by and among Five  Star Quality Care Trust and the Landlord under the Master Lease Agreement by  and among certain affiliates of Senior Housing Properties Trust, as Landlord,  and Five Star Quality Care Trust, as Tenant, dated December 31,  2001.  (*Incorporated by reference to the Company’s Registration Statement on  Form S-1, File No. 333-83648, as amended on December 5, 2001*.)                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.17  |   | Shared Services Agreement, dated January 2, 2002, by and between  the Registrant and Reit Management & Research LLC.  (*Incorporated  by reference to the Company’s Registration Statement on Form S-1, File No.  333-83648, as amended on December 5, 2001*.)                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.18  |   | Amendment No. 1 to Shared Services Agreement, dated  January 14, 2002, by and between the Registrant and Reit  Management & Research LLC.   (*Incorporated by reference to the  Company’s Registration Statement on Form S-1, File No. 333-83648*.)                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.19  |   | Amendment No. 2 to Shared Services Agreement, dated as of March 10,  2004, by and between the Company and Reit Management & Research LLC.  *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10,  2004.)*                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.20  |   | Guaranty Agreement, dated January 11, 2002, made by the  Registrant, as Guarantor, for the benefit of the Landlord under the Amended  Master Lease Agreement, dated January 11, 2002, by and among certain  affiliates of Senior Housing Properties Trust, as Landlord, and FS Tenant  Holding Company Trust and FS Tenant Pool III Trust, as Tenant.  (*Incorporated  by reference to Senior Housing Properties Trust’s Current Report on Form 8-K  dated December 31, 2001*.)                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.21  |   | Pledge of Shares of Beneficial Interest Agreement, dated  January 11, 2002, made by FSQ, Inc. for the benefit of the Landlord  under the Amended Master Lease Agreement, dated January 11, 2002, by and  among certain affiliates of Senior Housing Properties Trust, as Landlord, and  FS Tenant Holding Company Trust and FS Tenant Pool III Trust, as  Tenant.  (*Incorporated by reference to the Company’s Registration Statement on  Form S-1, File No. 333-83648, as amended on December 5, 2001*.) |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.22  |   | Security Agreement, dated January 11, 2002, by and among FS  Tenant Holding Company Trust and the Landlord under the Amended Master Lease  Agreement, dated January 11, 2002, by and among certain affiliates of  Senior Housing Properties Trust, as Landlord, and FS Tenant Holding Company  Trust and FS Tenant Pool III Trust, as Tenant. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-83648, as amended on  December 5, 2001*.)                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.23  |   | Receivables Purchase and Transfer Agreement, dated  as of October 24, 2002, by and among the Registrant, as Primary Servicer, the  Providers named therein, and FSQC Funding Co., LLC, as Purchaser.  (*Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the*                                                                                                                                                                                                                                |

 

36

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|   |   | *quarter  ended September 30, 2002*.)                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.24  |   | Loan and Security Agreement, dated as of October 24,  2002, by and among FSQC Funding Co., LLC, as Borrower, the Lenders party  thereto, Dresdner Kleinwort Wasserstein LLC, as Co-Program Manager,  Syndication Agent and Lead Arranger, Healthcare Finance Group, Inc., as  Co-Program Manager, and HFG Healthco-4 LLC, as Collateral Agent.  (*Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2002*.) |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.25  |   | Guaranty  Agreement, dated as of October 24, 2002, made by the Registrant, Five Star  Quality Care Trust and Five Star Quality Care Holding Co., Inc. in favor of  FSQC Funding Co., LLC.  (*Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 30, 2002*.)                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.26  |   | Pledge Agreement, dated as of October 24, 2002, by and among Five  Star Quality Care Trust and Five Star Quality Care Holding Co., Inc., as  Grantors, and HFG Healthco-4 LLC, as Collateral Agent for the benefit of the  Lenders and as assignee of the Purchaser. (*Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2002*.)                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.27  |   | Assignment of Contracts as Collateral Security, dated as of October  24, 2002, between FSCQ Funding Co., LLC and HFG Healthco-4, LLC, as  Collateral Agent.  (*Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 30, 2002*.)                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.28  |   | Lease Agreement, dated October 25, 2002, by and between SNH CHS  Properties Trust, as Landlord, and FVE-CHS LLC, as Tenant.  (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated October 25,  2002*.)                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.29  |   | First Amendment to Lease Agreement, dated as of May 30, 2003, by and  between SNH CHS Properties Trust and FVE-CHS LLC.*(Incorporated by reference to the Company’s Quarterly Report on Form  10-Q for the quarter ended June 30, 2003.)*                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.30  |   | Second Amendment to Lease Agreement dated as of September 30, 2003,  by and between SNH CHS Properties Trust and FVE-CHS LLC.  *(Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended September 30, 2003.)*                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.31  |   | Guaranty Agreement, dated October 25, 2002, for the benefit of SNH  CHS Properties Trust and Senior Housing Properties Trust made by the  Registrant.  (*Incorporated by reference to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2002*.)                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.32  |   | Guaranty Agreement, dated October 25, 2002, made by Five Star Quality  Care-MD, LLC, Five Star Quality Care-NC, LLC and Five Star Quality Care-VA,  LLC for the benefit of SNH CHS Properties Trust.  (*Incorporated by reference  to the Company’s Report on Form 10-K for the year ended December 31, 2002*.)                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.33  |   | Pledge Agreement, dated October 25, 2002, made by FSQ, Inc. for the  benefit of SNH CHS Properties Trust. (*Incorporated  by reference to the Company’s Report on Form 10-K for the year ended December  31, 2002*.)                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.34  |   | Security Agreement, dated October 25, 2002, by and between FVE-CHS  LLC and SNH CHS Properties Trust.  (*Incorporated by reference to the Company’s Report  on Form 10-K for the year ended December 31, 2002*.)                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.35  |   | Security Agreement, dated October 25, 2002, by and among Five Star  Quality Care-MD, LLC, Five Star Quality Care-NC, LLC, Five Star Quality  Care-VA, LLC and SNH CHS Properties Trust. (*Incorporated  by reference to the Company’s Report on Form 10-K for the year ended December  31, 2002*.)                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.36  |   | Partial Termination of Lease and Sublease dated as of June 5, 2003,  by and among SPTIHS Properties Trust, Five Star Quality Care Trust and Five  Star Quality Care - GA, LLC.  *(Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 30, 2003.)*                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.37  |   | Purchase and Sale Agreement, dated March 1, 2004, by and among  Ellicott City Land I, LLC and Ellicott City Land II, LLC, collectively as  Sellers and SNH CHS Properties Trust, as Purchaser.  *(Incorporated by reference  to the Company’s Current Report on Form 8-K dated March 1, 2004.)*                                                                                                                                                                               |

 

37

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| 10.38# |   | Form of  Indemnification Agreement.  *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated March 10, 2004.)*                                        |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                   |
| 21.1   |   | Subsidiaries of the Registrant.   (*Filed herewith*.)                                                                                                                             |
|   |   |                                                                                                                                                                                   |
| 31.1   |   | Certification required by Rule 13a-14(a)/15d-14(a) of the Securities  Exchange Act of 1934, as amended.  *(Filed herewith.)*                                                      |
|   |   |                                                                                                                                                                                   |
| 31.2   |   | Certification required by Rule 13a-14(a)/15d-14(a) of the Securities  Exchange Act of 1934, as amended.  *(Filed herewith.)*                                                      |
|   |   |                                                                                                                                                                                   |
| 32.1   |   | Certification required by 18 U.S.C. Section 1350 (Section 906 of the  Sarbanes-Oxley Act of 2002).  *(Furnished herewith.)*                                                       |
|   |   |                                                                                                                                                                                   |
| 99.1   |   | Charter of the Nominating and Governance Committee, dated March 10,  2004.  *(Incorporated by reference to the Company’s Current Report on Form  8-K dated March 10, 2004.)* |
|   |   |                                                                                                                                                                                   |
| 99.2   |   | Charter of  the Compensation Committee, dated March 10, 2004.  *(Incorporated by reference  to the Company’s Current Report on Form 8-K dated March 10, 2004.)*              |
|   |   |                                                                                                                                                                                   |
| 99.3   |   | Charter of the Audit Committee, dated March 10, 2004.  *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10,  2004.)*                     |
|   |   |                                                                                                                                                                                   |
| 99.4   |   | Governance Guidelines, dated March 10, 2004.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated March 10, 2004.)*                                      |
|   |   |                                                                                                                                                                                   |
| 99.5   |   | Code of  Business Conduct and Ethics, dated March 10, 2004.  *(Incorporated by reference  to the Company’s Current Report on Form 8-K dated March 10, 2004.)*                |
|   |   |                                                                                                                                                                                   |
| 99.6   |   | Charter of  the Quality of Care Committee, dated March 10, 2004.  *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10,  2004.)*          |
|   |   |                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                   |
|        |
| † |   | Indicates a  management contract or a compensatory plan, contract or arrangement.                                                                                                      |
|   |   |                                                                                                                                                                                   |
| #      |   | Agreement  filed is illustrative of numerous other agreements to which the Registrant is  a party.                                                                                     |

 

38

----

**Report of Independent Auditors**

 

To the Directorsand Shareholders of Five Star Quality Care, Inc.

