** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-K**

** **

| **ý**                                           | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                 |                                                                                                    |   |
| **For the fiscal year ended December 31, 2005** |
|                                                 |                                                                                                    |   |
| **OR**                                               |
|                                                 |                                                                                                    |   |
| **o**                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File Number 001-16817**

 

**FIVE STAR QUALITY CARE, INC.**

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

** **

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

 

**617-796-8387**

 

Securities to be registered pursuant to Section 12(b) of theAct:

 
| **Title of each class** | ** ** | **Name of each exchange on which registered** |
|-------------------------|------------|-----------------------------------------------|
| Common Stock            |       | American Stock Exchange                       |

 

Securities to be registered pursuant to Section 12(g) ofthe Act: **None**

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the SecuritiesAct.  Yes o  No ý

 

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o  No ý

 

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

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. ý

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer.  See definition of “large accelerated filerand accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

 

Large accelerated filer o  Accelerated filer ý   Non-accelerated filer o

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No ý

 

The aggregatemarket value of the voting shares of the registrant held by non-affiliates was$89.3 million based on the $7.30 closing price per common share on the AmericanStock Exchange on June 30, 2005.  For purposes of this calculation, an aggregate of 499,582.6 shares ofcommon stock are held by the directors and officers of the registrant and havebeen included in the number of shares of common stock held by affiliates, whichincludes 35,000 shares of common stock held by Senior Housing Properties Trust.

 

Number of theregistrant’s shares of common stock outstanding as of March 10, 2006:20,060,934.

 

 

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In this Annual Report on Form 10-K, the terms the“Company,” “Five Star”, “FVE”, “we”, “us” or “our” include Five Star QualityCare, Inc., and its consolidated subsidiaries, unless the contextindicates otherwise.

 

**DOCUMENTS INCORPORATED BYREFERENCE**

** **

Certain informationrequired in Items 10, 11, 12, 13 and 14 of Part III of this Annual Reporton Form 10-K is incorporated by reference from our definitive ProxyStatement for the Annual Meeting of Shareholders scheduled to be held on May 23,2006, or our definitive Proxy Statement.

 

**WARNINGCONCERNING FORWARD LOOKING STATEMENTS**

 

THIS ANNUAL REPORT ON FORM 10-K CONTAINSFORWARD LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIESLITIGATION REFORM ACT OF 1995 AND FEDERAL SECURITIES LAWS.  THESE STATEMENTS REPRESENT OUR PRESENTBELIEFS AND EXPECTATIONS, BUT THEY MAY NOT OCCUR FOR VARIOUS REASONS.  FOR EXAMPLE:

 

•                  OUR FUTURE INSURANCE COSTS ANDINSURANCE RESERVE CALCULATIONS MAY BE GREATER THAN WE NOW ANTICIPATE;

•                  WE MAY BE UNABLE TO CARRY OUT OUR BUSINESS PLAN TO EXPAND BECAUSE WEARE UNABLE TO LOCATE EXPANSION OPPORTUNITIES AT PRICES WE ARE WILLING OR ABLETO PAY;

•                  OUR RECEIVABLES RESERVES MAY BEINADEQUATE, ESPECIALLY THE RESERVES WHICH RELATE TO MEDICARE AND MEDICAIDPAYMENTS BECAUSE SUCH PAYMENTS ARE SUBJECT TO GOVERNMENTAL AUDITS AND TOGOVERNMENT FISCAL POLICIES;

•                  WE MAY BE UNABLE TO MAINTAIN ORIMPROVE OUR FUTURE OCCUPANCY RATES AND AS A RESULT OUR REVENUES MAY DECLINE;

•                  THE IMPROVING ECONOMY MAY RESULTIN WAGE PRESSURES WHICH INCREASE OUR FUTURE COSTS;

•                  FUTURE MEDICARE AND MEDICAID RATES MAY BELOWER THAN WE NOW ANTICIPATE;

•                  SUNRISE SENIOR LIVING SERVICES, INC.’S,OR SLS’S, OPERATIONS OF THE COMMUNITIES WHICH IT MANAGES FOR US MAY RESULTIN LOSSES TO US;

•                  THE TERMINATION OF CERTAIN OF OURMANAGEMENT AGREEMENTS WITH SLS MAY NOT IMPROVE OUR FINANCIAL RESULTS OR MAY CAUSEUS TO EXPERIENCE OPERATING LOSSES.  WE MAY BEUNABLE TO OPERATE THE COMMUNITIES WHICH ARE THE SUBJECT OF THE TERMINATEDMANAGEMENT AGREEMENTS FOR OUR OWN ACCOUNT IN A MANNER WHICH IS AS PROFITABLE ASTHEY HAVE BEEN OPERATED BY SLS;

•                  WE MAY NOT RECEIVE THE REQUIREDREGULATORY APPROVALS TO LEASE THE TWO HOSPITALS FROM SENIOR HOUSING PROPERTIESTRUST, OR SENIOR HOUSING, AND OUR LEASE WITH SENIOR HOUSING MAY NOT BECOMEEFFECTIVE.  HEALTHSOUTH CORPORATION’S, ORHEALTHSOUTH’S, LEASE OF THESE HOSPITALS MAY BE REINSTATED AND OUR LEASE OFTHESE HOSPITALS MAY BE TERMINATED. WE MAY BE UNABLE TO OPERATE THESE HOSPITALS PROFITABLY AND WE MAY EXPERIENCELOSSES FROM OUR OPERATION OF THESE HOSPITALS;

•                  OUR ACCOUNTING COSTS, PARTICULARLYTHOSE ARISING FROM COMPLIANCE WITH THE SARBANES-OXLEY ACT OF 2002, ORSARBANES-OXLEY, MAY BE HIGHER THAN WE NOW EXPECT;

•                  WE MAY BECOME SUBJECT TO FINESOR REGULATORY SANCTIONS WHICH MATERIALLY ADVERSELY AFFECT OUR FINANCIALCONDITION OR PERFORMANCE; OR

•                  OTHER RISKS MAY ADVERSELY IMPACTUS, AS DESCRIBED MORE FULLY UNDER “ITEM 1A. RISK FACTORS”.

 

IN ANY SUCH EVENT, OUR FUTURE FINANCIAL PERFORMANCE MAY BEADVERSELY AFFECTED AND WE MAY EXPERIENCE LOSSES.  IF OUR FINANCIAL RESULTS DO NOT IMPROVE, OURSTOCK PRICE LIKELY WILL DECLINE.  YOUSHOULD NOT PLACE UNDUE RELIANCE UPON FORWARD LOOKING STATEMENTS.

 

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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 STARQUALITY CARE, INC.**

**2005 FORM 10-KANNUAL REPORT**

 

**Table ofContents**

 
| **PART I**   | ** **                                                                                                             |
|-------------------|------------------------------------------------------------------------------------------------------------------------|
|              |                                                                                                                   |   |
| Item 1.           | Business                                                                                                               |   |
| Item  1A.         | Risk  Factors                                                                                                          |   |
| Item 1B.          | Unresolved Staff Comments                                                                                              |   |
| 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 23, 2006, to be filed pursuant to Regulation 14A. |
|--------|---|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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**PART I**

** **

**Item 1.  Business**

** **

**GENERAL**

** **

We operate senior living communities,including independent living and congregate care communities, assisted livingcommunities and nursing homes.  As of December 31,2005, we operated 153 communities containing 17,110 living units, including 102primarily independent and assisted living communities containing 12,403****living units and 51 nursing homes containing 4,707 livingunits.  Of our 102 primarily independentand assisted living communities, we leased 86 communities containing 11,221living units from Senior Housing, our former parent, including 18 communitieswhich were operated for our account by SLS, a wholly owned subsidiary ofSunrise Senior Living, Inc., or Sunrise, and we own or lease from partiesother than Senior Housing 16 communities containing 1,182 living units.  We lease all but two of our nursing homesfrom Senior Housing.  Our 153 communitiesinclude 4,960 independent living apartments, 5,725 assisted living suites, 283special care beds and 6,142****skillednursing beds.  We also operate fourinstitutional pharmacies, one of which provides mail order pharmaceuticals tothe general public.  Our principalexecutive offices are located at 400 Centre Street, Newton, Massachusetts02458, and our telephone number is (617) 796-8387.

 

**OUR HISTORY**

 

We were created by Senior Housing in April 2000to operate nursing homes repossessed or acquired from two former Senior Housingtenants.  We were incorporated inDelaware in April 2000 and reincorporated in Maryland on September 17,2001. On December 31, 2001, Senior Housing distributed substantially allof our outstanding shares to its shareholders and we became a separate publiclyowned company listed on the American Stock Exchange, or AMEX. Pursuant to thetransaction agreement governing this spin off:

 

•                  Senior Housing capitalized us withapproximately $50 million of equity, consisting of cash and workingcapital, primarily operating receivables, net of operating payables;

•                  we agreed to lease 31 primarilyindependent and assisted living communities then operated by Marriott SeniorLiving Services, Inc., or MSLS, a wholly owned subsidiary of MarriottInternational Inc., or Marriott, upon their acquisition by Senior Housing whichoccurred in 2002, as described below;

•                  we leased 53 nursing homes and twoassisted living communities from Senior Housing;

•                  we assumed one lease from the town ofCampbell, Nebraska; and

•                  we agreed to acquire FSQ, Inc.,or FSQ, the former operating company of the healthcare business we owned inorder to acquire the personnel, systems and assets necessary for our business.

 

During 2002, we commenced operations at 51senior living communities, including the 31 communities then operated by MSLS,and subsequently operated by SLS, and 20 additional communities.  In March and April 2002, we issuedan aggregate of 3,823,000 shares of common stock, or common shares, in anunderwritten public offering raising aggregate net proceeds of $26.1 million.  Also during 2002, we ceased operations at twocommunities, one of which was previously leased from Senior Housing and one ofwhich was previously leased from the town of Campbell, Nebraska.

 

During 2003, we commenced operations at threesenior living communities, which we lease from Senior Housing. Also during2003, we ceased operations at seven communities, one of which was previouslyleased from Senior Housing. During 2003, we also acquired an institutionalpharmacy located in Wisconsin for $1.8 million and we acquired a companyinsuring some of our workers compensation related risks for $1.3 million.

 

In March 2004, we ceased operations atone community that was leased from Senior Housing and was managed by SLS and weestablished an additional insurance company to insure a portion of ourliability insurance.

 

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

 

In November 2004, we acquired 100% ofthe capital stock of LTA Holdings, Inc., or LTA, for approximately$211.0 million, excluding closing costs. LTA owned, leased and operated 47 senior living communities with 2,636living 

 

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units, which primarily offerassisted living services, located in seven states.  The majority of these 47 communities werebuilt by LTA between 1997 and 2002, and 100% of the revenues at thesecommunities are paid by residents from their private resources.  In addition, LTA had two management contractswith third parties for 12 assisted living communities.  We terminated one contract for 11 of thesecommunities on March 1, 2005.  Tofinance the LTA acquisition, we entered into a $148.2 million saleleaseback transaction with Senior Housing for 31 of the communities acquiredfrom LTA. We also entered into a $16.8 million mortgage loan with SeniorHousing secured by five of our properties. We funded the balance of thepurchase 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 total of 3,620,000 common shares in an underwritten public offeringfor net proceeds of $28.8 million.  Weused a portion of the proceeds raised in this offering to pay off the $16.8million mortgage loan with Senior Housing described above, and we added theremainder to available cash balances.

 

In March 2005, we acquired a 62 unitassisted living community located in Georgia for approximately $6.9million.  We financed this acquisitionwith cash on hand.

 

In June 2005, we acquired six assistedliving communities from Gordon Health Ventures, LLC, or Gordon, for approximately$59.0 million.  These communities have alicensed resident capacity of 654 and are located in western Pennsylvania.  We funded this purchase using $10.0 milliondrawn under our revolving credit facility and the proceeds from a saleleaseback transaction and mortgage transaction with Senior Housing.  In connection with these transactions, wesold four assisted living communities in June 2005 to Senior Housing for$24.0 million and Senior Housing leased these communities back to us forinitial rent of $2.2 million per year. Senior Housing also provided a $43.5 million first mortgage line ofcredit secured by the six Gordon communities. We borrowed $24.0 million under this first mortgage line of credit whenwe closed the Gordon purchase and repaid it in August 2005 with proceedsfrom our sale of common shares described below. All of the revenues of the Gordon communities come from residents’private resources.

 

In June 2005, we acquired aninstitutional pharmacy business located in Omaha, Nebraska for approximately$4.6 million.

 

In August and September 2005, weissued a total of 7,750,000 common shares in an underwritten public offeringfor net proceeds of $55.6 million.  Weused the proceeds raised in this offering to pay off the $24.0 million mortgageline of credit with Senior Housing described above and to reduce amountsoutstanding under our revolving credit facility, and we added the remainder toavailable cash balances.

 

In August 2005, we sent notices to SLSto terminate management agreements for 12 of the 30 senior living communitiesthat SLS managed for us.  In November 2005,we terminated the SLS management agreements for these 12 communities for apayment of $81.5 million and we began to directly operate thesecommunities.  As a result, we no longerpay management fees for these communities to SLS.  We funded this termination payment with cashon hand, including the proceeds of our sale of common shares, and with theproceeds of a sale leaseback transaction with Senior Housing for the sixcommunities we acquired in June 2005 from Gordon.  We sold the six Gordon communities to SeniorHousing for net proceeds of $56.7 million and Senior Housing leased thesecommunities back to us.  Our initial rentto Senior Housing for these communities is $5.2 million per year.  The purchase price paid to us by SeniorHousing is the same amount as the purchase price we paid to the seller of theGordon communities.  In December 2005,we and SLS agreed to terminate one additional management agreement.  In February 2006, we terminated the SLSmanagement agreement for that community for a payment of $4.8 million and webegan to directly operate that community. SLS continues to manage 17 communities for us.

 

In December 2005, we acquired anadditional institutional pharmacy business located in West Hills, Californiafor approximately $450,000.

 

In December 2005,Senior Housing sold two of our communities where we had ceasedoperations.  Senior Housing sold one community located in Florida for netproceeds of approximately $5.4 million, which caused a $540,000 reduction inannual minimum rent payable in accordance with our lease terms.  Senior Housing sold the 

 

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other community located inCalifornia for net proceeds of approximately $2.6 million, which caused a$260,000 reduction in annual minimum rent payable also in accordance with ourlease terms.

 

**RECENT DEVELOPMENTS**

 

In February 2006, we agreed to lease twohospitals from Senior Housing.  The termof the lease for the two hospitals commences when we receive all healthregulatory approvals required to operate the hospitals.  These two hospitals provide healthrehabilitation services and are located in Braintree and Woburn,Massachusetts.  These hospitals offer extensiveinpatient and outpatient services.  Thehospitals are currently owned by Senior Housing but operated byHealthSouth.  Recently, the MassachusettsSuperior Court has decided that Senior Housing validly terminated HealthSouth’slease and ordered HealthSouth to cooperate in the transfer of the hospitals’operations to a new tenant designated by Senior Housing.  HealthSouth has appealed these decisions, butthe trial court and the appeals court have both denied HealthSouth’s requeststo stay these decisions until the appeal is decided.  Fully reliable financial information aboutthe current operations at these hospitals is not presently available.  Nonetheless, we believe that we will be ableto operate these hospitals profitably and that these profits may be material toour operating results.  We believe thatthe successful operation of these hospitals may enhance our reputation as aprovider of health and rehabilitation services and that this enhancedreputation may benefit us at other healthcare and senior living facilitieswhich we operate.

 

**OUR GROWTH STRATEGY**

 

We believe that the aging of the U.S.population will increase demand for existing independent living properties,assisted living communities and nursing homes. Our principal growth strategy isto profit from this demand by operating and acquiring properties that providehigh quality services to residents who pay with private resources.

 

We seek to improve the profitability of ourexisting operations by increasing revenues and improving margins. We attempt toincrease revenues by increasing rates and occupancies. We attempt to improvemargins by limiting increases in expenses and improving operating efficiencies.

 

In addition to managing our existingoperations, we intend to continue to grow our business through acquisitions ofindependent and assisted living communities where residents’ private resourcesaccount for a large majority of revenues. Since we became a public company inlate 2001, we added 101 primarily independent and assisted living communitiesto our business which in 2005 generated approximately 88% of their revenue fromresidents’ private resources, rather than from Medicare or Medicaid. We preferto purchase communities which have achieved or are close to stabilizedoperations. We also try to make acquisitions where we can realize cost savingsby combining operations with our existing 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 these communities arenow at or approaching stabilized operations and many of these financialinvestors are now anxious to sell.  Forexample: in 2004, we acquired 47 independent and assisted living communitieswhich were assembled and developed by LTA; and the controlling shareholder ofLTA prior to our acquisition of LTA was a private equity fund.  We expect to pursue similar acquisitions forthe next several years.

 

We also intend to expand our institutionalpharmacy business. We acquired our first pharmacy in Wisconsin in 2003.  During 2004 and 2005, we acquired threeadditional pharmacies; two located in Nebraska and one located in California.  One of our pharmacies provides mail orderpharmaceuticals to the general public. Whenever we buy an institutional pharmacy business, we seek to grow itsbusiness by providing pharmacy services at our senior living communities withinthe same service area.  We are currentlyinterested in acquiring pharmacies in other areas where we own senior livingcommunities.  In addition,assuming we obtain the necessary regulatory approvals and depending upon theresults we achieve at the rehabilitation hospitals we lease from SeniorHousing, we may seek to expand our rehabilitation hospitals’ operations.

 

Although expansion of our nursing homebusiness is not our primary growth strategy, we have in the past consideredacquiring additional nursing homes. Most nursing homes are financiallydependent upon the Medicare and 

 

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Medicaid programs. Accordingly,we believe the potential for profitable operations of nursing homes is limitedby government rate setting. In these circumstances, we are only interested inexpanding our nursing home operations at prices which we believe take intoaccount the risks inherent in government funding. In the past few years, wehave been unable to buy nursing homes at prices we consider appropriate, but weintend to investigate such opportunities in the future.

 

**TYPES OFCOMMUNITIES**

** **

Our present business plancontemplates the ownership, leasing and management of independent livingapartments or congregate care communities, assisted living communities, nursinghomes and rehabilitation hospitals. Some of our senior living communitiescombine more than one type of service in a single building or campus.

 

*Independent Living Apartments or CongregateCare Communities.* 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 10, 2006, our businessincludes 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 scheduledtimes.  As of March 10, 2006, ourbusiness includes 5,725 assisted living suites in 95 communities.

 

*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.  As of March 10, 2006, our businessincludes 6,142 skilled nursing beds in 74 communities.

 

 *Rehabilitation Hospitals. *Rehabilitationhospitals, also known as Inpatient Rehabilitation Facilities, or IRFs, provideintensive physical therapy, occupational therapy and speech language pathologyservices beyond the capabilities customarily available in skilled nursingfacilities.  Patients in IRFs generallyreceive a minimum of three hours of rehabilitation services daily.  Outpatient satellite clinics are oftenincluded as part of the continuum of care offered by IRFs.  The two rehabilitation hospitals that weexpect to begin operating in 2006 have 364 beds available for inpatientservices and provide extensive outpatient services from the hospitals’premises.  In addition, these twohospitals operate 23 affiliated outpatient clinics.

 

**OPERATING STRUCTURE**

 

We have several regional offices which arelocated throughout the country.  Eachregional office is responsible for multiple communities and is headed by aregional director of operations with extensive experience in the senior livingindustry.  Each regional office istypically supported by a clinical or wellness director, a rehabilitationservices director, a regional accounts manager, a human resources specialistand a sales and marketing specialist. Regional staffs are responsible for all our community operations withinthe region, including:

 

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•                  resident services;

•                  marketing and sales;

•                  hiring of community personnel;

•                  compliance with applicable legal andregulatory requirements; and

•                  supporting our development andacquisition plans within their region.

 

Our home office staff performs the followingtasks:

 

•                  general oversight of our regionalstaff and pharmacy operations;

•                  the establishment of company widepolicies and procedures relating to resident care;

•                  human resources policies andprocedures;

•                  information technology;

•                  Medicare and Medicaid billing;

•                  licensing and certificationmaintenance;

•                  legal services;

•                  central purchasing;

•                  budgeting and supervision ofmaintenance and capital expenditures;

•                  implementation of our growthstrategy; and

•                  accounting and finance functions,including operations budgeting, accounts receivable and collections, accountspayable, payroll, financial reporting, and tax planning and compliance.

 

**INDEPENDENT ANDASSISTED 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 and staffsupervision. 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.

 

****NURSINGHOME STAFFING****

** **

Each of our nursing homes is managed by astate licensed administrator who is supported by other professional personnel,including a director of nursing, 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.

 

**PHARMACYOPERATIONS AND STAFFING**

** **

Our institutional pharmacy operation providesprescriptions, medical supplies, equipment and services to operators andresidents of senior living communities; we do not sell to the publicgenerally.  Our mail order pharmacyoperation provides prescriptions and medical supplies to the general public.  Each of our pharmacies is managed by anexecutive director, who is responsible for the day to day operations of eachpharmacy and our mail order operation, including billings, sales and marketing,financial performance, compliance with regulatory codes regarding thedispensing of controlled substances and staff supervision.  Other pharmacy personnel include licenseddispensing pharmacists, a director of pharmacy consultation, a medical recordsdirector, a nurse consultant, pharmacy technicians and billing personnel.

 

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**REHABILITATIONHOSPITALS**

** **

**We intend to offer continuedemployment to substantially all of the employees of the two rehabilitationhospitals that we expect to begin operating in 2006.  Management supervision will be provideddirectly from our home office which is located within 20 miles of each of thesehospitals.**

** **

**EMPLOYEES**

** **

As of March 10,2006, we had approximately 11,637 employees, including 7,852 full timeequivalents. Approximately 461 employees, including 306 full time equivalents,are represented under four****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.

 

**GOVERNMENT REGULATION AND REIMBURSEMENT**

 

Our operations must comply with numerousfederal, state and local statutes and regulations. Also, the healthcareindustry depends significantly upon federal and state programs for revenuesand, as a result, is vulnerable to the budgetary policies of both the federaland state governments.

 

*Independent Living Communities.*Governmentbenefits generally are not available for services at independent livingcommunities and the resident charges in these communities are paid from privateresources. However, a number of Federal Supplemental Security Income programbenefits pay housing costs for elderly or disabled residents to live in thesetypes of residential communities. The Social Security Act requires states tocertify that they will establish and enforce standards for any category ofgroup living arrangement in which a significant number of Supplemental SecurityIncome residents reside or are likely to reside. Categories of livingarrangements which may be subject to these state standards include independentliving apartments and assisted living communities. Because independent livingcommunities usually offer common dining facilities, in many locations they arerequired to obtain licenses applicable to food service establishments inaddition to complying with land use and life safety requirements. In manystates, independent living communities are licensed by state or county healthdepartments, social service agencies or offices on aging with jurisdiction overgroup residential communities for seniors. To the extent that independentliving communities include units in which assisted living or nursing servicesare provided, these units are subject to applicable state licensingregulations, and if the communities receive Medicaid or Medicare funds, tocertification standards. In some states, insurance or consumer protectionagencies regulate independent living communities in which residents payentrance fees or prepay for services.

 

*Assisted Living Communities. *According to theNational Academy for State Health Policy, or the National Academy, a majorityof states provide or are approved to provide Medicaid payments for residents insome assisted living communities under waivers granted by the Federal Centersfor Medicare 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, and physicalconditions of, the participating communities. Different states apply differentstandards in these matters, but generally we believe these monitoring processesare similar to the concerned states’ inspection processes for nursing homes.

