** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

** **

**FORM 10-K**

** **

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

 

**For the fiscal year ended December 31, 2004**

 

**OR**

 

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

 

**Commission File Number 001-16817**

 

**FIVE STARQUALITY CARE, INC.**

** **

| **Maryland**              | ** ** | **04-3516029**                     |
|---------------------------|------------|------------------------------------|
| (State of  Incorporation) |       | (IRS Employer  Identification No.) |

 

**400 Centre Street, Newton,Massachusetts 02458**

 

**617-796-8387**

** **

Securities to be 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                       |

 

Securitiesto be registered pursuant to Section 12(g) of the Act: **None**

 

Indicateby check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.  ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).

Yes o  No ý

 

The aggregate marketvalue of the voting shares of the registrant held by non-affiliates was $35.6million based on the $4.40 closing price per common share on the American StockExchange on June 30, 2004.   For purposesof this calculation, an aggregate of 399,582.6 shares of common  stock are held by the directors and officersof the registrant and have been included in the number of shares of commonstock held by affiliates, which includes 35,000 shares of common stock held bySenior Housing Properties Trust.

 

Number of the registrant’sshares of common stock outstanding as of March 25, 2005: 12,227,634.

 

 

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Referencesin this Annual Report on Form 10-K to the “Company,” “Five Star”, “FVE”, “we”, “us”or “our” include Five Star Quality Care, Inc., and its consolidatedsubsidiaries, unless the context indicates otherwise.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

** **

Certain information required in Items 10, 11, 12, 13and 14 of Part III of this Annual Report on Form 10-K is incorporated byreference from our definitive Proxy Statement for the Annual Meeting ofShareholders scheduled to be held on May 11, 2005, or our definitive ProxyStatement.

 

**WARNINGCONCERNING 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 STATEMENTSREPRESENT OUR PRESENT BELIEFS AND EXPECTATIONS, BUT THEY MAY NOT OCCUR FORVARIOUS REASONS.  FOR EXAMPLE:

 

•                  OURFUTURE INSURANCE COSTS AND INSURANCE RESERVE CALCULATIONS MAY BE GREATER THANWE NOW ANTICIPATE;

•                  WEMAY BE UNABLE TO CARRY OUT OUR BUSINESS PLAN TO EXPAND BECAUSE WE ARE UNABLE TOLOCATE EXPANSION OPPORTUNITIES AT PRICES WE ARE WILLING OR ABLE TO PAY;

•                  OURRECEIVABLES RESERVES MAY BE INADEQUATE, ESPECIALLY THE RESERVES WHICH RELATE TOMEDICARE AND MEDICAID PAYMENTS BECAUSE SUCH PAYMENTS ARE SUBJECT TOGOVERNMENTAL AUDITS AND TO GOVERNMENT FISCAL POLICIES;

•                  OURPENDING ACQUISITION OF SIX ASSISTED LIVING COMMUNITIES MAY NOT BE CONCLUDEDBECAUSE OF OUR FAILURE TO RECEIVE LICENSING, THIRD PARTY CONSENTS OR OTHERWISE;

•                  WEMAY BE UNABLE TO MAINTAIN OR IMPROVE OUR FUTURE OCCUPANCY RATES AND AS A RESULTOUR REVENUES MAY DECLINE;

•                  THEIMPROVING ECONOMY MAY RESULT IN WAGE PRESSURES WHICH INCREASE OUR FUTURE COSTS;

•                  FUTUREMEDICARE AND MEDICAID RATES MAY BE LOWER THAN WE NOW ANTICIPATE;

•                  SUNRISESENIOR LIVING SERVICES INC.’S, OR SLS’S, OPERATIONS OF THE COMMUNITIES WHICH ITMANAGES FOR US MAY RESULT IN LOSSES TO US; OR

•                  WEMAY BECOME SUBJECT TO FINES OR REGULATORY SANCTIONS WHICH MATERIALLY ADVERSELYAFFECT OUR FINANCIAL CONDITION OR PERFORMANCE.

 

IN ANY SUCH EVENT, OURFUTURE FINANCIAL PERFORMANCE MAY CAUSE THE IMPROVEMENTS IMPLIED BY OUR RECENTPERFORMANCE TO REVERSE AND WE MAY EXPERIENCE LOSSES.  IF OUR FINANCIAL RESULTS DO NOT CONTINUE TOIMPROVE, OUR STOCK PRICE LIKELY WILL DECLINE. YOU SHOULD NOT PLACE UNDUE RELIANCE UPON FORWARD LOOKING STATEMENTS.

 

EXCEPT AS MAY BE REQUIREDBY APPLICABLE LAW, WE DO NOT INTEND TO IMPLY THAT WE WILL RELEASE PUBLICLY THERESULT OF ANY REVISION TO THE FORWARD LOOKING STATEMENTS CONTAINED IN THISANNUAL REPORT TO REFLECT THE FUTURE OCCURRENCE OF PRESENTLY UNANTICIPATEDEVENTS.

 

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**FIVE STAR QUALITY CARE, INC.**

**2004 FORM10-K ANNUAL REPORT**

**Table ofContents**

 
| ** ** | ** ** | **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, Related Shareholder Matters and Issuer  Purchases of Equity Securities |       |
| 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                                                                                                |       |
| Item 9B.   |       | Other Information                                                                                                       |       |
|       |       |                                                                                                                    |       |
|       |       | **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  and Financial Statement Schedules                                                                             |       |

 

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|   |   | * Incorporated by  reference from our Proxy Statement for the Annual Meeting of Shareholders  scheduled to be held on May 11, 2005, to be filed pursuant to Regulation 14A. |   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|

 

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**PART I**

**Item1**.  Business

** **

**GENERAL**

** **

We operate senior living communities, includingindependent living and congregate care communities, assisted living communitiesand nursing homes. As of December 31, 2004, excluding communities we managedunder third party management contracts, we operated 148 communities containing16,573 living units, including 96 primarily independent and assisted livingcommunities containing 11,724 living units and 52 nursing homes containing4,849 living units. Of our 96 primarily independent and assisted livingcommunities, we lease 77 communities containing 10,308 living units from SeniorHousing Properties Trust, or Senior Housing, our former parent, including 30communities which are directly operated for our account by SLS, a wholly ownedsubsidiary of Sunrise Senior Living, Inc., or Sunrise, and we own or lease fromparties other than Senior Housing 19 communities containing 1,416 livingunits.  All but one of our nursing homesare leased from Senior Housing. Our 148 communities include 4,960 independentliving apartments, 5,046 assisted living suites, 283 special care beds and6,284 nursing beds. Our principal executive offices are located at 400 CentreStreet, Newton, Massachusetts 02458, and our telephone number is(617) 796-8387.

 

**OURHISTORY**

 

We were created by Senior Housing in April 2000to operate nursing homes repossessed or acquired from two former Senior Housingtenants. We were reincorporated in Maryland 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, or AMEX. Pursuant to thetransaction agreement governing this spin off:

 

•                  SeniorHousing capitalized us with approximately $50 million of equity,consisting of cash and working capital, primarily operating receivables, net ofoperating payables;

•                  weagreed to lease 31 primarily independent and assisted living communities thenoperated by Marriott Senior Living Services, or MSLS, a wholly owned subsidiaryof Marriott International Inc., or Marriott, upon their acquisition by SeniorHousing which occurred in 2002, as described below;

•                  weleased 53 nursing homes and two assisted living communities from SeniorHousing;

•                  weassumed one lease from the town of Campbell, Nebraska; and

•                  weagreed to acquire FSQ, Inc., or FSQ, the former operating company of thehealthcare business we owned in order to acquire the personnel, systems andassets necessary for our business.

 

During 2002, we commenced operations at 51 seniorliving communities, including the 31 communities then operated by MSLS, andcurrently operated by SLS, and 20 additional communities. In March and April2002, we issued 3,823,000 common shares in an underwritten public offeringraising net proceeds of $26.1 million. Also during 2002, we ceased operations at two communities, one of whichwas previously leased from Senior Housing and one of which was previouslyleased from the town of Campbell, Nebraska.

 

During 2003, we commenced operations at three seniorliving communities, which we lease from Senior Housing. Also during 2003, weceased operations at seven communities, one of which was previously leased fromSenior Housing. During 2003, we also acquired an institutional pharmacy locatedin Wisconsin for $1.8 million and we acquired a company insuring some of ourworkers compensation related risks for $1.3 million.

 

In March 2004, we ceased operations at one communitythat is leased from Senior Housing and was managed by SLS and we established anadditional insurance company to insure a portion of our liability insurance.

 

In September 2004, we acquired an institutionalpharmacy business located in Lincoln, Nebraska for approximately $3.0 million.

 

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In November 2004, we acquired 100% of the capitalstock of LTA Holdings, Inc., or LTA, for approximately $211 million,excluding closing costs. LTA owned, leased and operated 47 senior livingcommunities with 2,636 living units, which primarily offer assisted livingservices, located in seven states.  Themajority of these 47 communities were built by LTA between 1997 and 2002, theaverage age of the 47 communities is approximately five years and 100% of therevenues at these communities were paid by residents from their privateresources.  In addition, LTA had twomanagement contracts with third parties for 12 assisted livingcommunities.  We terminated one contractfor 11 of these communities, on March 1, 2005.

 

To finance this acquisition, we entered into a$148.2 million sale leaseback transaction with Senior Housing for 31 of thecommunities acquired from LTA. We also entered into a $16.8 millionmortgage loan with Senior Housing secured by five of our properties. We fundedthe balance of the purchase price with cash on hand, and by assuming  Department of Housing and Urban Development,or HUD, insured long term mortgage debts and an operating lease for fourcommunities from Health Care Property Investors, Inc., or HCPI.

 

In December 2004 and January 2005, we issued a totalof 3,620,000 shares of common stock, or common shares, for net proceeds of$28.8 million.  We used a portion ofproceeds raised in this offering to pay off the $16.8 million mortgage loanwith Senior Housing described above.

 

In January 2005, we agreed to acquire six assistedliving communities for approximately $63.5 million from six limited liabilitycompanies known as Gordon Health Care Ventures, LLC, or Gordon.  We intend to finance this acquisition withcash on hand, borrowings under our line of credit and mortgage or saleleaseback transactions for some of the communities being purchased or forcertain other unencumbered communities which we currently own.  Completion of this acquisition is subject tovarious conditions customary in multi-community healthcare transactions of thistype, including completion of diligence, licensing and receiving third partyconsents.  We expect this acquisition toclose during the second quarter of 2005, but there is no assurance that it willclose.

 

In March 2005, we acquired one assisted livingcommunity for a purchase price of $6.9 million, excluding closing costs, andcommenced operations at that community. We funded the purchase price with cash on hand.  This community has 62 living units and 100%of the revenues at this community are paid by residents from their private resources.

 

**OUR GROWTH STRATEGY**

 

We believe that the aging of the U.S. population willincrease demand for existing independent living properties, assisted livingcommunities and nursing homes. Our principal growth strategy is to profit fromthis demand by operating and acquiring properties that provide high qualityservices to residents who pay with private resources.

 

We seek to improve the profitability of our existingoperations by increasing revenues and improving margins. We attempt to increaserevenues by increasing rates and occupancies. We attempt to improve margins bylimiting increases in expenses and improving operating efficiencies.

 

In addition to managing our existing operations, weintend to continue to grow our business through acquisitions of independent andassisted living communities where residents’ private resources account for alarge majority of revenues. Since we became a public company in late 2001, weadded 94 primarily independent and assisted living communities to our businesswhich generate approximately 87% of their revenue from residents’ privateresources, rather than from Medicare or Medicaid. We prefer to purchasecommunities which have achieved or are close to stabilized operations. Forexample, the LTA communities which we acquired were 86% occupied as of December31, 2004.  We also try to makeacquisitions where we can realize cost savings by combining operations with ourexisting operations.

 

Starting in the mid 1990s, a large number ofindependent and assisted living communities were developed with financing fromprivate equity and real estate opportunity funds. We believe that many of thesecommunities are now at or approaching stabilized operations and many of thesefinancial investors are now anxious to sell. For example: in 2002, we acquired15 independent and assisted living communities which were assembled anddeveloped by Constellation Health Services, Inc., a division ofConstellation Energy Group, Inc., f/k/a Baltimore Gas and ElectricCompany; and the controlling shareholder of LTA prior to our acquisition of LTAwas a private equity fund. We expect to pursue similar acquisitions for thenext several years.

 

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We also intend to expand our institutional pharmacybusiness. We acquired our first pharmacy in Wisconsin in 2003.  During 2004, we acquired a second pharmacylocated in Nebraska. Whenever we buy an institutional pharmacy business, weseek to grow its business by providing pharmacy services at our senior living communitieswithin the same service area.  We arecurrently interested in acquiring pharmacies in other areas where we own seniorliving communities.

 

Although expansion of our nursing home business is notour primary growth strategy, we have in the past considered acquiringadditional nursing homes. Most nursing homes are financially dependent upon theMedicare and Medicaid programs. Accordingly, we believe the potential forprofitable operations of nursing homes is limited by government rate setting.In these circumstances, we are only interested in expanding our nursing homeoperations at prices which we believe take into account the risks inherent ingovernment funding. In the past few years, we have been unable to buy nursinghomes at prices we consider appropriate, but we intend to investigate suchopportunities in the future.

** **

**RISK FACTORS**

** **

Wehave only recently been able to operate profitably.  Ownership of our securities involves a highdegree of risk.  The following is asummary of the material risks of ownership of our securities.

** **

**Asmall percentage decline in our revenues or increase in our expenses could havea material negative impact upon our operating results.**

 

For the year ended December 31, 2004, our revenueswere $628.0 million and our expenses were $624.7 million. A smallpercentage decline in our revenues or increase in our expenses could have amaterial negative impact upon our operating results.

 

**Ourgrowth strategy may not succeed.**

 

Our business plan includes acquiring additional seniorliving communities and institutional pharmacies. This growth strategy involvesrisks including the following:

 

•                  wemay be unable to locate senior living communities or pharmacies available forpurchase at acceptable prices;

•                  wemay be unable to access capital to make acquisitions or operate acquiredbusinesses;

•                  acquiredoperations may bring with them contingent liabilities which mature;

•                  tothe extent we incur acquisition debt or leases, our operating leverage mayincrease; and

•                  combiningour present operations with newly acquired operations may disrupt operations orcost more than anticipated when acquisition prices are determined.

 

For these reasons and others:

 

•                  thepending acquisition of the Gordon facilities may not be completed; or, if it iscompleted those facilities’ operations may not be profitably integrated intoour existing operations;

•                  ourbusiness plan to grow may not succeed;

•                  thebenefits which we hope to achieve by growing may not be achieved;

•                  wemay suffer declines in profitability or suffer recurring losses; and

•                  ourexisting operations may suffer from a lack of management attention or financialresources if such attention and resources are devoted to a failed growthstrategy.

 

**Ourinsurance costs have increased and may continue to increase.**

 

In several well publicized instances, privatelitigation by residents of senior living communities for alleged abuses hasresulted in large damage awards against other operating companies. Today, somelawyers and law firms specialize in bringing litigation against senior livingcompanies. As a result of this litigation and potential litigation, our cost ofliability insurance has increased dramatically during the past few years.Workers compensation and employee health insurance costs have also increased inrecent years. To partially offset these increases, we have increased the 

 

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amounts of our self insurance by use of higher deductibles and captiveinsurance companies. Medical liability insurance reform has become a topic ofpolitical debate and some states have enacted legislation to limit futureliability awards. However, if such reforms are not generally adopted, we expectour insurance costs may continue to increase. Although our reserves for selfinsurance have been determined with guidance from third party professionals,our reserves may prove inadequate. Increasing insurance costs and increasingreserves may materially negatively affect our results of operations.

 

**Ourbusiness is subject to extensive regulation which increases our costs and mayresult in losses**.

 

Licensing and Medicare and Medicaid laws requireoperators of senior living communities to comply with extensive standardsgoverning operations. There are also various laws prohibiting fraud by seniorliving operators, including criminal laws that prohibit false claims forMedicare and Medicaid and that regulate patient referrals. In recent years, thefederal and state governments have devoted increased resources to monitoring qualityof care at senior living communities and to anti-fraud investigations. Whenquality of care deficiencies are identified or improper billing is uncovered,various sanctions may be imposed, including denial of new admissions, exclusionfrom Medicare or Medicaid program participation, monetary penalties,governmental oversight or loss of licensure. Our communities receive notices ofsanctions from time to time. A result of this extensive regulatory system andincreasing enforcement initiatives has been to increase our costs of monitoringquality of care compliance and billing procedures, and we expect these costsmay continue to increase. Also, if we become subject to regulatory sanctions,our business may be adversely affected and we might experience financiallosses.

 

**Thefailure of Medicare and Medicaid rates to match our costs will reduce ourincome**.

 

Some of our operations, especially our nursing homes,receive significant revenues from the Medicare and Medicaid programs. Duringthe year ended December 31, 2004, approximately 41% of our total revenues wasreceived from these programs. The federal government and some states are nowexperiencing fiscal deficits. Historically, when governmental deficits haveincreased, cut backs in Medicare and Medicaid funding have often followed.These cut backs sometimes include rate reductions, but more often result in afailure of Medicare and Medicaid rates to increase by sufficient amounts tooffset increasing costs. We cannot now predict whether future Medicare andMedicaid rates will be sufficient to cover our future cost increases. FutureMedicare and Medicaid rate declines or a failure of these rates to coverincreasing costs would result in our experiencing lower earnings or losses.

 

**Sunrise’smanagement of 30 of our communities may have adverse consequences to us.**

 

In March 2003, Marriott sold its subsidiary whichmanages 30 communities for us to Sunrise. We believe Sunrise’s financialcondition and reputation as an operator of senior living communities is weakerthan the financial condition and reputation of Marriott. The operations and thefinancial results which we realize from the communities managed for us bySunrise have declined and become more volatile since this sale and this declineand volatility may continue in the future.

 

**Weare subject to possible conflicts of interest and we have engaged in, and willcontinue to engage in for the foreseeable future, transactions with relatedparties.**

 

Our business is subject to possible conflicts ofinterest as follows:

 

•                  ourChief Executive Officer, Evrett W. Benton, and our Chief Financial Officer,Bruce J. Mackey Jr., are also part-time employees of Reit Management andResearch LLC, or RMR. RMR is the manager for Senior Housing and we purchasevarious services from RMR pursuant to a shared services agreement;

•                  ourmanaging directors, Barry M. Portnoy and Gerard M. Martin, are also managingtrustees of Senior Housing. Messrs. Portnoy and Martin also own RMR andanother entity that leases office space to us; and

•                  underour shared services agreement with RMR, in the event of a conflict betweenSenior Housing and us, RMR may act on behalf of Senior Housing rather thanon our behalf.

 

We do not believe that these conflicts adverselyaffect our business.

 

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On December 31, 2001, Senior Housing distributedsubstantially all of its ownership of our shares to its shareholders. As acondition to the spin off, we entered into agreements with Senior Housingwhich, among other things, limit ownership of more than 9.8% of our votingshares, restrict our ability to take any action that could jeopardize the taxstatus of Senior Housing as a real estate investment trust and limit ourability to acquire real estate of types which are owned by Senior Housing orother real estate investment trusts managed by RMR.

 

One hundred twenty-eight of the 148 senior livingcommunities we currently operate are leased from Senior Housing for totalannual minimum rent of $95.8 million.

 

As a result of the agreements entered into inconnection with the spin off, our leases with Senior Housing and our sharedservices agreement with RMR, Senior Housing, RMR and their respectiveaffiliates play a significant role in our business and we do not anticipate anychanges to that role for the foreseeable future. Future business dealingsbetween us, Senior Housing, RMR and their respective affiliates may be on termsless favorable to us than we could achieve on an arm’s length basis.

 

**Ourbusiness requires regular capital expenditures.**

 

Physical characteristics of senior living communitiesare mandated by various governmental authorities. Changes in these regulationsmay require us to make significant expenditures. In the future, our communitiesmay require significant expenditures to address ongoing required maintenanceand to make them attractive to residents. Our available financial resources maybe insufficient to fund these expenditures.

 

**Ourbusiness is highly competitive and we may be unable to operate profitably.**

 

We compete with numerous other companies that 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 profitability atnursing homes, including those we operate. Many of our existing competitors arelarger and have greater financial resources than we do. Accordingly, we cannotprovide any assurances that we will be able to attract a sufficient number ofresidents to our communities or that we will be able to attract employees andkeep wages and other employee benefits, insurance costs and other operatingexpenses at levels which will allow us to compete successfully or to operateprofitably.

 

**Wemay not achieve the anticipated benefits of our recently completed acquisitionof LTA.**

 

The financial benefits we expect to realize from ouracquisition of LTA are largely dependent upon our ability to increase theoccupancy of the LTA communities and to realize cost savings by combining theLTA operations and our existing operations. If our management of the LTA communitiesdoes not increase revenues and lower costs, we may not achieve the anticipatedbenefits and we may experience losses.

 

**Anti-takeoverprovisions in our governing documents and in our material agreements mayprevent shareholders from receiving a takeover premium for their shares.**

 

Our charter places restrictions on the ability of anyperson or group to acquire beneficial ownership of more than 9.8% (in number ofshares or value, whichever is more restrictive) of any class of our equitysecurities. Additionally, the terms of our leases with Senior Housing and ourshared services agreement with RMR provide that our rights under theseagreements may be cancelled by Senior Housing and RMR, respectively, upon theacquisition by any person or group of more than 9.8% of our voting stock, andupon other change in control events, as defined in those documents. If thebreach of these ownership limitations causes a lease default, shareholderscausing the default may become liable to us or to other shareholders for damages.Additionally, on March 10, 2004, we entered into a rights agreementwhereby in the event a person or group of persons acquires or attempts toacquire 10% or more of our outstanding common shares, our shareholders, otherthan such person or group, will be entitled to purchase additional shares orother securities or property at a discount. These agreements and otherprovisions in our charter and bylaws may increase the difficulty of acquiringcontrol of us by means of a tender offer, open market purchases, a proxy fightor otherwise, if the acquisition is not 

 

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approved by our board of directors. Other provisions in our governingdocuments which may deter takeover proposals include the following:

 

•                  staggeredterms for members of our board of directors; the power of our board ofdirectors, without a shareholders’ vote, to authorize and issue additionalshares and classes of shares on terms that it determines;

•                  a75% shareholder vote and cause requirements for removal of directors; and

•                  advancenotice procedures with respect to nominations of directors and shareholderproposals.