 

We have auditedthe accompanying consolidated balance sheet of Five Star Quality Care, Inc., asof December 31, 2003 and 2002, and the related consolidated statements ofoperations, shareholders’ equity and cash flows for the three years in theperiod ended December 31, 2003. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted ouraudits in accordance with auditing standards generally accepted in the UnitedStates. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion,the financial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Five Star Quality Care, Inc.at December 31, 2003 and 2002, and the consolidated results of its operationsand its cash flows for the three years in the period ended December 31, 2003,in conformity with accounting principles generally accepted in the UnitedStates.

 
|                  | /s/ Ernst & Young  LLP |
|-----------------------|----------------------------|
| Boston, Massachusetts |                       |
| March 5, 2004         |                       |

 

F-1

----

 

**FIVE STAR QUALITY CARE, INC.**

 

**CONSOLIDATED BALANCE SHEET**

 

*(dollars in thousands, except share data)*

 
|                                                                                                                                                             |   | **December  31,** |    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|---------|
|                                                                                                                                                             |   | **2003**          |    | **2002** |   |
| **ASSETS**                                                                                                                                                       |   |              |    |   |   |
| Current assets:                                                                                                                                                  |   |              |    |   |   |
| Cash and cash equivalents                                                                                                                                        |   | $                 | 21,236  |   | $ | 10,270 |   |
| Accounts receivable, net of allowance of  $4,305 and $3,902 at December 31, 2003 and 2002, respectively                                                          |   | 30,581            |    | 33,877 |   |
| Due from Senior Housing Properties Trust                                                                                                                         |   | 544               |    | 62 |   |
| Prepaid expenses                                                                                                                                                 |   | 4,305             |    | 1,626 |   |
| Other current assets                                                                                                                                             |   | 3,022             |    | 2,474 |   |
| Total current assets                                                                                                                                             |   | 59,688            |    | 48,309 |   |
|                                                                                                                                                             |   |              |    |   |   |
| Property and equipment, net                                                                                                                                      |   | 55,484            |    | 70,329 |   |
| Restricted cash, insurance arrangements                                                                                                                          |   | 8,431             |    | 3,800 |   |
| Restricted cash, other                                                                                                                                           |   | 15,338            |    | 9,511 |   |
| Mortgage notes receivable                                                                                                                                        |   | 6,143             |    | — |   |
| Other long term assets                                                                                                                                           |   | 2,286             |    | 1,248 |   |
|                                                                                                                                                             |   | $                 | 147,370 |   | $ | 133,197 |   |
|                                                                                                                                                             |   |              |    |   |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                    |   |              |    |   |   |
|                                                                                                                                                             |   |              |    |   |   |
| Current liabilities:                                                                                                                                             |   |              |    |   |   |
| Accounts payable and accrued expenses                                                                                                                            |   | $                 | 23,984  |   | $ | 19,425 |   |
| Accrued compensation and benefits                                                                                                                                |   | 8,936             |    | 5,812 |   |
| Due to Senior Housing Properties Trust                                                                                                                           |   | 6,605             |    | — |   |
| Due to Sunrise Senior Living Services, Inc.                                                                                                                      |   | 6,134             |    | — |   |
| Mortgage note payable                                                                                                                                            |   | 54                |    | 141 |   |
| Secured revolving credit facility                                                                                                                                |   | 4,000             |    | — |   |
| Accrued real estate taxes                                                                                                                                        |   | 5,142             |    | 2,404 |   |
| Other current liabilities                                                                                                                                        |   | 3,290             |    | 6,663 |   |
| Total current liabilities                                                                                                                                        |   | 58,145            |    | 34,445 |   |
|                                                                                                                                                             |   |              |    |   |   |
| Long term liabilities:                                                                                                                                           |   |              |    |   |   |
| Mortgage note payable                                                                                                                                            |   | 6,381             |    | 15,982 |   |
| Continuing care contracts                                                                                                                                        |   | 10,164            |    | 10,681 |   |
| Other long term liabilities                                                                                                                                      |   | 8,253             |    | 7,042 |   |
| Total long term liabilities                                                                                                                                      |   | 24,798            |    | 33,705 |   |
|                                                                                                                                                             |   |              |    |   |   |
| Commitments and contingencies:                                                                                                                                   |   |              |    |   |   |
|                                                                                                                                                             |   |              |    |   |   |
| Shareholders’ equity:                                                                                                                                       |   |              |    |   |   |
| Preferred stock, par value $0.01: 1,000,000  shares authorized, none issued                                                                                      |   | —            |    | — |   |
| Common stock, par value $0.01: 10,000,000  shares authorized, 8,513,634 and 8,452,634 shares issued and outstanding at  December 31, 2003 and 2002, respectively |   | 85                |    | 84 |   |
| Additional paid-in capital                                                                                                                                       |   | 86,244            |    | 78,926 |   |
| Accumulated deficit                                                                                                                                              |   | (21,902           | )       | (13,963 | ) |
| Total shareholders’ equity                                                                                                                                  |   | 64,427            |    | 65,047 |   |
|                                                                                                                                                             |   | $                 | 147,370 |   | $ | 133,197 |   |

 

The accompanying notes are an integral part of these financialstatements*.*

 

F-2

----

 

**FIVE STAR QUALITYCARE, INC.**

** **

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

 

(*dollarsin thousands, except per share data)*

 
|                                                    |   | **2003** |    | **2002** |   | **2001** |   |
|---------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
|                                                    |   |     |    |     |   |     |   |
| REVENUES:                                               |   |     |    |     |   |     |   |
| Net revenues from residents                             |   | $        | 575,986 |     | $      | 519,106  |   | $ | 219,742 |   |
| Interest and other income                               |   | 229      |    | 297      |   | 92       |   |
| Total revenues                                          |   | 576,215  |    | 519,403  |   | 219,834  |   |
|                                                    |   |     |    |     |   |     |   |
| EXPENSES:                                               |   |     |    |     |   |     |   |
| Wages and benefits                                      |   | 315,615  |    | 274,248  |   | 153,438  |   |
| Other operating expenses                                |   | 151,013  |    | 143,053  |   | 48,009   |   |
| Management fee to Sunrise Senior Living  Services, Inc. |   | 17,391   |    | 16,643   |   | —   |   |
| Rent to Senior Housing Properties Trust                 |   | 77,266   |    | 75,210   |   | —   |   |
| General and administrative                              |   | 17,745   |    | 15,415   |   | 15,593   |   |
| Depreciation and amortization                           |   | 3,588    |    | 1,794    |   | 1,321    |   |
| Interest expense                                        |   | 1,164    |    | 198      |   | —   |   |
| Impairment of assets                                    |   | —   |    | 150      |   | —   |   |
| Restructuring costs                                     |   | —   |    | 122      |   | —   |   |
| Spin off and merger expense, non recurring              |   | —   |    | 2,829    |   | —   |   |
| Total expenses                                          |   | 583,782  |    | 529,662  |   | 218,361  |   |
|                                                    |   |     |    |     |   |     |   |
| (Loss) income from continuing operations                |   | (7,567   | )       | (10,259  | )      | 1,473    |   |
|                                                    |   |     |    |     |   |     |   |
| Loss from discontinued operations                       |   | (372     | )       | (2,915   | )      | (946     | )      |
|                                                    |   |     |    |     |   |     |   |
| Net (loss) income                                       |   | $        | (7,939  | )        | $      | (13,174  | )      | $ | 527 |   |
|                                                    |   |     |    |     |   |     |   |
| Weighted average shares outstanding                     |   | 8,482    |    | 7,556    |   | 4,374    |   |
|                                                    |   |     |    |     |   |     |   |
| Basic and diluted (loss) income per share  from:        |   |     |    |     |   |     |   |
| Continuing operations                                   |   | $        | (0.89   | )        | $      | (1.36    | )      | $ | 0.34 |   |
| Discontinued operations                                 |   | (0.05    | )       | (0.38    | )      | (0.22    | )      |
| Net (loss) income per share                             |   | $        | (0.94   | )        | $      | (1.74    | )      | $ | 0.12 |   |

 

The accompanying notes are an integral part of thesefinancial statements*.*

 

F-3

----

 

**FIVE STAR QUALITY CARE, INC.**

 

**CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ EQUITY**

 