 

In light of the large number of states usingMedicaid to purchase services at assisted living communities and the growth ofassisted living in recent years, a majority of states have adopted licensingstandards applicable to assisted living communities. A majority of states havelicensing statutes or standards specifically using the term “assisted living”and have requirements for communities servicing people with Alzheimer’s diseaseor dementia. 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 

 

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analysis of current economicand regulatory trends, we believe that assisted living communities that becomedependent upon Medicaid payments for a majority of their revenues may declinein value because Medicaid rates may fail to keep up with increasing costs. Wealso believe that assisted living communities located in states that adoptcertificate of need requirements or otherwise restrict the development of newassisted living communities may increase in value because these limitationsupon development may help ensure higher occupancy and higher non-governmentalrates.

 

The US. Department of Health and HumanServices, the Government Accountability Office, or GAO, and the Senate SpecialCommittee on Aging have recently studied and reported on the development ofassisted living and its role in the continuum of long-term care and as analternative to nursing homes.  In 2003,the GAO recommended that CMS strengthen its oversight of state qualityassurance in Medicaid home and community-based services waiver programs.  Since then, CMS has commenced a series ofactions to strengthen its ability to effectively oversee state qualityassurance programs and has provided guidance and technical assistance to thestates to improve their ability to monitor and improve the quality of servicesprovided through waivers.  Also in 2003,a working group of assisted living providers, consumers and regulatoryorganizations made recommendations to the Senate Special Committee on Aging ona range of subjects, including staffing, funding and regulation of assistedliving.  We cannot predict whether thesestudies and reports will result in governmental policy changes or newlegislation, or what impact any changes may have. Based upon our analysis ofcurrent economic and regulatory trends, we do not believe that the federalgovernment is likely to have a material impact upon the current regulatoryenvironment in which the assisted living industry operates unless it alsoundertakes expanded funding obligations, and we do not believe a materiallyincreased financial commitment from the federal government is presently likely.However, we do anticipate that assisted living communities will increasingly belicensed and regulated by the various states, and that, in the absence offederal standards, the states’ policies will continue to vary widely.

 

*Nursing Homes-Reimbursement. *About 61% of allnursing home revenues in the U.S. in 2004 (the most recent date for whichinformation seems to be publicly available) came from publicly funded programs,including about 44% from Medicaid programs and 14% from the Medicare program.Nursing homes are among the most highly regulated businesses in the country.The federal and state governments regularly monitor the quality of careprovided at nursing homes. State health departments conduct surveys of residentcare and inspect the physical condition of nursing home properties. Theseperiodic inspections 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 BalancedBudget Act of 1997, and was intended to reduce the rate of growth in Medicarepayments for skilled nursing communities. Before the current Medicare payment system, Medicare rates werecommunity specific and cost based. Under the current Medicare payment system,skilled nursing facilities receive a fixed payment for each day of careprovided to residents who are Medicare beneficiaries. Each resident is assignedto a care group depending on that resident’s medical characteristics andservice needs.  These care groups areknown as Resource Utilization Groups, or RUGs. Per diem payment rates are established for each of these care groups.  Medicare payments cover substantially allservices provided to Medicare residents in skilled nursing communities,including ancillary services such as rehabilitation therapies.  The PPS is intended to provide incentives toproviders to furnish only necessary services and to deliver those servicesefficiently.  During the three year phasein period, Medicare rates for skilled nursing communities were based on a blendof community specific costs and rates established by the new Medicare paymentsystem.  According to the GAO, betweenfiscal year 1998 and fiscal year 1999, the first full year of the changedMedicare payment system phase in, the average Medicare payment per day declinedby about 9%.

 

Since November 1999, Congress hasprovided some relief from the impact of the Balanced Budget Act of 1997.Effective April 1, 2000, the Medicare, Medicaid and State Children’sHealth Insurance Program Balanced Budget Refinement Act of 1999 temporarilyboosted payments for certain skilled nursing cases by 20% and allowed skillednursing communities to transition more rapidly to the federal payment system.This Act also increased the Medicare payment rates by 4% for fiscal years 2001and 2002 and imposed a two year moratorium on some therapy limitations for 

 

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skilled nursing residents coveredunder Medicare Part B. In December 2000, the Medicare, Medicaid andState Children’s Health Insurance Program Benefits Improvement and ProtectionAct of 2000 was approved. Effective April 1, 2001 to October 1, 2002,this Act increased the nursing component of the payment rate for each caregroup by 17%. This Act also increased annual inflation adjustments for fiscalyear 2001, increased rehabilitation care group rates by 7%, maintained thepreviously temporary 20% increase in the other care group rates established in1999, and extended the moratorium on some therapy reimbursement rate capsthrough 2002. However, as of October 1, 2002, the 4% across the boardincrease in Medicare payment rates and the 17% increase in the nursingcomponent of the rates expired. Effective October 1, 2003, CMS increasedthe annual inflation update to skilled nursing community rates by 3% per year,and added an additional 3% for the year beginning October 1, 2003, toaccount for inflation underestimates in prior years. The 20% increase for theskilled nursing care groups and the 7% increase in rehabilitation care grouprates expired when the current resource utilization groups were refined,effective January 1, 2006. Effective December 8, 2003, the MedicarePrescription Drug, Improvement and Modernization Act of 2003 set a newmoratorium on implementation of some therapy reimbursement rate caps through2005. This moratorium expired on January 1, 2006.

 

Effective January 1, 2006, CMSimplemented changes to the payment categories it uses to set daily paymentrates for Medicare beneficiaries in skilled nursing facilities. CMS hasintroduced nine new payment categories for medically complex patients,increasing the number of categories from 44 to 53, and has made revisions toits payment rates for current RUGS. Also effective January 1, 2006, theseRUG changes have caused the elimination of certain temporary additionalpayments for certain skilled nursing care and rehabilitation groups. We areunable to predict the financial impact of these changes to the Medicare rateson our operations at this time.

 

Under the Deficit Reduction Act of 2005, orthe DRA, enacted in February 2006, the federal government will slow thegrowth of Medicare and Medicaid payments for nursing home services by severalmethods.  Medicare bad debt reimbursementwill be reduced from 100% to 70% for uncollected cost sharing payments fromMedicare beneficiaries who are not eligible for Medicaid.  Limits on Medicare payments will also beimplemented for outpatient therapies.  Inaddition, the “look-back” period for prohibited asset transfers that disqualifyindividuals from qualifying for Medicaid nursing home benefits will beincreased from three to five years.  Theperiod of Medicaid ineligibility will begin on the date of the prohibitedtransfer or the date an individual has entered the nursing home and wouldotherwise be eligible for Medicaid coverage, whichever occurs later, ratherthan on the date of the prohibited transfer, effectively extending the Medicaidpenalty period and placing added burdens on nursing homes.  The DRA also includes a demonstration projectthat will provide increased federal funds to states that provide home andcommunity-based long term care services to qualified individuals relocated fromnursing homes, and a post acute payment reform demonstration program that willcompare and assess costs and outcomes of services at different long term caresites over three years.

 

*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 GAO investigation which found inadequate care in asignificant proportion of California nursing homes and CMS’s July 1998report to Congress on the effectiveness of the survey and enforcement system.In 1999, the U.S. Department of Health and Human Services, Office of InspectorGeneral issued several reports concerning quality of care in nursing homes, andthe GAO issued reports in 1999, 2000, 2002, 2003, 2004 and 2005 whichrecommended that CMS and the states strengthen their compliance and enforcementpractices, including federal oversight of state actions, to better ensure thatnursing homes provide adequate care and states act more consistently. Since1998, the Senate Special Committee on Aging has been holding hearings on theseissues. CMS is taking steps to focus more survey and enforcement efforts onnursing homes with findings of substandard care or repeat violations ofMedicare and Medicaid standards and to identify chain operated communities withpatterns of noncompliance. CMS is also increasing its oversight of state surveyagencies and requiring state agencies to use enforcement sanctions and remediesmore promptly when substandard care or repeat violations are identified, toinvestigate complaints more promptly, and to survey communities moreconsistently. In addition, CMS has adopted regulations expanding federal andstate authority to impose civil money penalties in instances of noncompliance.Medicare survey results and nursing staff hours per resident for each nursinghome are posted on the Medicare website at www.medicare.gov. CMS plans to issuea proposed rule in 2006 that would require older nursing homes to installsprinklers. When deficiencies under state licensing and Medicare and Medicaidstandards are identified, sanctions and remedies such as denials of payment fornew Medicare and Medicaid admissions, civil monetary penalties, state oversightand loss of Medicare and Medicaid participation or licensure may be imposed. Wereceive notices 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

 

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imposed, and if imposed, mayadversely affect our ability to meet our financial obligations and negativelyaffect our financial condition and results of operations.

 

In 2000 and 2002, CMS issued reports on itsstudy linking nursing staffing levels with quality of care, and CMS isassessing the impact that minimum staffing requirements would have on communitycosts and operations. In a report presented to Congress in 2002, the Departmentof Health and Human Services found that 90% of nursing homes lack the nurse andnurse aide 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 staffing at this time.  CMS ispublishing the nurse staffing level at each nursing home on the internet(www.medicare.gov) to create market pressure to improve nursing homeoperations.

 

*Rehabilitation Hospital Regulations and RateSetting.* The two rehabilitation hospitals that weexpect to begin operating in 2006 are subject to federal, state and localregulation that affect their business activities and determine the rates theyreceive for services. These facilities are subject to periodic inspection bygovernmental and non-governmental agencies to ensure continued compliance withvarious licensure and accreditation standards. In addition, these facilitiesare certified by CMS to participate in the Medicare program and receive asignificant portion of their revenues from that program.

 

On May 7, 2004, CMS issued a rule establishing revised Medicarestandards that rehabilitation hospitals are required to meet in order toparticipate as IRFs in the Medicare program known as the “75% Rule.” The 75%Rule generally provides that, to be considered an IRF and receive reimbursementfor services under the IRF prospective payment system, at least 75% of afacility’s total inpatient population must require intensive rehabilitationservices associated with treatment of at least one of 13 designated medicalconditions. This means that to maintain their current levels of revenues manyrehabilitation hospitals may need to reduce the number of non-qualifyingpatients treated and replace them with qualifying patients, establish othersources of revenues or both. The 75% Rule is being phased in over a four yearperiod that began on July 1, 2004. The DRA delayed the phase-in of the 75%Rule for a year by retaining the current 60% premium requirement for costreporting periods starting on and after July 1, 2006, and by delaying raisingthe requirement to 65% until July 1, 2007, and to 75% until July 1, 2008. AnIRF that fails to meet the requirements of the 75% Rule is subject toreclassification as a different type of healthcare provider; and the effect ofsuch reclassification would be to lower Medicare payment rates.

 

*Certificates of Need.*Most states limit the number of nursing homes and hospitals by requiringdevelopers to obtain certificates of need before new communities may be builtand a few states limit the number of assisted living facilities by requiringcertificates of need. Also, states such as California and Texas that haveeliminated certificate of need laws often have retained other means of limitingnew development, such as the use of moratoria, licensing laws or limitationsupon participation in the state Medicaid program. We believe that thesegovernmental limitations may make nursing homes more valuable by limitingcompetition.

 

*Other Matters*.Federal efforts to target fraud and abuse and violations of anti-kickback lawsand physician referral laws by Medicare and Medicaid providers have alsoincreased. In March 2000, the U.S. Department of Health and Human ServicesOffice of Inspector General issued compliance guidelines for nursingcommunities to assist them in developing voluntary compliance programs toprevent fraud and abuse. Also, new rules governing the privacy, use anddisclosure of individually identified health information became final in 2001and took effect in 2003, with civil and criminal sanctions for noncompliance.An adverse determination concerning any of our licenses or eligibility forMedicare or Medicaid reimbursement or the costs of required compliance withapplicable federal or state regulations could adversely affect our ability tomeet our financial obligations and negatively affect our financial conditionand results of operations.

 

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Under theMedicare Prescription Drug, Improvement and Modernization Act of 2003, Medicarebeneficiaries may receive prescription drug benefits beginning January 1, 2006by enrolling in private health plans or managed care organizations, or if theyremain in traditional Medicare, by enrolling in stand alone prescription drugplans. A number of legislative proposals that would affect major reforms of thehealthcare system have been introduced in the U.S. Congress and many are beingconsidered by some state governments, such as programs for national healthinsurance, the option of block grants for states rather than federal matchingmoney for certain state Medicaid services, additional Medicare and Medicaidreforms and federal and state cost containment measures, such as temporarilyfreezing Medicare nursing home payment rates at their current levels andreducing annual Medicare inflation allowances for nursing homes. In connectionwith recent fiscal pressures on state governments, legislation and regulationto reduce Medicaid nursing home payment rates in some states are possible inthe future. We cannot predict whether any of these legislative or regulatoryproposals will be adopted or, if adopted, what effect, if any, these proposalswould have on our business.

 

**INSURANCE**

 

Litigation against senior living operatorshas been increasing during the past few years. Several cases by nursing home patients or their families who have wonlarge monetary awards for mistreatment have been widely publicized.  The amount of such litigation in Florida hasbeen particularly significant.  As aresult, liability insurance costs are rising and, in some cases, such insuranceis not available to some senior living operators.  We have liability insurance for theproperties which we now operate.  As of December 31,2005, only three of the communities we operate were located in Florida (with anaggregate of 638 independent living apartments and 221 assisted living suites).  SLS is responsible for obtaining insurancefor the senior living communities which SLS manages for us.  As of December 31, 2005, three of thecommunities SLS manages for us were located in Florida (with an aggregate of382 independent living apartments, 180 assisted living suites and 95 nursinghome beds).

 

In recent years, our insurance costs forworkers compensation and employee healthcare have also increasedsignificantly.  This is especially sowith respect to workers compensation insurance in California where we operatedseven communities with approximately 905 employees as of December 31,2005.

 

To partially offset these insurance costincreases, we have taken a number of actions including the following:

 

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

•                  we have established an offshorecaptive insurance company which participates in our liability insuranceprogram. Some of our premiums for liability insurance are paid to this companywhich may retain some of these amounts and the earnings on these amounts basedupon 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 healthcare benefits;

•                  weare fully self insured for all employees health related claims;

•                  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 generallyare renewable in June 2006. 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.  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 

 

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competitors have greaterfinancial resources than we do. For all of these reasons and others, we cannotprovide any assurance that we will be able to compete successfully for businessin the senior living industry.

 

**ENVIRONMENTAL MATTERS**

 

Under various federal, state and local laws,owners as well as tenants and operators of real estate may be required toinvestigate and clean up hazardous substances released or otherwise present ata property, and may be held liable to a governmental entity or to third partiesfor property damage or personal injuries and for investigation and clean upcosts incurred in connection with any such hazardous substances.  Under our leases with Senior Housing, 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 all 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 a more in depth study of the properties orthat future uses or conditions (including, without limitation, changes inapplicable environmental laws and regulations) will not result in theimposition of environmental liability upon us. The presence or discovery of anymaterial environmental contaminants at our communities could have a materialadverse impact on us.

 

**INTERNETWEBSITES**

** **

Our internet website address iswww.5sqc.com.  Copies of our governanceguidelines, code of ethics and the charters of our audit, quality of care,compensation and nominating and governance committees may be obtained at ourwebsite or free of charge by writing to our Secretary, Five Star Quality Care, Inc.,400 Centre Street, Newton, MA 02458.  Wemake available, free of charge, through our website, our Annual Reports on Form 10-K,our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-Kand amendments to such reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as amended, or the ExchangeAct, as soon as reasonably practicable after such forms are filed with theSecurities and Exchange Commission.  Anyshareholder or other interested party who desires to communicate with ourindependent directors, individually or as a group, may do so by filling out areport on our website. Our board also provides a process for security holdersto send communications to our entire board. Information about the process forsending communications to our board can be found on our website.  Our website address and website addresses ofone or more unrelated third parties are included several times in this AnnualReport on Form 10-K as textual references only and the information in suchwebsites are not incorporated by reference into this Annual Report on Form 10-K.

 

**Item 1A.  Risk Factors**

** **

Our business faces many risks. The risks describedbelow may not be the only risks we face. Additional risks that we do not yetknow of, or that we currently think are immaterial, may also impair ourbusiness operations or financial results. If any of the events or circumstancesdescribed in the following risks actually occurs, our business, financialcondition or results of operations could suffer and the trading price of ourcommon shares could decline.  Investorsshould consider the following risks and the information contained under theheading “Warning Concerning Forward Looking Statements” before deciding toinvest in our common shares or other securities.

 

**A small percentage decline in ourrevenues or increase in our expenses could have a material negative impact uponour operating results.**

 

For the year ended December 31, 2005,our revenues were $757.5 million and our operating expenses were $836.2million (including our SLS termination expense of approximately $86.3million).  A small percentage decline inour revenues or increase in our expenses could have a material negative impactupon our operating results.

 

**SLS’s continuing management of someof our communities may have adverse consequences to us.**

 

In March 2003, Marriott sold itssubsidiary which managed 31 communities for us to Sunrise.  In 2004, we and SLS closed one of thesecommunities by mutual agreement because of the poor financial results at thatcommunity.  In 

 

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November 2005, weterminated SLS management agreements for an additional 12 communities.  In February 2006, we terminated themanagement agreement for one additional community.  As a result of these terminations, SLS may beunwilling to operate, or may not be able to profitably operate, the remaining17 communities which it operates for our account and the income we realizefrom these operations may decline.  Wecannot predict the effect that our terminations of these management agreementswill have on our ongoing relationship with SLS.

 

**Our growth strategy may not succeed.**

 

Since our spin-off from Senior Housing on December 31,2001, we have grown rapidly through acquisitions. Our business plan includesacquiring additional senior living communities, pharmacies and rehabilitationhospitals.  Our 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 not perform in line with expectations;

•                  acquiredoperations may subject us to unanticipated contingent liabilities or regulatoryproblems;

•                  tothe extent we incur acquisition debt or leases, our operating leverage mayincrease and, to the extent we issue additional equity, our shareholders’percentage of ownership will be diluted; and

•                  combiningour present operations with newly acquired operations may disrupt operations orcost more than anticipated.

 

For these reasons and others:

 

•                  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.

 

When we acquire new communities, wefrequently see a decline in community occupancy and it often takes some periodof time for us to stabilize acquired community operations.  For example, occupancy levels for the Gordoncommunities we acquired in June 2005 are still somewhat below theirhistorical levels.  Our efforts torestore occupancy or stabilize acquired communities’ operations may not besuccessful.

 

In addition, we have recently expanded intothe institutional and mail order pharmacy businesses and plan to operate tworehabilitation hospitals.  These arebusinesses with which we have limited experience, and our initiatives in theseareas may not be successful.

 

**We may be unable to lease the two hospitalsfrom Senior Housing, and, if we are able to lease these hospitals, we may notachieve the anticipated benefits of our operation of these hospitals.**

 

We may notreceive the required regulatory approvals to lease the two hospitals fromSenior Housing and our lease with Senior Housing may not become effective.  Also, Healthsouth’s appeal of theMassachusetts Superior Court’s order to cooperate in the transfer of these twohospitals may be successful, Healthsouth’s lease of these hospitals may bereinstated and our tenancy may be terminated.

 

Thehistorical operating and financial information concerning the two hospitals’operations that we received from Healthsouth may not be accurate.  Also, recent changes in Medicare rateformulas applicable to rehabilitation hospitals make it difficult to projectthe hospitals’ future financial results. In these circumstances, our projection that our future operation ofthese hospitals will be profitable may prove to be inaccurate.  In fact, we may be unable to operate thesehospitals profitably and we may experience losses from our operation of thesehospitals.

 

If we areunable to operate these hospitals successfully, our reputation as a provider ofhealth and rehabilitation services may be damaged.  Even if we successfully operate thesehospitals, these operations may have little or no benefit to our otheroperations.

 

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**We may not achieve the anticipated benefitsof our acquisition of the Gordon communities.**

 

The financial benefits we expect to realizefrom our 2005 acquisition of the Gordon communities are largely dependent uponour ability to increase the occupancy of the Gordon communities and to realizecost savings by combining the Gordon communities’ operations and our existingoperations.  Changing management atsenior living communities sometimes results in decreased occupancy, decliningrevenues and increased costs.  If ourmanagement of the Gordon communities does not increase occupancy, increaserevenues and lower costs, we may not achieve the anticipated benefits and wemay experience losses.

 

**We may not achieve the anticipated benefitsof our termination of management agreements for 13 communities that SLS managedfor us.**

 

The financial benefits we expect to realizefrom our termination of management agreements for 13 communities that SLSmanaged for us are largely dependent upon our ability to maintain the occupancyof the 13 communities and to lower certain operating costs.  Changingmanagement at senior living communities sometimes results in decreasedoccupancy, declining revenues and increased costs.  The transition of operations at senior livingcommunities is often complicated and we can provide no assurance that thebenefits we hope to achieve by terminating these SLS management agreements willbe realized.

 

**The nature of our business exposes us tolitigation risks.  As a result, ourinsurance costs have increased and may continue to increase, and we self insurea large portion of our litigation risks.**

 

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, some lawyers and law firms specializein bringing litigation against senior living companies.  As a result of this litigation and potentiallitigation, our cost of liability insurance has increased dramatically duringthe past few years.  Medical liabilityinsurance reform has become a topic of political debate and some states haveenacted legislation to limit future liability awards.  However, unless such reforms are notgenerally adopted, we expect our insurance costs may continue to increase.  To reduce costs, we self insure a significantamount of our litigation liability risks. Although our reserves for liability self insurance have been determinedwith guidance from third party professionals, our reserves may prove inadequate.  Increasing liability insurance costs andincreasing self insurance reserves may materially negatively affect our resultsof operations.

 

**Our business is subject to extensiveregulation which increases our costs and may result in losses.**

 

Licensing and Medicare and Medicaid lawsrequire operators of senior living communities to comply with extensivestandards governing operations. There are also various laws prohibiting fraudby senior living operators, including criminal laws that prohibit false claimsfor Medicare and Medicaid and that regulate patient referrals. In recent years,the federal and state governments have devoted increased resources tomonitoring the quality of care at senior living communities and to anti-fraudinvestigations. When quality of care deficiencies are identified or improperbilling is uncovered, various sanctions may be imposed, including denial of newadmissions, exclusion from Medicare or Medicaid program participation, monetarypenalties, governmental oversight or loss of licensure. Our communities receivenotices of sanctions from time to time. As a result of this extensive regulatory system and increasingenforcement initiatives, we have increased our costs of monitoring quality ofcare compliance and billing procedures, and we expect these costs may continueto increase. Also, if we become subject to regulatory sanctions, our businessmay be adversely affected and we might experience financial losses.

 

**The failure of Medicare and Medicaid rates tomatch our costs will reduce our income.**

 

Some of our operations, especially ournursing homes, receive significant revenues from the Medicare and Medicaidprograms.  During the year ended December 31,2005, approximately 36% of our net revenues from residents were received fromthese programs.  The federal governmentand some states are now experiencing fiscal deficits. Historically, whengovernmental deficits have increased, cut backs in Medicare and Medicaidfunding have often followed.  These cutbacks sometimes include rate reductions, but more often result in a failure ofMedicare and Medicaid rates to increase by sufficient amounts to offsetincreasing costs.  We cannot now predictwhether future Medicare and Medicaid rates will be sufficient to cover ourfuture cost increases.  Future Medicareand Medicaid rate declines or a 

 

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failure of these rates to coverincreasing costs could result in our experiencing lower earnings orlosses.  The rehabilitation hospitalsthat we expect to begin operating in 2006 receive a significant part of theirrevenues from the Medicare programs, and these operations will increase ourexposure to Medicare rate risks.