 

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.

 

**Asignificant increase in our labor costs could have a material adverse effect onus.**

 

We compete with other operators of senior livingcommunities with respect to attracting and retaining qualified personnelresponsible for the day to day operations of each of our communities. Ashortage of nurses or other trained personnel may require us to increase thewages and benefits offered to our employees in order to attract and retainthese personnel or to hire more expensive temporary personnel. No assurance canbe given that our labor costs will not increase or that any increase will bematched by corresponding increases in rates charged to residents. Anysignificant failure by us to control our labor costs or to pass on any increasedlabor costs to residents through rate increases could have a material adverseeffect on our business, financial condition and results of operations.

 

**Circumstancesthat adversely affect the ability of the elderly to pay for our services couldhave a material adverse effect on us.**

 

Approximately 59% of our total revenues from ourcommunities for the year ended December 31, 2004 were attributable to privatepay sources. We expect to continue to rely on the ability of our residents topay for our services from their own financial resources. Inflation or othercircumstances that adversely affect the ability of the elderly to pay for ourservices could have a material adverse effect on our business, financialcondition and results of operations.

 

**TYPES OF COMMUNITIES**

** **

Our present business plan contemplates the ownership,leasing and management of independent living apartments or congregate carecommunities, assisted living communities, specialty care suites and nursinghomes. Some communities combine more than one type of service in a singlebuilding or campus.

 

*Independent Living Apartments or Congregate CareCommunities.* Independent living apartments, or congregate care communities, providehigh levels of privacy to residents and require residents to be capable ofrelatively high degrees of independence. An independent living apartmentusually bundles several services as part of a regular monthly charge. Forexample, one or two meals per day in a central dining room, weekly maid serviceor services of a social director may be included in the base charge. Additionalservices are generally available from staff employees on a fee for servicebasis. In some independent living properties, separate parts of the communityare dedicated to assisted living or nursing services. As of March 25, 2005, ourbusiness includes 4,960 independent living apartments in 38 communities.

 

*Assisted Living Communities.*  Assisted living communities are typicallycomprised of one bedroom units which include private bathrooms and efficiencykitchens. Services bundled within one charge usually include three meals perday in a central dining room, daily housekeeping, laundry, medical remindersand 24 hour availability of assistance with the activities of daily livingsuch as dressing and bathing. Professional nursing and healthcare services areusually available at the community on call or at regularly scheduled times. Asof March 25, 2005, our business includes 5,046 assisted living suites in 95communities.

 

*Specialty Care Suites*.  Specialty care suites offer specializedprograms for patients suffering from specific illnesses, usually Alzheimer’sdisease. As of March 25, 2005, our business includes 283 specialty care suitesin 9 communities.

 

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*Nursing Homes*.  Nursing homes generally provide extensivenursing and healthcare services similar to those available in hospitals,without the high costs associated with operating theaters, emergency rooms orintensive care units. A typical purpose built nursing home includes mostly twobed rooms with a separate bathroom in each room and shared dining and bathingfacilities. Some private rooms are available for those residents who pay higherrates or for residents whose medical conditions require segregation. Nursinghomes are staffed by licensed nursing professionals 24 hours per day. Asof March 25, 2005, our business includes 6,284 nursing home beds in 78communities.

 

**OPERATING STRUCTURE**

 

We have several regional offices, which are locatedthroughout the country. Each regional office is responsible for multiplecommunities and is headed by a regional director of operations with extensiveexperience in the senior living industry. Each regional office is typicallysupported by a clinical or wellness director, a rehabilitation servicesdirector, a regional accounts manager, a human resources specialist and a salesand marketing specialist. Regional staff are responsible for all our communityoperations within the region, including:

 

•                  residentservices;

•                  marketingand sales;

•                  hiringof community personnel;

•                  compliancewith applicable legal and regulatory requirements; and

•                  supportingour development and acquisition plans within their region.

 

Our home office staff performs the following tasks:

 

•                  generaloversight of our regional staff and pharmacy operations;

•                  theestablishment of company wide policies and procedures relating to residentcare;

•                  humanresources policies and procedures;

•                  informationtechnology;

•                  Medicareand Medicaid billing;

•                  licensingand certification maintenance;

•                  legalservices;

•                  centralpurchasing;

•                  budgetingand supervision of maintenance and capital expenditures;

•                  implementationof our growth strategy; and

•                  accountingand finance functions, including operations budgeting, accounts receivable andcollections, accounts payable, payroll, financial reporting, and tax planningand compliance.

** **

**INDEPENDENT AND ASSISTED LIVING 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 and marketing, financial performance andstaff supervision. The executive director is supported by department heads, whooversee the care and service of the residents, a wellness director, who isresponsible for coordinating the services necessary to meet the health careneeds of our residents and a marketing director, who is responsible for sellingour services.  Other key positionsinclude the dining services coordinator, the activities coordinator and theproperty maintenance coordinator.

 

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****NURSING HOME STAFFING****

** **

Each of our nursing homes is managed by a statelicensed administrator who is supported by other professional personnel,including a director of nursing, an activities director, a marketing director,a social services director, a business office manager, and physical,occupational and speech therapists. Our directors of nursing are state licensednurses who supervise our registered nurses, licensed practical nurses andnursing assistants. Staff size and composition vary depending on the size andoccupancy of each nursing home and on the type of care provided by the nursinghome. Our nursing homes also contract with physicians who provide certainmedical services.

** **

**PHARMACY OPERATIONS AND STAFFING**

 

Our pharmacy operations provide goods and services tooperators and residents of senior living communities; we do not sell to thepublic generally. At each pharmacy, we have an executive director who is astate licensed pharmacist and who manages the pharmacy and supervises billing.The executive director is responsible for the day to day operations of thepharmacy including sales and marketing, financial performance, compliance withregulatory codes regarding the dispensing of controlled substances and staffsupervision. Other pharmacy personnel include licensed dispensing pharmacists,a director of pharmacy consultation, a medical records director, a nurseconsultant, pharmacy technicians and billing personnel.

** **

**EMPLOYEES**

** **

As of March 25, 2005, we had approximately 9,000employees, including 5,300 full time equivalents. Approximately 550 employees,including 350 full time equivalents, are represented under five collectivebargaining agreements which have remaining terms of one to three years. We haveno other employment agreements. We believe our relations with our union andnon-union employees are good.

 

**GOVERNMENTREGULATION AND REIMBURSEMENT**

 

Our operations must comply 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.

 

*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 communities 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 communities arelicensed 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 communities 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 livingcommunities in which residents pay entrance fees or prepay for services.

 

*Assisted Living Communities. *According to the NationalAcademy for State Health Policy, or the National Academy, a majority of statesprovide or are approved to provide Medicaid payments for residents in someassisted living communities under waivers granted by the Federal Centers forMedicare and Medicaid Services, or CMS, or under Medicaid state plans, andcertain other states are planning some Medicaid funding by preparing orrequesting waivers to fund assisted living demonstration projects. Becauserates paid to assisted living community operators are generally lower thanrates paid to nursing home operators, some states use Medicaid funding ofassisted living as a means of lowering the cost of services for residents whomay not need the higher intensity of health related services provided innursing homes. States that administer Medicaid programs for assisted livingcommunities are responsible for monitoring the services at, 

 

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and physical conditions of, the participating communities. Differentstates apply different standards in these matters, but generally we believethese monitoring processes are similar to the concerned states’ inspectionprocesses for nursing homes.

 

In light of the large number of states using Medicaidto purchase services at assisted living communities and the growth of assistedliving in recent years, a majority of states have adopted licensing standardsapplicable to assisted living communities. A majority of states have licensingstatutes or standards specifically using the term “assisted living” and haverequirements for communities servicing people with Alzheimer’s disease ordementia. The majority of states have revised their licensing regulationsrecently or are reviewing their policies or drafting or revising theirregulations. State regulatory models vary; there is no national consensus on adefinition of assisted living, and no uniform approach by the states toregulating assisted living communities. Most state licensing standards apply toassisted living communities whether or not they accept Medicaid funding. Also,according to the National Academy, a few states require certificates of needfrom state health planning authorities before new assisted living communitiesmay be developed. Based on our analysis of current economic and regulatorytrends, we believe that assisted living communities that become dependent uponMedicaid payments for a majority of their revenues may decline in value becauseMedicaid rates may fail to keep up with increasing costs. We also believe thatassisted living communities located in states that adopt certificate of needrequirements or otherwise restrict the development of new assisted livingcommunities may increase in value because these limitations upon developmentmay help ensure higher occupancy and higher non-governmental rates.

 

The US. Department of Health and Human Services, theGovernment Accountability Office and the Senate Special Committee on Aging haverecently studied and reported on the development of assisted living and itsrole in the continuum of long-term care and as an alternative to nursinghomes.   In 2003, the GovernmentAccountability Office recommended that CMS strengthen its oversight of stateMedicaid waiver programs and state quality assurance programs.  Also in 2003, a working group of assistedliving providers, consumers and regulatory organizations made recommendationsto the Senate Special Committee on Aging on a range of subjects, includingstaffing, funding and regulation of assisted living.  We cannot predict whether these studies andreports will result in governmental policy changes or new legislation, or whatimpact any changes may have. Based upon our analysis of current economic andregulatory trends, we do not believe that the federal government is likely tohave a material impact upon the current regulatory environment in which theassisted living industry operates unless it also undertakes expanded fundingobligations, and we do not believe a materially increased financial commitmentfrom the federal government is presently likely. However, we do anticipate thatassisted living communities will increasingly be licensed and regulated by thevarious states, and that, in the absence of federal standards, the states’policies will continue to vary widely.

 

*Nursing Homes-Reimbursement. *About 61% of all nursinghome revenues in the U.S. in 2003 (the most recent date for which informationseems to be publicly available) came from publicly funded programs, includingabout 46% from Medicaid programs and 12% from the Medicare program. Nursinghomes are among the most highly regulated businesses in the country. Thefederal and state governments regularly monitor the quality of care provided atnursing homes. State health departments conduct surveys of resident care andinspect the physical condition of nursing home properties. These periodicinspections and occasional changes in life safety and physical plantrequirements 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 Medicare prospective payment system, or the PPS, was phased in over threeyears beginning with cost reporting years starting on or after July 1,1998. Under the PPS, capital costs are part of the prospective rate and are notcommunity specific.  The PPS and otherrecent legislative and regulatory actions with respect to state Medicaid ratesare limiting the reimbursement levels for some nursing home services. At thesame time, federal and state enforcement and oversight of nursing homes areincreasing, making licensing and certification of these communities morerigorous.

 

The PPS was established by the Balanced Budget Act of1997, and was intended to reduce the rate of growth in Medicare payments forskilled nursing communities. Before the current Medicare payment system,Medicare rates were community specific and cost based. Under the currentMedicare payment system, skilled nursing facilities receive a fixed payment foreach day of care provided to residents who are Medicare beneficiaries. Eachresident is assigned to one of 44 care groups depending on that resident’s medicalcharacteristics and service needs. Per diem payment rates are established foreach of these care groups. Medicare payments cover substantially all servicesprovided to Medicare residents in skilled nursing communities, includingancillary services such as rehabilitation therapies. The PPS is intended toprovide incentives to providers to furnish only necessary services and todeliver those services efficiently. During the three year 

 

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phase in period, Medicare rates for skilled nursing communities werebased on a blend of community specific costs and rates established by the newMedicare payment system. According to the Government Accountability Office,between fiscal year 1998 and fiscal year 1999, the first full year of thechanged Medicare payment system phase in, the average Medicare payment per daydeclined by about 9%.

 

Since November 1999, Congress has provided some relieffrom the impact of the Balanced Budget Act of 1997. Effective April 1,2000, the Medicare, Medicaid and State Children’s Health Insurance ProgramBalanced Budget Refinement Act of 1999 temporarily boosted payments for certainskilled nursing cases by 20% and allowed skilled nursing communities totransition more rapidly to the federal payment system. This Act also increasedthe Medicare payment rates by 4% for fiscal years 2001 and 2002 and imposed atwo year moratorium on some therapy limitations for skilled nursing residentscovered under Medicare Part B. In December 2000, the Medicare,Medicaid and State Children’s Health Insurance Program Benefits Improvement andProtection Act of 2000 was approved. Effective April 1, 2001 toOctober 1, 2002, this Act increased the nursing component of the paymentrate for each care group by 17%. This Act also increased annual inflationadjustments for fiscal year 2001, increased rehabilitation care group rates by7%, maintained the previously temporary 20% increase in the other care grouprates established in 1999, and extended the moratorium on some therapyreimbursement rate caps through 2002. However, as of October 1, 2002, the4% across the board increase in Medicare payment rates and the 17% increase inthe nursing component of the rates expired. Effective October 1, 2003, CMSincreased the annual inflation update to skilled nursing community rates by 3%per year, and added an additional 3% for the year beginning October 1,2003, to account for inflation underestimates in prior years. The 20% increasefor the skilled nursing care groups and the 7% increase in rehabilitation caregroup rates will expire when the current resource utilization groups arerefined, currently anticipated to be effective October 1, 2005, for fiscal year2006. Effective December 8, 2003, the Medicare Prescription Drug,Improvement and Modernization Act of 2003 set a new moratorium onimplementation of some therapy reimbursement rate caps through 2005.

 

*Nursing Homes-Survey and Enforcement.*CMS has undertaken an initiative to increase the effectiveness of Medicare andMedicaid nursing home survey and enforcement activities. CMS’s initiativefollows a July 1998 Government Accountability Office investigation whichfound inadequate care in a significant proportion of California nursing homesand CMS’s July 1998 report to Congress on the effectiveness of the surveyand enforcement system. In 1999, the U.S. Department of Health and HumanServices, Office of Inspector General issued several reports concerning qualityof care in nursing homes, and the Government Accountability Office issuedreports in 1999, 2000, 2002, 2003 and 2004 which recommended that CMS and thestates strengthen their compliance and enforcement practices, including federaloversight of state actions, to better ensure that nursing homes provideadequate care. Since 1998, the Senate Special Committee on Aging has beenholding hearings on these issues. CMS is taking steps to focus more survey andenforcement efforts on nursing homes with findings of substandard care orrepeat violations of Medicare and Medicaid standards and to identify chainoperated communities with patterns of noncompliance. CMS is also increasing itsoversight of state survey agencies and requiring state agencies to useenforcement sanctions and remedies more promptly when substandard care orrepeat violations are identified, to investigate complaints more promptly, andto survey communities more consistently. In addition, CMS has adoptedregulations expanding federal and state authority to impose civil moneypenalties in instances of noncompliance. Medicare survey results and nursingstaff hours per resident for each nursing home are posted on the Medicarewebsite at www.medicare.gov. CMS plans to post fire safety survey results andsprinkler status of nursing homes on the Medicare website in 2005.  Whendeficiencies under state licensing and Medicare and Medicaid standards areidentified, sanctions and remedies such as denials of payment for new Medicareand Medicaid admissions, civil monetary penalties, state oversight and loss ofMedicare and Medicaid participation or licensure 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 curedeficiencies which have been identified or that are identified in the future,additional sanctions may be imposed, and if imposed, may adversely affect ourability to meet our financial obligations and negatively affect our financialcondition 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 publishing the nurse staffing level ateach nursing home on the internet (www.medicare.gov) to increase market pressures on nursing homeoperators.

 

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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 required compliancewith applicable federal or state regulations could adversely affect our abilityto meet our financial obligations and negatively affect our financial conditionand results of operations.

 

*Nursing Homes-Certificates of Need.*Most states limit the number of nursing homes by requiring developers to obtaincertificates of need before new communities may be built. Also, such  states 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.

 

*Other Matters*.  Under the Medicare Prescription Drug,Improvement and Modernization Act of 2003, Medicare beneficiaries may receiveprescription drug benefits beginning in 2006 by enrolling in private healthplans or managed care organizations, or if they remain in traditional Medicare,by enrolling in stand alone prescription drug plans. A number of legislativeproposals that would affect major reforms of the healthcare system have beenintroduced in the U.S. Congress and many are being considered by some stategovernments, such as programs for national health insurance, the option ofblock grants for states rather than federal matching money for certain stateMedicaid services, additional Medicare and Medicaid reforms and federal andstate cost containment measures. In connection with recent fiscal pressures onstate governments, legislation and regulation to reduce Medicaid nursing homepayment rates in some states are possible in the future. We cannot predictwhether any of these legislative or regulatory proposals will be adopted or, ifadopted, what effect, if any, these proposals would have on our business.

 

**INSURANCE**

 

Litigation against senior living operators has beenincreasing during the past few years. Several cases by nursing home patients ortheir families who have won large monetary awards for mistreatment have beenwidely publicized. The amount of such litigation in Florida has beenparticularly significant. As a result, liability insurance costs are risingand, in some cases, such insurance is not available to some senior livingoperators. We have liability insurance for the properties which we now operate.Only one of these communities is located in Florida and such community has nonursing home beds. SLS is responsible for obtaining insurance for the seniorliving communities which SLS manages for us. As of December 31, 2004, five ofthese communities were located in Florida (884 independent living apartments,331 assisted living suites and 95 nursing home beds).

 

In recent years, our insurance costs for workerscompensation and employee healthcare have also increased significantly. This isespecially so with respect to workers compensation insurance in Californiawhere we operated six communities with approximately 575 employees as ofDecember 31, 2004, and where SLS operated two communities with approximately300 employees for our account.

 

To partially offset these insurance cost increases, wehave taken several actions including the following:

 

•                  wehave increased the deductible or retention amounts for which we are liableunder our liability insurance;

•                  wehave established an offshore captive insurance company which participates inour liability insurance program. Some of our premiums for liability insuranceare paid to this company which may retain some of these amounts and theearnings on these amounts based upon our actual claims experiences;

•                  wehave acquired another offshore insurance company and established a captiveinsurance program for our workers compensation insurance obligations in thosestates which permit such arrangements. This program may allow us to reduce ournet workers compensation insurance costs by allowing us to retain the earningson our reserves, provided our claims experience is as projected by variousstatutory and actuarial formulas;

•                  wehave increased the amounts which some of our employees are required to pay forhealth insurance coverage and as co-payments for health services andpharmaceutical prescriptions and decreased the amount of certain healthcarebenefits;

 

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•                  wehave increased the deductible or retention amounts for our health insuranceobligations;

•                  wehave hired professional advisors to help us establish programs to reduce ourinsured workers compensation and professional and general liabilities,including a program to monitor and pro-actively settle liability claims and toreduce workplace injuries;

•                  wehave hired professionals to help us establish appropriate reserves for ourretained liabilities and captive insurance programs; and

•                  wehave hired an asset manager for the SLS managed communities who, among otherduties, monitors various insurance programs for these communities.

 

Our current insurance arrangements generally arerenewable in June 2005. We do not know if our insurance charges andself-insurance reserve requirements will continue to increase, and we cannotnow predict the amount of any such increase, or to what extent, if at all, wemay be able to offset any increase through use of higher deductibles, retentionamounts, self insurance or other means in the future.

 

**COMPETITION**

 

The senior living services business is highlycompetitive. We compete with service providers offering alternate types ofservices, such as home healthcare services, as well as other companiesproviding 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. We have large lease obligations and limited financeable assets.Many of our competitors have greater financial resources than we do. For all ofthese reasons and others, we cannot provide any assurance that we will be ableto compete successfully for business in the senior living industry.

 

**ENVIRONMENTALMATTERS**

 

Under various federal, state and local laws, owners aswell as tenants and operators of real estate may be required to investigate andclean up hazardous substances released or otherwise present at a property, andmay be held liable to a governmental entity or to third parties for propertydamage or personal injuries and for investigation and clean up costs incurredin connection with any such hazardous substances. Under our leases, we havealso agreed to indemnify Senior Housing for any such liabilities related to theleased communities. In addition, some environmental laws create a lien on acontaminated site in favor of the government for damages and costs it incurs inconnection with the contamination, which lien may be senior in priority to ourleases. We have reviewed environmental surveys of our leased and ownedcommunities. Based upon that review we do not believe that any of theseproperties are subject to any material environmental contamination. However, noassurances can be given that a prior owner, operator or occupant of ourcommunities did not create a material environmental condition not known to uswhich might have been revealed by more in depth study of the properties or thatfuture uses or conditions (including, without limitation, changes in applicableenvironmental laws and regulations) will not result in the imposition ofenvironmental liability upon us. The presence or discovery of any materialenvironmental contaminants at our communities could have a material adverseimpact on us.

** **

**INTERNET WEBSITE**

 

Our internet website address is www.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,MA 02458 or at our website.  We makeavailable, free of charge, through our website, our Annual Reports onForm 10-K, our Quarterly Reports on Form 10-Q, our Current Reports onForm 8-K and amendments to such reports filed or furnished pursuant toSection 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended,or the Exchange Act, as soon as reasonably practicable after such forms areelectronically filed with the Securities and Exchange Commission.  Any shareholder or other interested party whodesires to communicate with our independent directors, individually or as agroup, may do so by filling out a report on our website. Our board alsoprovides a process for security holders to send communications to our entireboard. Information about the process for sending communications to our boardcan be found on our website.  Our website address is included several timesin this Annual Report on Form 10-K as a textual reference only and 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 LIVING COMMUNITIES**

** **

As of December 31, 2004, excluding communities wemanaged under third party management contracts, our business included 148senior living communities which may be categorized into three groups asfollows:

 
| **Ownership**                                                                   | ** ** | **No. of   communities**      | ** ** | **Type of units**         | ** ** | **Total   living   units** | ** ** | **Occupancy  for   the year ended   Dec 31, 2004** | ** ** | **Revenues  for  the year ended   Dec. 31, 2004 (in  thousands)** | ** ** | **Percent  of  revenues  from   private   resources** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------|------------|---------------------------|------------|----------------------------|------------|----------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| **Indep.   living   apts.**                                                     | ** ** | **Assist.   living   suites** | ** ** | **Special   care   beds** | ** ** | **Nursing  home   beds**   |
| Communities we  operate and lease from Senior Housing                           |       | 98                            |       | 733                       |       | 2,395                      |       | —                                             |       | 4,605                                                             |       | 7,733                                                 |       | 89 | %(1) | $ | 336,570 | (1)  | 42 | % |
| Communities we  lease from Senior Housing and SLS manages                       |       | 30                            |       | 3,977                     |       | 1,485                      |       | 283                                                |       | 1,530                                                             |       | 7,275                                                 |       | 91 | % | 303,111 |   | 85 | % |
| Communities we  operate and own or lease from parties other than Senior Housing |       | 20                            |       | 250                       |       | 1,166                      |       | —                                             |       | 149                                                               |       | 1,565                                                 |       | 84 | %(1) | 49,787 | (1)  | 80 | % |
| Totals:                                                                         |       | 148                           |       | 4,960                     |       | 5,046                      |       | 283                                                |       | 6,284                                                             |       | 16,573                                                |       | 89 | % | $ | 689,468 |   | 62 | % |

 

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(1)          Includesamounts and data for periods prior to commencement of our lease or ownership.