*(dollarsin thousands, except share data)*

* *
|                                                  |   | **Number of  Shares** |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Accumulated  Deficit** |   | **Total** |    |
|-------------------------------------------------------|--------|-----------------------|--------|-------------------|--------|----------------------------------|--------|--------------------------|--------|-----------|---------|
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Balance at December 31, 2000                          |   | 1,000                 |   | $                 | — |                             | $      | 56,004                   |   | $         | (1,316  | ) | $ | 54,688 |   |
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Issuance of stock, pursuant to spin-off               |   | 4,373,334             |   | 44                |   | 189                              |   | —                   |   | 233       |    |
| Distribution to Senior Housing Properties Trust,  net |   | —                |   | —            |   | (5,215                           | )      | —                   |   | (5,215    | )       |
| Net income                                            |   | —                |   | —            |   | —                           |   | 527                      |   | 527       |    |
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Balance at December 31, 2001                          |   | 4,374,334             |   | 44                |   | 50,978                           |   | (789                     | )      | 50,233    |    |
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Issuance of stock, pursuant to merger of  FSQ, Inc.   |   | 250,000               |   | 2                 |   | 1,873                            |   | —                   |   | 1,875     |    |
| Issuance of stock, pursuant to equity  offering       |   | 3,823,300             |   | 38                |   | 26,039                           |   | —                   |   | 26,077    |    |
| Stock grants                                          |   | 5,000                 |   | —            |   | 36                               |   | —                   |   | 36        |    |
| Net loss                                              |   | —                |   | —            |   | —                           |   | (13,174                  | )      | (13,174   | )       |
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Balance at December 31, 2002                          |   | 8,452,634             |   | 84                |   | 78,926                           |   | (13,963                  | )      | 65,047    |    |
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Stock grants                                          |   | 61,000                |   | 1                 |   | 103                              |   | —                   |   | 104       |    |
| Capital contributions at lease inception              |   | —                |   | —            |   | 7,215                            |   | —                   |   | 7,215     |    |
| Net loss                                              |   | —                |   | —            |   | —                           |   | (7,939                   | )      | (7,939    | )       |
|                                                  |   |                  |   |              |   |                             |   |                     |   |      |    |
| Balance at December 31, 2003                          |   | 8,513,634             |   | $                 | 85     |                             | $      | 86,244                   |   | $         | (21,902 | ) | $ | 64,427 |   |

 

 

The accompanying notes are an integral part of these financialstatements*.*

 

F-4

----

* *

**FIVE STAR QUALITYCARE, INC.**

 

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

 

(*dollarsin thousands)*

* *
|                                                                                            |   | **For the  year ended December 31,** |   |
|-------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                            |   | **2003**                             |   | **2002** |   | **2001** |   |
|                                                                                            |   |                                 |   |   |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                           |   |                                 |   |   |   |   |   |
| Net   (loss) income                                                                        |   | $                                    | (7,939 | ) | $ | (13,174 | ) | $ | 527 |   |
| Adjustments to reconcile net (loss) income  to cash provided by (used in) operating activities: |   |                                 |   |   |   |   |   |
| Depreciation and amortization                                                                   |   | 3,588                                |   | 1,794 |   | 1,321 |   |
| Spin off and merger expense                                                                     |   | —                               |   | 2,829 |   | — |   |
| Impairment of assets                                                                            |   | —                               |   | 150 |   | — |   |
| Loss from discontinued operations                                                               |   | 372                                  |   | 2,915 |   | 867 |   |
| Provision for bad debt expense                                                                  |   | 403                                  |   | (1,916 | ) | 1,587 |   |
| Changes in assets and liabilities:                                                              |   |                                 |   |   |   |   |   |
| Accounts receivable                                                                             |   | 3,674                                |   | 12,310 |   | 9,571 |   |
| Prepaid expenses and other current assets                                                       |   | (9,583                               | )      | 778 |   | (2,685 | ) |
| Accounts payable and accrued expenses                                                           |   | 2,592                                |   | 6,802 |   | (4,905 | ) |
| Accrued compensation and benefits                                                               |   | 3,124                                |   | 524 |   | (492 | ) |
| Due to Senior Housing Properties Trust                                                          |   | 6,667                                |   | (3,480 | ) | 2,232 |   |
| Due to Sunrise Senior Living Services, Inc.                                                     |   | 6,134                                |   | — |   | — |   |
| Other current liabilities                                                                       |   | 10,132                               |   | 441 |   | (8,316 | ) |
| Cash provided by (used in) operating  activities                                                |   | 19,164                               |   | 9,973 |   | (293 | ) |
|                                                                                            |   |                                 |   |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                           |   |                                 |   |   |   |   |   |
| Transfer of working capital by lease                                                            |   | —                               |   | 10,722 |   | — |   |
| Payments on mortgage note receivable                                                            |   | 35                                   |   | — |   | — |   |
| Deposits into restricted cash accounts                                                          |   | (10,458                              | )      | (7,445 | ) | — |   |
| Acquisition of pharmacy, net of cash  acquired                                                  |   | (1,800                               | )      | — |   | — |   |
| Acquisition of insurance company, net of  cash acquired                                         |   | (1,310                               | )      | — |   | — |   |
| Real estate purchases                                                                           |   | —                               |   | (44,927 | ) | — |   |
| Real estate sales                                                                               |   | 16,331                               |   | — |   | — |   |
| Furniture, fixtures and equipment sales                                                         |   | 10,754                               |   | — |   | — |   |
| Furniture, fixtures and equipment purchases                                                     |   | (15,812                              | )      | (6,954 | ) | (2,176 | ) |
| Cash used in investing activities                                                               |   | (2,260                               | )      | (48,604 | ) | (2,176 | ) |
|                                                                                            |   |                                 |   |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                           |   |                                 |   |   |   |   |   |
| Proceeds from borrowings on revolving  credit facility                                          |   | 55,500                               |   | — |   | — |   |
| Repayments of borrowings on revolving  credit facility                                          |   | (51,500                              | )      | — |   | — |   |
| Proceeds from issuance of common stock, net                                                     |   | —                               |   | 26,113 |   | 233 |   |
| Owners contribution, net                                                                        |   | —                               |   | — |   | 12,783 |   |
| Payment of deferred financing costs                                                             |   | —                               |   | (1,055 | ) | (1,016 | ) |
| Repayments of mortgage payable                                                                  |   | (9,687                               | )      | — |   | 9,100 |   |
| Cash (used in) provided by financing  activities                                                |   | (5,687                               | )      | 25,058 |   | 21,100 |   |
|                                                                                            |   |                                 |   |   |   |   |   |
| Net cash used in discontinued operations                                                        |   | (251                                 | )      | (1,100 | ) | (867 | ) |
|                                                                                            |   |                                 |   |   |   |   |   |
| Change in cash and cash equivalents                                                             |   | 10,966                               |   | (14,673 | ) | 17,764 |   |
| Cash and cash equivalents at beginning of  year                                                 |   | 10,270                               |   | 24,943 |   | 7,179 |   |
| Cash and cash equivalents at end of year                                                        |   | $                                    | 21,236 |   | $ | 10,270 |   | $ | 24,943 |   |
|                                                                                            |   |                                 |   |   |   |   |   |
| SUPPLEMENTAL CASH FLOW INFORMATION:                                                             |   |                                 |   |   |   |   |   |
| Cash paid for interest                                                                          |   | $                                    | 1,386  |   | $ | 145 |   | $ | — |   |
|                                                                                            |   |                                 |   |   |   |   |   |
| Non-cash investing and financing  activities:                                                   |   |                                 |   |   |   |   |   |
| Notes exchanged in sale of properties                                                           |   | (6,261                               | )      | — |   | — |   |
| Capital contributions at lease inception                                                        |   | 7,215                                |   | — |   | — |   |
| Issuance of common stock                                                                        |   | 104                                  |   | — |   | — |   |
| Contribution of real estate and related  property from Senior Housing Properties Trust          |   | —                               |   | — |   | (2,232 | ) |
| Acquisition of assets by merger                                                                 |   | (2,220                               | )      | (1,052 | ) | — |   |
| Assumption of liabilities by merger                                                             |   | (890                                 | )      | 2,006 |   | — |   |
| Assumption of mortgage                                                                          |   | —                               |   | 15,775 |   | — |   |
| Issuance of common stock for merger                                                             |   | —                               |   | 1,875 |   | — |   |
| Assumption of assets by lease                                                                   |   | —                               |   | (12,061 | ) | — |   |
| Assumption of liabilities by lease                                                              |   | —                               |   | 22,783 |   | — |   |
| Distribution of**real estate and other  assets to Senior Housing Properties Trust               |   | —                               |   | — |   | 29,330 |   |
| Assumption of mortgage payable by Senior  Housing Properties Trust                              |   | —                               |   | — |   | (9,100 | ) |

 

The accompanying notesare an integral part of these financial statements*.*

 

F-5

----

 

**FIVESTAR QUALITY CARE, INC.**

** **

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(*dollars in thousands, except per share data)*

* *

**1. Organization and Business**

 

We were organizedon April 27, 2000, as a wholly owned subsidiary of Senior HousingProperties Trust, or Senior Housing.  Wewere incorporated in Delaware in 2000 and reincorporated in Maryland onSeptember 17, 2001. Effective July 1, 2000, we assumed the operationsof healthcare communities from two former bankrupt tenants of Senior Housing.

 

On December 31,2001, Senior Housing distributed all of our common shares to its shareholders,or the Spin-Off.  Concurrent withthe Spin-Off, we entered into a lease for 56 nursing home communities anda transaction agreement with Senior Housing and others to govern our initialcapitalization and other events related to the Spin-Off.  Pursuant to the transaction agreement,Senior Housing provided our initial capitalization of $50,000. In connectionwith the Spin-Off, we (1) transferred seven properties and other assetswith a net book value at December 31, 2001 of $29,330 to Senior Housing, (2)conveyed a mortgage obligation of $9,100 at December 31, 2001 to Senior Housingand (3) obtained title to two properties with a net book value of $2,232 atDecember 31, 2001 from Senior Housing.

