**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549


______________________





**FORM
      10-Q**


(Mark
                One)x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF****THE
                SECURITIES EXCHANGE ACT
                1934**





For
      the
      quarterly period ended September 30, 2006





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





Commission
      file number 1-14012











**EMERITUS
      CORPORATION**


(Exact
      name of registrant as specified in its charter)





WASHINGTON
            91-1605464(State
                or other jurisdiction
            (I.R.S
                Employerof
                incorporation or organization)
            Identification
                No.)





3131
      Elliott Avenue, Suite 500


Seattle,
      WA 98121


(Address
      of principal executive offices)





(206)
      298-2909


(Registrant's
      telephone number, including area code)


____________________________





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





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





Large
      accelerated filer  o  Accelerated
      filer  þ  Non-accelerated
      filer  o





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes  o  No  þ





As
      of
      October 31, 2006, there were  18,076,403 shares
      of the Registrant's Common Stock, par value $.0001, outstanding.











**EMERITUS
                CORPORATION****Table
                of Contents****Part
                I. Financial
                Information**Page
                No.**Item
                1. Financial Statements (unaudited):**
            1Condensed
                Consolidated Balance Sheets as of September 30, 2006,
                and December 31, 2005
            2Condensed
                Consolidated Statements of Operations for the Three
                months and Nine months ended September 30, 2006 and
                2005
            3Condensed
                Consolidated Statements of Cash Flows for the Nine
                months ended September 30, 2006 and 2005
            4Notes
                to Unaudited Condensed Consolidated Financial
                Statements
            5**Item
                2.**
            **Management's
                Discussion and Analysis of Financial Condition
                and Results of Operations**
            17**Item
                3.**
            **Quantitative
                and Qualitative Disclosures About Market
                Risk**
            45**Item
                4.**
            **Controls
                and Procedures**
            45**Part
                II. Other Information**Note:
            Items
                2, 3, 4, and 5 of Part II are omitted because they are not
                applicable.**Item
                1.**
            **Legal
                Proceedings**
            46**Item
                1A.**
            **Risk
                Factors**
            47**Item
                6.**
            **Exhibits**
            47**Signature**
            48

















**PART
      I. Financial Information**





**Item
      1. Financial Statements****(unaudited)**








[The
      rest
      of this page is intentionally left blank]








**1**


Table
      of
      Contents


**EMERITUS
                CORPORATION****CONDENSED
                CONSOLIDATED BALANCE SHEETS****(unaudited)****(In
                thousands, except share data)****ASSETS****September
                30,**
            
            **December
                31,****2006**
            
            **2005**Current
                Assets:Cash
                and cash equivalents
            
            $
            24,208
            
            $
            56,413Short-term
                investments
            
            
            1,705
            
            
            1,885Trade
                accounts receivable, net of allowance of $758 and $744
            
            
            5,034
            
            
            4,604Other
                receivables
            
            
            2,802
            
            
            2,297Tax
                and maintenance escrows
            
            
            7,308
            
            
            6,579Prepaid
                workers' compensation
            
            
            9,315
            
            
            7,542Other
                prepaid expenses
            
            
            8,037
            
            
            6,791Total
                current assets
            
            
            58,409
            
            
            86,111Property
                and equipment, net of accumulated depreciation of $142,970 and
                $109,035
            
            
            607,790
            
            
            619,146Property
                held for development
            
            
            428
            
            
            402Notes
                receivable and investments in affiliates
            
            
            3,631
            
            
            3,709Restricted
                deposits
            
            
            12,300
            
            
            9,660Lease
                and contract acquisition costs, net of amortization of $13,114 and
                $10,487
            
            
            26,940
            
            
            27,167Other
                assets, net
            
            
            3,809
            
            
            1,575Total
                assets
            
            $
            713,307
            
            $
            747,770**LIABILITIES
                AND SHAREHOLDERS' DEFICIT**Current
                Liabilities:Current
                portion of long-term debt
            
            $
            2,858
            
            $
            2,825Current
                portion of capital lease and financing obligations
            
            
            21,429
            
            
            19,028Current
                portion of convertible debentures
            
            
            -
            
            
            5,375Trade
                accounts payable
            
            
            5,378
            
            
            7,070Accrued
                employee compensation and benefits
            
            
            16,286
            
            
            17,372Accrued
                interest
            
            
            976
            
            
            2,355Accrued
                real estate taxes
            
            
            7,323
            
            
            6,478Accrued
                professional and general liability
            
            
            11,900
            
            
            27,994Accrued
                income taxes
            
            
            264
            
            
            4,649Other
                accrued expenses
            
            
            10,604
            
            
            7,280Deferred
                revenue
            
            
            9,266
            
            
            8,143Unearned
                rental income
            
            
            6,468
            
            
            6,350Total
                current liabilities
            
            
            92,752
            
            
            114,919Long-term
                debt, less current portion
            
            
            83,963
            
            
            77,650Capital
                lease and financing obligations, less current portion
            