 

**Compliance with Sarbanes-Oxley will continueto increase our accounting costs and reduce our income.**

 

Section 404 of Sarbanes-Oxley requiresthat our independent auditors audit our internal control over financialreporting for the year ended December 31, 2005 and thereafter.  Section 404 also requires our managementto assess the effectiveness of our internal control over financial reporting asof December 31, 2005 and to report the results of that assessment in ourannual report.  These additionalrequirements have increased our accounting costs and we expect that theseincreased costs will continue to reduce our income.

 

**A significant increase in our labor costs mayhave a material adverse effect on us.**

 

We compete with other operators of seniorliving communities with respect to attracting and retaining qualified personnelresponsible for the day to day operations of each of our communities.  A shortage of nurses or other trainedpersonnel may require us to increase the wages and benefits offered to ouremployees in order to attract and retain these personnel or to hire more expensivetemporary personnel.  Also, we have tocompete for lesser skilled workers with numerous other employers. Employmentstatistics recently published by the government indicate a tightening jobmarket. Historically, these statistics have often foretold increased wagepressures.  Although we have not yetexperienced any recent significant wage pressures, such wage pressures mayoccur in the near future.  Employeebenefits costs, including employee health insurance and workers compensationinsurance costs, have materially increased in recent years.  To help control these costs, we partiallyself insure our workers compensation insurance and fully self insure ouremployee health insurance.  Although ourself insurance reserves have been determined with guidance from third partyprofessionals, our reserves may be inadequate. Increasing employee health and workers compensation insurance costs andincreasing self insurance reserves for this type of insurance may materiallynegatively affect our earnings.  Noassurance can be given that our labor costs will not increase or that anyincrease will be matched by corresponding increases in rates charged toresidents.  Any significant failure by usto control our labor costs or to pass on any increased labor costs to residentsthrough rate increases could have a material adverse effect on our business,financial condition and results of operations.

 

**Our business may require regular capitalexpenditures.**

 

Physical characteristics of senior livingcommunities are mandated by various governmental authorities. Changes in theseregulations may require us to make significant expenditures. In the future, ourcommunities may require significant expenditures to address ongoing requiredmaintenance and to make them attractive to residents. Our available financialresources may be insufficient to fund these expenditures.

 

**Our business is highly competitive and we maybe unable to operate profitably.**

 

We compete with numerous other companies thatprovide senior living services, including home healthcare companies and otherreal estate based service providers. Historically, nursing homes have been somewhat protected fromcompetition by state laws requiring certificates of need to develop newcommunities; however, these barriers have been eliminated in many states.  Also, there are few barriers to competitionfor home healthcare or for independent and assisted living services.  Growth in the availability of nursing homealternatives, including assisted living communities, has had and may in thefuture have the effect of reducing the occupancy or profitability at nursinghomes, including those we operate.  Manyof our existing competitors are larger and have greater financial resourcesthan us.  Accordingly, we cannot provideany assurances that we will be able to attract a sufficient number of residentsto our communities or that we will be able to attract employees and keep wagesand other employee benefits, insurance costs and other operating expenses atlevels which will allow us to compete successfully or to operate profitably.

 

**We are subject to possible conflicts ofinterest; we have engaged in, and expect to continue to have, transactions withrelated parties.**

 

Our business is subject to possible conflictsof interest as follows:

 

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•                  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.  Mr. Portnoyalso is the majority beneficial owner of RMR and another entity that leases officespace to us and Mr. Martin is a director of RMR;

•                  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 than onour behalf; and

•                  welease 135 of the 153 senior living communities that we operate from SeniorHousing for total annual minimum rent of $103.5 million.

 

On December 31, 2001, Senior Housingdistributed substantially all of its ownership of our shares to itsshareholders.  Simultaneously with the spinoff, we entered into agreements with Senior Housing which, among other things,limit ownership of more than 9.8% of our voting shares, restrict our ability totake any action that could jeopardize the tax status of Senior Housing as areal estate investment trust and limit our ability to acquire real estate oftypes which are owned by Senior Housing or other real estate investment trustsmanaged by RMR.  As a result of theseagreements, our leases with Senior Housing and our shared services agreement withRMR, Senior Housing, RMR and their respective affiliates have significant rolesin our business and we do not anticipate any changes to those roles in thefuture.  Future business dealings betweenus, Senior Housing, RMR and their respective affiliates may be on terms lessfavorable to us than we could achieve on an arm’s length basis.  Although we do not believe these conflictshave adversely affected, or will adversely affect, our business, not everyonemay agree with our position.

 

**The limitations on the ownership of ourshares and other anti-takeover provisions in our governing documents and in ourmaterial agreements may prevent our shareholders from receiving a takeoverpremium for their shares.**

 

Our charter places restrictions on theability of any person or group to acquire beneficial ownership of more than9.8% (in number of shares or value, whichever is more restrictive) of any classof our equity securities.  The terms ofour leases with Senior Housing and our shared services agreement with RMRprovide that our rights under these agreements may be cancelled by SeniorHousing and RMR, respectively, upon the acquisition by any person or group ofmore than 9.8% of our voting stock, and upon other change in control events, asdefined 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 fordamages.  Additionally, on March 10,2004, we entered into a rights agreement whereby in the event a person or groupof persons acquires or attempts to acquire 10% or more of our outstandingcommon shares, our shareholders, other than such person or group, will beentitled to purchase additional shares or other securities or property at adiscount.  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 approved by our board of directors.  Other provisions in our governing documentswhich may deter takeover proposals include the following:

 

•                  staggeredterms for members of our board of directors;

•                  thepower of our board of directors, without a shareholders’ vote, to authorize andissue additional shares 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 beunable to cause a change of control of us or to realize a change of controlpremium for their common shares.

 

**The price of our common shares hasfluctuated, and a number of factors may cause our common share price to decline.**

 

The market price of our common shares hasfluctuated and could fluctuate significantly in the future in response tovarious factors and events, including, but not limited to, the risks set out inthis Annual Report on form 10-K, as well as:

 

15

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•                  theliquidity of the market for our common shares;

•                  variationsin our operating results;

•                  variationsfrom analysts’ expectations; and

•                  generaleconomic and industry trends and conditions.

 

In addition, the stock market in recent yearshas experienced broad price and volume fluctuations that often have beenunrelated to the operating performance of particular companies.  These market fluctuations may also cause themarket price of our common shares to decline. Investors may be unable to resell their common shares at or above theoffering price.

 

**Circumstances that adversely affectthe ability of seniors to pay for our services could have a material adverseeffect on us.**

 

Approximately 64% of our net revenues fromresidents from our communities for the year ended December 31, 2005 werepaid by residents from their private resources. We expect to continue to relyon the ability of our residents to pay for our services from their ownfinancial resources. Inflation or other circumstances that adversely affect theability of the elderly to pay for our services could have a material adverseeffect on our business, financial condition and results of operations.

 

**Item 1B.  Unresolved StaffComments**

 

None.

 

16

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**Item 2.  Properties**

 

**OUR SENIOR LIVING COMMUNITIES**

** **

As of December 31,2005, our business included 153 senior living communities which may becategorized into groups as follows:

 
| **Ownership**                                                                        | ** ** | **No. of  communities** |   | **Type of units**           |   | **Total  living  units** |   | **Occupancy  for  the year ended  Dec. 31, 2005** |   | **Revenues  for  the year ended  Dec. 31, 2005  (in thousands)** |   | **Percent  of   revenues   from   private   resources** |   |
|--------------------------------------------------------------------------------------|------------|------------------------------|--------|-----------------------------|--------|--------------------------|--------|---------------------------------------------------|--------|-----------------------------------------------------------------------|--------|---------------------------------------------------------|--------|
|                                                                                 |       | **Indep.  living  apts.**    |   | **Assist.  living  suites** |   | **Special  care  beds**  |   | **Nursing  home   beds**                          |   |                                                                  |   |                                                    |   |
| ** **                                                                           | ** ** | ** **                   |   |                        |   |                     |   |                                              |   |                                                                  |   |                                                    |   |   |   |   |   |   |   |
| Independent and Assisted living communities we   operate   (1)        | ** ** | 84                           |   | 2,476                       |   | 4,795                    |   | —                                            |   | 524                                                                   |   | 7,795                                                   |   | 88 | % | $ | 262,779 |   | 94 | % |
| Skilled nursing facilities we operate                                                |       | 51                           |   | 95                          |   | —                   |   | —                                            |   | 4,612                                                                 |   | 4,707                                                   |   | 89 | % | 259,111 |   | 19 | % |
| Independent and assisted living communities that SLS manages on our  behalf (1) |       | 18                           |   | 2,389                       |   | 930                      |   | 283                                               |   | 1,006                                                                 |   | 4,608                                                   |   | 90 | % | 200,079 |   | 82 | % |
| Totals:                                                                              |       | 153                          |   | 4,960                       |   | 5,725                    |   | 283                                               |   | 6,142                                                                 |   | 17,110                                                  |   | 90 | % | $ | 721,969 |   | 64 | % |
|                                                                                      |            |                              |        |                             |        |                          |        |                                                   |        |                                                                       |        |                                                         |        |  |  |  |  |  |  |  |  |

 

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**(1) **In February 2006, we terminated an SLS management agreement for onecommunity and we began to directly operate that community.  SLS continues to manage 17 communities forus.

** **

**INDEPENDENT AND ASSISTED LIVING COMMUNITIES WE OPERATE**

** **

As of December 31,2005, we operated 84 independent and assisted living communities.  We leased 68 of these communities from SeniorHousing and four of these communities from HCPI and we owned the remaining 12communities.  These communities had 7,795living units and were located in 18 states. The following table provides additional information about thesecommunities and their operations as of December 31, 2005:

 
| ** **          | ** ** | ** **                   | ** ** | **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, 2005** | ** ** | **year ended  Dec. 31, 2005  (in thousands)** | ** ** | **revenues from  private  resources** | ** ** |
| 1. Alabama          |       | 6                            |       | —                    |       | 256                         |       | —                  |       | 256                      |       | 88                                                    | %          | $ | 7,154 |   | 100 | % |
| 2. Arizona          |       | 2                            |       | 167                       |       | 85                          |       | 64                      |       | 316                      |       | 92                                                    | %          | 12,018 |   | 90 | % |
| 3.  California      |       | 3                            |       | 330                       |       | 180                         |       | 59                      |       | 569                      |       | 93                                                    | %          | 25,163 |   | 94 | % |
| 4. Delaware         |       | 1                            |       | 62                        |       | 26                          |       | 110                     |       | 198                      |       | 95                                                    | %          | 11,389 |   | 54 | % |
| 5. Florida          |       | 3                            |       | 638                       |       | 221                         |       | —                  |       | 859                      |       | 90                                                    | %          | 22,141 |   | 100 | % |
| 6. Georgia          |       | 8                            |       | —                    |       | 365                         |       | —                  |       | 365                      |       | 92                                                    | %          | 11,306 |   | 100 | % |
| 7. Kansas           |       | 2                            |       | 253                       |       | 30                          |       | 60                      |       | 343                      |       | 91                                                    | %          | 12,229 |   | 86 | % |
| 8. Kentucky         |       | 7                            |       | 380                       |       | 249                         |       | 171                     |       | 800                      |       | 94                                                    | %          | 32,605 |   | 82 | % |
| 9.  Massachusetts   |       | 1                            |       | —                    |       | 125                         |       | —                  |       | 125                      |       | 97                                                    | %          | 6,949 |   | 100 | % |
| 10. Maryland        |       | 6                            |       | 275                       |       | 324                         |       | —                  |       | 599                      |       | 92                                                    | %          | 22,735 |   | 100 | % |
| 11. Missouri        |       | 1                            |       | 114                       |       | —                      |       | —                  |       | 114                      |       | 69                                                    | %          | 1,734 |   | 100 | % |
| 12. Nebraska        |       | 1                            |       | —                    |       | 73                          |       | —                  |       | 73                       |       | 83                                                    | %          | 2,045 |   | 100 | % |
| 13. North  Carolina |       | 5                            |       | —                    |       | 440                         |       | —                  |       | 440                      |       | 88                                                    | %          | 14,654 |   | 99 | % |
| 14. New  Mexico     |       | 1                            |       | 114                       |       | 35                          |       | 60                      |       | 209                      |       | 97                                                    | %          | 10,732 |   | 91 | % |
| 15.  Pennsylvania   |       | 6                            |       | —                    |       | 618                         |       | —                  |       | 618                      |       | 89                                                    | %          | 10,526 |   | 100 | % |
| 16. South  Carolina |       | 12                           |       | —                    |       | 555                         |       | —                  |       | 555                      |       | 91                                                    | %          | 16,646 |   | 100 | % |
| 17.  Tennessee      |       | 9                            |       | —                    |       | 550                         |       | —                  |       | 550                      |       | 90                                                    | %          | 15,353 |   | 100 | % |
| 18. Virginia        |       | 10                           |       | 143                       |       | 663                         |       | —                  |       | 806                      |       | 89                                                    | %          | 27,400 |   | 100 | % |
| Totals:             |       | 84                           |       | 2,476                     |       | 4,795                       |       | 524                     |       | 7,795                    |       | 88                                                    | %          | $ | 262,779 |   | 94 | % |
|                     |            |                              |            |                           |            |                             |            |                         |            |                          |            |                                                       |            |  |  |  |  |  |  |

** **

**17**

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** **

**SKILLED NURSINGFACILITIES WE OPERATE**

** **

As of December 31, 2005, we operated 51skilled nursing facilities.  We lease 49of these facilities from Senior Housing and we own the other twofacilities.  These facilities had 4,707living units and were located in 12 states. The following table provides additional information about thesefacilities and their operations as of December 31, 2005:

 
| ** **      | ** ** | ** **                   | ** ** | ** **                | ** ** | ** **                  | ** ** | ** **              | ** ** | **Percent of**           | ** ** |
|-----------------|------------|------------------------------|------------|---------------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **      | ** ** | ** **                   | ** ** | **Types of units**        | ** ** | ** **                  | ** ** | **Occupancy**           | ** ** | **Revenues for the**     | ** ** | **revenues** | ** ** |
| **Location**    | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.** | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home  beds** | ** ** | **Total  living  units** | ** ** | **for the year   ended  Dec. 31, 2005** | ** ** | **year ended  Dec. 31, 2005  ( in thousands)** | ** ** | **from  private  resources** | ** ** |
| 1. Arizona      |       | 1                            |       | —                    |       | —                      |       | 125                     |       | 125                      |       | 83 | % | $ | 6,359 |   | 17 | % |
| 2.  California  |       | 4                            |       | —                    |       | —                      |       | 396                     |       | 396                      |       | 96 | % | 27,209 |   | 17 | % |
| 3. Colorado     |       | 7                            |       | 64                        |       | —                      |       | 752                     |       | 816                      |       | 86 | % | 43,654 |   | 25 | % |
| 4.  Connecticut |       | 2                            |       | —                    |       | —                      |       | 300                     |       | 300                      |       | 96 | % | 23,160 |   | 8 | % |
| 5. Georgia      |       | 3                            |       | —                    |       | —                      |       | 334                     |       | 334                      |       | 93 | % | 15,727 |   | 7 | % |
| 6. Iowa         |       | 7                            |       | 19                        |       | —                      |       | 476                     |       | 495                      |       | 91 | % | 26,258 |   | 15 | % |
| 7. Kansas       |       | 1                            |       | 4                         |       | —                      |       | 55                      |       | 59                       |       | 97 | % | 2,705 |   | 30 | % |
| 8. Michigan     |       | 2                            |       | —                    |       | —                      |       | 273                     |       | 273                      |       | 89 | % | 22,883 |   | 12 | % |
| 9. Missouri     |       | 2                            |       | —                    |       | —                      |       | 180                     |       | 180                      |       | 88 | % | 7,014 |   | 18 | % |
| 10. Nebraska    |       | 14                           |       | —                    |       | —                      |       | 815                     |       | 815                      |       | 86 | % | 35,979 |   | 27 | % |
| 11.  Wisconsin  |       | 6                            |       | —                    |       | —                      |       | 723                     |       | 723                      |       | 90 | % | 39,924 |   | 23 | % |
| 12. Wyoming     |       | 2                            |       | 8                         |       | —                      |       | 183                     |       | 191                      |       | 81 | % | 8,239 |   | 25 | % |
| Totals:         |       | 51                           |       | 95                        |       | —                      |       | 4,612                   |       | 4,707                    |       | 89 | % | $ | 259,111 |   | 19 | % |
|                 |            |                              |            |                           |            |                             |            |                         |            |                          |            |  |  |  |  |  |  |  |  |

 

**INDEPENDENT ANDASSISTED LIVING COMMUNITIES THAT SLS MANAGES ON OUR BEHALF**

** **

As of December 31, 2005, our businessincluded 18 communities that we leased from Senior Housing and that SLS managedon our behalf.  These communities had4,608 living units and were located in eight states.  In February 2006, we terminated the SLSmanagement agreement for one community and we began to directly operate thatcommunity.  SLS continues to manage 17communities for us.  The following tableprovides additional information about these communities and their operations asof December 31, 2005:

 
| ** **        | ** ** | ** **                   | ** ** | ** **                | ** ** | ** **                  | ** ** | ** **              | ** ** | ** **            | ** ** | **Percent of**           | ** ** |
|-------------------|------------|------------------------------|------------|---------------------------|------------|-----------------------------|------------|-------------------------|------------|-----------------------|------------|--------------------------|------------|
| ** **        | ** ** | ** **                   | ** ** | **Type of units**         | ** ** | ** **                  | ** ** | **Occupancy**           | ** ** | ** **            | ** ** | **revenues**             | ** ** |
| **Location**      | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.** | ** ** | **Assist.  living  suites** | ** ** | **Special  care  beds** | ** ** | **Nursing home beds** | ** ** | **Total  living  units** | ** ** | **for the year  ended  Dec. 31, 2005** | ** ** | **Revenues for the  year ended  Dec. 31, 2005  (in thousands)** | ** ** | **from  private  resources** | ** ** |
| 1. Arizona        |       | 2                            |       | 356                       |       | 109                         |       | 28                      |       | 124                   |       | 617                      |       | 88 | % | $ | 23,134 |   | 85 | % |
| 2. Delaware       |       | 4                            |       | 273                       |       | 147                         |       | 26                      |       | 231                   |       | 677                      |       | 93 | % | 35,030 |   | 80 | % |
| 3. Florida        |       | 3                            |       | 382                       |       | 180                         |       | —                  |       | 95                    |       | 657                      |       | 92 | % | 26,206 |   | 77 | % |
| 4. Indiana        |       | 1                            |       | 117                       |       | —                      |       | 30                      |       | 74                    |       | 221                      |       | 92 | % | 12,011 |   | 71 | % |
| 5. New  Jersey    |       | 1                            |       | 217                       |       | 108                         |       | 31                      |       | 60                    |       | 416                      |       | 72 | % | 14,443 |   | 88 | % |
| 6. Ohio           |       | 1                            |       | 144                       |       | 87                          |       | 25                      |       | 60                    |       | 316                      |       | 89 | % | 15,329 |   | 89 | % |
| 7. South Carolina |       | 1                            |       | —                    |       | 60                          |       | 36                      |       | 68                    |       | 164                      |       | 94 | % | 6,401 |   | 69 | % |
| 8. Texas          |       | 5                            |       | 900                       |       | 239                         |       | 107                     |       | 294                   |       | 1,540                    |       | 92 | % | 67,525 |   | 83 | % |
| Totals:           |       | 18                           |       | 2,389                     |       | 930                         |       | 283                     |       | 1,006                 |       | 4,608                    |       | 90 | % | $ | 200,079 |   | 82 | % |

** **

**OUR SENIOR HOUSINGLEASES**

** **

We have four leases with Senior Housing.  Three of these leases, or the Five StarLeases, are for communities that we operate. Under a fourth lease, or the SLS/Five Star Lease, we currently operate13 communities and SLS manages 17 communities for us under separate managementagreements.  The following is a summaryof the material 

 

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terms of our leases.  Because it is a summary, it does not containall of the information that may be important to you.  If you would like more information, you shouldread the leases which we have listed in Item 15 of this Annual Report on Form 10-Kand incorporated by reference.

 

*Minimum rent.* Our minimum rent obligation under the FiveStar Leases is approximately $39.4 million per year, and our minimum rent obligationunder the SLS/Five Star Lease is approximately $64.0 million per year.

 

*Percentage rent.*Our leases require us to pay additional rent equal to 4% of the amount by whichgross revenues of the communities we operate exceed gross revenues in a baseyear.

 

*Term.* The terms ofthese leases are as follows:

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

 

*Operating costs.*  Each lease is a so-called “triple-net” leasewhich requires us to pay all costs incurred in the operation of thecommunities, including the costs of personnel, service to residents, insuranceand real estate and personal property taxes.

 

*Rent during renewalterm.*  Rentduring each renewal term is the same as the minimum rent and percentage rentpayable during the initial term.

 

*Non economiccircumstances.* 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 in the leases.

 

*Maintenance andalterations.*  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.

 

*Assignment andsubletting.* Senior Housing’s consent is generally required for any direct orindirect assignment or sublease of any of the communities. In the event of anyassignment or subletting, we will remain liable under the applicable lease.

 

*Indemnification andinsurance.*  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;

•                  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 benamed as an additional insured under these policies.

 

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*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 will be adjusted pro rata.  We arealso required to remove and dispose of any hazardous substance at the leasedcommunities in compliance with all applicable environmental laws andregulations.

 

*Events of default.*  Events of default under each lease includethe 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 inpart;

•                  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 Housingfor all costs and expenses incurred in connection with any exercise of theforegoing remedies.

 

*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.

 

*Lease subordination.*  Our leases may be subordinated to anymortgages on properties leased from Senior Housing.

 

*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 receivable 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.

 

*FF&Ereserves.*  We arerequired under our SLS/Five Star lease to make deposits into certain accountsthat we own for replacements and improvements known as FF&E reserves.Senior Housing has a security and remainder interest in these accounts and inall property purchased with funding from these accounts.

 

**SUNRISESENIOR LIVING SERVICES, INC. MANAGEMENT AGREEMENTS**

 

The following is a summary of the materialterms of our 17 remaining management agreements with SLS.  Because it is a summary, it does not containall of the information that may be important to you.  If you would like 

 

20

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more information, you shouldread the form of operating agreement which we have listed in Item 15 of thisAnnual Report on Form 10-K and incorporated by reference.

 

*Term.*  Each of our remaining management agreementshas an initial term expiring in 2027, with one five year renewal term at SLS’soption.

 

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

 

*Central services.*  SLS also furnishes certain centraladministrative services, which are provided on a central or regional basis toall senior living communities managed by SLS. Such services include: (1) marketingand public relations; (2) human resources program development; (3) informationsystems development and support; and (4) centralized computer payroll andaccounting.

 

*FF&E reservesand 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.  TheFF&E reserve accounts are funded from the operating revenues of the managedcommunities.  The amount of this fundingvaries among the managed communities; however, for most communities it is currentlyset at 2.85% of gross revenues and will gradually increase to 3.5% of grossrevenues.  In 2005, 2004 and 2003, wedeposited $8.7 million, $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.  Anysuch separate funding which we provide increases 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 torequest Senior Housing to provide any required separate funding in return forrent adjustments to provide Senior Housing a return on its investment accordingto a formula set forth in the lease.