 

On January 2,2002, as required by the transaction agreement, we acquired FSQ, Inc., or FSQ,in order to acquire the personnel, systems and assets necessary to manage thehealthcare communities that we lease from Senior Housing.  On January 11, 2002, as required by thetransaction agreement, we entered into a lease with Senior Housing for 31independent and assisted living communities formerly managed by Marriott SeniorLiving Services, Inc., or MSLS, a subsidiary of Marriott International, Inc.,or Marriott, and now managed by Sunrise Senior Living Services, Inc., or SLS, asubsidiary of Sunrise Senior Living, Inc., or Sunrise.  Pursuant to the transaction agreement, wereceived the working capital assets and liabilities associated with thisleasehold as part of our initial capitalization.  During 2003, information became available to us which resulted in$7,215 of additional paid in capital. This amount was the result of our having received more working capitalassets and having assumed fewer liabilities than we had previously recorded. OnApril 1, 2002, we purchased and began to operate five additional independentand assisted living communities.  OnOctober 25, 2002, we sold one community purchased on April 1, 2002 to SeniorHousing and entered into a lease with Senior Housing for that community andeight other independent and assisted living communities.  On that same day, we also purchased andbegan operating seven additional independent and assisted living communities.

 

On May 1, 2003, weleased three additional communities from Senior Housing.  On September 15, 2003, we acquired aninstitutional pharmacy located in Wisconsin. On September 30, 2003, we sold one community purchased on April 1, 2002to Senior Housing and entered into a lease with Senior Housing for thatcommunity.  On December 8, 2003, weacquired Affiliates Insurers, Limited, or Affiliates, from Reit Management andResearch LLC, or RMR.  Affiliatesreinsures a portion of our workers compensation insurance.  Also in 2003, we closed one nursing home andsold six communities that were purchased on October 25, 2002.

 

At December 31,2003, our business included 101 communities containing 14,035 living units,including 48 primarily independent and assisted living communities containing7,790 living units and 53 nursing homes containing 6,255 living units as wellas one institutional pharmacy that services 10 nursing homes.

 

We experiencedlosses in 2003 and 2002. We believe that a combination of some or all of ourefforts to increase revenues, contain or reduce costs, our ability to borrow onour revolving credit facility, our ability to sell to Senior Housing capitalimprovements made to communities leased from Senior Housing and the possibilityof sales or financings of our owned communities will be sufficient for us tomeet our working capital needs, operating expenses, rent payments to SeniorHousing, debt service and capital expenditures in the normal course of ourbusiness for the foreseeable future.

 

F-6

----

 

**2.  Summary ofSignificant Accounting Policies**

 

*Basis of Presentation.*  The accompanying consolidated financialstatements include our accounts and those of all of our subsidiaries. Allintercompany transactions have been eliminated.

 

We were owned bySenior Housing until December 31, 2001 and 2001 transactions are presented onSenior Housing’s historical basis. During 2001, substantially all of the cash we received from thecommunities’ operations was deposited in and commingled with Senior Housing’sgeneral funds, and Senior Housing provided funds for working capital and othercash requirements. Our general and administrative expenses in 2001 arecomprised of costs incurred by Senior Housing and charged to us primarily basedon a specific identification basis, which, in the opinion of management, isreasonable. It is not practicable to estimate additional costs that we wouldhave incurred as a separate entity during 2001.

 

Under the terms ofour management agreements with SLS we have provided SLS with working capital tobe used in the operation of the communities. The components of the working capital, primarily cash and cash equivalents,inventories, trade accounts receivable and accounts payable, are controlled bySLS on our behalf, but we retain the risks and rewards associated with theunderlying assets and liabilities. Accordingly, the components of this working capital (including cash andcash equivalents of $13,167 and $2,655 at December 31, 2003 and 2002) areincluded in our consolidated balance sheet.

 

*Estimates and assumptions.*  Preparation of these financial statements inconformity with accounting principles generally accepted in the Unites Statesrequires us to make estimates and assumptions that may affect the amountsreported in these financial statements and related notes.  The actual results could differ from ourestimates.

 

*Cash and cash equivalent*s.  Cash and cash equivalents, consisting ofinvestments with original maturities of three months or less at the date ofpurchase, are carried at cost plus accrued interest, which approximates market.

 

*Restricted cash, insurancearrangements.* Restricted cash, insurance arrangements, is cash that we deposited assecurity for letters of credit which secure obligations arising from ourprofessional liability insurance program.

 

*Restricted cash, other. *Restricted cash, other asof December 31, 2003, includes the following amounts that we are required toescrow: (1) $518 required by certain healthcare regulatory agencies, (2) $5,000for future capital expenditures, as required by our lease with Senior Housingand our management agreements with SLS, (3) $339 for real estate taxes andcapital expenditures as required by a mortgage, (4) $9,168 for residentsecurity deposits for certain SLS managed communities and (5) $313 for otherbusiness reasons.  Restricted cash as ofDecember 31, 2002, includes the following amounts that we are required toescrow: (1) $518 required by certain healthcare regulatory agencies, (2) $1,150for future capital expenditures, as required by our lease with Senior Housingand our management agreements with SLS, (3) $419 for real estate taxes andcapital expenditures as required by mortgages, (4) $7,361 for resident securitydeposits for certain SLS managed communities and (5) $63 for other businessreasons.

 

*Accounts receivable and allowance.*  We record accounts receivable at theirestimated net realizable value.  In thecase of receivables generated from residents, we estimate allowances foruncollectible amounts based upon factors which include, but are not limited to,the age of the receivable and the terms of the agreements with residents ortheir third party payors.  In the caseof other receivables, such as those due from various governments or otherentities with which we have transacted business, we estimate allowances basedupon factors which include, but are not limited to, the agreements with suchpayors, their stated intent to pay, their financial capacity to pay and otherfactors which may include litigation. Accounts receivable allowances are estimates.  We periodically review and revise these estimates based on newinformation; such revisions may be material.

 

During 2003, 2002and 2001, we increased our allowance for doubtful accounts by $2,456, $4,387and $3,283, respectively, and wrote off accounts receivable of $2,053, $4,502and $1,696, respectively.

 

F-7

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Included in accountsreceivable as of December 31, 2003 and 2002 are amounts due from the FederalGovernment Medicare program of $4,174 and $11,026, respectively, and amountsdue from various state Medicaid programs of $12,368 and $14,985, respectively.

 

*Deferred finance costs*.  We capitalize issuance costs related toborrowings and amortize the deferred cost over the terms of the respectiveloans.  The unamortized balance ofdeferred finance costs was $503 and $828 at December 31, 2003 and 2002,respectively.  Accumulated amortizationrelated to deferred finance costs was $326 and $51 at December 31, 2003 and2002, respectively.  At December 31,2003, the weighted average amortization period remaining is approximately twoyears.  The amortization expense to beincurred over the next two years as of December 31, 2003 is $276 in 2004 and$227 in 2005.

 

*Income taxes*.  Prior to the Spin-Off, substantially all ofour taxable income was included in the taxable income of Senior Housing forfederal income tax purposes.  SeniorHousing qualified as a real estate investment trust, or REIT, under theInternal Revenue Code of 1986, as amended, and, prior to December 31, 2001, wewere a subsidiary of Senior Housing. After the Spin-Off, we became a separate taxable corporation and are responsiblefor our own tax liabilities and filings.

 

We account forincome taxes in accordance with SFAS No. 109, “*Accounting for Income Taxes”*,or SFAS 109.  SFAS No. 109 prescribes anasset and liability approach that requires the recognition of deferred taxassets and liabilities for the expected future tax consequences of temporarydifferences between the financial statement carrying amounts and the tax basesof assets and liabilities.  Because wehave a short operating history as a separate company during which we havegenerated no taxable income, we have fully reserved the value of the netdeferred tax asset (see note 5).

 

*Property and equipment.*  We expense depreciation on real estateproperties on a straight-line basis over estimated useful lives of up to 40years for buildings, up to 15 years for building improvements and up to sevenyears for personal property. We regularly evaluate whether events or changes incircumstances have occurred that could indicate an impairment in the value oflong-lived assets.  If there is anindication that the carrying value of an asset is not recoverable, we estimatethe projected undiscounted cash flows from the asset to determine if animpairment loss should be recognized. We determine the amount of impairment loss by comparing the historicalcarrying value of the asset to its estimated fair value.  We determine estimated fair value through anevaluation of recent financial performance and projected discounted cash flowsof properties using standard industry valuation techniques.  In addition to consideration of impairmentupon events or changes in circumstances as described above, we regularlyevaluate the remaining lives of our long-lived assets.  If we change estimated lives, we allocatethe carrying value of affected assets over the revised remaining lives.  During 2002, we wrote off certain impairedassets with a carrying value of $772.

 

*Self insurance.*  We self insure up to certain retained limitsfor workers compensation, professional liability, and, as of August 2002,employee health insurance.  Claims inexcess of these retained limits are insured by third party insurance providersup to contractual limits, over which we are self insured.  We accrue the estimated cost of self insuredamounts based on projected settlements for pending claims, known incidentswhich we expect may result in claims, estimates of incurred but not yetreported claims and incidents and expected changes in premiums for insuranceprovided by third party insurers whose policies provide for retroactiveadjustments.  We periodically adjustthese estimates based upon our claims experience, recommendations from ourprofessional consultants, changes in market conditions and other factors; suchadjustments may be material.