 

**COMMUNITIES WE OPERATE AND LEASE FROM SENIOR HOUSING**

** **

As of December 31, 2004, we operated 98 communitieswhich are leased from Senior Housing. These communities have 7,733 living unitsand are located in 19 states. The following table provides additionalinformation about these communities and their operations.

 
| ** **          | ** ** | ** **               | ** ** | **Type of  units**          | ** ** | ** **                    | ** ** | ** **               | ** ** | **Revenues  for the**      | ** ** | **Percent  of**                                         | ** ** |
|---------------------|------------|--------------------------|------------|-----------------------------|------------|-------------------------------|------------|--------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| **Location**        | ** ** | **No. of   communities** | ** ** | **Indep.   living   apts.** | ** ** | **Assist.   living   suites** | ** ** | **Nursing  home   beds** | ** ** | **Total   living   units** | ** ** | **Occupancy  for   the year ended   Dec. 31, 2004 (1)** | ** ** | **year  ended   Dec. 31, 2004   (in thousands) (1)** | ** ** | **revenues  from   private   resources** | ** ** |
| 1. Alabama          |       | 3                        |       | —                      |       | 132                           |       | —                   |       | 132                        |       | 96                                                      | %          | $ | 4,452 |   | 100 | % |
| 2. Arizona          |       | 2                        |       | —                      |       | 52                            |       | 125                      |       | 177                        |       | 78                                                      | %          | 6,429 |   | 23 | % |
| 3. California       |       | 6                        |       | 84                          |       | 165                           |       | 396                      |       | 645                        |       | 93                                                      | %          | 29,369 |   | 34 | % |
| 4. Colorado         |       | 7                        |       | 64                          |       | —                        |       | 752                      |       | 816                        |       | 87                                                      | %          | 42,203 |   | 24 | % |
| 5. Connecticut      |       | 2                        |       | —                      |       | —                        |       | 300                      |       | 300                        |       | 97                                                      | %          | 22,189 |   | 7 | % |
| 6. Georgia          |       | 10                       |       | —                      |       | 287                           |       | 338                      |       | 625                        |       | 91                                                      | %          | 24,455 |   | 42 | % |
| 7. Iowa             |       | 7                        |       | 19                          |       | —                        |       | 476                      |       | 495                        |       | 90                                                      | %          | 25,247 |   | 15 | % |
| 8. Kansas           |       | 2                        |       | 140                         |       | —                        |       | 55                       |       | 195                        |       | 84                                                      | %          | 5,111 |   | 64 | % |
| 9. Kentucky         |       | 4                        |       | —                      |       | 193                           |       | —                   |       | 193                        |       | 90                                                      | %          | 5,801 |   | 100 | % |
| 10. Maryland        |       | 6                        |       | 275                         |       | 324                           |       | —                   |       | 599                        |       | 89                                                      | %          | 21,029 |   | 100 | % |
| 11. Michigan        |       | 1                        |       | —                      |       | —                        |       | 124                      |       | 124                        |       | 90                                                      | %          | 11,279 |   | 9 | % |
| 12. Missouri        |       | 2                        |       | —                      |       | —                        |       | 180                      |       | 180                        |       | 82                                                      | %          | 5,060 |   | 19 | % |
| 13. Nebraska        |       | 14                       |       | —                      |       | —                        |       | 815                      |       | 815                        |       | 86                                                      | %          | 33,942 |   | 30 | % |
| 14. North  Carolina |       | 1                        |       | —                      |       | 89                            |       | —                   |       | 89                         |       | 96                                                      | %          | 3,424 |   | 100 | % |
| 15. South  Carolina |       | 7                        |       | —                      |       | 304                           |       | —                   |       | 304                        |       | 90                                                      | %          | 9,664 |   | 100 | % |
| 16. Tennessee       |       | 6                        |       | —                      |       | 301                           |       | —                   |       | 301                        |       | 89                                                      | %          | 9,586 |   | 100 | % |
| 17. Virginia        |       | 9                        |       | 143                         |       | 548                           |       | —                   |       | 691                        |       | 87                                                      | %          | 23,473 |   | 100 | % |
| 18. Wisconsin       |       | 7                        |       | —                      |       | —                        |       | 861                      |       | 861                        |       | 90                                                      | %          | 45,563 |   | 21 | % |
| 19. Wyoming         |       | 2                        |       | 8                           |       | —                        |       | 183                      |       | 191                        |       | 82                                                      | %          | 8,294 |   | 23 | % |
| Totals:             |       | 98                       |       | 733                         |       | 2,395                         |       | 4,605                    |       | 7,733                      |       | 89                                                      | %          | $ | 336,570 |   | 42 | % |

** **

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**(1)Includes amounts and data for periods prior to commencement of our lease.**

 

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**COMMUNITIES WE LEASE FROM SENIOR HOUSING AND SLSMANAGES**

** **

As of December 31, 2004, we leased 30 of ourcommunities from Senior Housing and SLS managed these communities for us. Thesecommunities have 7,275 living units and are located in 13 states. The followingtable provides additional information about these communities and theiroperations.

 
| ** **          | ** ** | **Types of  units**      | ** ** |
|---------------------|------------|--------------------------|------------|
| **Location**        | ** ** | **No. of   communities** | ** ** | **Indep.   living   apts.** | ** ** | **Assist.   living   suites** | ** ** | **Special   care   beds** | ** ** | **Nursing   home   beds** | ** ** | **Total   living   units** | ** ** | **Occupancy    for the year   ended   Dec. 31, 2004** | ** ** | **Revenues  for the   year ended  Dec. 31, 2004   (in thousands)** | ** ** | **Percent  of   revenues   from   private   resources** | ** ** |
| 1. Arizona          |       | 3                        |       | 523 |   | 142 |   | 28 |   | 188 |   | 881 |   | 90 | % | $ | 33,223 |   | 89 | % |
| 2. California       |       | 2                        |       | 246 |   | 100 |   | — |   | 59 |   | 405 |   | 91 | % | 20,025 |   | 95 | % |
| 3. Delaware         |       | 5                        |       | 335 |   | 173 |   | 26 |   | 341 |   | 875 |   | 94 | % | 45,197 |   | 77 | % |
| 4. Florida          |       | 5                        |       | 884 |   | 331 |   | — |   | 95 |   | 1,310 |   | 89 | % | 41,185 |   | 86 | % |
| 5. Indiana          |       | 1                        |       | 117 |   | — |   | 30 |   | 74 |   | 221 |   | 92 | % | 11,448 |   | 75 | % |
| 6. Kansas           |       | 1                        |       | 117 |   | 30 |   | — |   | 60 |   | 207 |   | 96 | % | 9,772 |   | 86 | % |
| 7. Kentucky         |       | 3                        |       | 380 |   | 55 |   | — |   | 171 |   | 606 |   | 95 | % | 25,266 |   | 81 | % |
| 8. Massachusetts    |       | 1                        |       | — |   | 125 |   | — |   | — |   | 125 |   | 97 | % | 6,708 |   | 100 | % |
| 9. New Jersey       |       | 1                        |       | 217 |   | 108 |   | 31 |   | 60 |   | 416 |   | 71 | % | 13,303 |   | 85 | % |
| 10. New Mexico      |       | 1                        |       | 114 |   | 35 |   | — |   | 60 |   | 209 |   | 97 | % | 10,537 |   | 93 | % |
| 11. Ohio            |       | 1                        |       | 144 |   | 87 |   | 25 |   | 60 |   | 316 |   | 88 | % | 14,241 |   | 90 | % |
| 12. South  Carolina |       | 1                        |       | — |   | 60 |   | 36 |   | 68 |   | 164 |   | 94 | % | 6,342 |   | 69 | % |
| 13. Texas           |       | 5                        |       | 900 |   | 239 |   | 107 |   | 294 |   | 1,540 |   | 92 | % | 65,864 |   | 86 | % |
| Totals:             |       | 30                       |       | 3,977 |   | 1,485 |   | 283 |   | 1,530 |   | 7,275 |   | 91 | % | $ | 303,111 |   | 85 | % |

 

**COMMUNITIES WE OPERATE AND OWN OR LEASE FROM PARTIESOTHER THAN SENIOR HOUSING**

 

As of December 31, 2004, our business included 20communities we owned or leased from parties other than Senior Housing which had1,565 living units located in nine states. The following table providesadditional information about these communities and their operations:

 
| ** **        | ** ** | ** **               | ** ** | **Type of  units**          | ** ** | ** **                    | ** ** | **Occupancy**             | ** ** | **Revenues  for the**      | ** ** | **Percent  of   revenues**                    | ** ** |
|-------------------|------------|--------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|----------------------------|------------|-----------------------------------------------|------------|
| **Location**      | ** ** | **No. of   communities** | ** ** | **Indep.   living   apts.** | ** ** | **Assist.   living   suites** | ** ** | **Nursing   home   beds** | ** ** | **Total   living   units** | ** ** | **for the  year   ended   Dec. 31, 2004 (1)** | ** ** | **year  ended   Dec. 31, 2004   (in thousands) (1)** | ** ** | **from   private resources** | ** ** |
| 1. Alabama        |       | 3                        |       | —                      |       | 121                           |       | —                    |       | 121                        |       | 63                                            | %          | $ | 2,472 |   | 100 | % |
| 2. Florida        |       | 1                        |       | 136                         |       | 70                            |       | —                    |       | 206                        |       | 92                                            | %          | 4,556 |   | 100 | % |
| 3. Michigan       |       | 1                        |       | —                      |       | —                        |       | 149                       |       | 149                        |       | 92                                            | %          | 11,310 |   | 13 | % |
| 4. Missouri       |       | 1                        |       | 114                         |       | —                        |       | —                    |       | 114                        |       | 61                                            | %          | 1,552 |   | 100 | % |
| 5. North Carolina |       | 4                        |       | —                      |       | 351                           |       | —                    |       | 351                        |       | 81                                            | %          | 11,963 |   | 100 | % |
| 6. Nebraska       |       | 1                        |       | —                      |       | 73                            |       | —                    |       | 73                         |       | 92                                            | %          | 2,201 |   | 100 | % |
| 7. South Carolina |       | 5                        |       | —                      |       | 238                           |       | —                    |       | 238                        |       | 88                                            | %          | 7,075 |   | 100 | % |
| 8. Tennessee      |       | 3                        |       | —                      |       | 226                           |       | —                    |       | 226                        |       | 92                                            | %          | 5,602 |   | 100 | % |
| 9. Virginia       |       | 1                        |       | —                      |       | 87                            |       | —                    |       | 87                         |       | 81                                            | %          | 3,056 |   | 100 | % |
| Totals:           |       | 20                       |       | 250                         |       | 1,166                         |       | 149                       |       | 1,565                      |       | 84                                            | %          | $ | 49,787 |   | 80 | % |

 

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**(1) Includes amounts and data for periods prior tocommencement of our lease or ownership.**

 

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**OUR SENIOR HOUSING LEASES**

** **

We have four leases with Senior Housing, three for thecommunities that we operate and one for the communities managed by SLS. Thematerial terms of these leases include the following:

 

*Minimumrent.* Our minimum rentobligations for the communities we operate is approximately $31.8 million peryear, and for the communities managed by SLS is approximately $64.0 million peryear.

 

*Percentagerent.* We are required to pay additional rent under our leases.This rent is payable and calculated separately for the lease relating to thecommunities that SLS manages for us and for the three leases, on a combinedbasis, relating to the communities we operate. The percentage rent equals 4% ofthe amount by which gross revenues of properties subject to the three leasesfor the communities we operate or the communities managed by SLS, as the casemay be, in a year exceeds gross revenues of the properties under the threeleases or the SLS lease, as the case may be, in a base year. The base year forthe communities we recently acquired from LTA and lease from Senior Housing is2006 and percentage rent begins in 2007. The base year for all othercommunities we lease from Senior Housing is 2005 and percentage rent begins in2006.

 

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

 
| ** **   | ** **                             | ** ** | **Initial  expiration date** | ** ** | **Renewal terms**                                                    | ** ** |
|--------------|----------------------------------------|------------|------------------------------|------------|----------------------------------------------------------------------|------------|
| •       | Leases for communities  operated by us |       | December 31, 2020            |       | One 15 year renewal  option                                          |       |
|         |                                   |       |                         |       |                                                                 |       |
| •  | Lease for communities  managed by SLS  |       | December 31, 2017            |       | Two consecutive renewal  options for 10 and 5 years (15 years total) |       |

 

*Operatingcosts.*  Each lease is aso-called “triple-net” lease which requires us to pay all costs incurred in theoperation of the communities, including the costs of personnel, service toresidents, insurance and real estate and personal property taxes.

 

*Rentduring renewal term.* Rent during each renewal term is the same as the minimum rent andpercentage rent payable during the initial term.

 

*Noneconomic circumstances.* If we determine that continued operations of one or more communities isnot economically practical, we may negotiate with Senior Housing to close orsell that community, including Senior Housing’s ownership in the property. Inthe event of such a sale, Senior Housing receives the net proceeds and our rentfor the remaining communities in the affected lease is reduced according toformulas set forth in the leases.

 

*Maintenanceand alterations.*  Weare required to operate continuously and maintain, at our expense, the leasedcommunities in good order and repair, including structural and nonstructuralcomponents. We may request Senior Housing to fund amounts needed for repairsand renovations in return for rent adjustments to provide Senior Housing areturn on its investment according to formulas set forth in the leases. At theend of each lease term, we are required to surrender the leased communities insubstantially the same condition as existed on the commencement date of thelease, subject to any permitted alterations and subject to ordinary wear andtear.

 

*Assignmentand subletting.*  SeniorHousing’s consent is generally required for any direct or indirect assignmentor sublease of any of the communities. In the event of any assignment orsubletting, we will remain liable under the applicable lease.

 

*Indemnificationand insurance.*  Withlimited exceptions, we are required to indemnify Senior Housing from allliabilities which may arise from the ownership or operation of the communities.We generally are required to maintain commercially reasonable insurance,including:

 

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

•                  businessinterruption insurance;

 

15

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

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

•                  workerscompensation insurance if required by law; and

•                  suchadditional insurance as may be generally maintained by companies providingsenior living services, including professional and general liability insurance.

 

Each lease requires that Senior Housing be named as anadditional insured under these policies.

 

*Damage,destruction, condemnation and environmental matters.*  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. We are also required to remove and dispose of anyhazardous substance at the leased communities in compliance with all applicableenvironmental laws and regulations.

 

*Eventsof default.*  Events ofdefault under each lease include the following:

 

•                  ourfailure to pay rent or any other sum when due;

•                  ourfailure to maintain the insurance required under such lease;

•                  anyperson or group acquiring ownership of 9.8% or more of our outstanding votingstock or any change in our control or sale of a material portion of our assetswithout Senior Housing’s consent;

•                  theoccurrence of certain events with respect to our insolvency or dissolution;

•                  ourdefault under indebtedness which gives the holder the right to accelerate;

•                  ourbeing declared ineligible to receive reimbursement under Medicare or Medicaidprograms for any of the leased communities which participate in such programsor the revocation of any material license required for our operations; and

•                  ourfailure to perform any terms, covenants or agreements of the leases and thecontinuance thereof for a specified period of time after written notice.

 

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

 

•                  acceleratethe rents;

•                  terminate the leases in whole or in part;

•                  enterthe property and take possession of any and all our personal property andretain or sell the same at a public or private sale;

•                  makeany payment or perform any act required to be performed by us under the leases;and

•                  rentthe property and recover from us the difference between the amount of rentwhich would have been due under the lease and the rent received from there-letting.

 

We are obligated to reimburse Senior Housing for allcosts and expenses incurred in connection with any exercise of the foregoingremedies.

 

*Management.*  We may not enter into any new managementagreement or amend or modify any management agreement with SLS affecting anyleased community without the prior written consent of Senior Housing.

 

*Leasesubordination.*  Ourleases may be subordinated to any mortgages on properties leased from SeniorHousing.

 

*Financinglimitations; security.* We may not incur debt secured by our investments in our tenantsubsidiaries. 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 have pledged 100% of the equity interests of certain of our tenantsubsidiaries to Senior Housing or its lenders, and we may pledge interests inour leases only if the pledge is consented to by Senior Housing.

 

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*FF&E reserves.*  We are required under our lease for thecommunities managed by SLS to make deposits into certain accounts that we ownfor replacements and improvements known as FF&E reserves. Senior Housinghas a security and remainder interest in these accounts and in all propertypurchased with funding from these accounts.

 

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

 

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

 

*Term.*  Generally each of the management agreementshas an initial term expiring in 2027, with one five year renewal term at SLS'soption.

 

*Communityservices.*  Our contractwith SLS delegates to SLS the responsibility for operations of the managedcommunities, including obtaining and maintaining all insurance, establishingresident care policies and procedures, carrying out and supervising allnecessary repairs and maintenance, procuring food, supplies, equipment,furniture and fixtures, and establishing prices, rates and charges for servicesprovided. SLS also recruits, employs and directs all community based employees.

 

*Centralservices.*  SLS alsofurnishes 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&Ereserves and capital improvements.*  SLS has established an FF&E reserveaccount under each management agreement to cover the expected recurring cost ofreplacements and renewals to the furniture, furnishings, fixtures, soft goods,case goods, vehicles and equipment, and for building repairs and maintenancewhich are normally capitalized. The FF&E reserve accounts are funded fromthe operating revenues of the managed communities. The amount of this fundingvaries among the managed communities; however, for most communities it iscurrently set at 2.85% of gross revenues and will gradually increase to 3.5% ofgross revenues. In 2004 and 2003, we deposited $8.6 million and$8.1 million into these accounts, respectively. In the event major capitalimprovements are required, or if the amounts set aside in the FF&E reserveaccounts are inadequate for required repairs, we may be required to separatelyfund such repairs and improvements. Any such separate funding which we provideincreases the amount of our owner’s priority, as described below. The amount ofFF&E reserve funding required under our SLS management agreements is thesame as the funding required by our Senior Housing lease for these communities.Also, under our lease, we have the option to request Senior Housing to provideany required separate funding in return for rent adjustments to provide SeniorHousing a return on its investment according to a formula set forth in thelease.

 

*Fees.*  For its management services, SLS receives abase fee generally equal to 5% of the managed communities’ gross revenues, plusan incentive fee generally equal to 20% of operating cash flows in excess ofowner’s priority amounts, as defined in the agreements. For its centralservices, SLS receives a fee generally equal to 2% of gross revenues. During2004 and 2003, management and central services fees paid to SLS and SLS’spredecessor, MSLS, totaled $19.3 million and $17.3 million,respectively.

 

*Owner’spriority.*  We receivethe profits of the SLS managed communities on a priority basis before SLSreceives any incentive fees. The amount of the owner’s priority for eachmanaged community is established based upon a specified rate of return onhistorical capital investments in these communities, including capitalimprovements during the term of the management agreements which are funded byus or Senior Housing in addition to the FF&E reserve. As of the year endedDecember 31, 2004 and 2003, the aggregate amount of owner’s priority for allcommunities managed by SLS was $72.5 million and $69.4 million,respectively.

 

*Pooling.*  Twenty nine of the communities are subject topooling arrangements whereby the calculation and payment of fees payable to SLSand owner’s priority for several groups of these 29 communities are combined.

 

*Defaults and termination.*  The SLS management agreements contain variousdefault and termination provisions. Our right to exercise termination optionsunder the SLS management agreements is subject to approval by Senior Housingunder the terms of the lease for these communities.

 

17

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**Item 3.    LegalProceedings**

** **

In the ordinary course of business we are involved inlitigation incidental to our business; however, we are not aware of any othermaterial pending legal proceeding affecting us for which we might become liableor the outcome of which we expect to have a material impact on us.

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

** **

**None.**

 

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**PARTII**

** **

**Item5.  Market for the Registrant’s CommonEquity, Related Shareholder Matters and Issuer Purchases of Equity Securities**

 

Our common shares are traded on the AMEX (symbol:FVE). The following table sets forth for the periods indicated the high and lowsales prices for our common shares as reported by the AMEX: 

 
| ** **     | ** ** | **Low**    | ** ** | **High**   | ** ** |
|----------------|------------|------------|------------|------------|------------|
| 2003           |       |       |       |       |       |
| First Quarter  |       | $          | 1.11       |       | $          | 1.80 |   |
| Second Quarter |       | 1.06       |       | 1.87       |       |
| Third Quarter  |       | 1.43       |       | 2.88       |       |
| Fourth Quarter |       | 2.06       |       | 4.50       |       |
|           |       |       |       |       |       |
| 2004           | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter  |       | $          | 3.50       |       | $          | 6.39 |   |
| Second Quarter |       | 3.55       |       | 5.25       |       |
| Third Quarter  |       | 4.10       |       | 7.69       |       |
| Fourth Quarter |       | 6.55       |       | 8.80       |       |

 

The closing price of our common shares on the AMEX onMarch 24, 2005, was $8.10 per share.

 

As of March 18, 2005, there were 3,594 record holdersof our common shares, and we estimate that as of such date there wereapproximately 55,000 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.