 

*Fees.*  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 ofthe amount of our owner’s priority, as defined in the agreements.  For its central services, SLS receives a feegenerally equal to 2% of gross revenues. During 2005, 2004 and 2003, management and central services fees paid toSLS and SLS’s predecessor, MSLS, totaled $21.3 million, $19.3 million and$17.3 million, respectively.

 

*Owner’s priority.*  We receive the profits of the SLS managedcommunities on a priority basis before SLS receives any incentive fees.  The amount of our 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 ended December 31, 2005,2004 and 2003, the aggregate amount of our owner’s priority for all communitiesmanaged by SLS was $48.9 million**,**$72.5 million and $69.4 million, respectively.  The decrease of owners priority between 2005and 2004 is a result of our termination of management agreements for 12communities that SLS managed for us in November 2005.

 

*Pooling.*  Four of the communities are subject to apooling arrangement whereby the calculation and payment of fees payable to SLSand our owner’s priority for these four communities are combined.

 

*Defaultsand termination.*  TheSLS management agreements contain various default and termination provisions.Our right to exercise termination options under the SLS management agreementsis subject to approval by Senior Housing under the terms of the lease for thesecommunities.

 

21

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**Item 3.    Legal Proceedings**

** **

In the ordinary course of business we are involved inlitigation incidental to our business; however, we are not aware of anymaterial 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.**

** **

**22**

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** **

**PART II**

** **

**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**   | ** ** |
|-----------------|------------|------------|------------|------------|------------|
| 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       |       |
|            |       |       |       |       |       |
| 2005            | ** ** | ** ** | ** ** | ** ** | ** ** |
| First  Quarter  |       | $          | 6.80       |       | $          | 9.19 |   |
| Second  Quarter |       | 5.60       |       | 8.65       |       |
| Third  Quarter  |       | 6.75       |       | 9.09       |       |
| Fourth  Quarter |       | 6.02       |       | 7.98       |       |

 

The closing price of our common shares on the AMEX on March 10,2006, was $11.23 per share.

 

As of March 10, 2006, there were 60,000 recordholders of our common shares, and we estimate that as of such date there wereapproximately 3,500 beneficial owners of our common shares.

 

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

 

23

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**Item 6.    Selected Financial Data**

 

Set forth below is selected financial data for theperiods and dates indicated. The following data should be read in conjunctionwith, 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. 

 
| ** **                                    | ** ** | **Year ended December 31,**          | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| Operating data:                               | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                                |       | $                                         | 757,527    |   | $ | 620,014 |   | $ | 567,465 |   | $ | 509,191 |   | $ | 211,545 |   |
| Net (loss) income from continuing  operations |       | (81,247                                   | )          | 5,685 |   | (5,559 | ) | (8,673 | ) | 1,487 |   |
| Net loss from discontinued operations         |       | (2,912                                    | )          | (2,394 | ) | (2,380 | ) | (4,501 | ) | (960 | ) |
| Net income (loss)                             |       | $                                         | (84,159    | ) | $ | 3,291 |   | $ | (7,939 | ) | $ | (13,174 | ) | $ | 527 |   |
| Net (loss)  income per share:                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| (Loss) income from continuing operations      |       | $                                         | (5.46      | ) | $ | 0.65 |   | $ | (0.66 | ) | $ | (1.14 | ) | $ | 0.34 |   |
| Loss from discontinued operations             |       | (0.20                                     | )          | (0.27 | ) | (0.28 | ) | (0.60 | ) | (0.22 | ) |
| Net (loss) income                             |       | $                                         | (5.66      | ) | $ | 0.38 |   | $ | (0.94 | ) | $ | (1.74 | ) | $ | 0.12 |   |
| Balance  sheet data (as of December 31): | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets                                  |       | $                                         | 228,940    |   | $ | 222,985 |   | $ | 147,370 |   | $ | 133,197 |   | $ | 68,043 |   |
| Total indebtedness                            |       | 45,329                                    |       | 42,581 |   | 10,435 |   | 16,123 |   | — |   |
| Other long term obligations                   |       | 25,465                                    |       | 18,065 |   | 18,417 |   | 17,723 |   | — |   |
| Total shareholders’ equity               |       | $                                         | 68,804     |   | $ | 95,904 |   | $ | 64,427 |   | $ | 65,047 |   | $ | 50,233 |   |

 

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

** **

**GENERAL INDUSTRYTRENDS**

** **

The senior living industry is experiencinggrowth as a result of demographic changes and various other factors.  According to census data, the population inthe United States over age 75 is growing much faster than the generalpopulation.  As a general rule, economicfactors that affect seniors will have a corresponding impact on the seniorliving industry.  For example, thecontinuing strength of the home resale market in most areas of the country hasbeen beneficial to seniors, since the equity from the sale of a home is asignificant source of funding for senior living care for many people.

 

A large number of independent and assistedliving communities were built in the 1990s. This development activity caused an excess supply of new, high pricedcommunities.  Longer than projected fillup periods resulted in low occupancy, price discounting and financial distressfor many independent and assisted living operators.  Development activity was significantlyreduced in the early part of this decade. We believe that the supply and demand for these types of facilities istoday nationwide about balanced.  Webelieve that the aging of the U.S. population and the almost complete relianceof independent and assisted living services upon revenues from residents’private pay resources should mean that these types of facilities can beprofitably operated for the foreseeable future. However, it appears to us that today some investors may be assuming thatthe improvements in financial results realized at these types of communitiesduring the past few years may continue indefinitely.  The reported sales price being paid today forsome independent and assisted living communities seem to exceed replacementcost, including fill up losses.  We areconcerned that new development activity may occur in the near future, and it iscurrently unclear whether this activity will result in excess or moderate newsupply which can be absorbed without adversely affecting existing marketconditions.

 

The increasing availability of assistedliving facilities in 1990s caused occupancy at many nursing homes todecline.  This fact, together withrestrictions on development of new nursing homes by most states, has causednursing care to be delivered in many older facilities.  We believe that many nursing homes currentlyin operation are becoming physically obsolete and that eventually politicalpressures from an aging population will cause governmental authorities topermit increased new construction.  Wehave made special efforts at our nursing homes to maintain the physical plantsso that we can continue to compete.

 

24

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Institutional pharmacies provide largequantities of drugs at locations where patients with recurring pharmacyrequirements are concentrated.  Thebusiness rationale for an institution pharmacy is to deliver drugs and pharmacyservices more efficiently and at lower costs than from expensive retaillocations which cater to short term requirements.  The aging of the population and recentpharmacological innovations have created rapidly growing demand for pharmacydrugs and services.  We believe that theMedicare D benefits program which became effective January 1, 2006 willincrease the demand for pharmacy drugs and services and that cost containmentpressures, which inevitably will be part of this government funded program,will increase business for efficient institutional pharmacy businesses such asthose we have recently begun to operate.

 

We earn our revenues primarily by providinghousing and services to our residents. During 2005, approximately 36% of our net revenues from residents camefrom Medicare and Medicaid and 64% of our net revenues from residents came fromprivate pay and other resources.  Allprivate pay residents are billed in advance for the next month’s housing andcare.

 

Our most significant expenses are:

 

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

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

•                  Rent expense –we lease 135 of our 153 senior living communities from Senior Housing and fourfrom HCPI.

•                  Management feeto SLS – fees for the 17 communities SLS manages for us (30 prior to November 1,2005).

•                  General andadministrative expenses – principally wage related costs for headquarters andregional staff supporting our communities.

•                  Depreciation andamortization expense – we incur depreciation expense on buildings and furnitureand equipment.

•                  Interest expense– includes interest on outstanding debt balances and amortization of deferredfinancing costs.

 

The following informationshould be read in conjunction with the consolidated financial statementsincluded in this Annual Report on Form 10-K.

 

**Yearended December 31, 2005 versus year ended December 31, 2004**

 

The following tablespresent an overview of our portfolio for the years ended December 31, 2005and 2004:

 
| ** **                                                             | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands, except per day amounts)**                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **$ ****Variance** | ** ** | **Change** | ** ** |
| Net revenues  from residents                                           |       | $                                         | 724,051    |   | $ | 606,805 |   | $ | 117,246 |   | 19 | % |
| Pharmacy  revenue                                                      |       | 33,476                                    |       | 13,209 |   | 20,267 |   | 153 | % |
| Wages and  benefits                                                    |       | 376,061                                   |       | 319,580 |   | 56,481 |   | 18 | % |
| Other  operating expenses                                              |       | 183,891                                   |       | 157,495 |   | 26,396 |   | 17 | % |
| Pharmacy  expenses                                                     |       | 32,167                                    |       | 12,093 |   | 20,074 |   | 166 | % |
| Management  fee to SLS                                                 |       | 21,256                                    |       | 19,293 |   | 1,963 |   | 10 | % |
| Termination  expense for certain SLS management agreements             |       | 86,286                                    |       | — |   | 86,286 |   | — |   |
| Rent expense                                                           |       | 99,691                                    |       | 83,235 |   | 16,456 |   | 20 | % |
| General and  administrative                                            |       | 27,775                                    |       | 19,635 |   | 8,140 |   | 41 | % |
| Depreciation and amortization                                          |       | 7,114                                     |       | 3,372 |   | 3,742 |   | 111 | % |
| Impairment of assets                                                   |       | 2,333                                     |       | — |   | 2,333 |   | — |   |
| Interest and other income                                              |       | 1,543                                     |       | 1,666 |   | (123 | ) | -7 | % |
| Interest expense                                                       |       | 3,743                                     |       | 1,172 |   | 2,571 |   | 219 | % |
| Provision for income taxes                                             |       | —                                    |       | 120 |   | (120 | ) | — |   |
| Loss from discontinued operations                                      |       | (2,912                                    | )          | (2,394 | ) | (518 | ) | 22 | % |
| Net (loss) income                                                      |       | (84,159                                   | )          | 3,291 |   | (87,450 | ) | — |   |
|                                                                   |       |                                      |       |   |   |   |   |   |   |
| No. of communities (end of period)                                |       | 153                                       |       | 146 |   | — |   | 7 |   |
| No. of living units (end of period)                               |       | 17,110                                    |       | 16,354 |   | — |   | 756 |   |
| Occupancy                                                              |       | 90                                        | %          | 89 | % | — |   | 1 | % |
| Average daily rate                                                     |       | $                                         | 129        |   | $ | 114 |   | 15 |   | 13 | % |
| Percent of net revenues from residents from  Medicare                  |       | 15                                        | %          | 18 | % | — |   | -3 | % |
| Percent of net revenues from residents from  Medicaid                  |       | 21                                        | %          | 24 | % | — |   | -3 | % |
| Percent of net revenues from residents from  private and other sources |       | 64                                        | %          | 58 | % | — |   | 6 | % |
|                                                                        |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

25

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ComparableCommunities (communities that we operated continuously since January 1,2004):

 
| ** **                                                             | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands, except per day amounts)**                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
| Net revenues from residents                                            |       | $                                         | 628,127    |   | $ | 597,142 |   | $ | 30,985 |   | 5 | % |
| Community expenses                                                     |       | 491,952                                   |       | 469,481 |   | 22,471 |   | 5 | % |
| No. of communities (end of period)                                |       | 99                                        |       | 99 |   | — |   | — |   |
| No. of living units (end of period)                               |       | 13,710                                    |       | 13,710 |   | — |   | — |   |
| Occupancy                                                              |       | 90                                        | %          | 90 | % | — |   | — |   |
| Average daily rate                                                     |       | $                                         | 139        |   | $ | 133 |   | 6 |   | 5 | % |
| Percent of net revenues from residents from  Medicare                  |       | 17                                        | %          | 18 | % | — |   | -1 | % |
| Percent of net revenues from residents from  Medicaid                  |       | 25                                        | %          | 25 | % | — |   | — |   |
| Percent of net revenues from residents from  private and other sources |       | 58                                        | %          | 57 | % | — |   | 1 | % |
|                                                                        |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

The 19% increase in net revenues from residents is dueprimarily to revenues from the 47 communities we acquired in November 2004,the six communities we acquired in June 2005, higher per diem charges toresidents and a 1% increase in occupancy. The 5% increase in net revenues from residents at the communities thatwe have operated continuously since January 1, 2004 is due primarily to 5%higher per diem charges to residents. The increase in revenues from our pharmacies is a result of ouracquiring one pharmacy in September 2004 and another pharmacy in June 2005.

 

Our 18% increase in wages and benefits costs isprimarily due to wages and benefits at the 47 communities we acquired in November 2004,the six communities we acquired in June 2005 and wage increases.  The 17% increase in other operating expenses,which include utilities, housekeeping, dietary, maintenance, insurance andcommunity level administrative costs, primarily results from the otheroperating expenses at the 47 communities we acquired in November 2004, thesix communities we acquired in June 2005 and increased charges from thirdparties.  This increase is also theresult of approximately $1.4 million of additional insurance costs related tothe 30 communities managed for us by SLS in 2005.  The community expenses for the communitiesthat we have operated continuously since January 1, 2004 have increased by5% principally due to wage and benefit increases, as well as approximately $1.4million of additional insurance costs related to the 30 communities managed forus by SLS in 2005.  The increase inpharmacy expenses is a result of our acquiring one pharmacy in September 2004and another pharmacy in June 2005. Management fees related to the 30 communities that SLS managed for usincreased by 10% because of increased revenues at these communities and acontractual increase in the formula for calculating the management fee.

 

26

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The 20% rent expense increaseis due to the addition of communities that we began to lease in 2004 and 2005,and our payment of additional rent for capital improvements purchased by SeniorHousing since January 1, 2004.

 

The termination expense for certain SLS managementagreements arose from our termination of management agreements for 13 of the 30senior living communities that SLS managed for us.  In August 2005, we notified SLS of thetermination of management agreements for 12 senior living communities, and, in November 2005,we terminated these SLS management agreements for a payment of $81.5million.  In February 2006, weterminated the management agreement for one additional community for a paymentof $4.8 million.  We sent a terminationnotice to SLS for this community in December 2005, and therefore accountedfor this termination in 2005.  We will nolonger pay management fees for these communities to SLS, and we are directlyoperating these communities.  SLScontinues to manage 17 communities for us.

 

The 41% increase in general and administrativeexpenses for the year ended December 31, 2005 primarily results from ourincreased operations at the 47 communities we acquired in November 2004,the six communities we acquired in June 2005, integration costs associatedwith our acquisition of those communities and increased audit and professionalservices fees for compliance with Sarbanes-Oxley.

 

The 111% increase in depreciation and amortization forthe year ended December 31, 2005 is primarily attributable to the 47communities we acquired in connection with the LTA acquisition in November 2004and the six communities we acquired in June 2005 and to our purchase offurniture and fixtures for our communities managed by SLS.

 

To partially fund our termination fee for the 12management agreements with SLS on November 1, 2005, we sold the six Gordoncommunities that we acquired in June 2005 to Senior Housing for netproceeds of $56.7 million and Senior Housing leased these communities back tous.  In connection with this sale ofthese communities to Senior Housing, we recognized a $2.3 million impairmentcharge to reduce the carrying value of these communities to the amount realizedupon their sale to Senior Housing.  Thepurchase price paid to us by Senior Housing is the same amount as the purchaseprice we paid to the seller of the Gordon communities.  The impairment loss which we recognizedrelates principally to transaction costs which we previously capitalized.

 

Our interest and other income decreased primarilybecause of lower levels of investable cash.

 

Our interest expense increased by $2.6 million,primarily due to the mortgages we assumed in connection with the LTAacquisition and mortgages assumed in connection with our acquisition of the sixGordon communities in June 2005.

 

The provision for income taxes decreased because we donot anticipate owing tax under the alternative minimum tax regime in 2005.  We accrued $120,000 of federal alternativeminimum income tax expense during the year ended December 31, 2004.

 

Loss from discontinued operations for the year ended December 31,2005 was $2.9 million, compared to a loss of $2.4 million for the year ended December 31,2004.  These losses in both years areprimarily the result of our ceasing operations at two communities in 2005 andthree communities in 2004.

 

27

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

 

The following tablespresent an overview of our portfolio for the years ended December 31, 2004and 2003:

 
| ** **                                                             | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands, except per day amounts)**                    | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
| Net revenues  from residents                                           |       | $                                         | 606,805    |   | $ | 565,695 |   | $ | 41,110 |   | 7 | % |
| Pharmacy  revenue                                                      |       | 13,209                                    |       | 1,770 |   | 11,439 |   | 646 | % |
| Wages and  benefits                                                    |       | 319,580                                   |       | 311,975 |   | 7,605 |   | 2 | % |
| Other  operating expenses                                              |       | 157,495                                   |       | 145,272 |   | 12,223 |   | 8 | % |
| Pharmacy  expenses                                                     |       | 12,093                                    |       | 1,666 |   | 10,427 |   | 626 | % |
| Management  fee to SLS                                                 |       | 19,293                                    |       | 17,272 |   | 2,021 |   | 12 | % |
| Rent expense                                                           |       | 83,235                                    |       | 77,280 |   | 5,955 |   | 8 | % |
| General and  administrative                                            |       | 19,635                                    |       | 15,073 |   | 4,562 |   | 30 | % |
| Depreciation  and amortization                                         |       | 3,372                                     |       | 3,276 |   | 96 |   | 3 | % |
| Interest and  other income                                             |       | 1,666                                     |       | 229 |   | 1,437 |   | 628 | % |
| Interest  expense                                                      |       | 1,172                                     |       | 1,439 |   | (267 | ) | -19 | % |
| Provision  for income taxes                                            |       | 120                                       |       | — |   | 120 |   | — |   |
| Loss from  discontinued operations                                     |       | (2,394                                    | )          | (2,380 | ) | (14 | ) | -1 | % |
| Net income (loss)                                                      |       | 3,291                                     |       | (7,939 | ) | 11,230 |   | 141 | % |
|                                                                   |       |                                      |       |   |   |   |   |   |   |
| No. of  communities (end of period)                               |       | 146                                       |       | 98 |   | — |   | 48 |   |
| No. of  living units (end of period)                              |       | 16,354                                    |       | 13,705 |   | — |   | 2,649 |   |
| Occupancy                                                              |       | 89                                        | %          | 89 | % | — |   | — |   |
| Average  daily rate                                                    |       | $                                         | 114        |   | $ | 127 |   | -13 |   | -10 | % |
| Percent of  net revenues from residents from Medicare                  |       | 18                                        | %          | 14 | % | — |   | 4 | % |
| Percent of  net revenues from residents from Medicaid                  |       | 24                                        | %          | 26 | % | — |   | -2 | % |
| Percent of net revenues from residents from  private and other sources |       | 58                                        | %          | 60 | % | — |   | -2 | % |
|                                                                        |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

 
| ** **                                                             | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands, except per day amounts)**                    | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **$ ****Variance** | ** ** | **Change** | ** ** |
| Net revenues  from residents                                           |       | $                                         | 600,041    |   | $ | 563,550 |   | $ | 36,491 |   | 6 | % |
| Community  expenses                                                    |       | 471,398                                   |       | 455,399 |   | 15,999 |   | 4 | % |
| No. of  communities (end of period)                               |       | 95                                        |       | 95 |   | — |   | — |   |
| No. of  living units (end of period)                              |       | 13,470                                    |       | 13,470 |   | — |   | — |   |
| Occupancy                                                              |       | 90                                        | %          | 89 | % | — |   | 1 | % |
| Average  daily rate                                                    |       | $                                         | 136        |   | $ | 129 |   | 7 |   | 5 | % |
| Percent of  net revenues from residents from Medicare                  |       | 17                                        | %          | 14 | % | — |   | 3 | % |
| Percent of  net revenues from residents from Medicaid                  |       | 25                                        | %          | 26 | % | — |   | -1 | % |
| Percent of net revenues from residents 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 2004and 47 communities in November 2004. The 6% increase in net revenues from residents at the communities thatwe have operated continuously since January 1, 2003 is due primarily to 5%higher per diem charges to residents and a 1% increase in occupancy.  The increase in revenues from our twopharmacies is a result of our acquiring these pharmacies during the thirdquarters of 2003 and 2004.

 

Our 2% 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 tooperate in May 2004 and the 47 communities we acquired in November 2004.  The 8% 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 in May 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 4% 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 

 

28

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began to lease in 2003 and 2004,and our payment of additional rent for capital improvements which were fundedby Senior Housing since January 1, 2003.

 

The 30% 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 3% increase in depreciation expense for the yearended December 31, 2004 is primarily attributable to our purchase offurniture and fixtures related to the communities managed by SLS and ouracquisition of 47 communities as a result of the LTA acquisition in November 2004,offset by our 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 January 2004settlement with Marriott and MSLS, whereby we and Senior Housing were each paid$1.3 million.  Under the terms of thesettlement, we and Senior Housing, and Marriott and MSLS, agreed to dismiss allclaims 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 isno provision for regular income taxes because we have net operating loss carryforwards.

 

Loss from discontinuedoperations for each of the years ended December 31, 2004 and 2003 was $2.4million.  These losses are primarily theresult of our ceasing operations at three communities in 2004 and ninecommunities in 2003.

 

**LIQUIDITY ANDCAPITAL RESOURCES**

** **

Our current assets at December 31, 2005were $94.9 million, compared to $95.7 million at December 31,2004.  At December 31, 2005 and2004, we had cash and cash equivalents of $16.7 million and$30.9 million, respectively.  Thisdecrease in cash and cash equivalents is primarily the result of the increasein accounts receivable due to increased activity.  Our current liabilities were $90.0 million atDecember 31, 2005, compared to $66.9 million at December 31,2004.  The increase in currentliabilities is primarily the result of an increase in insurance reserves andthe SLS termination fee payable for the community we terminated in February 2006.  Current liabilities also increased from ourexpanded operations which resulted from the Gordon acquisition in June 2005.

 

Reclassifications have been made to the prior years’ financialstatements to conform to the current year’s presentation, including areclassification of the refundable portion of resident admission fees atcertain communities, which had been presented as a long-term liability in 2004,to a current liability, and a reclassification of the related restricted casharising from such fees, which had been presented as a long term asset in 2004,to a current asset.

 

We lease 135 communities from Senior Housingunder four leases.  Our leases withSenior Housing require us to pay minimum rent of $103.5 million annuallyand percentage rent for most communities beginning in 2006.  We believe we are in compliance with theterms of our leases with Senior Housing.

 

Upon our request, Senior Housing reimbursesour capital expenditures made at the communities we lease from Senior Housingand increases our rent pursuant to contractual formulas.  Senior Housing reimbursed us $15.5 millionduring the year ended December 31, 2005 for capital expenditures made atthese leased communities and increased our annual rent by approximately $1.5million.

 

Our revenues from services to residents atour communities are our primary source of cash to fund our operating expenses,including rent, principal and interest payments on our debt and our capitalexpenditures.  At some of ourcommunities, operating revenues for nursing home services are received from theMedicare and Medicaid programs.  Medicareand Medicaid revenues were earned primarily at our 52 nursing homes.  For the years ended December 31, 2005and 2004, respectively, 36% and 41% of our net revenues from residents werederived from these programs.

 

Our Medicare net revenues from residentstotaled $110.1 million and $99.5 million for the years ended December 31, 2005 and 2004,respectively.  In each of October 2005and 2004, our Medicare rates increased by

 

 

29

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approximately 3% over the prior period. Our increase in Medicare revenues from 2004 to 2005 and from 2003 to2004 resulted from this rate increase and an increase in the number ofresidents at our facilities who were eligible for Medicare.  Effective January 1, 2006, CMSimplemented changes to the payment categories it uses to set daily paymentrates for Medicare beneficiaries in skilled nursing facilities.  These categories are known as ResourceUtilization Groups, or RUGs.  CMS hasintroduced nine new payment categories for medically complex patients,increasing the number of categories from 44 to 53, and has made revisions toits payment rates for current RUGs.  Alsoeffective January 1, 2006, these RUG changes eliminated certain temporaryadditional payments for certain skilled nursing care and rehabilitationgroups.  We are currently unable topredict the financial impact on our operations of these changes to Medicarerates.