 

*Continuingcare contracts. *Atsome of our communities that are managed by SLS, residents can enter intocontinuing care contracts.  Thesecontracts require residents to make advance payments some of which arerefundable and are carried as liabilities until they are refunded and some ofwhich are not refundable and are carried as liabilities until they areamortized into revenues during the periods we expect to provide theservice.  Portions of these payments areincluded in restricted cash on our balance sheet.

 

*Restructuring costs.*  During 2002, we reduced the number of ourregional offices and had staff reductions in our home office.  As a result, we incurred restructuring costsof $122 for severance payments to terminated employees, all of which was paidin 2002.

 

F-8

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*Per common share amounts.*  We computed loss per share for the yearsended December 31, 2003 and 2002, using the weighted average number of sharesoutstanding during the year.  Wepresented earnings per share for the year ended December 31, 2001, as if theshares outstanding at December 31, 2001, were outstanding as of January 1,2001. We have no common share equivalents, instruments convertible into commonshares or other dilutive instruments.

 

*Revenue recognition.*  Our revenues are derived primarily fromservices to residents at communities we own or lease.  We accrue revenues when services are provided and revenues areearned.  Some of our services areprovided with the expectation of payment from governments or other third partypayors; related revenues are reported at their estimated net realizable amountsat the time the services are provided. We derived approximately 39%, 39% and 78% of 2003, 2002 and 2001 netresident revenues, respectively, from payments under Federal and state medicalassistance programs.  Revenues undersome of these programs are subject to audit and retroactive adjustment.

 

Medicare revenuestotaled $86,100, $68,400 and $35,400 during 2003, 2002 and 2001,respectively.  Medicaid revenues totaled$148,600, $142,600 and $127,900 during 2003, 2002 and 2001, respectively.  Some of the states in which we operate arecontemplating plans to reduce Medicaid funding.  We cannot estimate the magnitude of potential Medicaid and futureMedicare rate reductions but it may be material.  Medicaid and Medicare rates reductions, if they occur, may have anegative impact on our revenues and may increase our losses.

 

*New Accounting Pronouncements.*  In April 2002, the FASB issued SFAS No. 145“Rescission of FASB Statements No. 44 and 64, Amendment of FASB Statement No.13, and Technical Corrections”, or FAS 145. The provisions of this standard eliminate the requirement that a gain orloss from the extinguishment of debt be classified as a extraordinary item, unlessit can be considered unusual in nature and infrequent in occurrence.

 

In July 2002, theFASB issued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities”, or FAS 146. FAS 146 reconsiders all of the prior guidanceregarding restructuring charges, employee termination benefits and other coststo exit an activity. FAS 146 applies to costs associated with (a) certaintermination benefits (commonly identified as one-time termination benefits),(b) costs to terminate a contract that is not a capital lease, and (c) otherassociated costs including costs to consolidate communities or relocateemployees.

 

We adopted FAS 145and FAS 146 on January 1, 2003 and such adoptions did not have an impact on ourfinancial position or our results of operations. *Reclassifications.*

* *

*Reclassifications. *Reclassifications havebeen made to the prior years’ financial statements to conform to the currentyear’s presentation.

 

**3.  Property and Equipment**

 

Property andequipment, as of December 31, 2003 and 2002, consist of:

 
|                              |   | **2003** |   | **2002** |   |
|-----------------------------------|--------|----------|--------|----------|--------|
| Land                              |   | $        | 3,542  |     | $      | 4,947 |   |
| Buildings and improvements        |   | 42,328   |   | 57,468   |   |
| Furniture, fixtures and equipment |   | 13,476   |   | 9,663    |   |
|                              |   | 59,346   |   | 72,078   |   |
| Accumulated depreciation          |   | (3,862   | )      | (1,749   | )      |
|                              |   | $        | 55,484 |     | $      | 70,329 |   |

 

**4. Line of Credit**

 

On October 24,2002, one of our subsidiaries entered into a revolving credit facilityagreement.  The interest rate onborrowings on this facility is LIBOR plus a spread.  The maximum amount available under this

 

F-9

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facility is $12,500, and is subject to limitations based uponqualifying collateral. The facility is available for acquisitions, workingcapital and general business purposes. The facility is secured by accounts receivable (totaling $19,100, net ofallowances of $1,000, as of December 31, 2003) generated at some of ourcommunities and contains covenants such as maintenance of collateral,maintenance of lockbox accounts designed to provide the lenders with access tothe collateral consolidated minimum net worth and certain other financialratios.  Accounts receivable whichsecure the facility are transferred by our subsidiary operators to a whollyowned finance subsidiary of ours.  Incertain circumstances subject to lender and collateral availability, themaximum borrowings under this facility may be increased to $25,000. Thefacility terminates on October 24, 2005. As of December 31, 2003, $4,000 wasoutstanding under the facility.  As of March24, 2004 no amounts were outstanding under this facility.  Interest expense related to this facilitywas $155 for the year ended December 31, 2003.

 

**5.  IncomeTaxes**

 

Significantcomponents of our deferred tax assets and liabilities as of December 31, 2003and 2002, are as follows: 

 
|                                                              |   | **2003** |   | **2002** |   |
|-------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets (liabilities) for the  income tax effects of: |   |     |   |     |   |
| Allowance for doubtful accounts                                   |   | $        | 1,826  |     | $      | 1,671 |   |
| Accrued liabilities                                               |   | 527      |   | 600      |   |
| Net operating loss carry forwards                                 |   | 1,706    |   | 3,112    |   |
| Tax vs. book depreciation                                         |   | 2,309    |   | (163     | )      |
| Continuing care contracts                                         |   | 2,276    |   | 2,235    |   |
| Deferred income                                                   |   | 323      |   | 200      |   |
| Insurance reserve                                                 |   | 1,703    |   | —   |   |
| Net deferred tax asset before valuation  allowance                |   | 10,670   |   | 7,655    |   |
| Valuation allowance                                               |   | (10,670  | )      | (7,655   | )      |
| Net deferred tax asset                                            |   | $        | — |     | $      | — |   |

 

During 2001 someof our subsidiaries were taxable entities separate from Senior Housing andgenerated net operating loss carryforwards for tax purposes. These subsidiarynet operating loss carryforwards totaled $666 at December 31, 2003 and 2002 andmay be used under certain conditions to reduce our future taxable income. Forthe year ended December 31, 2003, we estimate that we used net operating losscarry forwards of $3,687, leaving us with net operating loss carry forwards of$3,253 available to reduce future taxable income.  Because we have a short operating history as a separate companyduring which we have generated no taxable income, we have fully reserved thevalue of the net deferred tax asset.  Asa result, we recorded no income tax benefit for the years ended December 31,2003, 2002 and 2001.  Our net operatingloss carryforwards will expire beginning in 2020, if unused.

 

The principalreasons for the difference between our effective tax (benefit) rate and theU.S. federal statutory income tax (benefit) rate are as follows:

 
|                                                      |   | **For the  years ended December 31,** |   |
|-----------------------------------------------------------|--------|---------------------------------------|--------|
|                                                      |   | **2003**                              |   | **2002** |   | **2001** |   |
|                                                      |   |                                  |   |   |   |   |   |
| Taxes at statutory U.S. federal income tax  rate          |   | (34.0                                 | )%     | (34.0 | )% | (34.0 | )% |
| State and local income taxes, net of  federal tax benefit |   | (4.0                                  | )%     | (4.0 | )% | (4.0 | )% |
| Non deductible spin-off and merger expenses               |   | —                                |   | 8.4 | % | — |   |
| Other                                                     |   | 31.5                                  | %      | (2.2 | )% | — |   |
| Effective tax rate                                        |   | (6.5                                  | )%     | (31.8 | )% | (38 | )% |
| Tax valuation  allowance                                  |   | 6.5                                   | %      | 31.8 | % | 38 | % |

 

F-10

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**6.  Mortgages Payable**

** **

One of theproperties acquired by one of our subsidiaries in October 2002 was encumberedby two mortgage notes secured by first and second deeds of trust.  In accordance with the prepayment provisionsof the first mortgage, in December 2003, we prepaid the first mortgage notewhich totaled $9,323.  The remainingdeed of trust mortgage totaling $6,435 was prepaid on March 1, 2004.

 

**7.  Leases**

 

Effective January1, 2002, we entered into a noncancelable lease with Senior Housing for 56communities.  The lease is a“triple-net” lease which requires that we pay for all costs incurred in theoperation of the communities, including the cost of insurance and real estatetaxes.  The lease also requires us tomaintain the communities during the lease term and to indemnify Senior Housingfor any liability which may arise from its ownership during the leaseterm.  The lease initially requiredminimum rent payments to Senior Housing of $7,000 per year.  In 2002, we ceased to operate one of theseleased communities.  Pursuant to thelease terms, that community was sold, the net proceeds were paid to SeniorHousing and the annual rent was reduced by 10% of the net sales proceeds or$77.  In 2003, we ceased to operateanother one of these leased communities. Pursuant to the lease terms, we sold that community and paid netproceeds to Senior Housing, and our annual rent was reduced by 10% of the netsales proceeds or $28.  During 2003, wesold $7,477 of improvements on these properties to Senior Housing, pursuant tothe lease terms.  As a result of thistransaction, and in accordance with our leases, our annual minimum rent toSenior Housing increased by 10% of the sales proceeds, or $748.  Prior to the lease combination discussedbelow, we leased 53 properties under this lease.