 

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**Item 6.    SelectedFinancial 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, 2004. 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, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”, andour financial statements and the notes thereto included elsewhere in thisAnnual Report on Form 10-K.  As discussedunder “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations”, we are a relatively new company and we have recently expandedour operations; as a result, our historical financial information is not fullyreflective of our current operations. Accordingly, you should not place undue reliance on our historicalfinancial information. 

 
| ** **                                      | ** ** | **Year ended December 31,**               | ** ** | **Period from April  27, 2000 through** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                      | ** ** | **2004**                                  | ** ** | **2003**                                | ** ** | **2002** | ** ** | **2001** | ** ** | **December 31, 2000** | ** ** |
| ** **                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| Operating data:                                 |       |                                      |       |                                    |       |   |   |   |   |   |   |
| Total revenues                                  |       | $                                         | 628,005    |                                    | $          | 575,182 |   | $ | 519,106 |   | $ | 219,834 |   | $ | 2,222 |   |
| Net income  (loss) from continuing operations   |       | 4,110                                     |       | (6,490                                  | )          | (10,259 | ) | 1,473 |   | (1,614 | ) |
| Net income  (loss) from discontinued operations |       | (699                                      | )          | (1,449                                  | )          | (2,915 | ) | (946 | ) | 298 |   |
| Net income  (loss)                              |       | $                                         | 3,291      |                                    | $          | (7,939 | ) | $ | (13,174 | ) | $ | 527 |   | $ | (1,316 | ) |
| Per common share  data:                         |       |                                      |       |                                    |       |   |   |   |   |   |   |
| Income (loss)  from continuing operations       |       | $                                         | 0.46       |                                    | $          | (0.77 | ) | $ | (1.36 | ) | $ | 0.34 |   | $ | (0.37 | ) |
| Income (loss)  from discontinued operations     |       | (0.08                                     | )          | (0.17                                   | )          | (0.38 | ) | (0.22 | ) | 0.07 |   |
| Net income  (loss)                              |       | $                                         | 0.38       |                                    | $          | (0.94 | ) | $ | (1.74 | ) | $ | 0.12 |   | $ | (0.30 | ) |
| Balance sheet  data (as of December 31):        |       |                                      |       |                                    |       |   |   |   |   |   |   |
| Total assets                                    |       | $                                         | 222,985    |                                    | $          | 147,370 |   | $ | 133,197 |   | $ | 68,043 |   | $ | 54,788 |   |
| Total  indebtedness                             |       | 42,581                                    |       | 10,435                                  |       | 16,123 |   | — |   | 100 |   |
| Other long term  obligations                    |       | 25,558                                    |       | 18,417                                  |       | 17,723 |   | — |   | — |   |
| Total  shareholders’ equity                |       | $                                         | 95,904     |                                    | $          | 64,427 |   | $ | 65,047 |   | $ | 50,233 |   | $ | 54,688 |   |

 

The following table presents selected financial datafor the year ended December 31, 2000, derived from historical financialstatements of our two predecessors, Integrated Health Services, Inc. andMariner Post-Acute Network, Inc., prior to their acquisition by Senior Housing.

 
| ** **                               | ** ** | **Year ended  December 31,  2000** | ** ** |
|------------------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **(in thousands)**                 | ** ** |
| **Integrated  Health Services, Inc.**    |       |                               |       |
| Operating data:                          |       |                               |       |
| Operating  revenues                      |       | $                                  | 135,378    |   |
| Net loss                                 |       | (25,252                            | )          |
| Balance sheet  data (as of December 31): |       |                               |       |
| Total assets                             |       | $                                  | 34,942     |   |
| Long term  liabilities                   |       | —                             |       |
| **Mariner  Post-Acute Network, Inc.**    |       |                               |       |
| Operating data:                          |       |                               |       |
| Operating  revenues                      |       | $                                  | 85,325     |   |
| Net loss                                 |       | (7,421                             | )          |
| Balance sheet  data (as of December 31): |       |                               |       |
| Total assets                             |       | $                                  | 23,052     |   |
| Long term  liabilities                   |       | 32,090                             |       |

 

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**Item7.    Management’s Discussion and Analysisof Financial Condition and Results of Operations**

** **

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 real estate investment trusts, Senior Housing engaged FSQ,an independent operating company formed by our managing directors, to managethese communities.  At the time weassumed operations of these communities, we had not received substantially allof the required licenses for these communities. As a result, for the periodfrom July 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 necessarylicenses to operate these communities, and on January 1, 2001, we began toconsolidate the results of operations of these communities. OnDecember 31, 2001, Senior Housing distributed substantially all of ourshares to its shareholders in a spin off transaction and we became a separatelytraded public company. On January 2, 2002, in order to acquire the personnel,systems and assets necessary to operate these communities, we acquired FSQ bymerger.

 

**OVERVIEW OF INDUSTRYTRENDS**

** **

The senior livingindustry is experiencing growth as a result of demographic and various otherfactors.  According to census data, theover age 75 population in the United States is growing much faster than thegeneral population.  As a general rule,economic factors that affect seniors will have a corresponding impact on thesenior living industry.  For example,general concerns regarding lower interest rates on savings and uncertainty ofinvestment returns have impacted seniors during the past several years.  On the other hand, the continuing strength ofthe home resale market in most areas of the country has been beneficial toseniors, since the equity from the sale of a home is a significant source offunding for senior living care for many people. In addition, overall economicconditions and general consumer confidence can impact the industry, as manyadult children subsidize the cost for care of elderly parents and share indecisions regarding their care.

 

The independent andassisted living business is rapidly changing. The demand for these services increased significantly beginning with theemergence of the industry segment in the mid-1990s.  However, the development of new independentand assisted living communities across the country outstripped demand duringthis period, resulting in oversupply of unit capacity, longer fill up times,price pressures and deep discounting. The growing demand for independent and assisted living services,together with minimal new development activity, reduced to some extent theoversupply in many markets in recent years. As a result, we have been able toincrease occupancy and rates.  We believethat new development will remain at sustainable levels over the next few years.The average length of stay in independent and assisted living communities isapproximately three and a half and two years, respectively, which represents achallenge and an opportunity for us.  Wemust find a number of new residents to maintain and build occupancy.  However, we also have the opportunity to “mark-to-market”if we are able to attract new residents at higher current market rates,replacing prior residents that had lower or discounted rates.

 

The skilled nursingsegment is a more mature segment of the senior living industry, and has seenboth demand and price increases in recent years, with little new unit capacityentering the market.  We expect thisgrowth in demand to continue over the next several years, but with newalternatives available to seniors such as home health care and the growingindependent and assisted living market, this growth in demand may be reducedand in some cases reversed.  In addition,while we have had overall Medicare and Medicaid rate increases over the lasttwo years, we are not sure that future rates will increase as fast as ourcosts.  In fact, due to both federal andstate budget shortfalls we expect in some areas that our rates maydecline.  The average length of stay innursing homes is approximately one and a half years.  We believe that many of our skilled nursingfacilities benefit from significant barriers to entry from competitors,including the significant cost and length of time to develop competitivefacilities, the difficulty in finding acceptable development sites in thegeographical areas in which our facilities are located and some statescertificate of need and license processes.

 

**OVERVIEW OF FIVE STAR’S REVENUESAND EXPENSES**

 

We earn our revenuesprimarily by providing housing and services to our residents. Approximately 62%of our revenues come from private pay sources, meaning that residents or theirfamilies pay from their own funds (or from the proceeds of their long-term carepolicies). All private pay residents are billed in advance for the next month’shousing and care.

 

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Our most significantexpenses are:

 

•                  Wages andbenefits – includes wages for our employees working at our communities and wagerelated expenses such as health insurance, workers compensation insurance andother standard benefits.

 

•                  Other operatingexpenses – includes utilities, housekeeping, dietary, maintenance, marketing,insurance and community level administrative costs.

 

•                  Management feeto SLS – management fee related to the 30 communities SLS manages for us.

 

•                  Rent expense –we lease 132 of our 148 senior living communities from two entities, SeniorHousing and HCPI.

 

•                  General andadministrative expenses – wage related costs for headquarters and regionalstaff supporting our communities are the largest component of thiscategory.  Other significant items aretravel, marketing and legal and professional services.

 

•                  Depreciation andamortization expense – we incur depreciation expense on buildings and furnitureand equipment.  We incur amortizationexpense related to costs associated with our revolving credit facility andother debt.

 

•                  Interest expense–interest on outstanding balances on our revolving credit facility as well asother debt.

 

The following information should be read inconjunction with the consolidated financial statements included in this AnnualReport on Form 10-K.

 

**Yearended December 31, 2004 versus year ended December 31, 2003**

 

The following tables present an overview of ourportfolio for the years ended December 31, 2004 and 2003:

 
| ** **                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **$**   | **Variance** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|---------|--------------|------------|------------|------------|
| Net revenues  from residents (in 000s)              |       | $        | 614,796    |     | $          | 573,412 |         | $          | 41,384     |       | 7 | % |
| Pharmacy revenue  (in 000s)                         |       | 13,209   |       | 1,770    |       | 11,439  |         | 646        | %          |
| Wages and  benefits (in 000s)                       |       | 326,314  |       | 313,846  |       | 12,468  |         | 4          | %          |
| Other operating  expenses (in 000s)                 |       | 159,892  |       | 149,401  |       | 10,491  |         | 7          | %          |
| Pharmacy  expenses (in 000s)                        |       | 12,093   |       | 1,666    |       | 10,427  |         | 628        | %          |
| Management fee  to SLS (in 000s)                    |       | 19,293   |       | 17,272   |       | 2,021   |         | 12         | %          |
| Rent expense (in  000s)                             |       | 83,370   |       | 77,495   |       | 5,875   |         | 8          | %          |
| General and  administrative (in 000s)               |       | 20,053   |       | 17,470   |       | 2,583   |         | 15         | %          |
| Depreciation and  amortization (in 000s)            |       | 3,666    |       | 3,587    |       | 79      |         | 2          | %          |
| Interest and  other income (in 000s)                |       | 1,666    |       | 229      |       | 1,437   |         | 626        | %          |
| Interest expense  (in 000s)                         |       | 880      |       | 1,164    |       | (284    | )            | -24        | %          |
| Provision for  income taxes (in 000s)               |       | 120      |       | —   |       | 120     |         | —     |       |
| Loss from  discontinued operations (in 000s)        |       | 699      |       | 1,449    |       | (750    | )            | -52        | %          |
|                                                |       |     |       |     |       |    |         |       |       |
| No. of  communities (end of period)                 |       | 148      |       | 100      |       | —  |         | 48         |       |
| No. of living  units (end of period)                |       | 16,573   |       | 13,924   |       | —  |         | 2,649      |       |
| Occupancy                                           |       | 89       | %          | 89       | %          | —  |         | —     |       |
| Average daily  rate                                 |       | $        | 114        |     | $          | 127     |         | —     |       | -10        | % |
| Revenue per day  per available unit                 |       | $        | 101        |     | $          | 113     |         | —     |       | -11        | % |
| Percent of  revenues from Medicare                  |       | 16       | %          | 14       | %          | —  |         | 2          | %          |
| Percent of  revenues from Medicaid                  |       | 25       | %          | 26       | %          | —  |         | -1         | %          |
| Percent of  revenues from private and other sources |       | 59       | %          | 60       | %          | —  |         | -1         | %          |
|                                                     |            |          |            |          |            |         |              |            |            |            |  |  |  |

 

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Comparable Communities(communities that we operated continuously since January 1, 2003):

 
| ** **                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **$**   | **Variance** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|---------|--------------|------------|------------|------------|
| Net revenues  from residents (in 000s)              |       | $        | 598,184    |     | $          | 571,105 |         | $          | 27,079     |       | 5 | % |
| Community  expenses (in 000s)                       |       | 473,143  |       | 461,399  |       | 11,744  |         | 3          | %          |
| No. of  communities (end of period)                 |       | 97       |       | 97       |       | —  |         | —     |       |
| No. of living  units (end of period)                |       | 13,689   |       | 13,689   |       | —  |         | —     |       |
| Occupancy                                           |       | 90       | %          | 89       | %          | —  |         | 1          | %          |
| Average daily  rate                                 |       | $        | 133        |     | $          | 129     |         | —     |       | 3          | % |
| Revenue per day  per available unit                 |       | $        | 119        |     | $          | 114     |         | —     |       | 4          | % |
| Percent of  revenues from Medicare                  |       | 17       | %          | 14       | %          | —  |         | 3          | %          |
| Percent of  revenues from Medicaid                  |       | 25       | %          | 26       | %          | —  |         | -1         | %          |
| Percent of  revenues from private and other sources |       | 58       | %          | 60       | %          | —  |         | -2         | %          |
|                                                     |            |          |            |          |            |         |              |            |            |            |  |  |  |

 

The 7% increase in net revenues from residents is dueprimarily to higher per diem charges to residents and our beginning operationsat three additional communities in May 2003, one community in May 2004 and 47communities in November 2004. The 5% increase in net revenues from residents atthe communities that we have operated continuously since January 1, 2003 is dueprimarily to 4% higher per diem charges to residents and a 1% increase inoccupancy.  The increase in revenues fromour two pharmacies is a result of our acquiring these pharmacies during thethird quarters of 2003 and 2004.

 

Our 4% increase in wages and benefits costs isprimarily due to wage increases as well as wages related to the threecommunities we began to operate in May 2003, one community we began to operatein May 2004 and the 47 communities we acquired in November 2004.  The 7% increase in other operating expenses,which include utilities, housekeeping, dietary, maintenance, insurance andcommunity level administrative costs is primarily a result of increased chargesfrom third parties, our operation of three additional communities beginning inMay 2003, one community we began to operate in May 2004, and our 47 communitiesacquired in November 2004.   Theoperating expenses for the communities that we have operated continuously sinceJanuary 1, 2003 have increased by 3% principally due to wage and benefitincreases.  The increase in pharmacyexpenses is a result of our acquiring these pharmacies during the thirdquarters of 2003 and 2004.  Managementfees related to the 30 communities that SLS manages for us increased by 12%because of the increased revenues at these communities and a contractualincrease in the effective management fee calculation.  The 8% rent expense increase is due to theaddition of communities that we began to lease in 2003 and 2004, and ourpayment of additional rent for capital improvements which were funded by SeniorHousing since January 1, 2003.

 

The 15% increase in general and administrativeexpenses for the year ended December 31, 2004 is primarily due to costsresulting from our increased operations, as well as increases in wages andbenefits for our corporate and regional staff.

 

The 2% increase in depreciation expense for the yearended December 31, 2004 is primarily attributable to our purchase of furnitureand fixtures related to the communities managed by SLS and our acquisition of16 communities as a result of the LTA acquisition in November 2004, offset byour sale of seven communities in 2003.

 

Our interest and other income increased by $1.4million primarily due to the amounts received in connection with our January2004 settlement with Marriott and MSLS, whereby we and Senior Housing were eachpaid $1.3 million.  Under the terms ofthe settlement, we and Senior Housing, and Marriott and MSLS, agreed to dismissall claims and counterclaims asserted in the litigation.

 

We accrued $120,000 for federal alternative minimumincome taxes during the year ended December 31, 2004.  This provision was not required for the yearended December 31, 2003.  There is noprovision for regular income taxes because we have net operating loss carryforwards.

 

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Loss from discontinued operations for the year endedDecember 31, 2004 was $699,000, compared to a loss of $1.4 million for the yearended December 31, 2003.  This decreaseis primarily the result of our ceasing operations at one property in 2004compared with our ceasing operations at seven properties in 2003.

 

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

 

The following tables present an overview of ourportfolio for the years ended December 31, 2003 and 2002:

 
| ** **                                          | ** ** | **2003** | ** ** | **2002** | ** ** | **$**   | **Variance** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|---------|--------------|------------|------------|------------|
| Net revenues  from residents (in 000s)              |       | $        | 573,412    |     | $          | 519,106 |         | $          | 54,306     |       | 10 | % |
| Pharmacy revenue  (in 000s)                         |       | 1,770    |       | —   |       | 1,770   |         | —     |       |
| Wages and  benefits (in 000s)                       |       | 313,846  |       | 274,248  |       | 39,598  |         | 14         | %          |
| Other operating  expenses (in 000s)                 |       | 149,401  |       | 143,053  |       | 6,348   |         | 4          | %          |
| Pharmacy  expenses (in 000s)                        |       | 1,666    |       | —   |       | 1,666   |         | —     |       |
| Management fee to  SLS (in 000s)                    |       | 17,272   |       | 16,643   |       | 629     |         | 4          | %          |
| Rent expense (in  000s)                             |       | 77,495   |       | 75,210   |       | 2,285   |         | 3          | %          |
| General and  administrative (in 000s)               |       | 17,470   |       | 15,415   |       | 2,055   |         | 13         | %          |
| Depreciation and  amortization (in 000s)            |       | 3,587    |       | 1,794    |       | 1,793   |         | 100        | %          |
| Interest and other  income (in 000s)                |       | 229      |       | 297      |       | (68     | )            | -23        | %          |
| Interest expense  (in 000s)                         |       | 1,164    |       | 198      |       | 966     |         | 488        | %          |
| Loss from  discontinued operations (in 000s)        |       | 1,449    |       | 2,915    |       | (1,466  | )            | -50        | %          |
|                                                |       |     |       |     |       |    |         |       |       |
| No. of  communities (end of period)                 |       | 100      |       | 105      |       | —  |         | -5         |       |
| No. of living  units (end of period)                |       | 13,924   |       | 13,962   |       | —  |         | -38        |       |
| Occupancy                                           |       | 89       | %          | 89       | %          | —  |         | —     |       |
| Average daily  rate                                 |       | $        | 127        |     | $          | 114     |         | —     |       | 11         | % |
| Revenue per day  per available unit                 |       | $        | 113        |     | $          | 102     |         | —     |       | 11         | % |
| Percent of  revenues from Medicare                  |       | 14       | %          | 11       | %          | —  |         | 3          | %          |
| Percent of  revenues from Medicaid                  |       | 26       | %          | 31       | %          | —  |         | -5         | %          |
| Percent of  revenues from private and other sources |       | 60       | %          | 58       | %          | —  |         | 2          | %          |
|                                                     |            |          |            |          |            |         |              |            |            |            |  |  |  |

 

Comparable Communities(communities that we operated continuously since January 1, 2002):

 
| ** **                                          | ** ** | **2003** | ** ** | **2002** | ** ** | **$**   | **Variance** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|---------|--------------|------------|------------|------------|
| Net revenues  from residents (in 000s)              |       | $        | 236,667    |     | $          | 227,446 |         | $          | 9,221      |       | 4 | % |
| Community  expenses (in 000s)                       |       | 215,793  |       | 210,645  |       | 5,148   |         | 2          | %          |
| No. of  communities (end of period)                 |       | 53       |       | 53       |       | —  |         | —     |       |
| No. of living  units (end of period)                |       | 4,868    |       | 4,868    |       | —  |         | —     |       |
| Occupancy                                           |       | 90       | %          | 89       | %          | —  |         | 1          | %          |
| Average daily  rate                                 |       | $        | 148        |     | $          | 144     |         | —     |       | 3          | % |
| Revenue per day  per available unit                 |       | $        | 133        |     | $          | 128     |         | —     |       | 4          | % |
| Percent of  revenues from Medicare                  |       | 21       | %          | 20       | %          | —  |         | 1          | %          |
| Percent of  revenues from Medicaid                  |       | 58       | %          | 58       | %          | —  |         | —     |       |
| Percent of revenues  from private and other sources |       | 21       | %          | 22       | %          | —  |         | -1         | %          |
|                                                     |            |          |            |          |            |         |              |            |            |            |  |  |  |

 

The 10% increase in net revenues from residents isattributable primarily to our beginning operations at 15 communities in October2002, and at three communities in May 2003. The 4% increase in net revenues from residents at the communities weoperated throughout 2003 and 2002 is due primarily to 3% higher per diemcharges to residents

 

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and a 1% increase in occupancy.  The pharmacy revenue increase is a result ofour acquiring a pharmacy during the third quarter of 2003.  The 2% increase in revenues from Medicare andMedicaid is a result of our higher Medicare census throughout 2003.

 

Our 14% increase in wages and benefits costs isprimarily due to expenses at the 18 communities we began to operate sinceOctober 2002, as well as increases in workers compensation and employee healthinsurance costs.  The 4% increase inother operating expenses, which include utilities, housekeeping, dietary,maintenance, insurance and community level administrative costs is primarilydue to the expenses at the 18 communities we began to operate since October2002, as well as higher professional and general liability insurancecosts.  The operating expenses for the communitiesthat we have operated continuously since January 1, 2002 have increased by 2%primarily due to increases in employee health, workers compensation andprofessional and general liability insurance costs.  The pharmacy expenses are a result of our acquiringa pharmacy during the third quarter of 2003. Management fees related to the 31 communities managed for us by SLSincreased by 4%, primarily because these arrangements commenced on January 11,2002; therefore, 2003 includes 11 more days than 2002.  Rent expense to Senior Housing increased by3%, primarily due to rents for communities we began to lease since October2002, and rent increases which resulted from Senior Housing’s purchase ofimprovements at leased communities, partially offset by a lease modificationentered into in October 2002 which changed the ownership of certain FF&Ereserve escrows.

 

The 13% increase in our general and administrativeexpenses is primarily due to costs resulting from our increased operations andto legal costs incurred in connection with our litigation with Marriott andMSLS which was settled in January 2004.

 

The $1.8 million increase in depreciation expense isattributable to our purchase of seven communities in 2002, as well as tocapitalized improvements to some of our communities which increased ourdepreciable assets.

 

The $68,000 decrease in interest and other income isdue to lower cash balances and lower interest rates in 2003, partially offsetby interest earned on mortgage notes receivable.

 

The $1.4 million decrease in the loss fromdiscontinued operations is primarily attributable to our dispositions of theseoperations in 2002, as well as the recovery of some accounts receivable thatwere previously written off.