 

Our Medicaid net revenues from residentstotaled $153.2 million and $149.2 million for the years ended December 31, 2005 and 2004,respectively.  The Bush administrationand certain members of the Senate and the House of Representatives haverecently proposed Medicare and Medicaid policy changes and rate reductions tobe phased in during the next several years. In addition, some of the states in which we operate either have notraised Medicaid rates by amounts sufficient to offset increasing costs or areexpected to reduce Medicaid funding.  Themagnitude of the potential Medicaid rate reductions and the impact of thefailure of these programs to increase rates to match increasing expenses, aswell as the magnitude of the potential Medicaid policy changes, cannotcurrently be estimated, but they may be material to our operations, may affectour future results of operations and may produce losses.

 

We have recently agreed to lease tworehabilitation hospitals that we expect to begin operating in 2006.  A significant amount of the revenues at thesehospitals is paid by Medicare.  When webegin to operate these hospitals, we will become more dependent upon theMedicare programs.  Also, the January 1,2006 effective date for Medicare drug benefits means that our pharmacyoperations are becoming more dependent upon the Medicare program.

 

Recent increases in the costs of insurance,especially tort liability insurance, workers compensation and employee healthinsurance, which is affecting the senior living industry, may continue to havean adverse impact upon our future results of operations.  Although we self insure a portion of thesecosts, some of our insurance reserves may also increase.

 

Our revolving credit facility limits ourability to incur debt, as more fully described below in “Debt Instruments andCovenants”.  The terms of our leases withSenior Housing contain provisions whereby Senior Housing may cancel our rightsunder these agreements upon the acquisition by any person or group of more than9.8% of our voting stock and upon other “change of control” events.  These leases also limit our ability tocreate, incur, assume or guarantee indebtedness.

 

During 2003, Senior Housing agreed to sell ustwo nursing homes in Michigan that we leased from Senior Housing. The purchaseprice was $10.5 million, the appraised value of the properties.  In April 2004, we purchased the first ofthese two properties from Senior Housing for $5.9 million.  In May 2005, we purchased the secondproperty for $4.6 million.  We financedthese two acquisitions with proceeds we received from two new HUD insured mortgagesand by using cash on hand.  Under theterms of our lease with Senior Housing, the annual rent payable under the leasewas reduced by 10% of the prices we paid to Senior Housing for the two nursinghomes.

 

In November 2004, we acquired 100% ofthe capital stock of LTA for approximately $211 million, excluding closingcosts.  LTA owned, leased and operated 47senior living communities with 2,636 living units, which primarily offerassisted living services, located in seven states.  All of the revenues at these communities arepaid by residents from their private resources. We acquired LTA because its business complemented our business strategyof focusing our operations in high quality senior living assets where residentspay for our services with private resources. To finance this acquisition, we entered into a $148.2 million saleleaseback transaction with Senior Housing for 31 of the communities acquiredfrom LTA.  We also entered a$16.8 million mortgage loan with Senior Housing secured by five of ourproperties.  We funded the balance of thepurchase price with cash on hand and by assuming HUD insured long term mortgagedebt and an operating lease for four communities from HCPI.

 

In December 2004 and January 2005, we issued a total of 3,620,000 common shares in an underwritten public offering for net proceeds of $28.8 million.  We used a portion of the proceeds raised in this offering to pay off the $16.8 million mortgage loan with Senior Housing described above, and we added the remainder to available cash balances.

 

30

 

In March 2005, we acquired a 62 unitassisted living community located in Georgia for approximately $6.9million.  We financed the acquisitionwith cash on hand.

 

In June 2005, we acquired six assistedliving communities from Gordon for approximately $59.0 million.  These communities have a combined licensedresident capacity of 654 and are located in western Pennsylvania.  We funded this purchase using $10.0 milliondrawn under our revolving credit facility, the proceeds of a sale leasebacktransaction and a mortgage transaction with Senior Housing.  We sold four different assisted livingcommunities to Senior Housing for $24.0 million and Senior Housing leased thesecommunities back to us for initial rent of $2.2 million per annum.  Senior Housing also provided us with a $43.5million first mortgage line of credit secured by the six Gordoncommunities.  We borrowed $24.0 millionunder the first mortgage line of credit when we closed the Gordon purchase andrepaid it in August 2005 with proceeds raised from our sale of commonshares.  The mortgage line of credit wasterminated in connection with the sale and leaseback of the six Gordoncommunities with Senior Housing on October 31, 2005.

 

In August and September 2005, weissued a total of 7,750,000 common shares in an underwritten public offeringfor net proceeds of $55.6 million.  Weused the proceeds raised in this offering to pay off the $24.0 million mortgageline of credit with Senior Housing described above and to reduce amountsoutstanding under our revolving credit facility, and we added the remainder toavailable cash balances.

 

We issued 84,300 and 83,000 common shares toour directors, officers and others who provide services to us in 2005 and 2004,respectively.

 

In August 2005, we sent notices to SLSto terminate management agreements for 12 of the 30 senior living communitiesthat SLS managed for us.  In November 2005,we terminated the SLS management agreements for these 12 communities for a feeof $81.5 million and we began to directly operate these communities.  We no longer pay management fees for thesecommunities to SLS.  We funded this terminationpayment with cash on hand, including the proceeds of our sale of common sharesin August and September 2005, and with the proceeds of a saleleaseback transaction with Senior Housing for the six communities we acquiredin June 2005 from Gordon.  We soldthe six Gordon communities to Senior Housing for net proceeds of $56.7 millionand Senior Housing leased these communities back to us.  Our initial rent to Senior Housing for thesecommunities is $5.2 million per annum. The purchase price paid to us by Senior Housing is the same amount asthe purchase price we paid to the seller of the Gordon communities.  In December 2005, we and SLS agreed toterminate the management agreement for one additional community.  In February 2006, we terminated thismanagement agreement for a payment of $4.8 million and we began to directlyoperate this community.  SLS continues tomanage 17 communities for us.

 

We believe that a combination of our efforts toincrease 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.

 

In December 2005,Senior Housing sold two of our communities where we had ceasedoperations.  Senior Housing sold one community located in Florida for netproceeds of approximately $5.4 million, which caused a $540,000 reduction inannual minimum rent payable to Senior Housing in accordance with our leaseterms.  SeniorHousing sold the other community located in California for net proceeds ofapproximately $2.6 million, which caused a $260,000 reduction in annual minimumrent payable to Senior Housing in accordance with our lease terms.

 

In February 2006, as discussed above, we assumedthe operations of a community from SLS which is located in Coral Springs,Florida.  We expect to undertake a significant capital improvement projectat this community in 2006 and 2007 that may total approximately $5.0million.  Pursuant to the terms of our lease with Senior Housing, SeniorHousing will fund the cost of this capital improvement project and our annualrent payable to Senior Housing will increase pursuant to the formula set forthin the lease.

 

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As of December 31, 2005, our contractualobligations 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** | ** ** |
| Debt  Obligations (1)                                                      |       | $                         | 45,329     |   | $ | 626 |   | $ | 1,199 |   | $ | 1,345 |   | $ | 42,159 |   |
| Operating  Lease Obligations (2)                                           |       | 1,370,464                 |       | 104,642 |   | 209,284 |   | 209,284 |   | 847,254 |   |
| Other Long  Term Liabilities Reflected on our Balance Sheet under GAAP (3) |       | 14,308                    |       | — |   | 11,570 |   | 2,738 |   | — |   |
| Total (4)                                                                  |       | $                         | 1,430,101  |   | $ | 105,268 |   | $ | 222,053 |   | $ | 213,367 |   | $ | 889,413 |   |

 

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(1)                                  DebtObligations are the amounts due under several HUD insured mortgages.

(2)                                  OperatingLease Obligations are the minimum lease payments to Senior Housing and HCPIthrough 2014 and 2020, the current lease terms. They do not include percentage rent that may be payable under theseleases.

(3)                                  OtherLong Term Liabilities Reflected on our Balance Sheet under GAAP are primarilyinsurance reserves related to workers compensation and professional liabilityinsurance.

(4)                                  Thistotal excludes the security deposits we may owe to residents, which total $4.7million at December 31, 2005.

 

**Debt Instrumentsand Covenants**

** **

In May 2005, we entered into a new revolvingcredit facility.  The interest rate onborrowings under this facility is LIBOR plus a premium.  The maximum amount available under this facilityis $25.0 million, and is subject to limitations based upon qualifyingcollateral.  We are the borrower underthe revolving credit facility and certain of our subsidiaries guarantee ourobligations under the facility.  Thefacility is secured by our and our guarantor subsidiaries’ accounts receivable,deposit accounts and related assets.  Thefacility is available for acquisitions, working capital and general businesspurposes.  The facility contains covenantsrequiring us to maintain collateral, minimum net worth and certain otherfinancial ratios, places limits on our ability to incur or assume debt orcreate liens with respect to certain of our properties and contains othercustomary provisions.  In certaincircumstances and subject to available collateral and lender approvals, themaximum amounts which we may draw under this credit facility may be increasedto $50.0 million. The termination date of the facility is May 9,2007.  The termination date may beextended twice, in each case by twelve months, subject to lender approval, ourpayment of extension fees and other conditions. As of December 31, 2005, no amounts were outstanding and, as of March 10,2006, $9.5 million was outstanding under this credit facility.  As of March 10, 2006, we believe we arein compliance with all applicable covenants under this revolving creditagreement.

 

At December 31, 2005, we have 11 HUD insuredmortgage loans totaling $45.3 million that are secured by nine properties.  The weighted average interest rate on theseloans is 7.0%.  Payments of principal andinterest are due monthly until maturities at varying dates ranging from February 2032to June 2039.  These mortgagescontain standard HUD mortgage covenants. At March 10, 2006, we believe we are in compliance with allcovenants of these mortgages.  Werecorded mortgage premiums in connection with some of these HUD mortgagestotaling $6.3 million in order to record assumed mortgages at their estimatedfair value.  The mortgage premiums arebeing amortized as a reduction of interest expense until the maturity of themortgages.

 

**Off Balance SheetArrangements**

** **

**As of December 31, 2005, wehad no off-balance sheet arrangements, commercial paper, derivatives, swaps,hedges, third party guarantees, or material joint ventures or partnerships.**

** **

**Related PartyTransactions**

** **

On December 31, 2001, Senior Housingdistributed substantially all of its ownership of our shares to itsshareholders.  In order to effect thisspin off and to govern relations after the spin off, we entered into agreementswith Senior Housing and others pursuant to which it was agreed, among otherthings, that:

 

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•                  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 the consent of Senior Housing;

•                  solong as we are a tenant of Senior Housing, we will not permit nor 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 spin off from SeniorHousing, all of the persons serving as our directors were trustees of SeniorHousing.  Our two managing directors, Messrs. Martinand Portnoy, are currently the managing trustees of Senior Housing.

 

Of the 153 senior living communities weoperate, 135 are leased from Senior Housing for total annual minimum rent of$103.5 million.

 

Since January 1, 2005, we have entered intoseveral transactions with Senior Housing, including:

 

•                  In May 2005, we purchased aproperty that we had leased from Senior Housing for its appraised value of $4.6million.  This purchase was funded withproceeds we received from a HUD insured mortgage and our cash on hand.

 

•                  In June 2005, we acquired sixassisted living communities from Gordon for approximately $59.0 million.  We funded this purchase using $10.0 milliondrawn under our revolving credit facility and the proceeds of a sale leasebackand mortgage transaction with Senior Housing. We sold four of our assisted living communities to Senior Housing for$24.0 million and Senior Housing leased these communities back to us forinitial rent of $2.2 million per annum. Senior Housing also provided us with a $43.5 million first mortgage lineof credit secured by the six Gordon communities.  We borrowed $24.0 million under the firstmortgage line of credit when we closed the Gordon purchase, and repaid thisamount in August 2005 with proceeds from our sale of common shares.  The mortgage line of credit was terminated inOctober 2005 in connection with our sale and leaseback with Senior Housingfor the six Gordon communities.  SeniorHousing paid us approximately $59.0 million for these six communities.  Our initial rent to Senior Housing for thesesix communities is $5.2 million per annum.

 

•                  During2005, as permitted by our leases with Senior Housing, we sold to SeniorHousing, at cost, approximately $15.5 million of improvements made toproperties leased from Senior Housing, and the annual rent payable to SeniorHousing was increased by 10% of the amount Senior Housing paid for theimprovements, or approximately $1.5 million.

 

•                  In February 2006, weagreed to lease two hospitals from Senior Housing.  The term of the lease for these two hospitalscommences when we receive all health regulatory approvals required to operatethe two hospitals.  These two hospitalsprovide health rehabilitation services and are located in Braintree and Woburn,Massachusetts.  The hospitals are currently owned by SeniorHousing but operated by HealthSouth. Recently, the Massachusetts Superior Court has decided that SeniorHousing validly terminated HealthSouth’s lease and ordered HealthSouth tocooperate in the transfer of the hospitals’ operations to a new tenantdesignated by Senior Housing. HealthSouth has appealed these decisions, but the trial court and theappeals court have both denied HealthSouth’s requests to stay these decisions untilthe appeal is decided.

 

Our Chief Executive Officer and ChiefFinancial Officer are also officers and employees of RMR. These officers devotea substantial majority of their business time to our affairs and the remainderto RMR’s business which is separate from our business. We believe the compensationwe pay to these officers reasonably reflects their division of business time;however, periodically, these individuals may divide their business timedifferently than they do currently and their compensation from us may becomedisproportionate to this division.

 

RMR provides management and administrativeservices to us under a shared services agreement. RMR is compensated at anannual rate equal to 0.6% of our total revenues. Aggregate fees earned by RMRfor services during 2005, 2004 and 2003, were $4.7 million,$3.7 million and $3.4 million, respectively. RMR also provides theinternal audit function for us and for other publicly owned companies to whichit provides management services.  We paya proportionate 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

 

33

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responsibilities to other entities, including one of our landlords,Senior Housing, could create conflicts; and in the event of such conflictsbetween Senior Housing and us, the shared services agreement allows RMR to acton behalf of Senior Housing rather than on our behalf.  Prior to October 1, 2005, RMR wasbeneficially owned by Messrs. Barry M. Portnoy and Gerard M. Martin, each amanaging director and member of our board of directors. Effective October 1,2005, Messrs. Barry M. Portnoy and his son, Adam D. Portnoy, acquired Mr.Martin’s beneficial ownership interest in RMR. Mr. Adam D. Portnoy is anexecutive officer of RMR and the Executive Vice President of HRPT. Mr. Martinremains a director of RMR and, together with Mr. Barry M. Portnoy, continues toserve as one of our managing directors. All transactions between us and RMR are approved by our independentdirectors.

 

Mr. Barry M. Portnoy is the majorityowner of the building in which our headquarters is located.  This lease expires in 2011. We paid rent,which includes our proportional share of utilities and real estate taxes, underthis lease during 2005, 2004 and 2003 of $711,000, $561,000 and $569,000,respectively.  This lease has beenamended at various times to take into account our needs for increasing spaceand all amendments to this lease have been approved by our independentdirectors.

 

**CriticalAccounting Policies**

** **

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

 

Our revenue recognition policies involve judgmentsabout Medicare and Medicaid rate calculations. These judgments are based principally upon our experience with theseprograms and our knowledge and familiarity with the current rules andregulations of these programs.  Werecognize revenues when services are provided and these amounts are reported attheir estimated net realizable amounts. Some Medicare and Medicaid revenues are subject to audit and retroactiveadjustment.

 

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

 

We regularly evaluate whether events or changes incircumstances have occurred that could indicate impairment in the value of longlived assets.  If there is an indicationthat the carrying value of an asset is not recoverable, we estimate theprojected undiscounted cash flows from the asset to determine if an impairmentloss should be recognized.  We determinethe amount of impairment loss by comparing the historical carrying value of theasset to its estimated fair value.  Wedetermine estimated fair value through an evaluation of recent financialperformance, recent sales of similar assets, market conditions and projecteddiscounted cash flows of properties using standard industry valuation techniques.  This process requires that estimates be madeand errors in our judgments or estimates could have a material effect on ourfinancial statements.

 

At two of our communities, we offer continuing carecontracts under which residents may pay admission fees in exchange for reducedcharges during their occupancy.  Thesefees may be refundable or non-refundable, or partially refundable and partiallynon-refundable.  We record these fees asobligations and amortize the non-refundable amounts into revenue over theactuarially determined remaining lives of the individual residents which arethe expected periods of occupancy. Actuarially determined remaining lives are estimates based upon generaldemographic samplings and averages.  Ourdecision to amortize the non-refundable fees over actuarially determined livesis based upon our estimates that these residents will remain at our facilitiesfor that period.  The actual remaininglives and the actual period of occupancy of the individual residents who paythe non-refundable fees may differ materially from these estimates.  In the future, if we find that suchdifferences are material, we may change the actuarial tables which we use andwe may change our estimates that these residents will remain at our facilitiesfor these periods; and these changes could have a material impact upon ourfinancial statements.

 

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.

 

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Determining reserves for the self insurance portionsof our insurance programs involve significant judgments based upon ourexperience, including projected settlements for pending claims, known incidentswhich we expect may result in claims, estimates of incurred but not yetreported claims, claims experience, estimated litigation costs and otherfactors.  We also periodically receiveand rely upon recommendations from professional consultants in establishingthese reserves; however, these reserves may prove to be materially inaccurate.

 

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 andDeflation**

** **

Inflation in the past several years in the U.S. hasbeen modest.  Future inflation might haveeither positive or negative impacts on our business.  Rising price levels may allow us to increaseoccupancy charges to residents, but may also cause our operating costs,including our percentage rent, to increase. Also our ability to increase rates paid by Medicare and Medicaid will belimited despite inflation.

 

Deflation would likelyhave a negative impact upon us.  A largecomponent of our expenses consists of minimum rental obligations to SeniorHousing and HCPI.  Accordingly we believethat a general decline in price levels which could cause our charges to residentsto decline would likely not be fully offset by a decline in our expenses.

 

**Seasonality**

 

Our business is subject to modest effects ofseasonality.  During the calendar fourthquarter holiday periods, nursing home and assisted living residents are sometimesdischarged to join family celebrations and admission decisions are oftendeferred. The first quarter of each calendar year usually coincides withincreased illness among nursing home and assisted living residents which canresult in increased costs or discharges to hospitals. As a result of thesefactors, nursing home and assisted living operations sometimes produce greaterearnings in the second and third quarters of a calendar year and lesserearnings in the first and fourth quarters. We do not believe that thisseasonality will cause fluctuations in our revenues or operating cash flow tosuch an extent that we will have difficulty paying our expenses, includingrent, which do not fluctuate seasonally.

 

**Item7A.  Quantitative and Qualitative DisclosuresAbout Market Risk**

** **

We are exposed to risks associated with market changesin interest rates.  We manage ourexposure to this market risk through our monitoring of available financingalternatives.  Our strategy to manageexposure to changes in interest rates remain unchanged since December 31,2004.  Other than as described below wedo not now anticipate any significant changes in our exposure to fluctuationsin interest rates or in how we manage this risk in the future.

 

Changes in market interest rates also affect the fairvalue of our debt obligations; increases in market interest rates decrease thefair value of our fixed rate debt, while decreases in market interest ratesincrease the fair value of our fixed rate debt.   For example: based upon discounted cash flowanalysis, if prevailing interest rates were to decline by 10% and other creditmarket considerations remained unchanged, the market value of our $45.3 millionmortgage debt outstanding on December 31, 2005, would increase by about$3.1 million; and, similarly, if prevailing interest rates were to increase by10%, the market value of our $45.3 million mortgage debt would decline by about$2.8 million.

 

Our revolving creditfacility bears interest at floating rates and matures in May 2007.  As of December 31, 2005, no amounts wereoutstanding and, as of March 10, 2006, $9.5 million was outstanding underthis credit facility.  We borrow in U.S.dollars and borrowings under our revolving credit facility bear interest atLIBOR plus a premium.  Accordingly, weare vulnerable to changes in U.S. dollar based short term rates, specificallyLIBOR.  A change in interest rates wouldnot affect the value of any outstanding floating rate debt but could affect ouroperating results.  For example, if themaximum amount of $25.0 million were drawn under our credit facility andinterest rates decreased or increased by 1% per annum, our interest expensewould decrease or increase by $250,000 per year, or $0.02 per share,

 

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based on currently outstanding common shares.  If interest rates were to change graduallyover time, the impact would occur over time.

 

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

 

**Item8. Financial Statements and Supplementary Data**

** **

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

 

**Item9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure**

** **

None.

 

**Item9A.  Controls and Procedures**

** **

As of the end of the period covered by this report,our management carried out an evaluation, under the supervision and with theparticipation of our President and Chief Executive Officer and our Treasurerand Chief Financial Officer, of the effectiveness of our disclosure controlsand procedures pursuant to Rules 13a-15 and 15d-15 of the ExchangeAct.  Based upon that evaluation, ourPresident and Chief Executive Officer and our Treasurer and Chief FinancialOfficer concluded that our disclosure controls and procedures are effective.

 

There have been nochanges in our internal control over financial reporting during the quarterended December 31, 2005 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**ManagementReport on Assessment of Internal Control Over Financial Reporting**

 

We are responsible for establishing and maintaining adequate internalcontrol over financial reporting. Our internal control system is designed toprovide reasonable assurance to our management and board of directors regardingthe preparation and fair presentation of published financial statements. Allinternal control systems, no matter how well designed, have inherentlimitations. Therefore, even those systems determined to be effective canprovide only reasonable assurance with respect to financial statementpreparation and presentation.

 

Our management assessed the effectiveness of our internal control overfinancial reporting as of December 31, 2005. In making this assessment, itused the criteria set forth by the Committee of Sponsoring Organizations of theTreadway Commission in *InternalControl-Integrated Framework*. Based on our assessment, we believe that,as of December 31, 2005, our internal control over financial reporting iseffective.

 

Ernst & YoungLLP, the independent registered public accounting firm that audited our 2005consolidated financial statements included in this Annual Report on Form 10-K,has issued an attestation report on our assessment of our internal control overfinancial reporting. Its report appears elsewhere herein.

** **

**Item 9B.  Other Information**

** **

**None.**

** **

**36**

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** **

**PART III**

 

**Item10.  Directors and Executive Officers ofthe Registrant**

 

In March 2004, we adopted a code ofbusiness conduct and ethics that applies to all our representatives, includingour officers and directors.  Our code ofbusiness conduct and ethics is posted on our website, www.5sqc.com.  A printed copy of our code of businessconduct and ethics is also available free of charge to any shareholder whorequests a copy.  We intend to discloseany amendments or waivers to our code of business conduct and ethics applicableto our principal executive officer, principal financial officer, principalaccounting officer or controller (or any person performing similar functions)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.