 

On January 11,2002, we entered into a second noncancelable lease with Senior Housing for 31retirement communities.  Thesecommunities are managed by SLS.  Thelease is a “triple-net” lease which requires us to pay for all costs incurredin the operation of the communities, including insurance and real estatetaxes.  The lease also requires us tomaintain the communities during the lease term and to indemnify Senior Housingfor any liability which may arise from its ownership during the lease term.  The lease initially required minimum rentpayments to Senior Housing of $63,000 per year.  The lease expires on December 31, 2017, and we have two renewaloptions totaling an additional 15 years.On October 25, 2002, we and SeniorHousing agreed to modify this lease. Prior to this lease modification, the lease required us to make periodicdeposits into an escrow account for future capital expenditures at these 31leased communities.  We paid thesedeposits to Senior Housing as additional rent expense.  From the period January 11, 2002 throughSeptember 30, 2002, we deposited $5,376 into escrow accounts owned by SeniorHousing that was recorded as rent expense. As a result of this modification, effective October 1, 2002, we makedeposits into escrow accounts that we own and Senior Housing has a security andremainder interest in these accounts and in all property purchased with fundingfrom these accounts.  The amount and useof these escrows are unchanged by this amendment; however, subsequent to September30, 2002, we do not record rent expense as a result of these deposits.  During 2003, we sold $3,194 of improvementson these properties to Senior Housing, pursuant to the lease terms.  As a result of this transaction, and inaccordance with our leases, our annual minimum rent to Senior Housing increasedby 10% of the sales proceeds, or $319. Also in 2003 we paid $355 in percentage rent related to this lease.  Taking these transactions into account, ourrevised annual minimum rent payable to Senior Housing under this lease is$63,674.

 

On October 25,2002, we sold one community to Senior Housing for approximately $12,700, whichwas the approximate net book value of that community and its estimated fairvalue at the time of the sale. On the same day, we leased this property alongwith eight other senior living properties from Senior Housing. The lease is a“triple-net” lease that requires us to pay for all costs incurred in theoperation of the communities, including insurance and real estate taxes.  The lease also requires us to maintain thecommunities during the lease term and to indemnify Senior Housing for anyliability which may arise from its ownership during the lease term.  The lease initially required minimum rentpayments to Senior Housing of $6,285 per year and percentage rent starting in2005.  On May 30, 2003, we leased anadditional three properties that are now included as a part of this lease for$650 per year.  On September 30, 2003,we sold one additional community to Senior Housing for approximately $12,300,which was its appraised value at the time of the sale and then leased thatcommunity from Senior Housing for annual minimum rent of 10% of the salesproceeds or $1,230 per year.  During2003, we sold $732 of improvements on these properties to Senior Housing,pursuant to the lease terms.  As aresult of this transaction, and in accordance

 

F-11

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with our leases, annual minimumrent to Senior Housing increased by 10% of the sales proceeds, or $73.  Prior to the lease combination discussedbelow, we leased 13 properties under this lease.

 

During 2003, two of our above mentioned three leases with SeniorHousing were for 53 nursing homes and for 13 independent and assisted livingcommunities, respectively.  On March 1,2004, these leases were combined into one lease.  Simultaneously with this lease combination, the lease terms werechanged as follows:

 

•                                          The lease expiration date under the combinedlease is December 31, 2020.  Prior tothe lease combination, the lease maturity date for the nursing home lease andthe independent and assisted living community lease was December 31, 2018 and2019, respectively.  The lease containsone 15 year renewal option for all, but not less than all communities.

•                                          Under the combined lease, we will pay toSenior Housing as additional rent an amount equal to 4% of the increase inrevenues at the leased properties beginning in 2006.  Prior to the lease combination, the percentage and the beginningtime period for the nursing home lease and the independent and assisted livingcommunity lease was 3% and 2004 and 4% and 2005, respectively.  

•                                          Underthe lease for the 31 properties operated by SLS, we will pay to Senior Housingas additional rent an amount equal to 4% of the increase in revenues at theleased properties beginning in 2006.  In2003, Senior Housing earned $355 of additional rent based on the increase inrevenues at the leased properties.  Thisamount is now included in our fixed annual rent for these properties.

•                                          OnMarch 1, 2004, Senior Housing also purchased from us one independent andassisted living community with 229 units located in Maryland.  The purchase price was $24,100, itsappraised value.  This property wasadded to the combined lease.

•                                          Theannual rent under the combined lease for 53 nursing homes and 14 independentand assisted living communities is $18,290. And

•                                          Allother lease terms remained substantially unchanged.

 

The future minimumrent required by our leases with Senior Housing as of March 24, 2004, is asfollows:

 

| 2004       |   | $       | 81,964    |   |
|------------|--------|---------|-----------|--------|
| 2005       |   | 81,964  |      |
| 2006       |   | 81,964  |      |
| 2007       |   | 81,964  |      |
| 2008       |   | 81,964  |      |
| Thereafter |   | 774,263 |      |
|       |   | $       | 1,184,083 |   |

 

**8. Shareholders’ Equity**

 

During 2002, weissued 3,823,300 common shares, in an underwritten public offering, for grossproceeds of approximately $28,522. Proceeds received, net of underwritingcommissions and other costs, were $26,077.

 

On May 7, 2002, weissued 1,000 common shares to each of our five directors as part of theirannual compensation.  The shares werevalued at $7.10 per share, which was the closing price of our common shares onthe American Stock Exchange on the date of issue.

 

On May 6, 2003, weissued 1,000 common shares to each of our five directors as part of theirannual compensation.  The shares werevalued at $1.17 per share, which was the closing price of our common shares onthe American Stock Exchange on the date of issue.

 

On July 15, 2003,we issued 56,000 common shares to our officers and others who provide servicesto us.  The shares were valued at $1.75per share, which was the average price of our common shares on the AmericanStock Exchange on the date of issue.

 

F-12

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On January 14,2004, we issued 1,000 common shares to our new director, Barbara Gilmore, aspart of her annual compensation.  Theshares were valued at $5.49 per share, which was the closing price of ourcommon shares on the American Stock Exchange on the date of issue.

 

We initiallyreserved an aggregate of 650,000 shares of our common shares under the terms ofthe 2001 Stock Option and Stock Incentive Plan, or the Award Plan.  As of December 31, 2003, we have reserved583,000 of our common shares under the terms of the Award Plan.

 

**9.  CommunityAcquisitions**

 

In January 2002,we entered into a lease with Senior Housing for 31 independent and assistedliving communities then managed by MSLS and currently managed by SLS.  In connection with this transaction, weacquired the net working capital of the communities of $6,537, received cash of$5,665, and assumed certain long term liabilities totaling $12,202.  We allocated the purchase price on the basisof the fair value of assets acquired and liabilities assumed.

 

In April 2002, wepurchased five senior living communities for $45,500 in cash. We allocated thepurchase price to the property and equipment acquired.

 

In October 2002,we purchased an additional seven senior living communities for $27,000.  We allocated the purchase price to theproperty and equipment acquired.  Tofinance this purchase, we sold one of our existing communities to SeniorHousing for approximately $12,700 and assumed $15,798 of mortgage debt, whichhad a fair value of $16,210.  Inconnection with this transaction, we leased another eight senior livingcommunities from Senior Housing, which Senior Housing simultaneously acquired.

 

We account foreach of these acquisitions using the purchase method of accounting.  As such, we have included the results ofoperations of each of the communities acquired in our statement of operationsfrom the date of acquisition.  We didnot record any goodwill related to any of the acquisitions.

 

**10.  Pro FormaInformation (Unaudited)**

 

Pro formaoperating results assuming commencement of operations as of January 1, 2002, ofthe 53 communities we acquired or leased during 2003 and 2002, and assumingthat our sale of 3,823,000 common shares occurred on January 1, 2002, are asfollows:

 
|                                          |   | **2003**        |    | **2002** |   |
|-----------------------------------------------|--------|-----------------|---------|----------|--------|
|                                          |   | **(unaudited)** |    |
| Revenues                                      |   | $               | 576,215 |     | $      | 563,193 |   |
| Expenses                                      |   | 583,782         |    | 573,688  |   |
| Net (loss) income from continuing  operations |   | (7,567          | )       | (10,495  | )      |
| Loss from discontinued operations             |   | (372            | )       | (2,798   | )      |
| Net (loss) income                             |   | $               | (7,939  | )        | $      | (13,293 | ) |
|                                          |   |            |    |     |   |
| Weighted average shares outstanding           |   | 8,482           |    | 8,447    |   |
| Net (loss) income per share                   |   | $               | (0.94   | )        | $      | (1.57 | ) |

 

**11. Discontinued Operations**

 

During 2002, weceased operations at two leased nursing homes: one community in Phoenix,Arizona, which we leased from Senior Housing; and one community in Campbell,Nebraska, which we leased from that municipality.  The Arizona community was closed and subsequently sold by SeniorHousing for $770 which caused a $77 reduction in annual minimum rent payable inaccordance with the lease terms.  Theoperations of the Nebraska community were assumed by its owner.