 

**LIQUIDITY AND CAPITALRESOURCES**

 

Our current assets atDecember 31, 2004 were $76.0 million, compared to $55.5 million atDecember 31, 2003.  This increase isprimarily attributable to our acquisition of LTA in November 2004, and ourequity offering in December 2004.  AtDecember 31, 2004 and 2003, we had cash and cash equivalents of$26.2 million and $17.6 million, respectively.  Our current liabilities were$59.1 million at December 31, 2004, compared to $58.1 million atDecember 31, 2003.

 

In 2003, informationbecame available to us which resulted in our recording $7.2 million ofadditional paid in capital. This amount was the result of our having receivedmore working capital assets and our having assumed fewer liabilities than wehad previously recorded at the time of our spin off from Senior Housing.

 

We lease 128 communitiesfrom Senior Housing under four leases. Our leases with Senior Housing requireus to pay minimum rent of $95.8 million annually and percentage rentbeginning in 2006. We believe we are in compliance with the terms of our leaseswith Senior Housing.

 

Our revenues fromservices to residents at our communities is the primary source of cash to fundoperating expenses, including rent, principal and interest payments on our debtand capital expenditures. At some of our communities, operating revenues fornursing home services are received from the Medicare and Medicaid programs. Foreach of 2004 and 2003, 41% of our total revenues were derived from theseprograms.  Medicare and Medicaid revenueswere earned primarily from the 51 nursing homes we lease from Senior Housing.Since 1998, the PPS has generally lowered Medicare rates paid to senior livingcommunities, including many that we operate. In October 2004 and 2003, Medicare rates increased by approximately 3%and 6%, respectively. Our Medicare revenues totaled $109.8 million and$86.1 million for the yearsended December 31, 2004 and 2003, respectively. Our Medicaid revenues totaled$152.1 million and $148.6 million for the years ended December 31, 2004 and 2003, respectively. Someof the states in which we operate have not raised rates by amounts sufficientto offset increasing costs or are expected to reduce Medicaid funding.

 

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The magnitude of thepotential Medicaid rate reductions cannot currently be estimated, but it may bematerial and may affect our future results of operations. Further Medicare andMedicaid rate declines may have a dramatic negative impact on our revenues andmay produce losses.

 

Recent increases in the costsof insurance, especially tort liability insurance, workers compensation andemployee health insurance, which are affecting the senior living industry, maycontinue to have an adverse impact upon our future results of operations. Also,we believe Marriott’s sale of its senior living management business to Sunrisehas had, and may continue to have, an adverse impact on our financial results.

 

Also, prior toJuly 2004, pursuant to existing contract terms, a portion of ourmanagement fees payable to SLS were conditional, based on exceeding a thresholdof net operating income that was not achieved and, therefore, was not beingpaid. As of July 2004, this portion of the management fee is no longerconditional and we are now required to pay the full fee. We expect the annualamount of this additional management fee to be approximately $3.0 millionper year. We expect improvements in our operations will offset this increasedcost, but our efforts in this regard may not be successful.

 

Our revolving creditfacility limits our ability to incur debt as more fully described below in “DebtInstruments and Covenants”. The terms of our leases with Senior Housing containprovisions whereby Senior Housing may cancel our rights under these agreementsupon the acquisition by any person or group of more than 9.8% of our votingstock, and upon other change of control events. These leases also limit ourability to create, incur, assume or guarantee indebtedness.

 

In August 2003, we sold acommunity in Bloomfield, Connecticut for $3.5 million, $3.15 millionof which was paid in the form of a promissory note from the purchaser securedby a mortgage on that property. This note is payable in monthly installments of$8,750 of principal, plus interest which accrues on the unpaid principalbalance at a rate of 8% per year. This note matures on August 26, 2009,but we have the right to require prepayment as of August 31, 2008.

 

In December 2003, we soldfive group homes in Maryland for $3.55 million, $3.11 million ofwhich was paid in the form of a promissory note from the purchaser secured by amortgage on those five properties. 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 note matures on November 30, 2018, but wehave the right to require prepayment earlier by giving notice afterNovember 30, 2009.

 

During 2003, SeniorHousing agreed to sell us two nursing homes in Michigan that we leased fromSenior Housing. The purchase price is $10.5 million, the appraised valueof the properties. On April 19, 2004, we purchased one of these propertiesfrom Senior Housing for $5.9 million. We financed this acquisition with$5.0 million of proceeds we received from a new HUD insured mortgage and by usingcash on hand. We expect the second purchase to occur during 2005 and we intendto finance the second sale with proceeds that we receive from a second HUDinsured mortgage and with available cash. The second property is currentlyleased from Senior Housing on a combined basis with 97 other properties. Underthe terms of our lease with Senior Housing, upon completion of the sale, theannual rent payable under the combined lease will be reduced by 10% of the saleprices we pay to Senior Housing.

 

In November 2004, weacquired 100% of the capital stock of LTA for approximately $211 million,excluding closing costs.  To finance thisacquisition, we entered into a $148.2 million sale leaseback transactionwith Senior Housing for 31 of the communities acquired from LTA. We alsoentered a $16.8 million mortgage loan with Senior Housing secured by fiveof our properties. We funded the balance of the purchase price with cash onhand and by assuming HUD insured long term mortgage debt and an operating leasefor four communities from HCPI.

 

In December 2004 and January 2005, we issued a total of 3,620,000 common shares for net proceeds in the amount of $28.8 million.  A portion of proceeds raised in this offering were used to pay off the $16.8 million mortgage loan with Senior Housing described above.

 

On January 21, 2005, we agreed to purchase six assisted living communities for approximately $63.5 million from Gordon.  We intend to finance this acquisition with cash on hand, borrowings under our line of credit and mortgage or sale leaseback transactions for some of the communities being purchased or for certain other communities which we currently own.  Completion of this acquisition is subject to various conditions customary in multi-community

 

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healthcare transactions of this type, including completion of diligence, licensing and receiving third party consents.  We expect this acquisition to close during the second quarter of 2005, but there is no assurance that it will close.

 

**We will be required to comply withSection 404 of the Sarbanes-Oxley Act of 2002, or Section 404, for our fiscalyear ending December 31, 2005 if our “public float” exceeds $75 million as ofJune 30, 2005, or in any event for our fiscal year ending December 31,2006.  Based on the closing price of ourstock on March 24, 2005, our “public float” was $99.0 million.  As such, we have commenced our plan forcomplying with Section 404 and are currently in the process of documenting ourprocesses and controls.  We expect todevote substantial time and effort and incur substantial costs in complyingwith Section 404 in fiscal year 2005 and beyond.**

 

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 theforeseeable future.

 

As of December 31,2004, 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)                                            |       | $                         | 42,581     |   | $ | 463 |   | $ | 1,016 |   | $ | 1,181 |   | $ | 39,921 |   |
| Operating Lease  Obligations (2)                                           |       | 1,256,178                 |       | 97,017 |   | 291,051 |   | 291,051 |   | 577,059 |   |
| Purchase  Obligations (3)                                                  |       | 4,600                     |       | 4,600 |   | — |   | — |   | — |   |
| Other Long Term  Liabilities Reflected on our Balance Sheet under GAAP (4) |       | 25,842                    |       | 5,385 |   | 10,450 |   | 6,370 |   | 3,637 |   |
| Total                                                                      |       | $                         | 1,329,201  |   | $ | 107,465 |   | $ | 302,517 |   | $ | 298,602 |   | $ | 620,617 |   |

 

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(1)                                  Theseamounts represent amounts due under several HUD insured mortgages.

(2)                                  Theseamounts represent minimum lease payments through 2014 and 2020.  It does not include percentage rent that maybe payable under these leases.

(3)                                  Thisamount represents our obligation to purchase a property from SeniorHousing.  This obligation is contingentupon our receiving HUD insured financing for a significant part of this purchaseprice.

(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 are not refundable andare carried as liabilities until they are recognized as revenues over theperiods during which we expect to provide the service. These amounts alsoinclude insurance reserves related to workers compensation and professionalliability insurance as well as deferred gains related to property sales.

 

**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 facilityis $12.5 million, and is subject to limitations based upon qualifyingcollateral. The borrower under this facility is a subsidiary that we organizedwith the intention that it be “bankruptcy-remote”.  Certain of our other subsidiaries sell orcontribute their accounts receivable to the borrower on a true sale basis andmake certain representations and other undertakings in favor of the borrower inconnection with each sale.  The sellersubsidiaries have granted security interests in their assets to secure theirobligations to the borrower.  Weguarantee the obligations of the seller subsidiaries obligations to theborrower subsidiary and have pledged the stock or membership interests in eachof the seller subsidiaries to the borrower. The borrower has in turncollaterally assigned these undertakings, guarantees and collateral to therevolving credit facility lenders, and has granted a security interest in thepurchased receivables and all of its other assets to secure its obligationsunder the facility. The facility is available for acquisitions, working capitaland general business purposes.  The facilitycontains covenants and

 

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events of default requiring the maintenance of collateral, minimum networth and certain other financial ratios, and places limits on our ability toincur or assume debt or create liens with respect to certain of our properties,and other customary provisions.  Theaccounts receivable collateralizing the facility totaled $16.6 million as ofDecember 31, 2004.  In certaincircumstances and subject to available collateral and lender approvals, themaximum amounts which we may draw under this credit agreement may be increasedto $25.0 million. The termination date of the facility is October 24, 2005. Asof December 31, 2004, no amounts were outstanding under the facility.  At March 25, 2005, we believe we are incompliance with all applicable covenants under this revolving credit agreementand no amounts were outstanding under the facility.  We have begun negotiations with a bankconcerning a substitute credit facility to become effective before our currentcredit facility expires; however, we can provide no assurance that thesenegotiations will be successfully concluded.

 

On April 19, 2004, we purchased a property from SeniorHousing for $5.9 million.  We financedthis acquisition with $5.0 million in proceeds we received from a HUD insuredmortgage and with cash on hand.  Theinterest cost on this debt is 5.6% per year. Principal and interest is due monthly through April 2039.  This mortgage contains standard HUD mortgagecovenants.  At March 25, 2005, we believewe are in compliance with all material covenants of this mortgage.

 

As part of our recent LTA acquisition, we assumed$30.9 million of HUD insured mortgage debt. The interest cost on this debtis a weighted average rate of 7.1% per year. Principal and interest is duemonthly through varying dates ranging from February 2032 to June 2039. Mortgagepremiums totaling $6.5 million were recorded in accounting for the acquisitionof the mortgaged properties in order to record the assumed mortgages at theirestimated fair value.  The mortgagepremiums will be amortized as a reduction to interest expense over the periodthe mortgages remain outstanding.  Thesemortgages are secured by seven of our communities and contain standard HUDmortgage covenants.  At March 25, 2005,we believe we are in compliance with all material covenants of these mortgages.

 

**Off Balance SheetArrangements**

 

**We have no off balance sheet arrangements as definedin Regulation S-K, Item 303(a)(4)(iii).**

 

**Related PartyTransactions**

 

On December 31,2001, Senior Housing distributed substantially all of its ownership of ourshares to its shareholders. 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, among other things, that:

 

•                  solong as Senior Housing remains a real estate investment trust, or a REIT, wemay not waive the share ownership restrictions in our charter on the ability ofany person or group to acquire more than 9.8% of any class of our equity shareswithout, among other requirements, the consent of Senior Housing and ourdetermination that the exception to the ownership limitations would not cause adefault 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 (another REIT which owns shares of Senior Housing), or HRPT, mightjeopardize the tax status of Senior Housing or HRPT as REITs;

•                  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, we will not acquireor finance any real estate without first giving Senior Housing, HRPT or anyother publicly owned REIT or other entity managed by RMR, the opportunity toacquire or finance real estate investments of the type in which Senior Housing,HRPT or any other publicly owned REIT or other entity managed by RMR,respectively, invest.

 

At the time of our spinoff from Senior Housing, all of the persons serving as our directors weretrustees of Senior Housing. Our two managing directors, Messrs. Martin andPortnoy, are currently the managing trustees of Senior Housing.

 

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Of the 148 seniorliving communities we currently operate, 128 are leased from Senior Housing fortotal annual minimum rent of $95.8 million.

 

During 2003, we andSenior Housing were jointly involved in litigation with Marriott, the operatorof the senior living communities which we leased from Senior Housing. We andSenior Housing equally shared the costs of this litigation. This litigation wassettled in January 2004.

 

Since January 1, 2004, wehave entered into or agreed to enter into multiple transactions with SeniorHousing, including the following:

 

•                  OnMarch 1, 2004, Senior Housing purchased from us one independent andassisted living community with 229 units located in Maryland. The purchaseprice was $24.1 million, the appraised value of the property. Simultaneouswith this purchase, our existing leases with Senior Housing were modified asfollows:

 

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

•                  thecombined lease maturity date was changed to December 31, 2020 fromDecember 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 $2.4 million;

•                  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. Prior to the lease combination, the percentageand the beginning time period for the nursing home lease and the independentand assisted living community lease was 3% in 2004 and 4% in 2005,respectively; and 

•                  allother lease terms remain substantially unchanged.

 

•                  In2003, Senior Housing evicted a nursing home tenant that had defaulted on itsobligations to Senior Housing. Until May 2004, we managed this nursinghome for Senior Housing’s account. Effective on May 1, 2004, we agreedwith Senior Housing to add this nursing home to a multi-property lease fromSenior Housing and to increase the annual rent by $180,000. All other leaseterms remained unchanged.

•                  Oneof the properties we lease from Senior Housing was subject to a ground leasefrom an unaffiliated third party. We were responsible for paying the groundrent of $307,000 per year. On June 3, 2004, Senior Housing exercised anoption to purchase this land for $3.6 million and acquired the landlord’srights and obligations under the ground lease. We now pay the ground rent toSenior Housing.

•                  OnNovember 18, 2004, Senior Housing loaned us $117.0 million inconnection with our acquisition of LTA. Such loan was repaid onNovember 19, 2004 with the proceeds we received from a $148.2 millionsale leaseback with Senior Housing for 31 of the 47 acquired communities and a$16.8 million mortgage loan from Senior Housing secured by five of ourcommunities.  This mortgage was repaid inDecember 2004.

•                  During2004, pursuant to the terms of our leases with Senior Housing, we sold toSenior Housing $9.5 million of improvements we had made to its properties,and our annual rent payable to Senior Housing was increased by 10% of SeniorHousing’s purchase price, or $945,700.

 

We obtained a workerscompensation insurance policy for the year beginning June 15, 2003, from athird party insurer. This third party insurer ceded a portion of the premiumswe paid to a Bermuda based company, Affiliates Insurers, Limited, orAffiliates, which was owned by RMR. Affiliates was organized by RMR to assistus in creating a partial self insurance program on an expedited basis. OnDecember 8, 2003, we acquired Affiliates from RMR for an amount equal toRMR’s cost of organizing and capitalizing that company, approximately $1.3million.

 

Our Chief ExecutiveOfficer and Chief Financial Officer are also officers and employees of RMR.These officers devote a substantial majority of their business time to ouraffairs and the remainder to RMR’s business which is separate from ourbusiness. We believe the compensation we pay to these officers reasonablyreflects their division of business time; however, periodically, theseindividuals may divide their business time differently than they do currentlyand their compensation from us may become disproportionate to this division.

 

29

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RMR provides managementand administrative services to us under a shared services agreement. RMR iscompensated at an annual rate equal to 0.6% of our total revenues. Aggregatefees earned by RMR for services during 2004, 2003 and 2002, were $3.7 million,$3.4 million and $2.9 million, respectively. RMR also provides theinternal audit function for us and for other publicly owned companies to whichit provides management services.  We paya pro rata share of RMR’s costs in providing that function.  Our audit committee approves the identity andsalary of the individual serving as our director of internal audit, as well asthe pro rata share of the costs which we pay. The fact that RMR has responsibilities to other entities, including oneof our landlords, Senior Housing, could create conflicts; and in the event ofsuch conflicts between Senior Housing and us, the shared services agreementallows RMR to act on behalf of Senior Housing rather than on our behalf. RMR isowned by Messrs. 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 usand RMR are approved by our independent directors. Our compensation committeehas approved the renewal of the shared services agreement for its current termwhich will end December 31, 2005.

 

Messrs. Martin andPortnoy own the building in which our headquarters is located. Our lease forspace was originally executed by FSQ. This lease expires in 2011. We paid rent,which includes our proportional share of utilities and real estate taxes, underthis lease during 2004, 2003 and 2002 of $561,000, $569,000 and $539,000,respectively.

 

Until March 31, 1997, Mr.Portnoy was a partner of Sullivan & Worcester LLP, our counsel and counselto Senior Housing, RMR and affiliates of each of the foregoing, and he receivedpayments from that firm during 2004, 2003 and 2002 in respect of hisretirement.

 

Wells Fargo & Companybeneficially owns 8.1% of our common shares. Wells Fargo Bank, N.A., anaffiliate of Wells Fargo & Company, became the transfer agent andregistrar for our common shares, effective as of December 13, 2004.

 

**Critical AccountingPolicies**

 

Our critical accounting policies concern revenue recognition,our assessment of the net realizable value of our accounts receivable, therealizable value of long term assets, accounting for long term care contracts,accounting for business combinations and our assessment of reserves related toour 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 areprovided and these amounts are reported at their estimated net realizableamounts.  Some Medicare and Medicaidrevenues are subject 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.

 

We monitor our long term assets to determine whetherany impairment of these assets may have occurred.  If the facts and circumstances indicate thatan impairment may have occurred, we evaluate the asset’s carrying value todetermine whether an impairment charge is required.  This process includes a review of historicaland projected future financial results realized or to be realized from theaffected assets, market conditions affecting the sale of similar assets and thelike.  This process requires thatestimates be made and errors in our judgments or estimates could have amaterial effect on our financial statements.

 

At certain of our communities, 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 record suchdeposits as a long term obligation and amortize the non-refundable portion ofsuch deposits into revenue over our estimate of the periods during which futureservices will be provided.  We base theseestimates on our experience and actuarial information.

 

Since we became a separate public company, each of ouracquisitions has been accounted for as a purchase business combination inaccordance with Statement of Financial Accounting Standards No. 141.  Purchase accounting requires that we makecertain judgments and estimates based on our experience, including determiningthe fair value and useful lives of assets acquired and the fair value ofliabilities assumed.  Some of ourjudgments and estimates are also based upon published industry statistics andin some cases third party appraisals.

 

30

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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 otherfactors.  We also periodically receiveand rely upon recommendations from professional consultants in establishingthese 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 thesepremises underlying our critical accounting policies may have on our futureresults 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 likely have a negative impact upon us.A large component of our expenses consist of minimum rental obligations toSenior Housing. Accordingly we believe that a general decline in price levelswhich could cause our charges to residents to decline would likely not be fullyoffset 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.

 

**Item7A.  Quantitative and QualitativeDisclosures About 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.  Other than as describedbelow we do not now anticipate any significant changes in our exposure tofluctuations in 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 flowanalysis, if prevailing interest rates were to decline by 10% and other creditmarket considerations remained unchanged, the market value of our $42.6millionmortgage debt outstanding on December 31, 2004, would increase by about $4.2million; and, similarly, if prevailing interest rates were to increase by 10%,the market value of our $42.6 million mortgage debt would decline by about $4.2million.

 

Our revolving credit facility bears interest atfloating rates and matures in October 2005. As of December 31, 2004, we had no amounts outstanding under thisrevolving credit facility.  We borrow inU.S. dollars and borrowings under our revolving credit facility are subject tointerest at LIBOR plus a spread. Accordingly, we are vulnerable to changes in U.S. dollar based shortterm rates, specifically LIBOR.  A changein interest rates would not affect the value of any outstanding floating ratedebt but would affect our operating results. For example, if the maximum amount of our credit facility of $12.5million were drawn and interest rates decrease or increase by 1% per annum, ourinterest expense would decrease or increase by $125,000 per year, or $0.01 pershare, based on currently outstanding

 

31

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common shares, respectively.  If interest rates were to change graduallyover time, the impact would be spread over time.

 

Our exposure to fluctuations in interest rates mayincrease in the future if we incur debt to fund acquisitions or otherwise.

 

As of March 25, 2005, we have no commercial paper,derivatives, swaps, hedges, joint ventures or partnerships.

 

**Item8. Financial Statements and Supplementary Data**

 

The information required by this Item is included inItem 15 of this Annual Report on Form 10-K.

 

**Item9. Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure**

 

We have had no changes in or disagreements with ouraccountants on accounting and financial disclosure.

 

**Item 9A.  Controls and Procedures**

 

As of the end ofthe period covered by this report, our management carried out an evaluation,under the supervision and with the participation of our President and ChiefExecutive Officer and our Treasurer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures pursuant to Rules13a-15 and 15d-15 of the Exchange Act. 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 no changes in our internal controlover financial reporting during the quarter ended December 31, 2004 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Item 9B.  Other Information**

** **

**None.**

 

32

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**PART III**

 

**Item 10.  Directors and Executive Officers of theRegistrant**

 

In March 2004, we adopteda code of business conduct and ethics that applies to all our representatives,including our officers and directors. Our code of business conduct and ethics is posted on our website,www.5sqc.com.  A printed copy of our codeof business conduct and ethics is also available free of charge to anyshareholder who requests a copy.  Weintend to disclose any amendments or waivers to our code of business conductand ethics applicable to our principal executive officer, principal financial officer,principal accounting officer or controller (or any person performing similarfunctions) on our website.

 

The remainder of the information required by Item 10is incorporated by reference to our definitive Proxy Statement, which will befiled not later than 120 days after the end of our fiscal year.

 

**Item 11. Executive Compensation**

 

The information required by Item 11 is incorporated byreference to our definitive Proxy Statement, which will be filed not later than120 days after the end of our fiscal year.

 

**Item 12.  Security Ownership of Certain BeneficialOwners and Management and Related Shareholder Matters**

 

Equity Compensation Plan Information.  We may grant options and common shares to ourofficers, directors, employees and other individuals who render services to us,subject to vesting requirements under our 2001 Stock Option and Stock IncentivePlan, or the Plan.  In addition, ourdirectors receive 4,000 shares per year each as part of their annual compensationfor serving as our directors and such shares may be awarded under thePlan.  The terms of grants made under thePlan are determined by our directors at the time of the grant.  The following table is as of December 31,2004.

 
| ** **                                                  | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights****(a)** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights****(b)** | ** ** | **Number of securities  remaining available for future  issuance under equity  compensation plans (excluding  securities reflected in  column (a))****(c)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | None                                                                                                       |       | None                                                                                      |       | 500,000                                                                                                                                                     | (1)        |
| Equity  compensation plans not approved by security holders |       | None                                                                                                       |       | None                                                                                      |       | None                                                                                                                                                        |       |
| Total                                                       |       | None                                                                                                       |       | None                                                                                      |       | 500,000                                                                                                                                                     |       |

 

----

(1)  Pursuant to the terms of the Plan, in no eventshall the number of shares issued exceed 650,000.