 

**Item11.  Executive Compensation**

 

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

 

**Item12.  Security Ownership of CertainBeneficial Owners and Management and Related Shareholder Matters**

 

Equity Compensation PlanInformation.  We maygrant options and common shares to our officers, directors, employees and otherindividuals who render services to us, subject to vesting requirements underour 2001 Stock Option and Stock Incentive Plan, or the Plan.  In addition, our directors receive 4,000shares per year each as part of their annual compensation for serving as ourdirectors and such shares may be awarded under the Plan.  The terms of grants made under the Plan aredetermined by our board of directors or a committee thereof at the time of thegrant.  The following table is as of December 31,2005.
| ** **                                                  | ** ** | **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                                                                                      |       | 416,700                                                                                                                                                       | (1)        |
| Equity  compensation plans not approved by security holders |       | None                                                                                                       |       | None                                                                                      |       | None                                                                                                                                                          |       |
| Total                                                       |       | None                                                                                                       |       | None                                                                                      |       | 416,700                                                                                                                                                       |       |

 

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(1) Pursuantto the terms of the Plan, in no event shall the number of shares issued exceed650,000.

 

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

 

**Item13.  Certain Relationships and RelatedTransactions**

 

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

 

**Item 14. Principal Accountant Fees and Schedules**

 

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

 

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**Item 15.  Exhibits and Financial Statement Schedules**

 

(a)  Index to Financial Statements

 
| **Consolidated Financial Statements of Five Star  Quality Care, Inc.**                                     | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                      | ** ** | ** ** |
| Reports of Independent Registered Public Accounting Firm                                                        |       |       |
|                                                                                                            |       |       |
| Consolidated  Balance Sheet at December 31, 2005 and 2004                                                  |       |       |
|                                                                                                            |       |       |
| Consolidated Statement of Operations for the years ended  December 31, 2005, 2004 and 2003                 |       |       |
|                                                                                                            |       |       |
| Consolidated  Statement of Shareholders’ Equity for the years ended December 31, 2005,  2004 and 2003 |       |       |
|                                                                                                            |       |       |
| Consolidated  Statement of Cash Flows for the years ended December 31, 2005, 2004 and  2003                |       |       |
|                                                                                                            |       |       |
| 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 the Company, dated February 22, 2002  and Second Amendment to Sale-Purchase Agreement among ILM II Senior  Living, Inc., ILM II Holding, Inc., and the Company, 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.)*                                                                                                                                                                                                                                                                                                                |

 

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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. (*Incorporated by reference to the Company’s Annual  Report on form 10-K for the year ended December 31, 2004*).                      |
| 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. (*Incorporated  by reference to the Company’s Annual Report on form 10-K for the year ended December 31,  2004*). |
| 2.10 |   | Second Amendment to Purchase and Sale  Agreement, dated as of May 13, 2005, by and among the Company, as  Purchaser, and Franciscan Manor Associates, LLC, Muirfield Associates, LLC,  Prestwicke Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates,  LLC and Turnberry Associates, LLC, as Sellers. *(Incorporated by reference to the Company’s Current Report on Form 8-K  dated June 3, 2005.)*      |
| 2.11 |   | Third Amendment to Purchase and Sale  Agreement, dated as of May 16, 2005, by and among the Company, as  Purchaser, and Franciscan Manor Associates, LLC, Muirfield Associates, LLC,  Prestwicke Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates,  LLC and Turnberry Associates, LLC, as Sellers. *(Incorporated by reference to the Company’s Current Report on Form 8-K  dated June 3, 2005.)*       |
| 2.12 |   | Fourth Amendment to Purchase and Sale Agreement,  dated as of May 25, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke  Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates, LLC and  Turnberry Associates, LLC, as Sellers. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated June 3,  2005.)*     |
| 2.13 |   | Fifth Amendment to Purchase and Sale  Agreement, dated as of May 27, 2005, by and among the Company, as  Purchaser, and Franciscan Manor Associates, LLC, Muirfield Associates, LLC,  Prestwicke Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates,  LLC and Turnberry Associates, LLC, as Sellers. *(Incorporated by reference to the Company’s Current Report on Form 8-K  dated June 3, 2005.)*       |
| 2.14 |   | Sixth Amendment to Purchase and Sale  Agreement, dated as of June 3, 2005, by and among the Company, as  Purchaser, and Franciscan Manor Associates, LLC, Muirfield Associates, LLC,  Prestwicke Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates,  LLC and Turnberry Associates, LLC, as Sellers. *(Incorporated by reference to the Company’s Current Report on Form 8-K  dated June 3, 2005.)*       |
| 2.15 |   | Purchase and Sale Agreement, dated as of June 3,  2005, by and among FSQ Crown Villa Business Trust, Morningside of Belmont,  LLC, Morningside of Greenwood, L.P. and Five Star Quality Care-GA, LLC, as  Sellers, and SNH CHS Properties Trust, SNH/LTA Properties Trust and SNH/LTA  Properties GA LLC, as Purchasers. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated June 3,  2005.)* |
| 2.16 |   | Purchase and Sale Agreement, dated as of October 31,  2005, by and among SNH/LTA Properties Trust, as Purchaser, and Five Star  Quality Care-GHV, LLC and Five Star Quality Care-MVSP, LLC, as Sellers. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated November 4, 2005.)*                                                                                                               |
| 3.1  |   | Composite copy of Articles of Amendment and  Restatement of the Company. (*Incorporated  by reference to the Company’s Current Report on form 8-K dated August 23,  2005*.)                                                                                                                                                                                                                                                        |
| 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*                                                                                                                                                                                                                                                                                                                                        |

 

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|        |   | *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.*)                                                                                                                                                                                                                                                 |
| 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*.)                                                                                                                                                           |

 

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| 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 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 |   | 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*.)                                                                                                                                                                                                                                                                                                |
| 10.24 |   | 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.)*                                                                                                                                                                                                                                                                                    |
| 10.25 |   | Second Amendment to Lease Agreement dated  as of September 30, 2003, by and between SNH CHS Properties Trust and  FVE-CHS LLC. *(Incorporated by reference to  the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30,  2003.)*                                                                                                                                                                                                                                                                        |
| 10.26 |   | 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*.)                                                                                                                                                                                                                                                           |
| 10.27 |   | 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*.)                                                                                                                                                                                                                |

 

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| 10.28        |   | 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*.)                                                                                                                                                                                                                                                                                                                                     |
|--------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.29        |   | 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*.)                                                                                                                                                                                                                                                                                                                                              |
| 10.30        |   | 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*.)                                                                                                                                                                                                                                                            |
| 10.31        |   | 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.)*                                                                                                                                                                                                                                                 |
| 10.32        |   | 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.)*                                                                                                                                                                                                                                                               |
| 10.33†# |   | Representative Indemnification Agreement. *(Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.)*                                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.34†  |   | Summary of Director Compensation. (*Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended March 31, 2005.*)                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.35        |   | 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.)*                                                                                                                                                                                                                                    |
| 10.36        |   | 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.)*                                                                                                                                                                                                                                                                                |
| 10.37        |   | 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.)*                                                                                                                                                                                                                                                                                                                               |
| 10.38        |   | 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.)*                                                                                                                                                                                                                         |
| 10.39        |   | 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.)*                                                                                                                                                                                                                          |
| 10.40        |   | 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.)*                                                                                                                                                                                                                                                                                         |
| 10.41        |   | 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.)*                                                                                                                                                                                                                          |
| 10.42        |   | 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.)*                                                                                                                                                                                                                                                                                         |
| 10.43        |   | 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.)* |
| 10.44        |   | Amended and Restated Pledge of Shares of  Beneficial Interest Agreement, dated as of May 6, 2005,                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |

 

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|   |   | made by FSQ, Inc. for the benefit of  the Landlord under the Second Amended and Restated Lease Agreement, dated as  of November 19, 2004, by and among certain affiliates of Senor Housing,  as Landlord, and Five Star Quality Care Trust, as Tenant. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated June 3, 2005.)*                                                                                                                                                        |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.45  |   | First Amendment to Second Amended and  Restated Lease Agreement, dated as of May 17, 2005, 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 Current  Report on Form 8-K dated June 3, 2005.)*         |
| 10.46  |   | Second Amendment to Second Amended and  Restated Lease Agreement, dated as of June 3, 2005, 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 Current  Report on Form 8-K dated June 3, 2005.)*        |
| 10.47  |   | Third Amendment to Second Amended and  Restated Lease Agreement, dated as of October 31, 2005, 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 Current  Report on Form 8-K dated November 4, 2005.)* |
| 10.48  |   | Second Amendment to Security Agreement,  dated as of May 17, 2005, 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 June 3, 2005.)*                                                                                                                                                                                                                 |
| 10.49  |   | Confirmation of Guarantees and Confirmation  and Amendment of Other Incidental Documents, dated as of June 3, 2005,  by and among the Company, certain affiliates of the Company and certain  affiliates of Senior Housing Properties Trust. *(Incorporated by reference to the Company’s Current Report on Form 8-K  dated June 3, 2005.)*                                                                                                                                                                       |
| 10.50  |   | Confirmation of Guarantees and Confirmation  and Amendment of Other Incidental Documents, dated as of October 31,  2005, by and among the Company, certain affiliates of the Company and certain  affiliates of Senior Housing Properties Trust. *(Incorporated by reference to the Company’s Current Report on Form 8-K  dated November 4, 2005.)*                                                                                                                                                               |
| 10.51  |   | Credit and Security Agreement, dated as of May 9,  2005, by and among the Company, each of the Guarantors party thereto and  Wachovia Bank, National Association. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated May 13,  2005.)*                                                                                                                                                                                                                                                 |
| 10.52  |   | First Amendment to Credit and Security  Agreement, dated as of July 22, 2005, by and among the Company, each of  the Guarantors party thereto and Wachovia Bank, National Association. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated August 23, 2005.)*                                                                                                                                                                                                                          |
| 10.53  |   | Second Amendment to Credit and Security  Agreement, dated as of August 15, 2005, by and among the Company, each  of the Guarantors party thereto and Wachovia Bank, National Association. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated August 23, 2005.)*                                                                                                                                                                                                                       |
| 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   |   | Rule 13a-14(a) Certification of  Chief Executive Officer. *(Filed herewith.)*                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.2   |   | Rule 13a-14(a) Certification of  Chief Financial Officer. *(Filed herewith.)*                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 32.1   |   | Section 1350 Certification of Chief  Executive Officer and Chief Financial Officer. *(Furnished herewith.)*                                                                                                                                                                                                                                                                                                                                                                                                                      |

 

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| † | 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. |

 

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**Report of Independent Registered Public AccountingFirm**

** **

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

 

We have audited the accompanying consolidated balancesheets of Five Star Quality Care, Inc., as of December 31, 2005 and2004, and the related consolidated statements of operations, shareholders’equity and cash flows for each of the three years in the period ended December 31,2005.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Five Star Quality Care, Inc. at December 31, 2005 and2004, and the consolidated results of their operations and their cash flows foreach of the three years in the period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles.

 

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Five Star Quality Care, Inc.’s internal control overfinancial reporting as of December 31, 2005, based on criteria establishedin Internal Control – Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission and our report dated February 28,2006 expressed an unqualified opinion thereon.

 

 
|                   | /s/ Ernst & Young, LLP |   |
|------------------------|---------------------------------|--------|
|                   |                            |
|                   |                            |
| Boston, Massachusetts  |                            |
| February 28, 2006 |                            |

 

F-1

----

 

**Report ofIndependent Registered Public Accounting Firm**

 

Tothe Directors and Shareholders of Five Star Quality Care, Inc.

 

We have audited management’s assessment, included in Item 9Aof Five Star Quality Care, Inc.’s Annual Report on Form 10-K underthe heading Management Report on Assessment of Internal Control Over FinancialReporting, that Five Star Quality Care, Inc. maintained effective internalcontrol over financial reporting as of December 31, 2005, based oncriteria established in the Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (the COSOcriteria).  Five Star Quality Care, Inc.’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards ofthe Public Company Accounting Oversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects.  Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances.  We believe that our auditprovides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is aprocess designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.  Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures for the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

In our opinion, management’s assessment that Five StarQuality Care, Inc. maintained effective internal control over financialreporting as of December 31, 2005, is fairly stated, in all materialrespects, based on the COSO criteria.  Also in our opinion, Five StarQuality Care, Inc., maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, basedon the COSO criteria.

 

We also have audited, in accordance with the standards of thePublic Company Accounting Oversight Board (United States), the 2005 consolidatedfinancial statements of Five Star Quality Care, Inc. and our report dated February 28,2006 expressed an unqualified opinion thereon.

 

 
|                   | /s/ Ernst & Young LLP |   |
|------------------------|--------------------------------|--------|
|                   |                           |
|                   |                           |
| Boston, Massachusetts  |                           |
| February 28, 2006 |                           |

 

F-2

----

 

**FIVE STAR QUALITY CARE, INC.**

 

**CONSOLIDATEDBALANCE SHEET**

 

*(dollars in thousands, except share data)*

 
| ** **                                                                                                                                                               | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current  assets:                                                                                                                                                         |       |                  |       |   |   |
| Cash and  cash equivalents                                                                                                                                               |       | $                     | 16,729     |   | $ | 30,942 |   |
| Accounts  receivable, net of allowance of $6,124 and $5,278 at December 31, 2005  and 2004, respectively                                                            |       | 46,124                |       | 36,742 |   |
| Prepaid  expenses                                                                                                                                                        |       | 8,047                 |       | 10,417 |   |
| Restricted  cash – insurance arrangements                                                                                                                           |       | 2,427                 |       | 1,771 |   |
| Restricted  investments – insurance arrangements                                                                                                                    |       | 2,442                 |       | 931 |   |
| Restricted  cash – other                                                                                                                                            |       | 10,281                |       | 12,165 |   |
| Other  current assets                                                                                                                                                    |       | 8,830                 |       | 2,690 |   |
| Total  current assets                                                                                                                                                    |       | 94,880                |       | 95,658 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| Property and  equipment, net                                                                                                                                             |       | 96,743                |       | 95,189 |   |
| Restricted  cash – insurance arrangements                                                                                                                           |       | 6,004                 |       | 6,660 |   |
| Restricted  investments – insurance arrangements                                                                                                                    |       | 6,039                 |       | 3,501 |   |
| Restricted  cash – other                                                                                                                                            |       | 914                   |       | 588 |   |
| Mortgage  notes receivable                                                                                                                                               |       | 5,971                 |       | 6,099 |   |
| Goodwill and  other intangible assets                                                                                                                                    |       | 14,059                |       | 11,548 |   |
| Other long  term assets                                                                                                                                                  |       | 4,330                 |       | 3,742 |   |
|                                                                                                                                                                     |       | $                     | 228,940    |   | $ | 222,985 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                           |       |                  |       |   |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                    |       |                  |       |   |   |
| Accounts  payable                                                                                                                                                        |       | $                     | 14,595     |   | $ | 12,625 |   |
| Accrued  expenses                                                                                                                                                        |       | 14,514                |       | 10,941 |   |
| Accrued  compensation and benefits                                                                                                                                       |       | 18,341                |       | 14,830 |   |
| Due to  Senior Housing Properties Trust (“SNH”)                                                                                                                |       | 8,659                 |       | 7,961 |   |
| Due to  Sunrise Senior Living Services, Inc. (“SLS”)                                                                                                      |       | 7,185                 |       | 309 |   |
| Mortgage  notes payable                                                                                                                                                  |       | 626                   |       | 463 |   |
| Accrued real  estate taxes                                                                                                                                               |       | 7,872                 |       | 3,449 |   |
| Security  deposit liability                                                                                                                                              |       | 11,854                |       | 12,491 |   |
| Other  current liabilities                                                                                                                                               |       | 6,322                 |       | 3,829 |   |
| Total  current liabilities                                                                                                                                               |       | 89,968                |       | 66,898 |   |
|                                                                                                                                                                     |       |                  |       |   |   |
| Long term  liabilities:                                                                                                                                                  |       |                  |       |   |   |
| Mortgage  notes payable                                                                                                                                                  |       | 44,703                |       | 42,118 |   |
| Continuing  care contracts                                                                                                                                               |       | 3,638                 |       | 3,130 |   |
| Other long  term liabilities                                                                                                                                             |       | 21,827                |       | 14,935 |   |
| Total long  term liabilities                                                                                                                                             |       | 70,168                |       | 60,183 |   |
| Commitments  and contingencies                                                                                                                                           |       |                  |       |   |   |
| Shareholders’  equity:                                                                                                                                              |       |                  |       |   |   |
| Preferred  stock, par value $0.01: 1,000,000 shares authorized, none issued                                                                                              |       | —                |       | — |   |
| Common  stock, par value $0.01: 30,000,000 shares authorized, 20,060,934 and  12,096,634 shares issued and outstanding at December 31, 2005 and 2004,  respectively |       | 201                   |       | 121 |   |
| Additional  paid-in capital                                                                                                                                              |       | 171,552               |       | 114,434 |   |
| Accumulated  deficit                                                                                                                                                     |       | (102,770              | )          | (18,611 | ) |
| Unrealized  loss on investments                                                                                                                                          |       | (179                  | )          | (40 | ) |
| Total  shareholders’ equity                                                                                                                                         |       | 68,804                |       | 95,904 |   |
|                                                                                                                                                                     |       | $                     | 228,940    |   | $ | 222,985 |   |

 

See accompanying notes*.*

 

F-3

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

 

*(inthousands, except per share data)*

 
| ** **                                                    | ** ** | **For the year ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                          |       |                                      |       |   |   |   |   |
| Revenues:                                                     |       |                                      |       |   |   |   |   |
| Net revenues  from residents                                  |       | $                                         | 724,051    |   | $ | 606,805 |   | $ | 565,695 |   |
| Pharmacy  revenue                                             |       | 33,476                                    |       | 13,209 |   | 1,770 |   |
| Total  revenues                                               |       | 757,527                                   |       | 620,014 |   | 567,465 |   |
|                                                          |       |                                      |       |   |   |   |   |
| Operating  expenses:                                          |       |                                      |       |   |   |   |   |
| Wages and  benefits                                           |       | 376,061                                   |       | 319,580 |   | 311,975 |   |
| Other  operating expenses                                     |       | 183,891                                   |       | 157,495 |   | 145,272 |   |
| Pharmacy  expenses                                            |       | 32,167                                    |       | 12,093 |   | 1,666 |   |
| Management  fee to SLS                                        |       | 21,256                                    |       | 19,293 |   | 17,272 |   |
| Termination  expense for certain SLS management agreements    |       | 86,286                                    |       | — |   | — |   |
| Rent expense                                                  |       | 99,691                                    |       | 83,235 |   | 77,280 |   |
| General and  administrative                                   |       | 27,775                                    |       | 19,635 |   | 15,073 |   |
| Depreciation  and amortization                                |       | 7,114                                     |       | 3,372 |   | 3,276 |   |
| Impairment  of assets                                         |       | 2,333                                     |       | — |   | — |   |
| Total  operating expenses                                     |       | 836,574                                   |       | 614,703 |   | 571,814 |   |
|                                                          |       |                                      |       |   |   |   |   |
| Operating  (loss) income                                      |       | (79,047                                   | )          | 5,311 |   | (4,349 | ) |
| Interest and  other income                                    |       | 1,543                                     |       | 1,666 |   | 229 |   |
| Interest  expense                                             |       | (3,743                                    | )          | (1,172 | ) | (1,439 | ) |
|                                                          |       |                                      |       |   |   |   |   |
| (Loss)  income from continuing operations before income taxes |       | (81,247                                   | )          | 5,805 |   | (5,559 | ) |
| Provision  for income taxes                                   |       | —                                    |       | (120 | ) | — |   |
| (Loss)  income from continuing operations                     |       | (81,247                                   | )          | 5,685 |   | (5,559 | ) |
|                                                          |       |                                      |       |   |   |   |   |
| Loss from  discontinued operations                            |       | (2,912                                    | )          | (2,394 | ) | (2,380 | ) |
|                                                          |       |                                      |       |   |   |   |   |
| Net (loss)  income                                            |       | $                                         | (84,159    | ) | $ | 3,291 |   | $ | (7,939 | ) |
|                                                          |       |                                      |       |   |   |   |   |
| Weighted  average shares outstanding                          |       | 14,879                                    |       | 8,716 |   | 8,482 |   |
|                                                          |       |                                      |       |   |   |   |   |
| Basic and  diluted (loss) income per share from:              |       |                                      |       |   |   |   |   |
| Continuing  operations                                        |       | $                                         | (5.46      | ) | $ | 0.65 |   | $ | (0.66 | ) |
| Discontinued  operations                                      |       | (0.20                                     | )          | (0.27 | ) | (0.28 | ) |
| Net (loss)  income per share                                  |       | $                                         | (5.66      | ) | $ | 0.38 |   | $ | (0.94 | ) |

 

See accompanying notes*.*

 

F-4

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY**

*(dollarsin thousands, except share data)*

 
| ** **                                      | ** ** | **Number of  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Unrealized  Loss on****Investments** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|----------------------------------------|------------|-----------|------------|
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| 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    |       |
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Comprehensive income:                           |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Net income                                      |       | —                |       | —            |       | —                           |       | 3,291                    |       | —                                 |       | 3,291     |       |
| Unrealized loss on  investments                 |       | —                |       | —            |       | —                           |       | —                   |       | (40                                    | )          | (40       | )          |
| Total comprehensive income                      |       | —                |       | —            |       | —                           |       | 3,291                    |       | (40                                    | )          | 3,251     |       |
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Stock grants                                    |       | 83,000                |       | 1                 |       | 540                              |       | —                   |       | —                                 |       | 541       |       |
| Issuance of stock,  pursuant to equity offering |       | 3,500,000             |       | 35                |       | 27,650                           |       | —                   |       | —                                 |       | 27,685    |       |
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Balance at December 31,  2004              |       | 12,096,634            |       | 121               |       | 114,434                          |       | (18,611                  | )          | (40                                    | )          | 95,904    |       |
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Comprehensive income:                           |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Net loss                                        |       | —                |       | —            |       | —                           |       | (84,159                  | )          | —                                 |       | (84,159   | )          |
| Unrealized loss on  investments                 |       | —                |       | —            |       | —                           |       | —                   |       | (139                                   | )          | (139      | )          |
| Total comprehensive income                      |       | —                |       | —            |       | —                           |       | (84,159                  | )          | (139                                   | )          | (84,298   | )          |
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Stock grants                                    |       | 84,300                |       | 1                 |       | 584                              |       | —                   |       | —                                 |       | 585       |       |
| Issuance of stock,  pursuant to equity offering |       | 7,880,000             |       | 79                |       | 56,534                           |       | —                   |       | —                                 |       | 56,613    |       |
|                                            |       |                  |       |              |       |                             |       |                     |       |                                   |       |      |       |
| Balance at December 31,  2005              |       | 20,060,934            |       | $                 | 201        |                             | $          | 171,552                  |       | $                                      | (102,770   | )         | $          | (179 | ) | $ | 68,804 |   |

 

See accompanying notes*.*

 

F-5

----

 

**FIVE STARQUALITY CARE, INC.**

 