 

F-13

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Also in 2002, wedecided to sell one additional nursing home located in Connecticut.  Until this decision, we were exploringalternative uses for this property, including the possibility of developing agerestricted housing at this community. Our decision to abandon these efforts and sell this property resulted inthe classification of this community as a discontinued operation in 2002.  The shut down of the healthcare operationsof this community occurred in 2001 and was accomplished pursuant to anagreement with, and authorization from, the Connecticut Department of SocialServices.  That agreement provided forcertain Medicaid rate adjustments to compensate for shut down losses attributableto Medicaid patients who were residents at the community.  Based on the agreement, we recorded areceivable of approximately $1,450 of expected Medicaid rate adjustments forthese shut down costs.  In November2002, we received a revised notice from the Connecticut Medicaid authoritiesthat rate adjustments of approximately $512 would be authorized.  We wrote off the remainder of thisreceivable and reported the loss with the loss from discontinued operations for2002.  In addition, during 2002, we recordedan asset impairment charge of $772 related to this community, primarily becauseof a decline in the value of skilled nursing bed licenses which were held forsale.

 

During 2003, weceased operations at one nursing home which was leased from SeniorHousing.  The community was closed andsubsequently sold by Senior Housing for $345 which caused a $35 reduction inannual minimum rent payable in accordance with the lease terms.  In August 2003, we sold an assisted livingcommunity and in December 2003, we sold another five assisted livingcommunities.  We received $3,500,consisting of $350 of cash and a $3,150 six-year mortgage note at 8% interest,for the assisted living community that was sold in August 2003.  We deferred the $1,100 gain on the sale andwe expect to recognize the gain as income over the life of the note inproportion to note principal payments that we receive.  We received $3,550, consisting of $440 ofcash and a $3,110 fifteen year mortgage note at 9% interest, for the fiveassisted living communities that we sold in December 2003.  We deferred the $1,200 gain on the sale andwe expect to recognize the gain as income when it is demonstrated that thebuyer has the ability to pay the mortgage note.  These deferred gains are included in other long term liabilitieson our consolidated balance sheet.

 

As of December 31,2003, substantially all of our assets and liabilities related to thesecommunities have been disposed of and paid, respectively.  The income statements for all periods presentedhave been reclassified to present the results of operations of thesecommunities as discontinued.  Below is asummary of the operating results of these discontinued operations included inthe financial statements for years ended December 31, 2003, 2002 and 2001:

 
|     |   | **2003** |   | **2002** |   | **2001** |   |
|----------|--------|----------|--------|----------|--------|----------|--------|
|     |   |     |   |     |   |     |   |
| Revenues |   | $        | 5,033  |     | $      | 5,763    |   | $ | 9,752 |   |
| Expenses |   | 5,405    |   | 8,678    |   | 10,698   |   |
| Net loss |   | $        | (372   | )        | $      | (2,915   | )      | $ | (946 | ) |

 

**12. Transactions With Affiliates**

 

On December 31, 2001,Senior Housing distributed substantially all of its ownership of our shares toits shareholders.  In order to effectthe Spin-Off and to govern relations after the Spin-Off, we entered intoagreements with Senior Housing, pursuant to which it was agreed that:

 

•                                          so long as Senior Housing remains a REIT, we maynot waive the share ownership restrictions in our charter on the ability of anyperson or group to acquire more than 9.8% of any class of our equity shareswithout, among other requirements, the consent of Senior Housing and our determinationthat the exception to the ownership limitations would not cause a default underany of our leases;

 

•                                          so long as we are a tenant of Senior Housing, wewill neither permit any person or group to acquire more than 9.8% of any classof our voting stock or permit the occurrence of other change in control events,as defined, nor will we take any action that, in the reasonable judgment ofSenior Housing or

 

F-14

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HRPTProperties Trust, or HRPT, might jeopardize the tax status of Senior Housing orHRPT as a REIT;

 

•                                          Senior Housing has the option, upon theacquisition by a person or group of more than 9.8% of our voting stock and uponother change in control events, as defined, to cancel all of our rights underthe leases we have with Senior Housing; and

 

•                                          so long as we maintain our shared servicesagreement with RMR or are a tenant under a lease with Senior Housing then wewill not acquire or finance any real estate without first giving SeniorHousing, HRPT, Hospitality Properties Trust, or HPT, or any other publiclyowned REIT or other entity managed by RMR the opportunity to acquire or financereal estate investments of the type in which Senior Housing, HRPT, HPT or anyother publicly owned REIT or other entity managed by RMR respectively, invest.

 

At the time of the Spin-Off, all of the persons serving as our directorswere trustees of Senior Housing.  Two ofour current directors, Messrs. Martin and Portnoy, are current trustees ofSenior Housing.

 

As of March 24, 2004, we lease 98 senior living communities from SeniorHousing for total annual minimum rent of $81,964.

 

During 2003, we and Senior Housing were jointly involved in litigationwith Marriott and MSLS, the operator of 31 of the senior living communitieswhich we leased from Senior Housing. We and Senior Housing equally shared thecosts of this litigation.  Thislitigation was settled in January 2004.

 

Since January 1,2003, we have entered or agreed to enter into several transactions with SeniorHousing, including the following:

 

•                                          During 2003Senior Housing purchased $11,403 of improvements to its properties leased by usand, pursuant to the terms of our leases with Senior Housing, the annual rentpayable to Senior Housing was increased by 10% of the amounts invested, or$1,140.

 

•                                          In March 2003, one of Senior Housing’s privatecompany tenants defaulted on its lease for a nursing home in Missouri.  Senior Housing terminated this lease andengaged us to manage this property for Senior Housing’s account.  Currently this property is being offered forsale or lease.  We are paid a managementfee of 5% of the gross revenues at this nursing home, totaling $135,000 throughDecember 31, 2003.

 

•                                          In May 2003,Senior Housing purchased from an unrelated third party three assisted livingproperties with 143 living units located in Virginia for $6,500.  InSeptember 2003, we sold Senior Housing one independent living property with 164units in California for $12,300, its appraised value. These four propertieswere added to an existing lease with Senior Housing for nine other independentand assisted living properties.  Our minimum rent for the propertiesincluded in this lease was increased by $1,880 per year.  All other termsof the lease remained unchanged.

 

•                                          In July 2003,we agreed to buy two nursing homes in Michigan that we lease from SeniorHousing.  The purchase price is $10,500,the appraised value of the properties. These two properties are leased on acombined basis with other nursing home properties. Under the terms of our leasewith Senior Housing, upon consummation of the sale, our annual rent payableunder the combined lease will be reduced by 10% of the net proceeds that SeniorHousing receives from the sale.  Weexpect the sale of these properties to occur during the first half of 2004.However, this sale is contingent upon our obtaining Department of Housing andUrban Development insured financing for this purchase, and this sale may notclose because of a failure of this condition or for some other reason.

 

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•                                          On March 1,2004, Senior Housing purchased from us one independent and assisted livingcommunity with 229 units located in Maryland. The purchase price was $24,100, the appraised value of theproperty.  Simultaneous with thispurchase, our existing leases with Senior Housing were modified as follows:

 

•  thelease for 53 nursing homes and the lease for 13 independent and assisted livingcommunities were combined into one lease andthe property acquired on March 1, 2004 was added to this combined lease;

 

•  thecombined lease maturity date was changed to December 31, 2020 from December 31,2018 and 2019 for the separate leases;

 

•  ourminimum rent for the combined lease of 53 nursing homes and 14 independentliving communities was increased by $2,410 per year;

 

•  forall of our leases with Senior Housing the amount of additional rent, to be paidto Senior Housing was changed to 4% of the increase in revenues at the leasedproperties beginning in 2006; and

 

•  all other lease terms remain substantiallyunchanged.

 

We obtained aworkers compensation insurance policy for the year beginning June 15,2003, from a third-party insurer.  This third-party insurer ceded aportion of the premiums we paid to a Bermuda based company, Affiliates, whichwas owned by RMR.  Affiliateswas organized by RMR to assist us increating a partial self insurance program on an expedited basis. On December 8,2003, we acquired Affiliates from RMRfor an amount equal to RMR cost oforganizing and capitalizing that company, approximately $1,310.

 

Our Chief Executive Officer and Chief Financial Officer are alsoofficers and employees of RMR. These officers devote a substantial majority oftheir business time to our affairs and the remainder to RMR’s business which isseparate from our business.  We believethe compensation we pay to these officers reasonably reflects their division ofbusiness time; however, periodically, these individuals may divide theirbusiness time differently than they do currently and their compensation from usmay become disproportionate to this division.