 

The remainder of the information required by Item 12is incorporated by reference to our definitive Proxy Statement, which will befiled not later than 120 days after the end of our fiscal year.

 

**Item 13.  Certain Relationships and RelatedTransactions**

 

The information required by Item 13 is incorporated byreference to our definitive Proxy Statement, which will be filed not later than120 days after the end of our fiscal year.

 

**Item14.  Principal Accountant Fees andSchedules**

 

The information requiredby Item 14 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 15.  Exhibits and Financial Statement Schedules.**

 

(a)  Index toFinancial Statements 

 
| **Consolidated Financial  Statements of Five Star Quality Care, Inc.**                                          | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** |
| Report  of Independent Registered Accounting Firm                                                               |       |
|                                                                                                            |       |
| Consolidated Balance Sheet  at December 31, 2004 and 2003                                                  |       |
|                                                                                                            |       |
| Consolidated  Statement of Operations for the years ended December 31, 2004, 2003 and  2002                |       |
|                                                                                                            |       |
| Consolidated  Statement of Shareholders’ Equity for the years ended December 31, 2004,  2003 and 2002 |       |
|                                                                                                            |       |
| Consolidated  Statement of Cash Flows for the years ended December 31, 2004, 2003 and  2002                |       |
|                                                                                                            |       |
| Notes to  Consolidated Financial Statements                                                                     |       |

 

All other schedules for which provision is made in theapplicable accounting regulations of the Securities and Exchange Commission arenot required under the related instructions, or are inapplicable, and thereforehave been omitted.

 

(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  Company, certain subsidiaries of the Company 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 Company, 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 Company, collectively as Buyer. (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated October 25,  2002*.)                                                    |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 2.4             |       | Agreement and Plan of  Merger, dated as of September 23, 2004, by and among the Company, FVE  Acquisition Inc. and LTA Holdings, Inc. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated September 23,  2004.)*                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 2.5             |       | Purchase and Sale  Agreement, dated as of November 19, 2004, by and among certain  affiliates of the Company, as Sellers, and certain affiliates of Senior  Housing Properties Trust, as Purchasers. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 2.6             |       | Purchase and Sale  Agreement, dated as of November 19, 2004, by and among certain  affiliates of the Company, as Sellers, and certain affiliates of Senior  Housing Properties Trust, as Purchasers. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                                                                                                                               |

 

34

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| 2.7        |   | Purchase and Sale  Agreement, dated as of November 19, 2004, by and among certain  affiliates of the Company, as Sellers, and SNH/LTA Properties Trust and  SNH/LTA Properties GA LLC, as Purchasers. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                 |
|------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.8        |   | Purchase and Sale  Agreement, dated as of January 21, 2005, by and among the Company, as  Purchaser, and Franciscan Manor Associates, LLC, Muirfield Associates, LLC,  Prestwicke Associates, LLC, Royal Aberdeen, LLC, Troon Associates, LLC and  Turnberry Associates, LLC, as Seller. (*Filed  herewith*).                                                                                                                                             |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.9        |   | First Amendment to  Purchase and Sale Agreement, dated as of February 3, 2005, by and among the  Company, as Purchaser, and Franciscan Manor Associates, LLC, Muirfield  Associates, LLC, Prestwicke Associates, LLC, Royal Aberdeen, LLC, Troon  Associates, LLC and Turnberry Associates, LLC, as Seller. (*Filed herewith*).                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.1        |   | Composite copy of  Articles of Amendment and Restatement of the Company. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-119955, as amended  on November 12, 2004*.)                                                                                                                                                                                                                        |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.2        |   | Composite copy of  Amended and Restated Bylaws of the Company. (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10, 2004*.)                                                                                                                                                                                                                                                                                      |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.3        |   | Articles Supplementary,  as corrected by Certificate of Correction dated March 19, 2004. *(Incorporated by reference to the Company’s Form  8-A dated March 19, 2004 and the Company’s Quarterly Report on Form 10-Q for  the quarter ended March 31, 2004, respectively.)*                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.1        |   | Specimen Certificate  for shares of common stock of the Company. (*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 Company. *(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.)*                                                                                                                                                                                                                                        |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 4.4        |   | Appointment of  Successor Rights Agent, dated as of December 13, 2004, by and between the  Company and Wells Fargo Bank, National Association, a national banking association.  (*Incorporated by reference to the  Company’s Current Report on Form 8-K dated December 13, 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 Company. (*Incorporated  by reference to the Company’s Registration Statement on Form S-1, File No.  333-69846, as amended on December 5, 2001.*)                                                                                                                                                                                                                                                 |

 

35

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| 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 Company 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 March 20, 2002*.)                                                                                                                                       |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8#       |   | Representative  Form of Pooling Agreement by and among certain subsidiaries of the Company  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 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. *(Incorporated by reference to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2004.)*                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 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 Company, 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  Company 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 Company 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  Company and Reit Management & Research LLC. (*Incorporated by reference to the Company’s*                                                                                                                                                                                                                                                                     |

 

36

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|   |   | *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 Company, 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 Company, 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  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 Company, 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.)*                                                                                                                                                                                                                                                                        |

 

37

----

 
| 10.31        |   | Guaranty Agreement,  dated October 25, 2002, for the benefit of SNH CHS Properties Trust and  Senior Housing Properties Trust made by the Company. (*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.)*                                      |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.38†# |   | Representative  Indemnification Agreement. *(Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended June 30, 2004.)*                                                                                                                                                                       |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.39        |   | Partial Termination and  Amendment of Lease, dated April 19, 2004, by and among certain subsidiaries  of Senior Housing Properties Trust, as Landlord, and Five Star Quality Care  Trust, as Tenant. *(Incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended March 31, 2004.)*            |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.40        |   | Amended and Restated  Purchase and Sale Agreement, dated April 19, 2004, by and between  SPT-Michigan Trust and Five Star Quality Care-Howell, LLC. *(Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended  March 31, 2004.)*                                                   |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.41        |   | Mortgage, dated April  19, 2004, between Five Star Quality Care-Howell, LLC and Love Funding  Corporation. *(Incorporated by reference to  the Company’s Quarterly Report on Form 10-Q for the quarter ended  March 31,  2004.)*                                                                                           |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.42        |   | First Amendment to  Amended and Restated Lease Agreement, dated June 23, 2004, by and among  certain subsidiaries of Senior Housing Properties Trust, as Landlord, and  Five Star Quality Care Trust, as Tenant. *(Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended June 30, 2004.)* |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.43        |   | Promissory Note, dated  as of November 18, 2004, made by FVE Acquisition Inc. to the order of  Senior Housing Properties Trust. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                       |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.44        |   | Loan Agreement, dated  as of November 19, 2004, by and among Senior Housing Properties Trust,  the Company and FSQ/LTA Holdings Inc. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                  |
|         |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.45        |   | Joint and Several  Promissory Note, dated as of November 19, 2004, made by the Company and  FSQ/LTA Holdings Inc. to the order of Senior Housing Properties Trust. *(Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-119955, as amended  on*                             |

 

38

----

 
|   |   | *November 29,  2004.)*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.46  |   | Lease Agreement, dated  as of November 19, 2004, by and among certain affiliates of Senior  Housing Properties Trust, as Landlord, and certain affiliates of the Company  as Tenant. *(Incorporated by reference to  the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.47  |   | Guaranty Agreement,  dated as of November 19, 2004, made by the Company in favor of the  Beneficiaries named therein. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.48  |   | Lease Agreement, dated  as of November 19, 2004, by and among certain affiliates of Senior  Housing Properties Trust, as Landlord, and certain affiliates of the Company  as Tenant. *(Incorporated by reference to  the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.49  |   | Guaranty Agreement,  dated as of November 19, 2004, made by the Company in favor of the  Beneficiaries named therein. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.50  |   | Second Amended and  Restated Lease Agreement, dated as of November 19, 2004, by and among,  Ellicott City Land I LLC, Ellicott City Land II LLC, HRES2  Properties Trust, SNH CHS Properties Trust, SPTIHS Properties Trust,  SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA Properties Trust and  SNH/LTA Properties GA LLC, 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. 333-119955, as amended on November 29, 2004.)* |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 12.1   |   | Computation of Ratio of  Earnings to Fixed Charges. (*Filed herewith*.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 21.1   |   | Subsidiaries of the  Company. (*Filed herewith*.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 23.1   |   | Consent of Ernst &  Young LLP. *(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   |   | Composite Copy of  Governance Guidelines, effective January 19, 2005. *(Furnished herewith.)*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |

 

----

| † | Indicates a management  contract or a compensatory plan, contract or arrangement.              |
|--------|------------------------------------------------------------------------------------------------|
| #      | Agreement filed is  illustrative of numerous other agreements to which the Company is a party. |

 

39

----

 

**Reportof Independent Registered Public Accounting Firm**

** **

To the Directors and Shareholders of Five Star QualityCare, Inc.

 

We have audited the accompanying consolidated balancesheet of Five Star Quality Care, Inc., as of December 31, 2004 and 2003, and therelated consolidated statements of operations, shareholders’ equity and cashflows for each of the three years in the period ended December 31, 2004. Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  We were not engaged toperform an audit of the Company’s internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal controls over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financial positionof Five Star Quality Care, Inc. at December 31, 2004 and 2003, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2004, in conformity with U.S. generallyaccepted accounting principles.

 

 
|   | /s/ Ernst &  Young, LLP |   |
|--------|-----------------------------|--------|

 

Boston,Massachusetts

March 21, 2005

 

F-1

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATEDBALANCE SHEET**

 

*(dollarsin thousands, except share data)*

 
| ** **                                                                                                                                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                                                                                        |       |     |       |     |       |
| Current assets:                                                                                                                                                   |       |     |       |     |       |
| Cash and cash  equivalents                                                                                                                                        |       | $        | 26,194     |     | $          | 17,611 |   |
| Accounts  receivable, net of allowance of $5,278 and $4,305 at December 31, 2004 and  2003, respectively                                                          |       | 36,742   |       | 30,581   |       |
| Due from Senior  Housing Properties Trust                                                                                                                         |       | —   |       | 544      |       |
| Prepaid expenses                                                                                                                                                  |       | 10,417   |       | 4,305    |       |
| Other current  assets                                                                                                                                             |       | 2,690    |       | 2,412    |       |
| Total current  assets                                                                                                                                             |       | 76,043   |       | 55,453   |       |
|                                                                                                                                                              |       |     |       |     |       |
| Property and  equipment, net                                                                                                                                      |       | 95,189   |       | 55,484   |       |
| Restricted cash -  insurance arrangements                                                                                                                         |       | 17,611   |       | 12,056   |       |
| Restricted cash -  other                                                                                                                                          |       | 12,753   |       | 15,338   |       |
| Mortgage notes  receivable                                                                                                                                        |       | 6,099    |       | 6,143    |       |
| Goodwill                                                                                                                                                          |       | 11,548   |       | 610      |       |
| Other long term  assets                                                                                                                                           |       | 3,742    |       | 2,286    |       |
|                                                                                                                                                              |       | $        | 222,985    |     | $          | 147,370 |   |
|                                                                                                                                                              |       |     |       |     |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                     |       |     |       |     |       |
|                                                                                                                                                              |       |     |       |     |       |
| Current  liabilities:                                                                                                                                             |       |     |       |     |       |
| Accounts payable                                                                                                                                                  |       | $        | 12,625     |     | $          | 13,820 |   |
| Accrued expenses                                                                                                                                                  |       | 13,951   |       | 7,759    |       |
| Accrued  compensation and benefits                                                                                                                                |       | 11,382   |       | 8,936    |       |
| Due to Senior  Housing Properties Trust                                                                                                                           |       | 7,961    |       | 6,605    |       |
| Due to Sunrise  Senior Living, Inc.                                                                                                                               |       | 309      |       | 6,134    |       |
| Mortgage notes  payable                                                                                                                                           |       | 463      |       | 54       |       |
| Secured  revolving credit facility                                                                                                                                |       | —   |       | 4,000    |       |
| Accrued real  estate taxes                                                                                                                                        |       | 3,449    |       | 5,142    |       |
| Security deposit  liability                                                                                                                                       |       | 3,325    |       | 2,405    |       |
| Other current  liabilities                                                                                                                                        |       | 5,656    |       | 3,290    |       |
| Total current  liabilities                                                                                                                                        |       | 59,121   |       | 58,145   |       |
|                                                                                                                                                              |       |     |       |     |       |
| Long term  liabilities:                                                                                                                                           |       |     |       |     |       |
| Mortgage notes  payable                                                                                                                                           |       | 42,118   |       | 6,381    |       |
| Continuing care  contracts                                                                                                                                        |       | 9,094    |       | 10,164   |       |
| Other long term  liabilities                                                                                                                                      |       | 16,748   |       | 8,253    |       |
| Total long term  liabilities                                                                                                                                      |       | 67,960   |       | 24,798   |       |
|                                                                                                                                                              |       |     |       |     |       |
| Commitments and  contingencies:                                                                                                                                   |       |     |       |     |       |
|                                                                                                                                                              |       |     |       |     |       |
| Shareholders’  equity:                                                                                                                                       |       |     |       |     |       |
| Preferred stock,  par value $0.01: 1,000,000 shares authorized, none issued                                                                                       |       | —   |       | —   |       |
| Common stock,  par value $0.01: 20,000,000 shares authorized, 12,096,634 and 8,513,634  shares issued and outstanding at December 31, 2004 and 2003, respectively |       | 121      |       | 85       |       |
| Additional  paid-in capital                                                                                                                                       |       | 114,394  |       | 86,244   |       |
| Accumulated  deficit                                                                                                                                              |       | (18,611  | )          | (21,902  | )          |
| Total  shareholders’ equity                                                                                                                                  |       | 95,904   |       | 64,427   |       |
|                                                                                                                                                              |       | $        | 222,985    |     | $          | 147,370 |   |

 

The accompanyingnotes are an integral part of these financial statements*.*

 

F-2

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATED STATEMENT OFOPERATIONS**

 

(*in thousands, except per share data)*

 
| ** **                                                    | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                          |       |                                |       |   |   |   |   |
| Revenues:                                                     |       |                                |       |   |   |   |   |
| Net revenues  from residents                                  |       | $                                   | 614,796    |   | $ | 573,412 |   | $ | 519,106 |   |
| Pharmacy revenue                                              |       | 13,209                              |       | 1,770 |   | — |   |
| Total revenues                                                |       | 628,005                             |       | 575,182 |   | 519,106 |   |
|                                                          |       |                                |       |   |   |   |   |
| Operating  expenses:                                          |       |                                |       |   |   |   |   |
| Wages and  benefits                                           |       | 326,314                             |       | 313,846 |   | 274,248 |   |
| Other operating  expenses                                     |       | 159,892                             |       | 149,401 |   | 143,053 |   |
| Pharmacy  expenses                                            |       | 12,093                              |       | 1,666 |   | — |   |
| Management fee  to Sunrise Senior Living Services, Inc.       |       | 19,293                              |       | 17,272 |   | 16,643 |   |
| Rent expense                                                  |       | 83,370                              |       | 77,495 |   | 75,210 |   |
| General and  administrative                                   |       | 20,053                              |       | 17,470 |   | 15,415 |   |
| Depreciation and  amortization                                |       | 3,666                               |       | 3,587 |   | 1,794 |   |
| Impairment of  assets                                         |       | —                              |       | — |   | 150 |   |
| Restructuring  costs                                          |       | —                              |       | — |   | 122 |   |
| Spin off and  merger expense, non recurring                   |       | —                              |       | — |   | 2,829 |   |
| Total operating  expenses                                     |       | 624,681                             |       | 580,737 |   | 529,464 |   |
|                                                          |       |                                |       |   |   |   |   |
| Operating income  (loss)                                      |       | 3,324                               |       | (5,555 | ) | (10,358 | ) |
| Interest and  other income                                    |       | 1,666                               |       | 229 |   | 297 |   |
| Interest expense                                              |       | (880                                | )          | (1,164 | ) | (198 | ) |
|                                                          |       |                                |       |   |   |   |   |
| Income (loss)  from continuing operations before income taxes |       | 4,110                               |       | (6,490 | ) | (10,259 | ) |
| Provision for  income taxes                                   |       | (120                                | )          | — |   | — |   |
| Income (loss)  from continuing operations                     |       | 3,990                               |       | (6,490 | ) | (10,259 | ) |
|                                                          |       |                                |       |   |   |   |   |
| Loss from  discontinued operations                            |       | (699                                | )          | (1,449 | ) | (2,915 | ) |
|                                                          |       |                                |       |   |   |   |   |
| Net income  (loss)                                            |       | $                                   | 3,291      |   | $ | (7,939 | ) | $ | (13,174 | ) |
|                                                          |       |                                |       |   |   |   |   |
| Weighted average  shares outstanding                          |       | 8,716                               |       | 8,482 |   | 7,556 |   |
|                                                          |       |                                |       |   |   |   |   |
| Basic and  diluted income (loss) per share from:              |       |                                |       |   |   |   |   |
| Continuing  operations                                        |       | $                                   | 0.46       |   | $ | (0.77 | ) | $ | (1.36 | ) |
| Discontinued  operations                                      |       | (0.08                               | )          | (0.17 | ) | (0.38 | ) |
| Net income  (loss) per share                                  |       | $                                   | 0.38       |   | $ | (0.94 | ) | $ | (1.74 | ) |

 

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

 

F-3

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY**

 

*(dollarsin thousands, except share data)*

* *
| ** **                                          | ** ** | **Number of  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|-----------|------------|
|                                                |       |                  |       |              |       |                             |       |                     |       |      |       |
| 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 income                                          |       | —                |       | —            |       | —                           |       | (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    |       |
|                                                |       |                  |       |              |       |                             |       |                     |       |      |       |
| Stock grants                                        |       | 83,000                |       | 1                 |       | 540                              |       | —                   |       | 541       |       |
| Issuance of  stock, pursuant to equity offering     |       | 3,500,000             |       | 35                |       | 27,610                           |       | —                   |       | 27,645    |       |
| Net income                                          |       | —                |       | —            |       | —                           |       | 3,291                    |       | 3,291     |       |
|                                                |       |                  |       |              |       |                             |       |                     |       |      |       |
| Balance at  December 31, 2004                       |       | 12,096,634            |       | $                 | 121        |                             | $          | 114,394                  |       | $         | (18,611    | ) | $ | 95,904 |   |

 

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

 

F-4

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATED STATEMENT OF CASHFLOWS**

(*dollars in thousands)*

 
| ** **                                                                            | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2002** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                |       |                                |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                   | 3,291      |   | $ | (7,939 | ) | $ | (13,174 | ) |
| Adjustments to  reconcile net income (loss) to cash provided by operating activities: |       |                                |       |   |   |   |   |
| Depreciation and  amortization                                                        |       | 3,666                               |       | 3,588 |   | 1,794 |   |
| Spin off and  merger expense                                                          |       | —                              |       | — |   | 2,829 |   |
| Impairment of  assets                                                                 |       | —                              |       | — |   | 150 |   |
| Loss from  discontinued operations                                                    |       | 699                                 |       | 372 |   | 2,915 |   |
| Provision for  bad debt expense                                                       |       | 973                                 |       | 403 |   | (1,916 | ) |
| Changes in  assets and liabilities:                                                   |       |                                |       |   |   |   |   |
| Accounts  receivable                                                                  |       | (6,098                              | )          | 3,674 |   | 12,310 |   |
| Prepaid expenses  and other current assets                                            |       | 162                                 |       | (9,583 | ) | 778 |   |
| Accounts payable  and accrued expenses                                                |       | (10,547                             | )          | 2,592 |   | 6,802 |   |
| Accrued  compensation and benefits                                                    |       | 2,423                               |       | 3,124 |   | 524 |   |
| Due to Senior  Housing Properties Trust                                               |       | 2,501                               |       | 6,667 |   | (3,480 | ) |
| Due to Sunrise  Senior Living Services, Inc.                                          |       | (5,825                              | )          | 6,134 |   | — |   |
| Security deposits  and other liabilities                                              |       | 9,092                               |       | 10,132 |   | 441 |   |
| Cash provided by  operating activities                                                |       | 337                                 |       | 19,164 |   | 9,973 |   |
| ** **                                                                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Transfer of  working capital by lease                                                 |       | —                              |       | — |   | 10,722 |   |
| Payments on  mortgage note receivable                                                 |       | 44                                  |       | 35 |   | — |   |
| Deposits into  restricted cash accounts                                               |       | (10,491                             | )          | (18,250 | ) | (7,445 | ) |
| Withdrawals from  restricted cash for purchases of furniture, fixtures and equipment  |       | 7,521                               |       | 4,167 |   | — |   |
| Acquisition of  pharmacy, net of cash acquired                                        |       | (3,525                              | )          | (1,800 | ) | — |   |
| Acquisition of  insurance company, net of cash acquired                               |       | —                              |       | (1,310 | ) | — |   |
| Acquisition of  LTA Holdings, Inc., net of cash acquired                              |       | (112,431                            | )          | — |   | — |   |
| Acquisition of  real estate                                                           |       | (6,084                              | )          | — |   | — |   |
| Proceeds from  real estate sales                                                      |       | 122,682                             |       | 16,331 |   | (44,927 | ) |
| Proceeds from  disposition of assets held for sale                                    |       | 9,457                               |       | 10,754 |   | — |   |
| Furniture,  fixtures and equipment purchases                                          |       | (20,421                             | )          | (15,812 | ) | (6,954 | ) |
| Cash used in  investing activities                                                    |       | (13,248                             | )          | (5,885 | ) | (48,604 | ) |
|                                                                                  |       |                                |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                |       |                                |       |   |   |   |   |
| Proceeds from  borrowings on revolving credit facility                                |       | 22,000                              |       | 55,500 |   | — |   |
| Repayments of  borrowings on revolving credit facility                                |       | (26,000                             | )          | (51,500 | ) | — |   |
| Proceeds from  issuance of common stock, net                                          |       | 27,645                              |       | — |   | 26,113 |   |
| Payment of  deferred financing costs                                                  |       | —                              |       | — |   | (1,055 | ) |
| Proceeds from  mortgage note payable                                                  |       | 122,015                             |       | — |   | — |   |
| Repayments of  mortgage notes payable                                                 |       | (123,467                            | )          | (9,687 | ) | — |   |
| Cash provided by  (used in) financing activities                                      |       | 22,193                              |       | (5,687 | ) | 25,058 |   |
|                                                                                  |       |                                |       |   |   |   |   |
| Net cash used in  discontinued operations                                             |       | (699                                | )          | (251 | ) | (1,100 | ) |
|                                                                                  |       |                                |       |   |   |   |   |
| Change in cash  and cash equivalents                                                  |       | 8,583                               |       | 7,341 |   | (14,673 | ) |
| Cash and cash  equivalents at beginning of year                                       |       | 17,611                              |       | 10,270 |   | 24,943 |   |
| Cash and cash  equivalents at end of year                                             |       | $                                   | 26,194     |   | $ | 17,611 |   | $ | 10,270 |   |
|                                                                                  |       |                                |       |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                  |       |                                |       |   |   |   |   |
| Cash paid for  interest                                                               |       | $                                   | 512        |   | $ | 1,381 |   | $ | 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                                                             |       | 541                                 |       | 104 |   | — |   |
| Acquisition of  assets by merger                                                      |       | —                              |       | (2,220 | ) | (1,052 | ) |
| Assumption of  liabilities by merger                                                  |       | —                              |       | (890 | ) | 2,006 |   |
| Assumption of  mortgage                                                               |       | 86,764                              |       | — |   | 15,775 |   |
| Issuance of  common stock for merger                                                  |       | —                              |       | — |   | 1,875 |   |
| Assumption of  assets by lease                                                        |       | —                              |       | — |   | (12,061 | ) |
| Assumption of  liabilities by lease                                                   |       | —                              |       | — |   | 22,783 |   |

 

The accompanyingnotes are an integral part of these financial statements*.*

 

F-5

----

 

**FIVE STAR QUALITY CARE, INC.**

 

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

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

 

**1. Organization andBusiness**

** **

We were organized on April 27, 2000, as a whollyowned subsidiary of Senior Housing Properties Trust, or Senior Housing.