**CONSOLIDATED STATEMENT OF CASH FLOWS**

*(dollars inthousands)*

 
| ** **                                                                                       | ** ** | **For the year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                           |       |                                     |       |   |   |   |   |
| Net (loss)  income                                                                               |       | $                                        | (84,159    | ) | $ | 3,291 |   | $ | (7,939 | ) |
| Adjustments  to reconcile net (loss) income to cash (used in) provided by operating  activities: |       |                                     |       |   |   |   |   |
| Depreciation  and amortization                                                                   |       | 7,114                                    |       | 3,372 |   | 3,276 |   |
| Impairment  of assets                                                                            |       | 2,333                                    |       | — |   | — |   |
| Loss from  discontinued operations                                                               |       | 2,912                                    |       | 2,394 |   | 2,380 |   |
| Provision for  bad debt expense                                                                  |       | 846                                      |       | 973 |   | 403 |   |
| Changes in  assets and liabilities:                                                              |       |                                     |       |   |   |   |   |
| Accounts  receivable                                                                             |       | (8,235                                   | )          | (6,098 | ) | 3,674 |   |
| Prepaid  expenses and other current assets                                                       |       | (1,444                                   | )          | 941 |   | (9,583 | ) |
| Accounts  payable and accrued expenses                                                           |       | 1,748                                    |       | (10,212 | ) | 2,592 |   |
| Accrued  compensation and benefits                                                               |       | 3,511                                    |       | 4,066 |   | 3,124 |   |
| Due to SNH                                                                                       |       | 698                                      |       | 1,900 |   | 6,667 |   |
| Due (from)  to SLS                                                                               |       | 6,876                                    |       | (5,825 | ) | 6,134 |   |
| Other  current and long term liabilities                                                         |       | 13,835                                   |       | 7,234 |   | 10,564 |   |
| Cash (used  in) provided by operating activities                                                 |       | (53,965                                  | )          | 2,036 |   | 21,292 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| Net cash  used in discontinued operations                                                        |       | (2,912                                   | )          | (2,394 | ) | (2,380 | ) |
|                                                                                             |       |                                     |       |   |   |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                           |       |                                     |       |   |   |   |   |
| Deposits  into restricted cash and investment accounts                                           |       | (11,105                                  | )          | (5,743 | ) | (18,250 | ) |
| Acquisition  of property and equipment                                                           |       | (105,474                                 | )          | (138,936 | ) | (17,087 | ) |
| Acquisition  of pharmacy, net of cash acquired                                                   |       | (4,880                                   | )          | (3,525 | ) | (1,800 | ) |
| Proceeds  from sales of property and equipment                                                   |       | 80,678                                   |       | 122,682 |   | 16,331 |   |
| Proceeds  from disposition of property and equipment held for sale                               |       | 15,470                                   |       | 9,457 |   | 10,754 |   |
| Withdrawals  from restricted cash for purchases of property and equipment                        |       | 8,614                                    |       | 7,521 |   | 4,168 |   |
| Cash used in  investing activities                                                               |       | (16,697                                  | )          | (8,544 | ) | (5,884 | ) |
|                                                                                             |       |                                     |       |   |   |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                           |       |                                     |       |   |   |   |   |
| Proceeds  from issuance of common stock, net                                                     |       | 56,613                                   |       | 27,685 |   | — |   |
| Proceeds  from borrowings on revolving credit facility                                           |       | 32,000                                   |       | 22,000 |   | 55,500 |   |
| Repayments  of borrowings on revolving credit facility                                           |       | (32,000                                  | )          | (26,000 | ) | (51,500 | ) |
| Proceeds  from first mortgage line of credit                                                     |       | 24,000                                   |       | — |   | — |   |
| Repayments  of first mortgage line of credit                                                     |       | (24,000                                  | )          | — |   | — |   |
| Proceeds  from mortgage note payable                                                             |       | 3,485                                    |       | 122,015 |   | — |   |
| Repayments  of mortgage notes payable                                                            |       | (737                                     | )          | (123,467 | ) | (9,687 | ) |
| Cash  provided by (used in) financing activities                                                 |       | 59,361                                   |       | 22,233 |   | (5,687 | ) |
|                                                                                             |       |                                     |       |   |   |   |   |
| Change in  cash and cash equivalents                                                             |       | (14,213                                  | )          | 13,331 |   | 7,341 |   |
| Cash and  cash equivalents at beginning of year                                                  |       | 30,942                                   |       | 17,611 |   | 10,270 |   |
| Cash and  cash equivalents at end of year                                                        |       | $                                        | 16,729     |   | $ | 30,942 |   | $ | 17,611 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                             |       |                                     |       |   |   |   |   |
| Cash paid  for interest                                                                          |       | $                                        | 2,634      |   | $ | 512 |   | $ | 1,381 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| 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                                                                        |       | 585                                      |       | 541 |   | 104 |   |
| Acquisition  of assets by merger                                                                 |       | —                                   |       | — |   | (2,220 | ) |
| Assumption  of liabilities by merger                                                             |       | —                                   |       | — |   | (890 | ) |
| Assumption  of mortgage                                                                          |       | —                                   |       | 86,764 |   | — |   |

 

See accompanying notes*.*

 

F-6

----

 

**FIVE STAR QUALITY CARE, INC.**

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(*dollars inthousands, except per share data)*

 

**1. Organizationand Business**

** **

We were organized on April 27, 2000, as a whollyowned subsidiary of Senior Housing Properties Trust, or Senior Housing.  On December 31, 2001, Senior Housingdistributed all of our common shares to its shareholders.  Concurrent with our spin-off, we entered intoagreements with Senior Housing and others to govern our initial capitalizationand other events related to the spin-off.

 

As of December 31, 2005 we operated 153 seniorliving communities containing 17,110 living units, including 102 primarilyindependent and assisted living communities containing 12,403 living units and51 nursing homes containing 4,707 living units. Of our 102 primarily independent and assisted living communities, welease 86 communities containing 11,221 living units from Senior Housing,including 18 communities that Sunrise Senior Living Services Inc., or SLS, awholly owned subsidiary of Sunrise Senior Living, Inc., or Sunrise,operated for our account, and we own or lease from parties other than SeniorHousing 16 communities containing 1,182 living units.  We lease all but two of our nursing homesfrom Senior Housing.  Our 153 communitiesinclude 4,960 independent living apartments, 5,725 assisted living suites, 283special care beds and 6,142 skilled nursing beds.  We also operate four institutionalpharmacies, one of which provides mail order pharmaceuticals to the generalpublic.

 

We experienced losses in 2002, 2003 and 2005.  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 SLS,we have provided SLS with working capital to be used in the operation of thecommunities.  The components of theworking capital, primarily cash and cash equivalents, inventories, tradeaccounts receivable and accounts payable, are controlled by SLS on our behalf,but we retain the risks and rewards associated with the underlying assets andliabilities.  Accordingly, the componentsof this working capital (including cash and cash equivalents of $7,125 and$8,387 at December 31, 2005 and 2004, 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.  Some significant estimates include our selfinsurance reserves.  The actual resultscould differ from our estimates.

 

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

 

*Restricted cash –insurancearrangements.*  Restricted cash - insurance arrangementsis cash that we deposited as security for letters of credit which secureobligations arising from our self insurance programs.

 

*Restricted investments – insurance arrangements*.  Restricted investments – insurancearrangements are investments held by our captive insurance companies that maybe used to pay claims under our self insurance programs.  These investments are classified as availablefor sale and carried at fair value, with unrealized gains and

 

F-7

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losses reported as aseparate component of shareholders’ equity. The unrealized loss on investments shown on the consolidated balancesheet represents the difference between the market value of these investmentscalculated by using quoted market prices on the date they were acquired and on December 31,2005.  At December 31, 2005, ourinvestments had a fair value of $9,497 and an unrealized holding loss of$179.  At December 31, 2004, our investments had a fair value of$4,432 and an unrealized holding loss of $40.

 

*Restricted cash - other. *Restricted cash - other asof December 31, 2005 and 2004 includes the following amounts for which weare required to establish escrows: (i) Florida regulatory requirements, (ii) futurecapital expenditures, as required by our leases with Senior Housing and ourmanagement agreements with SLS, (iii) real estate taxes and capitalexpenditures as required by our mortgages, (iv) resident security depositsand (v) miscellaneous business reasons.

 
| ** ** | ** **                                                                                                         | **2005**    | ** ** | **2004**      | ** ** |
|------------|--------------------------------------------------------------------------------------------------------------------|-------------|------------|---------------|------------|
| ** ** | ** **                                                                                                         | **Current** | ** ** | **Long term** | ** ** | **Current** | ** ** | **Long term** | ** ** |
| (i)        | Florida  regulatory requirements                                                                                   |        | $          | —        |       | $ | 518 |   | $ | — |   | $ | 518 |   |
| (ii)       | Future  capital expenditures, as required by our leases with Senior Housing or our  management agreements with SLS |        | 5,060      |          | —     |   | 5,540 |   | — |   |
| (iii)      | Real estate  taxes and capital expenditures as required by our mortgages                                           |        | 2,000      |          | —     |   | 2,585 |   | — |   |
| (iv)       | Resident  security deposits                                                                                        |        | 3,221      |          | —     |   | 4,040 |   | — |   |
| (v)        | Miscellaneous  business reasons                                                                                    |        | —     |          | 396        |   | — |   | 70 |   |
| **Total**  |                                                                                                               | $           | 10,281     |          | $          | 914 |   | $ | 12,165 |   | $ | 588 |   |

 

*Accounts receivable and allowance for doubtfulaccounts.*  We recordaccounts receivable at their estimated net realizable value.  We estimate allowances for uncollectibleamounts based upon factors which include, but are not limited to, the age ofthe receivable and the terms of the agreements, the residents’ or third partypayors’ stated intent to pay, their financial capacity to pay and other factorswhich may include likelihood and cost of litigation.  Accounts receivable allowances areestimates.  We periodically review andrevise these estimates based on new information; such revisions may bematerial.

 

During 2005, 2004 and 2003, we increased our allowancefor doubtful accounts by $3,950, $3,600 and $2,456, respectively, and wrote offaccounts receivable of $3,104, $2,627 and $2,053, respectively.

 

Included in accounts receivable as of December 31,2005 and 2004 are amounts due from the Federal Government Medicare program of$14,103 and $10,952, respectively, and amounts due from various state Medicaidprograms of $16,392 and $14,570, 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 $1,214 and $925 at December 31, 2005 and 2004,respectively.  Accumulated amortizationrelated to deferred finance costs was $1,013 and $617 at December 31, 2005and 2004, respectively.  At December 31,2005, the weighted average amortization period remaining is approximately 16years.  The amortization expenses to beincurred during the next five years as of December 31, 2005 are $337 in2006, $182 in 2007, $26 in 2008, $26 in 2009 and $26 in 2010.

 

*Property and equipment.*  Property and equipment is stated atcost.  We record depreciation on propertyand equipment on a straight line basis over estimated useful lives of up to 40years for buildings, up to 15 years for building improvements and up to sevenyears for personal property.  Weregularly evaluate whether events or changes in circumstances have occurredthat could indicate impairment in the value of long lived assets.  If there is an indication that the carryingvalue of an asset is not recoverable, we estimate the projected undiscountedcash flows from the asset to determine if an impairment loss should be recognized.  We determine the amount of impairment loss bycomparing the historical carrying value of the asset to its estimated fairvalue.  We determine estimated fair valuethrough an evaluation of recent financial performance, recent sales of similarassets, market conditions and projected discounted cash flows of propertiesusing standard industry valuation techniques.

 

F-8

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During 2005, we recognized a $2,333 impairment chargeto reduce the carrying value of six communities to the amount realized upontheir planned sale to Senior Housing (see Footnote 9).

 

*Goodwill.*   Goodwill representsthe costs of business acquisitions in excess of the fair value of identifiablenet assets acquired.  We review goodwillannually, or more frequently if events or changes in circumstances exist, forimpairment.  If our review indicates thatthe carrying amount of goodwill exceeds its fair value, we reduce the carryingamount of goodwill to fair value.  Theincrease in goodwill from 2004 to 2005 relates to our acquisition of LTA in November 2004and the pharmacies we acquired in 2005.

 

*Self insurance.*  We self insure up to certain limits forworkers compensation and professional liability.  Claims in excess of these limits are retainedby third party insurance providers up to contractual limits, over which we areself insured.  We fully self insure allemployee health related claims.  Weaccrue 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 bematerial.

 

*Continuing care contracts. *Residents at two of ourcommunities that are managed by SLS may enter into continuing carecontracts.  We offer two forms ofcontinuing care contracts to new residents. One form of contract provides that 10% of the resident admission feebecomes non-refundable upon occupancy, and the remaining 90% becomes non-refundableat the rate of 1.5% per month of the original amount over the subsequent 60months.  The second form of contractprovides that 30% of the resident admission fee is non-refundable uponoccupancy and 70% is refundable.  Threeother forms of continuing care contracts are in effect for existing residentsbut are not offered to new residents. One historical form of contract provides that the resident admission feeis 10% non-refundable upon occupancy and 90% refundable.  A second historical form of contract providesthat the resident admission fee is 100% refundable.  A third historical form of contract providesthat the resident admission fee is 1% refundable and 99% non-refundable uponadmission.  In each case, we amortize thenon-refundable part of these fees into revenue over the actuarially determinedremaining life of the resident, which is the expected period of occupancy bythe resident.  We pay refunds of ouradmission fees when residents relocate from our communities.  We report the refundable amount of theseadmission fees as current liabilities and the nonrefundable amount as deferredrevenue, a portion of which is classified as a current liability.  Portions of the refundable payments areincluded in restricted cash in our consolidated balance sheet.  The refundable admission fees as of December 31,2005 and 2004 were $6,197 and $7,051, respectively.

 

*Income taxes*.  We account for income taxes under theprovisions of Statement of Financial Accounting Standards, or SFAS, No. 109,*“Accounting for Income Taxes”*, or SFAS109.  Under SFAS No. 109, deferredtax assets and liabilities are determined based on the difference between thefinancial statement and tax bases of assets and liabilities using enacted tax ratesin effect for the year in which the differences are expected to affect taxableincome. Valuation allowances are established when necessary to reduce deferredtax assets to the amounts that are expected to be realized (see Footnote 5).

 

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

 

*Revenue recognition.*  Our revenues are derived primarily fromservices to residents at our communities. We accrue revenues when services are provided and revenues areearned.  Some of our services areprovided with the expectation of payment from governments or other third partypayors.  We derived approximately 36%,41% and 39% of our net resident revenues in 2005, 2004 and 2003, respectively,from payments under federal and state medical assistance programs.  Revenues under some of these programs aresubject to audit and retroactive adjustment.

 

Medicare revenues totaled $110,121, $99,516 and$75,319 during 2005, 2004 and 2003, respectively.  Medicaid revenues totaled $153,214, $149,153and $145,302 during 2005, 2004 and 2003, respectively.  Both the Federal Government and some of thestates in which we operate are considering plans to reduce Medicare andMedicaid funding, or to stop or reduce the projected increases in suchfunding.  We cannot estimate themagnitude

 

F-9

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of potential Medicaid andMedicare rate reductions but it may be material.  Medicaid and Medicare rates reductions or afailure of such program to increase rates to match our increasing costs, ifthey occur, may have a negative impact on our revenues, may decrease our netincome 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.  In November 2005, we terminatedmanagement agreements for 12 senior living communities that SLS managed for usand we began to directly operate these communities.  In December 2005, we sent a terminationnotice to SLS for one additional community and therefore accounted for thistermination expense in 2005.  In February 2006,we began to directly operate this one additional community.  We will no longer pay management fees forthese 13 communities to SLS.  SLScontinues to manage 17 communities for us. During 2005, 2004 and 2003, we paid fees totaling $21,256, $19,293 and$17,272, respectively, under our management agreements with SLS.

 

*Per common share amounts.*  We computed earnings (loss) per share for theyears ended December 31, 2005, 2004 and 2003, using the weighted averagenumber of shares outstanding during each year. We have no common share equivalents, instruments convertible into commonshares or other dilutive instruments.

 

*Reclassifications.*  Reclassificationshave been made to the prior years’ financial statements to conform to thecurrent year’s presentation, including a reclassification of the refundableportion of resident admission fees at certain communities, which had beenpresented as a long-term liability in 2004, to a current liability, and areclassification of restricted cash arising from such fees, which had beenpresented as a long term asset in 2004, to a current asset.  These reclassifications had no effecton net income (loss) or shareholders’ equity.

 

*Recently Issued Accounting Standards*.On December 16, 2004, the FASB issued SFAS Statement No. 123 (revised2004), “Share-Based Payment”, or SFAS 123(R), which is a revision of SFASStatement No. 123, “Accounting for Stock-Based Compensation”, or SFAS 123. SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for StockIssued to Employees”, and amends SFAS Statement No. 95, “Statement of CashFlows”. Generally, the approach in SFAS 123(R) is similar to the approachdescribed in SFAS 123.  However, SFAS 123(R) requires all share basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values.  Pro forma disclosure is no longer analternative.  The Company will adopt SFAS 123(R) on January 1, 2006using the prospective method as described in SFAS No. 148.  TheCompany does not expect the adoption of this standard to have any impact infiscal year 2006, as the Company historically utilized restricted stock awardsgranted at market prices as to which, the accounting treatment is the sameunder SFAS 123(R) as it has been under SFAS 123.

 

**3.  Property and Equipment**

** **

Property and equipment, at cost, as of December 31,2005 and 2004, consists of:

 
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |
| Land                               |       | $        | 6,439      |     | $          | 7,362 |   |
| Buildings  and improvements        |       | 75,540   |       | 74,111   |       |
| Furniture,  fixtures and equipment |       | 26,215   |       | 19,954   |       |
|                               |       | 108,194  |       | 101,427  |       |
| Accumulated  depreciation          |       | (11,451  | )          | (6,238   | )          |
|                               |       | $        | 96,743     |     | $          | 95,189 |   |

** **

**F-10**

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** **

**4.  Line of Credit**

** **

**In May 2005, we entered into anew revolving credit facility.  Theinterest rate on borrowings under this facility is LIBOR plus a premium.  The maximum amount available under this facilityis $25,000, and is subject to limitations based upon qualifyingcollateral.  We are the borrower underthis revolving credit facility and certain of our subsidiaries guarantee ourobligations under the facility.  Thefacility is secured by our and our guarantor subsidiaries’ accounts receivable,deposit accounts and related assets.  Thefacility is available for acquisitions, working capital and general businesspurposes.  The facility containscovenants requiring us to maintain collateral, minimum net worth and certainother financial ratios, places limits on our ability to incur or assume debt orcreate liens with respect to certain of our properties and contains othercustomary provisions.  In certaincircumstances and subject to available collateral and lender approvals, themaximum amounts which we may draw under this credit facility may be increasedto $50,000. The termination date of the facility is May 9, 2007.  The termination date may be extended twice,in each case by twelve months, subject to lender approval, our payment ofextension fees and other conditions.  Asof December 31, 2005, no amounts were outstanding and, as of March 10,2006, $9,500 was outstanding under this credit facility.  Interest expense and other associated costsrelated to this facility and our prior revolving credit facility were $167, $85and $155 for the years ended December 31, 2005, 2004 and 2003,respectively.**

** **

**5.  Income Taxes**

** **

Significant components of our deferred tax assets andliabilities as of December 31, 2005 and 2004, are as follows:

 
| ** **                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                                        |       |     |       |     |       |
| Continuing  care contracts                                   |       | $        | 2,473      |     | $          | 2,880 |   |
| Depreciable  assets                                          |       | 825      |       | (2,162   | )          |
| Allowance  for doubtful accounts                             |       | 2,462    |       | 2,073    |       |
| Deferred  gains on sale lease-back transactions              |       | 3,494    |       | 2,642    |       |
| Insurance  reserves                                          |       | 3,615    |       | 1,076    |       |
| Tax credits                                                  |       | 1,464    |       | 1,190    |       |
| Tax loss  carry forwards (including SLS termination expense) |       | 33,042   |       | 1,769    |       |
| Other                                                        |       | 212      |       | 473      |       |
| Total  deferred tax asset before valuation allowance         |       | 47,587   |       | 9,941    |       |
| Valuation  allowance:                                        |       | (42,482  | )          | (9,808   | )          |
|                                                         |       | 5,105    |       | 133      |       |
| Deferred tax  liabilities:                                   |       |     |       |     |       |
| Lease  expense                                               |       | (2,570   | )          | —   |       |
| Goodwill                                                     |       | (2,522   | )          | (67      | )          |
| Other                                                        |       | (13      | )          | (66      | )          |
| Total                                                        |       | (5,105   | )          | (133     | )          |
|                                                         |       |     |       |     |       |
| Net deferred  tax assets:                                    |       | $        | —     |     | $          | — |   |

 

As a result of ourshort operating history and reported losses, we have not currently recognizedthe benefit of our deferred tax assets. We will continue to assess our ability to generate sufficient taxableincome during future periods in which our deferred tax assets may be utilized.  When we believe that we will more likely thannot recover our deferred tax assets, we will record a reduction in thevaluation reserve as an income tax benefit in the consolidated statement ofoperations, which will affect our results of operations.

 

Our operations in the year ended December 31,2005 resulted in a taxable loss.  As of December 31,2005 we have tax loss carry forwards of approximately $81,121 that may becarried forward to offset future taxable income.  Our net operating loss carry forwards willexpire beginning in 2026, if unused.  Thetax loss carry forward

 

F-11

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is subject to audit and adjustments by the Internal RevenueService.  We did not have taxable incomein the years ended December 31, 2004 and 2003.  In 2004, we provided $120 for alternativeminimum taxes that are payable without regard to our tax loss carry forwards.

 

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,** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                      |       |                                      |       |   |   |   |   |
| Taxes at  statutory U.S. federal income tax rate          |       | (35.0                                     | )%         | 34.0 | % | (34.0 | )% |
| State and  local income taxes, net of federal tax benefit |       | (5.2                                      | )%         | 5.3 | % | (4.0 | )% |
| Tax credits                                               |       | (0.3                                      | )%         | (17.9 | )% | (5.0 | )% |
| Alternative  Minimum Tax                                  |       | 0.0                                       | %          | 3.5 | % | 0.0 | % |
| Change in  federal statutory rate                         |       | (0.2                                      | )%         | 0.0 | % | 0.0 | % |
| Change in  valuation allowance                            |       | 38.9                                      | %          | (21.4 | )% | 6.5 | % |
| Other  differences, net                                   |       | 1.8                                       | %          | 0.0 | % | 36.5 | % |
| Effective  tax rate                                       |       | 0.0                                       | %          | 3.5 | % | 0.0 | % |

 

**6. Mortgages Payable**

 

At December 31, 2005, nine of our communities areencumbered by 11 Department of Housing and Urban Development, or HUD, insuredmortgages.  In order to record themortgages that we assumed in connection with the November 2004 acquisitionof mortgaged properties from LTA Holdings, Inc., or LTA, at theirestimated fair value, we recorded mortgage premiums totaling $6,534.  We are amortizing the mortgage premiums as areduction to interest expense over the remaining term of the mortgages.  Mortgage interest expense, net of premiumamortization, was $2,427 and $521 for the years ended December 31, 2005and 2004, respectively.  The mortgagesrequire monthly payments into escrowfor taxes, insurance and property replacement funds.  Withdrawals from escrow require HUD approval.