 

RMR providesinvestment, management and administrative services to us under a sharedservices agreement which is subject to renewal annually.  RMR iscompensated at an annual rate equal to 0.6% of our total revenues.  Fees earned by RMR for services to us during2003 were approximately $3,400.  Thefact that RMR has responsibilities to other entities, including our landlord,Senior Housing, could create conflicts; and in the event of such conflictsbetween Senior Housing and us, the shared services agreement allows RMR to acton behalf of Senior Housing rather than on our behalf. RMR is owned byMessrs. Martin and Portnoy who are our managing directors.Messrs. Martin and Portnoy each have material interests in thetransactions between us and RMR described above.  All transactions between us and RMR are approved by ourindependent directors.  Ourindependent directors have approved the renewal of the shared servicesagreement for its current term through December 31, 2004.

 

Messrs. Martin and Portnoy own the building in which ourheadquarters is located. Our lease for space was originally executed byFSQ, Inc. This lease expires in 2011. During 2003, we paid rent under thislease of $569,000.

 

UntilMarch 31, 1997, Mr. Portnoy was a partner of Sullivan &Worcester LLP, our counsel and counsel to Senior Housing, RMR and affiliates ofeach of the foregoing, and he received payments from that firm during 2003 inrespect of his retirement.

 

**13.  Employee Benefit Plan**

** **

During 2001, weestablished an employee savings plan under the provisions of the InternalRevenue Code section 401(k).  Allemployees are eligible to participate in the plan and are entitled, upontermination or retirement,

 

F-16

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to receive their portion of the plan assets.  We do not contribute to this plan, but do pay certain expenses ofthe plan.  Plan expenses were $23, $24and $30 for the years ended December 31, 2003, 2002 and 2001, respectively.

 

**14.  Fair Valueof Financial Instruments**

 

Our financialinstruments are limited to cash and cash equivalents, accounts receivable,accounts payable, continuing care contracts, mortgage notes receivable andmortgage notes payable.  The fair valueof these financial instruments was not materially different from their carryingvalues at December 31, 2003 and 2002. Our estimates of fair values were based on current market prices anddiscounted cash flow analysis.

 

**15. Commitments and Contingencies**

 

*ConnecticutStrike Costs.*  During2001, we incurred costs to hire temporary staff and to provide securityservices for residents and temporary employees during a Connecticut laborstrike.  At the time of this strike, theGovernor of Connecticut and the Connecticut Department of Social Servicesagreed to adjust Medicaid rates to compensate for a portion of these increasedcosts.  Litigation was brought by thestriking union against the Governor and Commissioner of the Department ofSocial Services, and, on September 13, 2002, the United States District Courtfor Connecticut issued a declaratory ruling that Medicaid subsidies other thanthose to reimburse costs incurred to protect the health and safety of residentsare violations of federal labor law. The Connecticut Department of Social Services continues to review andprocess our claims for these adjustments, which total approximately $1,500 asof December 31, 2003, which is net of payments received of $350.  In the event that the Connecticut Departmentof Social Services determines not to make payments or seeks reimbursement ofpayments previously made, and our defenses and claims are not fully successful,the uncollected amounts, net of applicable reserves will be recorded as a lossin future periods.  We intend to pursuethese claims.  

 

*Receivablesfrom United States Department of Health and Human Services.*  During 2000, we assumed the operations of 40nursing homes from Integrated Health Services, Inc. and certain relatedentities, or together, IHS, a company then in bankruptcy, pursuant to a courtapproved settlement agreement.  Becauseof complex legal and governmental processes necessary to transfer nursing homelicenses and Medicare and Medicaid payments, arrangements were agreed upon forIHS to continue to receive payments from such third party payors for servicesprovided at the nursing homes following our assumption of operations, includingan agreement among us, IHS and the Secretary of the United States Department ofHealth and Human Services, or HHS. These arrangements were approved by the bankruptcy court and generallyhonored by IHS with respect to approximately $42,000 received by IHS for ouraccount.  We initially believed IHS hadreceived an additional $2,000 which was due to us.  When IHS refused to pay this amount we commenced suit against IHSin the bankruptcy court in August 2002. Following the filing of the suit, settlement discussions werestarted.  In December 2002, IHS paidapproximately $700 of the receivable balance. IHS has asserted that it is only obligated to deliver funds it receivedfrom third-party payors, including HHS, and that HHS has withheld paymentswhich are due to us.  In March 2003, wecommenced suit against IHS, HHS and the State of Colorado Department ofHealthcare Policy and Financing concerning the remaining receivablebalance.  Shortly after filing,settlement was reached with the State of Colorado providing us a payment of approximately$400.  In December 2003, the courtgranted a motion to dismiss HHS, but took no action on IHS’s motion todismiss.  In January 2004, we appealedthe courts decision to dismiss HHS.  InFebruary 2004, the court denied IHS’s motion to dismiss.  We intend to pursue these claims, but we cannotpredict the outcome of this litigation. If we do not collect this claim, the uncollected amounts, net ofapplicable reserves, will be recorded as a loss in future periods.

 

*SLS Management Agreements. *During 2002, about the time Marriott determined to sell MSLS toSunrise, we and Senior Housing became involved in litigation with Marriott andMSLS.  On January 7, 2004, we and SeniorHousing settled the pending litigation with Marriott and MSLS.  Under the terms of the settlement we andSenior Housing, and Marriott and MSLS, agreed to dismiss all claims andcounterclaims asserted in the litigation. Also under the terms of the settlement, Marriott paid to us and SeniorHousing $1,250 each.  The settlement wasa compromise of the parties’ disputes entered into to avoid the expense andinconvenience of litigation and neither us or Senior Housing, nor Marriott orMSLS, has admitted any liability, violation of law or wrongdoing in connectionwith the matters in the litigation.  Webelieve the settlement resolves all of our litigation with Marriott. Thissettlement does not affect our or Senior Housing’s rights vis-à-vis SLS orSunrise which arise by reason of events after Sunrise purchased MSLS.

 

F-17

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**16.  SegmentInformation**

 

We operate in onereportable segment, which is the business of operating senior livingcommunities, including independent living and congregate care communities,assisted living communities and nursing homes. All of our operations and assets are located in the United States.

** **

**17.  SelectedQuarterly Financial Data (Unaudited)**

 

Following issummary unaudited quarterly results of operations for the years ended December31, 2003 and 2002:

 
|                           |   | **2003**           |    |
|--------------------------------|--------|--------------------|---------|
|                           |   | **First  Quarter** |    | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   |
| Revenues                       |   | $                  | 142,178 |   | $ | 141,110 |   | $ | 146,524 |   | $ | 146,403 |   |
| Net loss                       |   | (2,537             | )       | (1,974 | ) | (1,166 | ) | (2,262 | ) |
| (Loss)   per common share |   | $                  | (0.27   | ) | $ | (0.24 | ) | $ | (0.14 | ) | $ | (0.27 | ) |

 
|                             |   | **2002**           | ** ** |
|----------------------------------|--------|--------------------|------------|
|                             |   | **First  Quarter** |       | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                         |   | $                  | 119,270    |   | $ | 131,278 |   | $ | 132,895 |   | $ | 139,068 |   |
| Net (loss) income                |   | (3,369             | )          | (7,330 | ) | (2,506 | ) | 31 |   |
| (Loss) earnings per common share |   | $                  | (0.66      | ) | $ | (0.87 | ) | $ | (0.30 | ) | $ | 0.08 |   |

 

F-18

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**SIGNATURES**

** **

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                        | FIVE STAR  QUALITY CARE, INC.         |
|-----------------------------|---------------------------------------|
|                        |                                  |
|                        |                                  |
|                        | By:                                   | /s/  Evrett W. Benton |   |
|                        | Evrett W. Benton                      |
|                        | President and Chief Executive Officer |
| Dated:  March 25, 2004 |                                  |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated. 

 
| **Signature**                    |   | **Title**                              |   | **Date**        |   |
|----------------------------------|--------|----------------------------------------|--------|-----------------|--------|
|                             |   |                                   |   |            |   |
|  /s/ Evrett W. Benton       |   | President  and Chief Executive Officer |   | March 25,  2004 |   |
| Evrett W. Benton                 |   |                                   |   |            |   |
|                             |   |                                   |   |            |   |
|  /s/ Bruce J. Mackey Jr.    |   | Chief  Financial Officer and Treasurer |   | March 25,  2004 |   |
| Bruce J. Mackey Jr.              |   |                                   |   |            |   |
|                             |   |                                   |   |            |   |
|  /s/ Barry M. Portnoy       |   | Managing  Director                     |   | March 25,  2004 |   |
| Barry M. Portnoy                 |   |                                   |   |            |   |
|                             |   |                                   |   |            |   |
|  /s/ Gerard M. Martin       |   | Managing  Director                     |   | March 25,  2004 |   |
| Gerard M. Martin                 |   |                                   |   |            |   |
|                             |   |                                   |   |            |   |
|  /s/ Bruce M. Gans          |   | Director                               |   | March 25,  2004 |   |
| Bruce M. Gans                    |   |                                   |   |            |   |
|                             |   |                                   |   |            |   |
|  /s/ Barbara D. Gilmore     |   | Director                               |   | March 25,  2004 |   |
| Barbara D. Gilmore               |   |                                   |   |            |   |
|                             |   |                                   |   |            |   |
|  /s/ Arthur G. Koumantzelis |   | Director                               |   | March 25,  2004 |   |
| Arthur G. Koumantzelis           |   |                                   |   |            |   |

 

 

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