 

On December 31, 2001, Senior Housing distributed allof our common shares to its shareholders. Concurrent with our spin-off, we entered into a transaction agreementwith Senior Housing and others to govern our initial capitalization and otherevents related to the spin-off.  OnJanuary 11, 2002, 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 tous which resulted in $7,215 of additional paid in capital.  This amount was the result of our havingreceived more working capital assets and having assumed fewer liabilities thanwe had previously recorded.

 

As of December 31, 2004, excluding communities wemanaged under third party management contracts, we operated 148 communitiescontaining 16,573 living units, including 96 primarily independent and assistedliving communities containing 11,724 living units and 52 nursing homescontaining 4,849 living units. Of our 96 primarily independent and assistedliving communities, we lease 77 communities containing 10,308 living units fromSenior Housing, our former parent, including 30 communities which are directlyoperated for our account by SLS, and we own or lease from parties other than SeniorHousing 19 communities containing 1,416 living units.  All but one of our nursing homes are leasedfrom Senior Housing. Our 148 communities include 4,960 independent livingapartments, 5,046 assisted living suites, 283 special care beds and 6,284 nursingbeds.  We also operate two institutionalpharmacies.

 

We experienced losses in 2003 and 2002.  We believe that a combination of our effortsto increase revenues and contain costs, our ability to borrow on our revolvingcredit facility, our ability to sell to Senior Housing certain capitalimprovements made to communities leased from Senior Housing and the possibilityof sales or financings of our owned communities will be sufficient to meet ourworking capital needs, operating expenses, rent payments to Senior Housing,debt service and capital expenditures for the next 12 months and theforeseeable future.

 

**2.  Summary of Significant Accounting Policies**

** **

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

 

Under the terms of our management agreements with SLSwe have provided SLS with working capital to be used in the operation of thecommunities.  The components of the workingcapital, primarily cash and cash equivalents, inventories, trade accountsreceivable and accounts payable, are controlled by SLS on our behalf, but weretain the risks and rewards associated with the underlying assets andliabilities.  Accordingly, the componentsof this working capital (including cash and cash equivalents of $17,787 and$13,167 at December 31, 2004 and 2003, respectively, are included in ourconsolidated balance sheet.

 

*Estimates and assumptions.*  Preparation of these financial statements inconformity with accounting principles generally accepted in the United 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.

 

F-6

----

 

*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 - insurance arrangements.*  Restricted cash - insurance arrangements iscash that we deposited as security for letters of credit which secureobligations arising from our professional liability insurance program.  Restricted cash - insurance arrangements alsoincludes amounts held by our captive insurance companies that will be used topay for future workers compensation and liability claims.

 

*Restricted cash - other. *Restricted cash - other asof December 31, 2004, includes the following amounts that we are required toescrow: (i) $518 required by certain healthcare regulatory agencies, (ii)$5,540 for future capital expenditures, as required by our lease with SeniorHousing and our management agreements with SLS, (iii) $2,585 for real estatetaxes and capital expenditures as required by mortgages, (iv) $3,859 forresident security deposits for certain SLS managed communities and (v) $251 forother business reasons.  Restricted cash- other as of December 31, 2003, includes the following amounts that we arerequired to escrow: (i) $518 required by certain healthcare regulatoryagencies, (ii) $5,000 for future capital expenditures, as required by our leasewith Senior Housing and our management agreements with SLS, (iii) $339 for realestate taxes and capital expenditures as required by a mortgage, (iv) $9,168for resident security deposits for certain SLS managed communities and (v) $313for other business reasons.

 

*Accounts receivable and allowance for doubtfulaccounts.*  We recordaccounts receivable at their estimated net realizable value.  In the case of receivables generated fromresidents, we estimate allowances for uncollectible amounts based upon factorswhich include, but are not limited to, the age of the receivable and the termsof the agreements with residents or their third party payors.  In the case of other receivables, such asthose due from various governments or other entities with which we have transactedbusiness, we estimate allowances based upon factors which include, but are notlimited to, the agreements with such payors, their stated intent to pay, theirfinancial capacity to pay and other factors which may include litigation.  Accounts receivable allowances areestimates.  We periodically review andrevise these estimates based on new information; such revisions may bematerial.

 

During 2004, 2003 and 2002, we increased our allowancefor doubtful accounts by $3,600, $2,456 and $4,387, respectively, and wrote offaccounts receivable of $2,627, $2,053 and $4,502, respectively.

 

Included in accounts receivable as of December 31,2004 and 2003 are amounts due from the Federal Government Medicare program of$10,952 and $9,651, respectively, and amounts due from various state Medicaidprograms of $14,570 and $13,463, respectively.

 

*Deferred finance costs*.  We capitalize issuance costs related toborrowings and amortize the deferred costs over the terms of the respectiveloans.  The unamortized balance ofdeferred finance costs was $925 and $503 at December 31, 2004 and 2003,respectively.  Accumulated amortizationrelated to deferred finance costs was $617 and $326 at December 31, 2004 and2003, respectively.  At December 31,2004, the weighted average amortization period remaining is approximately 34years.  The amortization expense to beincurred over the next five years as of December 31, 2004 is $262 in 2005, $36in 2006, $35 in 2007, $35 in 2008 and $35 in 2009.

 

*Property and equipment.*  Property and equipment is stated atcost.  We expense depreciation on realestate properties on a straight line basis over estimated useful lives of up to40 years for buildings, up to 15 years for building improvements and up toseven years for personal property. We regularly evaluate whether events or changesin circumstances have occurred that could indicate an impairment in the valueof long 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.  Wedetermine the amount of impairment loss by comparing the historical carryingvalue of the asset to its estimated fair value. We determine estimated fair value through an evaluation of recentfinancial performance and projected discounted cash flows of properties usingstandard industry valuation techniques. During 2002, we wrote off certain impaired assets with a carrying valueof $772.

 

*Goodwill.*  Goodwill represents the costs of businessacquisitions in excess of the fair value of identifiable net assets acquired.Goodwill is reviewed annually for impairment. If the review indicates that carrying amount of

 

F-7

----

 

goodwill exceeds its fair value, the carryingvalue of goodwill will be adjusted.  Todate, no impairment charges have been recorded.

 

*Self insurance.*  We self insure up to certain retained limitsfor workers compensation and professional liability.  Claims in excess of these retained limits areinsured by third party insurance providers up to contractual limits, over whichwe are self insured.  We are fully selfinsured for all employee health related claims. We accrue the estimated cost of self insured amounts based on projectedsettlements for pending claims, known incidents which we expect may result inclaims, estimates of incurred but not yet reported claims and incidents andexpected changes in premiums for insurance provided by third party insurerswhose policies provide for retroactive adjustments.  We periodically adjust these estimates basedupon our claims experience, recommendations from our professional consultants,changes in market conditions and other factors; such adjustments may be material.

 

*Continuing care contracts. *At some of our communitiesthat are managed by SLS, residents can enter into continuing carecontracts.  These contracts requireresidents to make advance payments some of which are refundable and are carriedas liabilities until they are refunded and some of which are not refundable andare carried as liabilities until they are amortized into revenues during theperiods we expect to provide the service. Portions of these payments are included in restricted cash on our consolidatedbalance sheet.

 

*Incometaxes*.  We account forincome taxes in accordance with Statement of Financial Accounting Standards, orSFAS, No. 109, “*Accounting for Income Taxes”*, orFAS 109.  FAS No. 109 prescribes an assetand liability approach that requires the recognition of deferred tax assets andliabilities for the expected future tax consequences of temporary differencesbetween the financial statement carrying amounts and the tax bases of assetsand liabilities (see Footnote 5).

 

We pay franchise taxes in certain states in which wehave operations.  We have included thefranchise taxes in general and administrative and other operating expenses inour consolidated statements of operations.

 

*Revenue recognition.*  Our revenues are derived primarily fromservices to residents at communities we own or lease.  We accrue revenues when services are providedand revenues are earned.  Some of ourservices are provided with the expectation of payment from governments or otherthird party payors; related revenues are reported at their estimated netrealizable amounts at the time the services are provided.  We derived approximately 38%, 39% and 39% of2004, 2003 and 2002 net resident revenues, respectively, from payments underfederal and state medical assistance programs. Revenues under some of these programs are subject to audit andretroactive adjustment.

 

Medicare revenues totaled $109,800, $86,100 and$68,400 during 2004, 2003 and 2002, respectively.  Medicaid revenues totaled $152,100, $148,600and $142,600 during 2004, 2003 and 2002, respectively.  Both the Federal Government and some of thestates in which we operate are contemplating plans to reduce Medicare andMedicaid funding.  We cannot estimate themagnitude of potential Medicaid and Medicare rate reductions but it may bematerial.  Medicaid and Medicare ratesreductions, if they occur, may have a negative impact on our revenues and maydecrease our net income and may cause us to incur losses.

 

*Management Agreements.*  Our management agreements with SLS providefor payment of base management fees equal to 5% of revenues at the managedcommunities and incentive management fees equal to 20% of the operating profitat the managed communities, as defined, over a priority return to us.  SLS is also entitled to centraladministrative services fees equal to 2% of our revenues at the managedcommunities.  Our management agreementswith SLS expire in 2027 and have a five year renewal term at SLS’s option.  During 2004, 2003 and 2002, we incurred feesunder these management agreement with SLS totaling $19,293, $17,272 and$16,643, respectively.

 

*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 were paidin 2002.

 

F-8

----

 

*Per common share amounts.*  We computed earnings (loss) per share for theyears ended December 31, 2004, 2003 and 2002, using the weighted average numberof shares outstanding during each year. We have no common share equivalents, instruments convertible into commonshares or other dilutive instruments.

 

*Reclassifications.*  Reclassifications have been made to the prioryears’ financial statements to conform to the current year’s presentation,including a reclassification of $3,625 of cash related to our captive insurancecompany, which was presented as cash and cash equivalents in 2003, torestricted cash.  These reclassificationshad no effect on net income (loss) or shareholders’ equity.

 

**3.  Property and Equipment**

 

Property and equipment, at cost, as of December 31,2004 and 2003, consist of:

 
| ** **                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |
| Land                               |       | $        | 7,362      |     | $          | 3,542 |   |
| Buildings and  improvements        |       | 74,111   |       | 42,328   |       |
| Furniture, fixtures  and equipment |       | 19,954   |       | 13,476   |       |
|                               |       | 101,427  |       | 59,346   |       |
| Accumulated  depreciation          |       | (6,238   | )          | (3,862   | )          |
|                               |       | $        | 95,189     |     | $          | 55,484 |   |

 

**4.  Line of Credit**

 

On October 24, 2002, one of our subsidiaries enteredinto a revolving credit facility agreement. The interest rate on borrowings on this facility is LIBOR plus aspread.  The maximum amount availableunder this 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 $16,556 as ofDecember 31, 2004) generated at some of our communities and contains covenantssuch as maintenance of collateral, maintenance of lockbox accounts designed toprovide the lenders with access to the collateral, consolidated minimum networth and certain other financial ratios. In certain circumstances, subject to lender and collateral availability,the maximum borrowings under this facility may be increased to $25,000. Thefacility terminates on October 24, 2005. As of December 31, 2004, no amountswere outstanding under the facility. Interest expense related to this facility was $85 and $155 for the yearsended December 31, 2004 and 2003, respectively.

 

F-9

----

 

**5.  Income Taxes**

 

Significant components of our deferred tax assets andliabilities as of December 31, 2004 and 2003, are as follows:

 
| ** **                                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets (liabilities) for the income tax effects of: |       |     |       |     |       |
| Allowance for  doubtful accounts                                  |       | $        | 2,073      |     | $          | 1,826 |   |
| Accrued  liabilities                                              |       | 405      |       | 527      |       |
| Deferred income                                                   |       | 2,642    |       | 323      |       |
| Insurance  reserve                                                |       | 1,076    |       | 1,703    |       |
| Continuing care  contracts                                        |       | 2,880    |       | 2,276    |       |
| Depreciable  assets                                               |       | (2,162   | )          | 2,309    |       |
| Charitable  contributions                                         |       | 68       |       | 43       |       |
| Net operating  loss carry forwards                                |       | 1,769    |       | 1,268    |       |
| Tax credits                                                       |       | 984      |       | 395      |       |
| Other                                                             |       | (133     | )          | —   |       |
| Net deferred tax  asset before valuation allowance                |       | 9,602    |       | 10,670   |       |
| Valuation  allowance                                              |       | (9,602   | )          | (10,670  | )          |
| Net deferred tax  asset                                           |       | $        | —     |     | $          | — |   |

 

As a result of our short operating history and thelosses we incurred during 2002 and 2003, we continue to record a valuationreserve for the full amount of our deferred tax assets.  If our operating results continue to beprofitable, we may reduce or eliminate the valuation reserve.  In such event, we would record a reduction inthe valuation reserve as an income tax benefit in the consolidated statement ofoperations, which would impact our results of operations.

 

Our operations in the year ended December 31, 2004 producedtaxable income of approximately $4,827. Our 2002 and 2003 operations resulted in tax loss carry forwards whicheliminated our taxable income in 2004. After 2004, we have tax losses of approximately $3,709 that may becarried forward to offset future taxable income.  During the year endedDecember 31, 2004, we incurred approximately $120 for alternative minimum taxesthat are payable without regard to our tax loss carry forwards.  Our net operating loss carry forwards willexpire beginning in 2020, if unused.

 

The principal reasons for the difference between oureffective tax (benefit) rate and the U.S. Federal statutory income tax(benefit) rate are as follows:

 
| ** **                                                | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                      |       |                                 |       |   |   |   |   |
| 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 |       | 5.3                                  | %          | (4.0 | )% | (4.0 | )% |
| Tax credits                                               |       | (17.9                                | )%         | (5.0 | )% | — |   |
| Alternative  minimum tax                                  |       | 3.5                                  | %          | 0.0 | % | 0.0 | % |
| Change in  valuation allowance                            |       | (21.4                                | )%         | 6.5 | % | — |   |
| Other  differences, net                                   |       | 0.0                                  | %          | 36.5 | % | 38.0 | % |
| Effective tax  rate                                       |       | (0.0                                 | )%         | (0.0 | )% | 0.0 | % |
| Tax valuation allowance                                   |       | 0.0                                  | %          | 0.0 | % | 0.0 | % |

 

F-10

----

 

**6.  Mortgages Payable**

 

One of the properties acquired by one of oursubsidiaries in October 2002 was encumbered by two mortgage notes secured byfirst and second deeds of trust.  Inaccordance with the prepayment provisions of the first mortgage, in December2003, we prepaid the first mortgage note which totaled $9,323.  The remaining deed of trust mortgage totaling$6,435 was prepaid on March 1, 2004.

 

On April 19, 2004, we purchased from Senior Housing aproperty that was previously leased to us by Senior Housing.  We funded part of the purchase price withproceeds we received from a Department of Housing and Urban Development, orHUD, insured mortgage in the amount of $5,015. Seven of the properties acquired by us on November 19, 2004 from LTA areencumbered by nine mortgages.  These ninemortgages are also insured by HUD. Mortgage premiums totaling $6,534 were recorded in accounting for theacquisition of the mortgaged properties in order to record the assumedmortgages at their estimated fair value. The mortgage premiums will be amortized as a reduction to interestexpense over the period the mortgages remain outstanding.  Interest expense on the mortgages was $521for the year ended December 31, 2004, which is net of mortgage premium amortizationof $14.

 

The following table is a summary of the mortgage notespayable as of December 31, 2004:

 
| **Principal  Balance** | ** ** | **Monthly  Payment** | ** ** | **Cash  Interest  Rate** | ** ** | **Effective  Interest  Rate** | ** ** | **Maturity  Date** | ** ** | **Fair Value  Premium  Adjustment** | ** ** | **Total  Mortgage  Payable** | ** ** |
|------------------------|------------|----------------------|------------|--------------------------|------------|-------------------------------|------------|--------------------|------------|-------------------------------------|------------|------------------------------|------------|
|                   |       |                 |       |                     |       |                          |       |               |       |                                |       |                         |       |
| $                      | 4,987      |                 | $          | 45                       |       | 5.55                          | %          | 5.55               | %          | 1-May-39                            |       | $                            | —     |   | $ | 4,987 |   |
| 1,377                  |       | 14                   |       | 8.00                     | %          | 5.60                          | %          | 1-Jan-38           |       | 405                                 |       | 1,782                        |       |
| 1,187                  |       | 11                   |       | 8.45                     | %          | 5.60                          | %          | 1-Nov-37           |       | 422                                 |       | 1,609                        |       |
| 1,018                  |       | 10                   |       | 7.50                     | %          | 5.60                          | %          | 1-Oct-36           |       | 229                                 |       | 1,247                        |       |
| 5,448                  |       | 47                   |       | 7.00                     | %          | 5.60                          | %          | 1-Jun-36           |       | 889                                 |       | 6,337                        |       |
| 5,856                  |       | 47                   |       | 7.15                     | %          | 5.60                          | %          | 1-Nov-38           |       | 1,113                               |       | 6,969                        |       |
| 5,370                  |       | 44                   |       | 7.00                     | %          | 5.60                          | %          | 1-Jun-36           |       | 900                                 |       | 6,270                        |       |
| 712                    |       | 6                    |       | 8.50                     | %          | 5.60                          | %          | 1-Feb-32           |       | 213                                 |       | 925                          |       |
| 5,894                  |       | 51                   |       | 7.25                     | %          | 5.60                          | %          | 1-Jun-39           |       | 1,209                               |       | 7,103                        |       |
| 4,198                  |       | 41                   |       | 8.13                     | %          | 5.60                          | %          | 1-Feb-32           |       | 1,154                               |       | 5,352                        |       |
|                   |       |                 |       |                     |       |                          |       |               |       |                                |       |                         |       |
| $                      | 36,047     |                 | $          | 316                      |       | 7.13                          | %(1)       |               |       |                                |       | $                            | 6,534      |   | $ | 42,581 |   |

 

----

(1)  Weightedaverage interest rate

 

Monthly payments arerequired to be made into a replacement reserve fund from which withdrawals aresubject to the approval of HUD for all our mortgages.  In addition, we are required to make monthlyescrow deposits for taxes and insurance.

 

Principal payments due under the terms of thesemortgages are as follows:

 

| 2005       |   | $      | 293    |   |
|------------|--------|--------|--------|--------|
| 2006       |   | 318    |   |
| 2007       |   | 343    |   |
| 2008       |   | 362    |   |
| 2009       |   | 445    |   |
| Thereafter |   | 34,286 |   |
|       |   | $      | 36,047 |   |

 

F-11

----

 

**7.  Leases**

 

We lease 128 communities under four non-cancelableleases with Senior Housing and 4 communities under a lease with HealthcareProperty Investors, Inc., or HCPI.  Theseleases are “triple-net” leases which require that we pay for all costs incurredin the operation of the communities, including the cost of insurance and realestate taxes, maintain the communities and indemnify the landlord for anyliability which may arise from its ownership during the lease term. SLS manages30 of the communities included in one of our leases with Senior Housing.

 

Our leases with Senior Housing require us to pay, asadditional rent, 4% of the amount by which gross revenues of the leasedcommunities exceeds gross revenue for a base year.  The base year for the former LTA communitiesthat we lease from Senior Housing is 2006 and percentage rent begins in 2007.The base year for all other communities we lease from Senior Housing is 2005 andpercentage rent begins in 2006.  Theadditional rent is payable and calculated separately for the lease relating tothe communities that SLS manages for us and on a combined basis for the threeleases relating to the communities we operate.