 

The following table is a summary of the mortgage notespayable as of December 31, 2005:

 
| **Principal  Balance** | ** ** | **Monthly  Payment** | ** ** | **Cash  Interest  Rate** | ** ** | **Effective  Interest  Rate** | ** ** | **Maturity Date**  | ** ** | **Fair Value  Premium  Adjustment** | ** ** | **Total  Mortgage  Payable** | ** ** |
|------------------------|------------|----------------------|------------|--------------------------|------------|-------------------------------|------------|--------------------|------------|-------------------------------------|------------|------------------------------|------------|
| $                      | 672        |                 | $          | 5                        |       | 8.50                          | %          | 5.60               | %          | February 2032                  |       | $                            | 198        |   | $ | 870 |   |
| 4,146                  |       | 32                   |       | 8.13                     | %          | 5.60                          | %          | February 2032 |       | 1,115                               |       | 5,261                        |       |
| 3,461                  |       | 19                   |       | 5.25                     | %          | 5.25                          | %          | June 2035     |       | —                              |       | 3,461                        |       |
| 5,357                  |       | 35                   |       | 7.00                     | %          | 5.60                          | %          | June 2036     |       | 861                                 |       | 6,218                        |       |
| 1,000                  |       | 7                    |       | 7.50                     | %          | 5.60                          | %          | October 2036  |       | 222                                 |       | 1,222                        |       |
| 5,282                  |       | 34                   |       | 7.00                     | %          | 5.60                          | %          | October 2036  |       | 874                                 |       | 6,156                        |       |
| 1,191                  |       | 9                    |       | 8.45                     | %          | 5.60                          | %          | November 2037 |       | 401                                 |       | 1,592                        |       |
| 1,348                  |       | 10                   |       | 8.00                     | %          | 5.60                          | %          | January 2038  |       | 402                                 |       | 1,750                        |       |
| 5,770                  |       | 38                   |       | 7.15                     | %          | 5.60                          | %          | November 2038 |       | 1,092                               |       | 6,862                        |       |
| 4,938                  |       | 27                   |       | 5.55                     | %          | 5.55                          | %          | May 2039      |       | —                              |       | 4,938                        |       |
| 5,822                  |       | 39                   |       | 7.25                     | %          | 5.60                          | %          | June 2039     |       | 1,177                               |       | 6,999                        |       |
|                   |       |                 |       |                     |       |                          |       |               |       |                                |       |                         |       |
| $                      | 38,987     |                 | $          | 255                      |       | 6.96                          | %(1)       |               |       |                                |       | $                            | 6,342      |   | $ | 45,329 |   |

 

----

(1)          Weighted averageinterest rate

 

F-12

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

 
| 2006       |   | $      | 375    |   |
|------------|--------|--------|--------|--------|
| 2007       |   | 402    |   |
| 2008       |   | 429    |   |
| 2009       |   | 459    |   |
| 2010       |   | 492    |   |
| Thereafter |   | 36,830 |   |
|       |   | $      | 38,987 |   |

** **

**7.  Leases**

** **

As of December 31, 2005 we leased 135 communitiesunder four non-cancelable leases with Senior Housing and 4 communities under alease with Healthcare Property Investors, Inc., or HCPI.  SLS currently manages 17 of the communitiesthat we lease from Senior Housing.  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.

 

Our leases with Senior Housing require us to payadditional rent equal to 4% of the amount by which gross revenues of thecommunities we operate exceed gross revenues in a base year.

 

Our lease with Senior Housing for the communitiescurrently and formally managed by SLS requires us to make deposits intoaccounts known as FF&E Reserves to fund future replacements andimprovements at 17 communities still managed for us by SLS.  Senior Housing has a security and remainderinterest in these accounts and in all property purchased with funding fromthese accounts.

 

Senior Housing has agreed to fund amounts that werequest for renovations and improvements to communities we lease from them inreturn for rent increases according to formulas in the leases.  In 2005, Senior Housing funded $15,470 forrenovations and improvements to some of our communities.  As a result and in accordance with ourleases, our annual minimum rent to Senior Housing increased by 10% of the amountfunded, or $1,547.

 

The following table is a summary of our leases: 

 
| **Landlord**                    | ** ** | **Number of  communities**                | ** ** | **Annual  minimum rent as of  December 31, 2005** | ** ** | **Initial expiration  date** | ** **             | **Renewal terms**                                            | ** **                  |
|---------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------|------------------------|--------------------------------------------------------------|-----------------------------|
| Senior  Housing – 3 leases |       | 105                                       |       | $                                                      | 39,434     |                         | December 31, 2020 |                                                         | One 15-year renewal option. |   |
| Senior Housing  – 1 lease  |       | 30 (including 17 SLS managed communities) |       | 64,025                                                 |       | December 31, 2017       |                   | Consecutive options for one 10-year and one  5-year renewal. |                        |
| HCPI                            |       | 4                                         |       | 1,183                                                  |       | June 30, 2014           |                   | Two 10-year renewal options.                                 |                        |
|                            |       |                                      |       |                                                   |       |                         |                   |                                                         |                        |
| Totals                          |       | 139                                       |       | $                                                      | 104,642    |                         |                   |                                                         |                        |   |

 

F-13

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The future minimum rents required by our leases as of December 31,2005, are as follows:

 
| 2006       |   | $       | 104,642   |   |
|------------|--------|---------|-----------|--------|
| 2007       |   | 104,642 |      |
| 2008       |   | 104,642 |      |
| 2009       |   | 104,642 |      |
| 2010       |   | 104,642 |      |
| Thereafter |   | 847,254 |      |
|       |   | $       | 1,370,464 |   |

** **

**8.   Shareholders’ Equity**

** **

On December 13, 2004, we issued 3,500,000 commonshares, in an underwritten public offering for proceeds, net of underwritingcommissions and other costs, of $27,685.

 

On January 11, August 29and September 27, 2005, we issued a total of 7,880,000 common shares, inan underwritten public offering for proceeds, net of underwriting commissionsand other costs, of $56,613.

 

We issued 84,300 and 83,000 common shares in 2005 and2004, respectively, to our directors, officers and others who provide servicesto us.  We valued the shares at theaverage price of our common shares on the American Stock Exchange on the datesof issue, or $585 in total ($6.20 to $7.27 per share) in 2005 and $541 in total($4.04 to $6.99 per share) in 2004. Shares issued to directors vested immediately; shares issued to ourofficers and other individuals who provide services to us vested over two yearsand are recognized in the income statement ratably.  As of December 31, 2005, 416,700 of ourcommon shares remain available for issuance under our 2001 Stock Option andStock Incentive Plan.

 

**9.   Acquisitions**

** **

In November 2004, we acquired 100% of the capitalstock of LTA for $217,944 including closing costs.  LTA owned, leased and operated 47 seniorliving communities with 2,636 living units, which primarily offer assistedliving services, located in seven states. All of the revenues at these communities are paid by residents fromtheir private resources.  We acquired LTAbecause its business complemented our business strategy of focusing ouroperations in high quality senior living assets where residents pay for ourservices with private resources.  Tofinance this acquisition, we entered into a $148,250 sale leaseback transactionwith Senior Housing for 31 of the communities acquired from LTA.  We funded the balance of the purchase pricewith cash on hand and by assuming HUD insured long term mortgage debts, othershort term liabilities and an operating lease for four communities from HCPI.  We allocated the purchase price $5,307 tocash and cash equivalents, $6,354 to other assets, $48,348 to land, buildingsand equipment, $148,250 to the land and buildings sold to Senior Housing,$2,590 to lease acquisition costs and $7,095 to goodwill which represents thecost of the acquisition in excess of the fair value of the identifiable netassets acquired.

 

In March 2005, we acquired a 62 unit assistedliving community located in Georgia for approximately $6,900.  We financed this acquisition with cash onhand.

 

In June 2005, we acquired six assisted livingcommunities from Gordon Health Ventures, LLC, or Gordon, for approximately$59,000, including closing costs.  Thesecommunities have a licensed resident capacity of 654 and are located in westernPennsylvania.  We funded this purchaseusing $10,000 drawn under our revolving credit facility and the proceeds from asale leaseback and mortgage transaction with Senior Housing.  We acquired these communities because theycomplement our business strategy of focusing our operations in high qualitysenior living assets where residents pay for our services with privateresources.  All of the revenues of thesecommunities come from residents’ private resources.  In connection with this acquisition, we soldfour different assisted living communities in June 2005 to Senior Housingfor $24,000 and Senior Housing leased these communities back to us for initialrent of $2,160 per annum.  Senior Housingalso provided a $43,500 first mortgage line of credit secured by

 

F-14

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the six Gordoncommunities.  We borrowed $24,000 underthis first mortgage line of credit when we closed the Gordon purchase andrepaid it in August 2005 with the proceeds from our sale of common sharesdescribed in Footnote 8 above.  Weallocated the purchase price of approximately $59,000 to land, buildings andequipment.

 

In connection with our termination of managementagreements for 12 communities managed by SLS in November 2005, we sold thesix Gordon communities to Senior Housing for $56,680, and Senior Housing leasedthese communities back to us.  Ourinitial rent to Senior Housing for these communities is $5,220 per annum.  We recognized a $2,333 impairment charge toreduce the carrying value of these communities to the amount realized upon thesale to Senior Housing, or $56,680.  Thegross purchase price paid to us by Senior Housing was equal to the same amountas the purchase price we paid to the seller of the Gordon communities.  The impairment loss which we recognizedrelates principally to transaction costs.

 

In addition to our community acquisitions, we havepurchased four institutional pharmacies. In September 2003, we purchased one pharmacy in Wisconsin forapproximately $1,800.  In September 2004,we purchased another pharmacy in Nebraska for approximately $3,000.  In June 2005, we purchased anotherpharmacy located in Nebraska for approximately $4,600.  In December 2005, we purchased apharmacy located in California for approximately $450.  We allocated the purchase prices of thesepharmacies to working capital assets, customer relationships and goodwill basedon the fair value of the assets acquired and liabilities assumed.

 

**We accounted for each of theseacquisitions using the purchase method of accounting, and we have included theresults of operations of each of the communities and pharmacies acquired in ourconsolidated statement of operations from the date of acquisition.  Our purchase accounting allocations forcertain 2005 acquisitions is preliminary, primarily with respect to ourvaluations of intangibles.  We expect tocomplete our purchase accounting allocations during 2006.**

** **

**10.   Discontinued Operations**

** **

During 2003, we ceased operating one nursing home thatwe leased from Senior Housing.  Thisfacility was sold by Senior Housing in 2003 and our minimum rent was reduced by$35 per year.

 

In August 2003, we sold an assisted livingcommunity and we received $3,500,consisting of $350 of cash and a $3,150 six year mortgage note at 8%interest.  We deferred the $1,100 gain onthis sale, and we expect to recognize this gain as income over the life of themortgage note in proportion to principal payments on the note that we receive.  In December 2003, we soldfive small assisted living communitiesand we received $3,550, consisting of $440 of cash and a $3,110 fifteen yearmortgage note at 9% interest.  Wedeferred the $1,200 gain on this sale and we expect to recognize this gain asincome when the buyer demonstrates it has the ability to pay the mortgagenote.  These deferred gains are includedin other long term liabilities on our consolidated balance sheet.

 

During 2004,we ceased operations at one assisted living community that we lease from SeniorHousing which was managed for us by SLS. Senior Housing sold that community in December 2005 for netproceeds of approximately $5,400, which caused a $540 reduction in annualminimum rent payable in accordance with our lease terms.

 

During 2005, we ceased operations at two communities:one skilled nursing community in Milwaukee, Wisconsin, which we lease fromSenior Housing; and one assisted living community in Los Angeles, California,which we also lease from Senior Housing.  Senior Housing sold the assistedliving community located in California in December 2005 for net proceedsof approximately $2,600, which caused a $260 reduction in annual minimum rentpayable in accordance with our lease terms. We and Senior Housing are in the process of selling the skilled nursingfacility located in Wisconsin and, upon its sale, our annual minimum rentpayable will decrease in accordance with the lease terms.

 

As of December 31, 2005, substantially all of ourassets and liabilities related to the communities where we have ceasedoperations have been disposed of and paid, respectively.  We have reclassified the consolidatedstatement of operations for all periods presented to show the results ofoperations of these communities as discontinued.  Below is a summary of the operating resultsof these discontinued operations included in the financial statements for theyears ended December 31, 2005, 2004 and 2003:

 

F-15

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| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
|       |       |     |       |     |       |     |       |
| Revenues   |       | $        | 8,515      |     | $          | 8,272    |       | $ | 14,762 |   |
| Expenses   |       | 11,427   |       | 10,666   |       | 17,142   |       |
| Net loss   |       | $        | (2,912     | )        | $          | (2,394   | )          | $ | (2,380 | ) |

** **

**11.  Transactions with Affiliates**

** **

On December 31, 2001, Senior Housingdistributed substantially all of our shares to its shareholders.  In order to effect this spin off and to governrelations after the spin off, we entered into agreements with Senior Housingand others 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 the consent of Senior Housing;

•                  solong as we are a tenant of Senior Housing, we will not permit nor take any actionthat, in the reasonable judgment of Senior Housing or HRPT Properties Trust(another REIT which owns shares of Senior Housing), or HRPT, might jeopardizethe 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 REIT Management andResearch LLC, or RMR, we will not acquire or finance any real estate withoutfirst giving Senior Housing, HRPT or any other publicly owned REIT or otherentity managed by RMR, the opportunity to acquire or finance real estate investmentsof the type in which Senior Housing, HRPT or any other publicly owned REIT orother entity managed by RMR, respectively, invest.

 

At the time of our spin off from SeniorHousing, all of the persons serving as our directors were trustees of SeniorHousing.  Our two managing directors, Messrs. Martinand Portnoy, are currently the managing trustees of Senior Housing.

 

Of the 153 senior living communities weoperate, 135 are leased from Senior Housing for total annual minimum rent of$103,459.

 

Since January 1, 2005, we have entered intoseveral transactions with Senior Housing, including:

 

•                  In May 2005, we purchased acommunity that we had leased from Senior Housing for its appraised value of$4,600.  This purchase was funded withproceeds we received from a HUD insured mortgage and our cash on hand.

 

•                  In June 2005, we acquired sixassisted living communities from Gordon for approximately $59,000.  We funded this purchase using $10,000 drawnunder our revolving credit facility and the proceeds of a sale leaseback andmortgage transaction with Senior Housing. We sold four of our assisted living communities to Senior Housing for$24,000 and Senior Housing leased these communities back to us for initial rentof $2,160 per annum.  Senior Housing alsoprovided us with a $43,500 first mortgage line of credit secured by the sixGordon communities.  We borrowed $24,000under this line of credit when we closed the Gordon purchase, and repaid thisamount in August 2005 with the proceeds from our sale of common shares.  The mortgage line of credit was terminated inOctober 2005 in connection with our sale and leaseback with Senior Housingof the six Gordon communities.  SeniorHousing paid us approximately $59,000 for these six communities.  Our initial rent to Senior Housing for thesesix communities is $5,220 per annum.

 

F-16

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•                  During2005, as permitted by our leases with Senior Housing, we sold to SeniorHousing, at cost, approximately $15,470 of improvements made to propertiesleased from Senior Housing, and the annual rent payable to Senior Housing wasincreased by 10% of the amount Senior Housing paid for the improvements, or approximately$1,547.

 

•                  In February 2006, weagreed to lease two hospitals from Senior Housing.  The term of the lease for these two hospitalscommences when we receive all health regulatory approvals required to operatethe two hospitals.  These two hospitalsprovide health rehabilitation services and are located in Braintree and Woburn,Massachusetts.  The hospitals are currently owned by SeniorHousing but operated by HealthSouth Corporation, or HealthSouth. Recently, theMassachusetts Superior Court has decided that Senior Housing validly terminatedHealthSouth’s lease and ordered HealthSouth to cooperate in the transfer of thehospitals’ operations to a new tenant designated by Senior Housing.  HealthSouth has appealed these decisions, butthe trial court and the appeals court have both denied HealthSouth’s requeststo stay these decisions until the appeal is decided.

 

Our Chief Executive Officer and ChiefFinancial Officer are also officers and employees of RMR. These officers devotea substantial majority of their business time to our affairs and the remainderto RMR’s business which is separate from our business. We believe thecompensation we pay to these officers reasonably reflects their division ofbusiness time; however, periodically, these individuals may divide theirbusiness time differently than they do currently and their compensation from usmay become disproportionate to this division.

 

RMR provides management and administrativeservices to us under a shared services agreement. RMR is compensated at anannual rate equal to 0.6% of our total revenues.  Aggregate fees earned by RMR for servicesduring 2005, 2004 and 2003, were $4,663, $3,700 and $3,400, respectively.  RMR also provides the internal audit functionfor us and for other publicly owned companies to which it provides management services.  We pay a proportionate share of RMR’s costsin providing that function.  Our auditcommittee approves the identity and salary of the individual serving as ourdirector of internal audit, 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, SeniorHousing, could create conflicts; and in the event of such conflicts betweenSenior Housing and us, the shared services agreement allows RMR to act onbehalf of Senior Housing rather than on our behalf.  Prior to October 1, 2005, RMR wasbeneficially owned by Messrs. Barry M. Portnoy and Gerard M. Martin, each amanaging director and member of our board of directors. Effective October 1,2005, Messrs. Barry M. Portnoy and his son, Adam D. Portnoy, acquired Mr.Martin’s beneficial ownership interest in RMR. Mr. Adam D. Portnoy is anexecutive officer of RMR and the Executive Vice President of HRPT. Mr. Martinremains a director of RMR and, together with Mr. Barry M. Portnoy, continues toserve as one of our managing directors. All transactions between us and RMR are approved by our independentdirectors.

 

Mr. Barry M. Portnoy is the majorityowner of the building in which our headquarters is located.  This lease expires in 2011.  We paid rent, which includes our proportionalshare of utilities and real estate taxes, under this lease during 2005, 2004and 2003 of $711, $561 and $569, respectively. This lease has been amended atvarious times to take into account our needs for increasing space and all amendmentsto this lease have been approved by our independent directors.

 

**12.  Employee Benefit Plan**

 

We have established and assumed several employeesavings plans under the provisions of Section 401(k) of the InternalRevenue Code.  All employees are eligible to participate in at least oneof our plans and are entitled, upon termination or retirement, to receive theirvested portion of the plan assets.  For some of our plans, we match acertain level of employee contributions.  We also pay certain expenses relatedto all of our plans.  Expenses for all our plans, including ourcontributions, were $244, $35 and $23 for the years ended December 31,2005, 2004 and 2003, respectively.

 

**13.  Fair Value of Financial Instruments**

** **

Our financial instruments are limited to cash and cashequivalents, accounts receivable, accounts payable, the refundable portion ofcontinuing care contracts, mortgage notes receivable and payable.  The fair value of these financial instrumentswas not materially different from their carrying values at December 31,2005 and 2004.  Our estimates of fairvalues were based on current market prices and discounted cash flow analysis.

 

**14.  Segment Information**

** **

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

** **

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

** **

The following is a summary of unaudited quarterlyresults of operations for the years ended December 31, 2005 and 2004:

 

F-17

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| ** **                                    | ** ** | **2005**           | ** ** |
|-----------------------------------------------|------------|--------------------|------------|
| ** **                                    | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                      |       | $                  | 180,206    |   | $ | 183,946 |   | $ | 193,624 |   | $ | 199,751 |   |
| Net income  (loss) from continuing operations |       | 1,739              |       | 1,884 |   | (83,755 | ) | (1,115 | ) |
| Net income  (loss)                            |       | 1,253              |       | 1,167 |   | (84,374 | ) | (2,205 | ) |
| Net income  (loss) per common share           |       | $                  | 0.10       |   | $ | 0.10 |   | $ | (5.65 | ) | $ | (0.11 | ) |

 
|                                   |   | **2004**           |       |
|----------------------------------------|--------|--------------------|------------|
|                                   |   | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** |   |
| Revenues                               |   | $                  | 149,630    |   | $ | 151,830 |   | $ | 151,913 |   | $ | 166,641 |   |
| Net income  from continuing operations |   | 1,311              |       | 1,744 |   | 1,167 |   | 1,463 |   |
| Net income                             |   | 507                |       | 943 |   | 776 |   | 1,065 |   |
| Net income  per common share           |   | $                  | 0.06       |   | $ | 0.11 |   | $ | 0.10 |   | $ | 0.11 |   |

 

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

** **

Pro forma operating results assuming commencement ofoperations, as of January 1, 2004, of the 47 communities we acquired fromLTA during 2004 and the six communities we acquired from Gordon, and assumingthat our sale of 7,880,000 common shares occurred on January 1, 2004, areas follows:

 
| ** **                                              | ** ** | **2005**        | ** ** | **2004** | ** ** |
|---------------------------------------------------------|------------|-----------------|------------|----------|------------|
|                                                    |       | **(unaudited)** |       |
| Revenues                                                |       | $               | 765,773    |     | $          | 708,037 |   |
| Expenses                                                |       | 846,556         |       | 700,915  |       |
| Net (loss)  income from continuing operations           |       | (80,783         | )          | 7,122    |       |
| Loss from  discontinued operations                      |       | (2,912          | )          | (2,394   | )          |
| Net (loss)  income                                      |       | $               | (83,695    | )        | $          | 4,728 |   |
|                                                    |       |            |       |     |       |
| Shares  outstanding                                     |       | 20,061          |       | 20,061   |       |
| Net (loss)  income per share from continuing operations |       | $               | (4.03      | )        | $          | 0.36 |   |

 

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.

 

**17.  Subsequent Events**

** **

In February 2006, we agreed to lease twohospitals from Senior Housing.  The termof the lease for the two hospitals commences when we receive all healthregulatory approvals required to operate the hospitals.  These two hospitals provide healthrehabilitation services and are located in Braintree and Woburn,Massachusetts.  These hospitals offerextensive inpatient and outpatient services. The hospitals are currently owned by Senior Housing but operated byHealthSouth.  Recently, the MassachusettsSuperior Court has decided that Senior Housing validly terminated HealthSouth’slease and ordered HealthSouth to cooperate in the transfer of the hospitals’operations to a new tenant designated by Senior Housing.  HealthSouth has appealed these decisions, butthe trial court and the appeals court have both denied HealthSouth’s requeststo stay these decisions until the appeal is decided. Fully reliable financialinformation about the current operations at these hospitals is not presentlyavailable.  Nonetheless, we believe thatwe will be able to operate these hospitals profitably and that these profitsmay be material to our operating results. We believe that the successful operation of these hospitals may enhanceour reputation as a provider of health and rehabilitation services and thatthis enhanced reputation may benefit us at other healthcare and senior livingfacilities which we operate.

 

F-18

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**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 13, 2006

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| **Signature**               | ** ** | **Title**                      | ** **                            | **Date** | ** **          |
|-----------------------------|------------|--------------------------------|---------------------------------------|----------|---------------------|
|                        |       |                           |                                  |     |                |
| /s/ Evrett  W. Benton       |       |                           | President and Chief Executive Officer |     | March 13, 2006 |   |
| Evrett W.  Benton           |       |                           |                                  |     |                |
|                        |       |                           |                                  |     |                |
| /s/ Bruce J.  Mackey Jr.    |       |                           | Chief Financial Officer and Treasurer |     | March 13, 2006 |   |
| Bruce J.  Mackey Jr.        |       | (Principal Accounting Officer) |                                  |     |                |
|                        |       |                           |                                  |     |                |
| /s/ Barry M.  Portnoy       |       |                           | Managing Director                     |     | March 13, 2006 |   |
| Barry M.  Portnoy           |       |                           |                                  |     |                |
|                        |       |                           |                                  |     |                |
| /s/ Gerard  M. Martin       |       |                           | Managing Director                     |     | March 13, 2006 |   |
| Gerard M.  Martin           |       |                           |                                  |     |                |
|                        |       |                           |                                  |     |                |
| /s/ Bruce M.  Gans          |       |                           | Director                              |     | March 13, 2006 |   |
| Bruce M.  Gans              |       |                           |                                  |     |                |
|                        |       |                           |                                  |     |                |
| /s/ Barbara  D. Gilmore     |       |                           | Director                              |     | March 13, 2006 |   |
| Barbara D.  Gilmore         |       |                           |                                  |     |                |
|                        |       |                           |                                  |     |                |
| /s/ Arthur  G. Koumantzelis |       |                           | Director                              |     | March 13, 2006 |   |
| Arthur G.  Koumantzelis     |       |                           |                                  |     |                |
|                             |            |                                |                                       |          |                     |  |  |  |  |  |  |

 

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