 

We are required under our lease for the communitiesmanaged by SLS to make deposits into accounts known as FF&E Reserves tofund future replacements and improvements at these communities. Senior Housinghas a security and remainder interest in these accounts and in all propertypurchased with funding from these accounts.

 

Senior Housing has agreed to fund amounts that werequest for repairs, renovations and improvements to communities we lease fromthem in return for rent increases according to formulas set forth in theleases.  In 2004, Senior Housing funded$9,457 for repairs, renovations and improvements to some of ourcommunities.  As a result of thistransaction, and in accordance with our leases, our annual minimum rent toSenior Housing increased by 10% of the amount funded, or $945.

 

The following table is a summary of our leases:

 
| **Landlord**                              | ** ** | **Number of  Communities** | ** ** | **Minimum rent as  of December 31,  2004** | ** ** | **Initial expiration date** | ** **        | **Renewal terms**                                            | ** **                      |
|-------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|-----------------------------|-------------------|--------------------------------------------------------------|---------------------------------|
| Senior Housing  (3 leases)                |       | 98                         |       | $                                          | 31,841     |                        | December 31, 2020 |                                                         | Option for one 15-year renewal. |   |
| Senior Housing  (SLS managed communities) |       | 30                         |       | 63,993                                     |       | December 31, 2017           |              | Consecutive options for one 10-year and one 5-year  renewal. |                            |
| HCPI                                      |       | 4                          |       | 1,183                                      |       | December 31, 2014           |              | Option for one 5-year renewal.                               |                            |
|                                      |       |                       |       |                                       |       |                        |              |                                                         |                            |
| Totals                                    |       | 132                        |       | $                                          | 97,017     |                        |              |                                                         |                            |   |

 

The future minimum rent required by our leases as ofDecember 31, 2004, is as follows:

 

| 2005       |   | $       | 97,017    |   |
|------------|--------|---------|-----------|--------|
| 2006       |   | 97,017  |      |
| 2007       |   | 97,017  |      |
| 2008       |   | 97,017  |      |
| 2009       |   | 97,017  |      |
| Thereafter |   | 771,093 |      |
|       |   | $       | 1,256,178 |   |

 

F-12

----

 

**8.   Shareholders’ Equity**

** **

During 2003, we issued 61,000 common shares to ourdirectors, officers and others who provide services to us.  The shares were valued at $1.17 to $1.75 pershare, the average price of our common shares on the American Stock Exchange,or AMEX, on the date of issue, or $104 in the aggregate.

 

During 2004, we issued 83,000 common shares to ourdirectors, officers and others who provide services to us.  The shares were valued at $4.04 to $6.99 pershare, the average price of our common shares on the AMEX on the dates ofissue, or $541 in the aggregate.

 

On December 13, 2004, we issued 3,500,000 commonshares, in an underwritten public offering, for proceeds, net of underwritingcommissions and other costs, of $27,645. On January 11, 2005, we issued an additional 120,000 common shares, aspart of an underwriter’s over allotment option in this public offering, forproceeds, net of underwriting commissions and other costs, of $960.

 

We initially had an aggregate of 650,000 shares of ourcommon shares available to be issued under the terms of the 2001 Stock Optionand Stock Incentive Plan, or the Award Plan. As of December 31, 2004, 500,000 of our common shares remain reservedfor issuance under the Award Plan. Shares issued under this plan to directors vest immediately.  Shares issued to our officers and otherindividuals who provide services to us vest over three years.

 

**9.   Acquisitions**

** **

In January 2002, we entered into a lease with SeniorHousing for 31 independent and assisted living communities then managed by MSLSand currently managed by SLS.  Inconnection with this transaction, we acquired the net working capital of thecommunities of $6,537, received cash of $5,665, and assumed certain long termliabilities totaling $12,202.  Weallocated the purchase price on the basis of the fair value of assets acquiredand liabilities assumed.

 

In April 2002, we purchased five senior livingcommunities for $45,500 in cash. We allocated the purchase price to the land,buildings and equipment acquired.

 

In October 2002, we purchased an additional sevensenior living communities for $27,000. We allocated the purchase price to the land, buildings and equipmentacquired.  To finance this purchase, wesold one of our existing communities to Senior Housing for approximately$12,700 and assumed $15,798 of mortgage debt, which had a fair value of$16,210.  In connection with thistransaction, we leased another eight senior living communities from SeniorHousing, which Senior Housing simultaneously acquired.

 

In November 2004, we purchased 100% of the capitalstock of LTA for $211,000 exclusive of closing costs.  To finance this acquisition, we entered intoa $148,200 sale leaseback transaction with Senior Housing for 31 of thecommunities acquired from LTA. We funded the balance of the purchase price withcash on hand and by assuming HUD insured long term mortgage debt and anoperating lease for four communities from HCPI. We allocated the purchase price to $11,661 of working capital assets,$48,348 to land, buildings and equipment, $7,095 to goodwill, $2,590 to leaseacquisition costs, $11,709 to working capital liabilities and $37,601 tomortgage notes payable based on the fair value of the assets acquired and theliabilities assumed.

 

In addition to our community acquisitions, we havepurchased two institutional pharmacies. In September 2003, we purchased one pharmacy in Wisconsin for$1,800.  In September 2004, we purchasedanother pharmacy in Nebraska for $3,000. We allocated the purchase prices principally to working capital assets,customer relationships and goodwill based on the fair value of the assetsacquired and liabilities assumed.

 

We account for each of these acquisitions using thepurchase method of accounting.  As such,we have included the results of operations of each of the communities andpharmacies acquired in our consolidated statement of operations from the dateof acquisition.  Purchase accounting forcertain 2004 acquisitions is preliminary, primarily with respect toidentification and valuation of intangibles, and is expected to be finalized inthe second or third quarter of 2005.  

 

F-13

----

 

**10.  Pro Forma Information (Unaudited)**

 

Pro forma operating results assuming commencement ofoperations as of January 1, 2003, of the 47 communities we acquired from LTAduring 2004 and assuming that our sale of 3,500,000 common shares occurred onJanuary 1, 2003, are as follows:

 
| ** **                                    | ** ** | **2004**        | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|-----------------|------------|----------|------------|
| ** **                                    | ** ** | **(unaudited)** | ** ** |
| Revenues                                      |       | $               | 701,040    |     | $          | 650,830 |   |
| Expenses                                      |       | 695,597         |       | 657,205  |       |
| Net (loss)  income from continuing operations |       | 5,443           |       | (6,375   | )          |
| Loss from  discontinued operations            |       | (699            | )          | (1,449   | )          |
| Net (loss)  income                            |       | $               | 4,744      |     | $          | (7,824 | ) |
|                                          |       |            |       |     |       |
| Shares  outstanding                           |       | 12,097          |       | 12,097   |       |
| Net (loss)  income per share                  |       | $               | 0.45       |     | $          | (0.53 | ) |

 

**These unaudited pro forma operating results do notrepresent or are not indicative of our operating results for any future date orperiod.  Actual future results may bematerially different from pro forma results. Differences could arise from many factors.**

 

**11.  Discontinued Operations**

 

During 2002, we ceased operations at two leasednursing homes: one community in Phoenix, Arizona, which we leased from SeniorHousing; and one community in Campbell, Nebraska, which we leased from thatmunicipality.  The Arizona community wasclosed and subsequently sold by Senior Housing for $770 which caused a $77reduction in annual minimum rent payable in accordance with the lease terms forthe multiple property lease which had included this community.  The operations of the Nebraska community wereassumed by its owner.  Also in 2002, wedecided to sell one additional nursing home located in Connecticut.

 

During 2003, we ceased operating one nursing home thatwe leased from Senior Housing.  In August2003, we sold an assisted living community and we received $3,500, consistingof $350 of cash and a $3,150 six year mortgage note at 8% interest.  We deferred the $1,100 gain on this sale andwe expect to recognize this gain as income over the life of the note inproportion to principal payments on the note that we receive.  In December 2003, we sold five assistedliving communities and we received $3,550, consisting of $440 of cash and a$3,110 fifteen year mortgage note at 9% interest.  We deferred the $1,200 gain on this sale andwe expect to recognize this gain as income when the buyer demonstrates it hasthe ability to pay the mortgage note. These deferred gains are included in other long term liabilities on ourconsolidated balance sheet.

 

During the first quarter of 2004, we ceased operationsat one assisted living community that we lease from Senior Housing which wasmanaged for us by SLS.  We and SeniorHousing are exploring other uses for that property as well as its potentialsale.

 

As of December 31, 2004, substantially all of ourassets and liabilities related to these communities have been disposed of andpaid, respectively.  We have reclassifiedthe consolidated statement of operations for all periods presented to show theresults of operations of these communities as discontinued.  Below is a summary of the operating resultsof these discontinued operations included in the financial statements for yearsended December 31, 2004, 2003 and 2002:

 
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
|       |       |     |       |     |       |     |       |
| Revenues   |       | $        | 281        |     | $          | 7,045    |       | $ | 5,763 |   |
| Expenses   |       | 980      |       | 8,494    |       | 8,678    |       |
| Net loss   |       | $        | (699       | )        | $          | (1,449   | )          | $ | (2,915 | ) |

 

F-14

----

 

**12.  Transactions With Affiliates**

** **

On December 31, 2001,Senior Housing distributed substantially all of its ownership of our shares toits shareholders. In order to effect this spin off and to govern relationsafter the spin off, we entered into agreements pursuant to which it was agreed,among other things, 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 theexception to the ownership limitations would not cause a default under any ofour 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 (another REIT which owns shares of Senior Housing), or HRPT, mightjeopardize the tax status of Senior Housing or HRPT as REITs;

•                  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, tocancel 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, we will not acquire or finance any realestate without first giving Senior Housing, HRPT, or any other publicly ownedREIT or other entity managed by RMR the opportunity to acquire or finance realestate investments of the type in which Senior Housing, HRPT, or any otherpublicly owned REIT or other entity managed by RMR, respectively, invest.

 

At the time of our spinoff from Senior Housing, all of the persons serving as our directors weretrustees of Senior Housing. Our two managing directors, Messrs. Martin andPortnoy, are the managing trustees of Senior Housing.

 

Of the 148 seniorliving communities we currently operate, 128 are leased from Senior Housing fortotal annual minimum rent of $95,834.

 

During 2003, we andSenior Housing were jointly involved in litigation with Marriott, the operatorof the senior living communities which we leased from Senior Housing. We andSenior Housing equally shared the costs of this litigation. This litigation wassettled in January 2004.

 

Since January 1, 2004, wehave entered into or agreed to enter into multiple transactions with SeniorHousing, including the following:

 

•                  OnMarch 1, 2004, Senior Housing purchased from us one independent andassisted living community with 229 units located in Maryland. The purchaseprice was $24,100, the appraised value of the property. 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 and the property acquired onMarch 1, 2004 was added to this combined lease;

•                  thecombined lease maturity date was changed to December 31, 2020 fromDecember 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. Prior to the lease combination, the percentageand the beginning time period for the nursing home lease and the independentand assisted living community lease was 3% for 2004 and 4% for 2005,respectively; and all other lease terms remain substantially unchanged.

 

F-15

----

 

•                  In2003, Senior Housing evicted a nursing home tenant that had defaulted on itsobligations to Senior Housing. Until May 2004, we managed this nursinghome for Senior Housing’s account. Effective on May 1, 2004, we agreedwith Senior Housing to add this nursing home to a multi-property lease fromSenior Housing and to increase the annual rent by $180. All other lease termsremained unchanged.

•                  Oneof the properties we lease from Senior Housing was subject to a ground leasewith an unaffiliated third party. We are responsible for paying the ground rentof $307 per year. On June 3, 2004, Senior Housing exercised an option topurchase this land for $3,600  and acquired the landlord’s rights andobligations under the ground lease. We now pay the ground rent to SeniorHousing.

•                  OnNovember 18, 2004, Senior Housing loaned us $117,000 in connection withour acquisition of LTA. Such loan was repaid on November 19, 2004 with theproceeds we received from a $148,200 sale leaseback with Senior Housingfor 31 of the 47 acquired communities and a $16,800 mortgage loan from SeniorHousing secured by five of our communities. This mortgage was repaid in December 2004.

•                  During2004, pursuant to the terms of our leases with Senior Housing, we sold toSenior Housing $9,500 of improvements we had made to its properties, andour annual rent payable to Senior Housing was increased by 10% of SeniorHousing’s purchase price or $946.

 

We obtained a workerscompensation insurance policy for the year beginning June 15, 2003, from athird party insurer. This third party insurer ceded a portion of the premiumswe paid to a Bermuda based company, Affiliates Insurers, Limited, orAffiliates, which was owned by RMR. Affiliates was organized by RMR to assistus in creating a partial self insurance program on an expedited basis. OnDecember 8, 2003, we acquired Affiliates from RMR for an amount equal toRMR’s cost of organizing and capitalizing that company, approximately $1,310.

 

Our Chief ExecutiveOfficer and Chief Financial Officer are also officers and employees of RMR.These officers devote a substantial majority of their business time to ouraffairs and the remainder to RMR’s business which is separate from ourbusiness. We believe the compensation we pay to these officers reasonablyreflects their division of business time; however, periodically, theseindividuals may divide their business time differently than they do currentlyand their compensation from us may become disproportionate to this division.

 

RMR provides managementand administrative services to us under a shared services agreement. RMR iscompensated at an annual rate equal to 0.6% of our total revenues. Aggregatefees earned by RMR for services during 2004, 2003 and 2002, were $3,700, $3,400and $2,900, respectively. RMR also provides the internal audit function for usand for other publicly owned companies to which it provides managementservices.  We pay a pro rata share of RMR’scosts in providing that function.  Ouraudit committee approves the identity and salary of the individual serving asour internal audit manager, as well as the pro rata share of the costs which wepay.  The fact that RMR hasresponsibilities to other entities, including one of our landlords, 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 and RMR are approved by our independentdirectors. Our independent directors have approved the renewal of the sharedservices agreement for its current term which will end December 31, 2005.

 

Messrs. Martin andPortnoy own the building in which our headquarters is located. Our lease forspace was originally executed by FSQ. This lease expires in 2011. We paid rent,which includes our proportional share of utilities and real estate taxes, underthis lease during 2004, 2003 and 2002 of $561, $569 and $539, respectively.

 

Wells Fargo & Companybeneficially owns 8.1% of our common shares. Wells Fargo Bank, N.A., anaffiliate of Wells Fargo & Company, became the transfer agent andregistrar for our common shares, effective as of December 13, 2004.

 

**13. Employee Benefit Plan**

 

During 2001, we established an employee savings planunder the provisions of section 401(k) of the Internal Revenue Code.  All employees are eligible to participate inthe plan and are entitled, upon termination or retirement, to receive theirportion of the plan assets.  We do notcontribute to this plan, but do pay certain expenses

 

F-16

----

 

of the plan. Plan expenses were $35, $23 and $24 for the years ended December 31,2004, 2003 and 2002, respectively.

 

In connection with our acquisition of LTA, we assumedan additional employee savings plan under the provisions of section 401(k) ofthe Internal Revenue Code.  All formerLTA employees are eligible to participate in this plan and are entitled, upontermination or retirement, to receive their portion of the plan assets.  We match a certain level of employeecontributions to this plan and pay certain expenses of the plan.  The plan’s expenses, including ourcontribution to the plan, were $13 for the year ended December 31, 2004.

 

**14.  Fair Value of Financial Instruments**

 

Our financial instruments are limited to cash and cashequivalents, accounts receivable, accounts payable, continuing care contracts,mortgage notes receivable and payable. The fair value of these financial instruments was not materiallydifferent from their carrying values at December 31, 2004 and 2003.  Our estimates of fair values were based oncurrent market prices and discounted cash flow analysis.

 

**15. Commitments andContingencies**

** **

*Connecticut Strike Costs.*  During 2001, we incurred costs to hiretemporary staff and to provide security services for residents and temporaryemployees during a Connecticut labor strike. At the time of this strike, the Governor of Connecticut and theConnecticut Department of Social Services agreed to adjust Medicaid rates tocompensate for a portion of these increased costs.  During 2004, we received $666, whichrepresents substantially all amounts due from the Connecticut Department ofSocial Services related to this matter.

 

*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, collectively, 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 Medicare and Medicaid payors forservices provided at the nursing homes following our assumption of operations,including an agreement among us, IHS and the Secretary of the United StatesDepartment of Health and Human Services, or HHS.  These arrangements were approved by the bankruptcycourt and generally honored by IHS with respect to approximately $42,000received by IHS for our account.  Weinitially believed IHS had received an additional $2,000 that was due tous.  When IHS refused to pay this amount,we commenced suit against IHS in the bankruptcy court in August 2002.  Following the filing of the suit, settlementdiscussions were started.  In December2002, IHS paid approximately $700 of the receivable balance.  IHS has asserted that it is only obligated todeliver funds it received from Medicare and Medicaid payors, including HHS, andthat HHS has withheld payments that are due to us.  In March 2003, we commenced suit against IHS,HHS and the State of Colorado Department of Healthcare Policy and Financingconcerning the remaining receivable balance. Shortly after we commenced this litigation, settlement was reached withthe State of Colorado providing us a payment of approximately $400.  In December 2003, the court granted a motionto dismiss HHS, but took no action on IHS’s motion to dismiss.  In January 2004, we appealed the court’sdecision to dismiss HHS.  On February 24,2004, the court denied in all material respects IHS’s motion to dismiss.  We intend to pursue these claims, but wecannot predict the outcome of this litigation.

 

*SLS Management Agreements. *During 2002, about the timeMarriott decided to sell MSLS to Sunrise, we and Senior Housing became involvedin litigation with Marriott and MSLS.  OnJanuary 7, 2004, we and Senior Housing settled the pending litigation withMarriott and MSLS.  Under the terms ofthe settlement, we and Senior Housing, and Marriott and MSLS, agreed to dismissall claims and counterclaims asserted in the litigation.  Also, under the terms of the settlement,Marriott paid to us and Senior Housing $1,250 each.  The settlement was a compromise of theparties’ disputes entered into to avoid the expense and inconvenience oflitigation and neither we or Senior Housing, nor Marriott or MSLS, has admittedany liability, violation of law or wrongdoing in connection with the matters inthe litigation.  We believe thesettlement resolves all of our litigation with Marriott. This settlement doesnot affect our or Senior Housing’s rights vis-à-vis SLS or Sunrise which ariseby reason of the events that occurred after Sunrise purchased MSLS.  This settlement payment is included in otherincome for the year ended December 31, 2004.

 

F-17

----

 

**16.  Segment Information**

 

**We operate substantially in one reportable segment,which is the business of operating senior living communities, includingindependent living and congregate care communities, assisted living communitiesand nursing homes.  All of our operationsand assets are located in the United States.**

** **

**17.  Selected Quarterly Financial Data (Unaudited)**

** **

Following is summary unaudited quarterly results ofoperations for the years ended December 31, 2004 and 2003:

 
| ** **                             | ** ** | **2004**           | ** ** |
|----------------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                               |       | $                  | 150,141    |   | $ | 153,348 |   | $ | 155,248 |   | $ | 169,268 |   |
| Net income from  continuing operations |       | 1,142              |       | 1,067 |   | 869 |   | 912 |   |
| Net income                             |       | 691                |       | 943 |   | 891 |   | 766 |   |
| Net income per  common share           |       | $                  | 0.08       |   | $ | 0.11 |   | $ | 0.10 |   | $ | 0.09 |   |

 
| ** **                             | ** ** | **2003**           | ** ** |
|----------------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                               |       | $                  | 141,597    |   | $ | 140,499 |   | $ | 145,964 |   | $ | 147,122 |   |
| Net income from  continuing operations |       | (2,189             | )          | (1,427 | ) | (733 | ) | (2,141 | ) |
| Net loss                               |       | (2,537             | )          | (1,974 | ) | (1,166 | ) | (2,262 | ) |
| Loss per common  share                 |       | $                  | (0.27      | ) | $ | (0.24 | ) | $ | (0.14 | ) | $ | (0.27 | ) |

 

**18.  Subsequent Events**

 

In January2005, we agreed to acquire six assisted living communities for approximately$63,500 from six limited liability companies known as Gordon Health CareVentures, LLC, or Gordon.  We intend tofinance this acquisition with cash on hand, borrowings under our line of creditand mortgage or sale leaseback transactions for some of the communities beingpurchased or for certain other unencumbered communities which we currentlyown.  Completion of this acquisition issubject to various conditions customary in multi-community healthcaretransactions of this type, including completion of diligence, licensing andreceiving third party consents.  Weexpect this acquisition to close during the second quarter of 2005, but thereis no assurance that it will close.

 

In March 2005, we acquired one assisted livingcommunity for a purchase price of approximately $6,900, excluding closingcosts, and commenced operations at that community.  We funded the purchase price with cash onhand.

 

F-18

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto 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 29, 2005

 

Pursuant to therequirements 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         |     | March 29, 2005 |
| Evrett W. Benton            |       |      | Officer                                |     |   |
|                        |       |      |                                   |     |   |
| /s/ Bruce J. Mackey Jr.     |       |      | Chief Financial Officer  and Treasurer |     | March 29, 2005 |
| Bruce J. Mackey Jr.         |       |      | (Principal Accounting  Officer)        |     |   |
|                        |       |      |                                   |     |   |
| /s/ Barry M. Portnoy        |       |      |                                   |     |   |
| Barry M. Portnoy            |       |      | Managing Director                      |     | March 29, 2005 |
|                        |       |      |                                   |     |   |
| /s/ Gerard M. Martin        |       |      |                                   |     |   |
| Gerard M. Martin            |       |      | Managing Director                      |     | March 29, 2005 |
|                        |       |      |                                   |     |   |
| /s/ Bruce M. Gans           |       |      |                                   |     |   |
| Bruce M. Gans               |       |      | Director                               |     | March 29, 2005 |
|                        |       |      |                                   |     |   |
| /s/ Barbara D. Gilmore      |       |      |                                   |     |   |
| Barbara D. Gilmore          |       |      | Director                               |     | March 29, 2005 |
|                        |       |      |                                   |     |   |
| /s/ Arthur G.  Koumantzelis |       |      |                                   |     |   |
| Arthur G. Koumantzelis      |       |      | Director                               |     | March 29, 2005 |

 

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