            
            591,850
            
            
            607,677Convertible
                debentures, less current portion
            
            
            26,575
            
            
            26,625Deferred
                gain on sale of communities
            
            
            24,348
            
            
            26,009Deferred
                rent
            
            
            6,206
            
            
            5,496Other
                long-term liabilities
            
            
            2,249
            
            
            2,467Total
                liabilities
            
            
            827,943
            
            
            860,843Commitments
                and contingenciesShareholders'
                Deficit:Preferred
                stock, $.0001 par value. Authorized 5,000,000 shares, none
                issuedCommon
                stock, $.0001 par value. Authorized 40,000,000 shares; issued and
                outstanding18,063,678
                and 16,486,944 shares at September 30, 2006, and December 31, 2005,
                respectively
            
            
            2
            
            
            2Additional
                paid-in capital
            
            
            87,080
            
            
            79,321Accumulated
                deficit
            
            
            (201,718
            )
            
            (192,396
            )Total
                shareholders' deficit
            
            
            (114,636
            )
            
            (113,073
            )Total
                liabilities and shareholders' deficit
            
            $
            713,307
            
            $
            747,770








See
      accompanying Notes to Unaudited Condensed Consolidated Financial Statements
      and
      Management's


Discussion
      and Analysis of Financial Condition and Results of Operations.








**2**


Table
      of
      Contents


**EMERITUS
                CORPORATION****CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS****(unaudited)****(In
                thousands, except per share data)****Three
                Months ended September 30,**
            
            **Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenues:Community
                revenue
            
            $
            105,394
            
            $
            95,357
            
            $
            305,860
            
            $
            281,873Other
                service fees
            
            
            1,537
            
            
            1,698
            
            
            4,869
            
            
            5,178Management
                fees
            
            
            380
            
            
            455
            
            
            1,321
            
            
            1,517Total
                operating revenues
            
            
            107,311
            
            
            97,510
            
            
            312,050
            
            
            288,568Expenses:Community
                operations (exclusive of depreciation and amortizationand
                facility lease expense shown separately below)
            
            
            69,763
            
            
            68,539
            
            
            203,792
            
            
            190,887Texas
                lawsuit settlement
            
            
            -
            
            
            -
            
            
            (12,207
            )
            
            -General
                and administrative
            
            
            10,380
            
            
            8,250
            
            
            27,832
            
            
            23,440Depreciation
                and amortization
            
            
            12,820
            
            
            11,627
            
            
            37,221
            
            
            34,427Facility
                lease expense
            
            
            11,254
            
            
            10,534
            
            
            33,264
            
            
            30,658Total
                operating expenses
            
            
            104,217
            
            
            98,950
            
            
            289,902
            
            
            279,412Operating
                income (loss) from continuing operations
            
            
            3,094
            
            
            (1,440
            )
            
            22,148
            
            
            9,156Other
                income (expense):Interest
                income
            
            
            759
            
            
            448
            
            
            2,311
            
            
            883Interest
                expense
            
            
            (12,581
            )
            
            (13,049
            )
            
            (36,787
            )
            
            (37,417
            )Gain
                on sale of investment in Alterra Healthcare Corporation
            
            
            -
            
            
            -
            
            
            -
            
            
            21,323Equity
                earnings (losses) in unconsolidated joint ventures
            
            
            (138
            )
            
            2,328
            
            
            (630
            )
            
            2,277Other,
                net
            
            
            561
            
            
            594
            
            
            1,719
            
            
            1,986Net
                other expense
            
            
            (11,399
            )
            
            (9,679
            )
            
            (33,387
            )
            
            (10,948
            )Loss
                from continuing operations before income taxes
            
            
            (8,305
            )
            
            (11,119
            )
            
            (11,239
            )
            
            (1,792
            )Provision
                for income taxes
            
            
            1,877
            
            
            (122
            )
            
            1,967
            
            
            (1,211
            )Loss
                from continuing operations
            
            
            (6,428
            )
            
            (11,241
            )
            
            (9,272
            )
            
            (3,003
            )Loss
                from discontinued operations (net of tax)
            
            
            (6
            )
            
            (328
            )
            
            (50
            )
            
            (3,248
            )Net
                loss
            
            
            (6,434
            )
            
            (11,569
            )
            
            (9,322
            )
            
            (6,251
            )Preferred
                stock dividends
            
            
            -
            
            
            -
            
            
            -
            
            
            (599
            )Net
                loss to common shareholders
            
            $
            (6,434
            )
            $
            (11,569
            )
            $
            (9,322
            )
            $
            (6,850
            )Basic
                and diluted loss per common share:Continuing
                operations
            
            $
            (0.36
            )
            $
            (0.69
            )
            $
            (0.53
            )
            $
            (0.28
            )Discontinued
                operations
            
            
            -
            
            
            (0.02
            )
            
            -
            
            
            (0.26
            )$
            (0.36
            )
            $
            (0.71
            )
            $
            (0.53
            )
            $
            (0.54
            )Weighted
                average common shares outstanding - basic and diluted :
            
            
            18,024
            
            
            16,271
            
            
            17,664
            
            
            12,690











See
      accompanying Notes to Unaudited Condensed Consolidated Financial Statements
      and
      Management's


Discussion
      and Analysis of Financial Condition and Results of Operations.








**3**


Table
      of
      Contents   
 **EMERITUS
                  CORPORATION****CONDENSED
                  CONSOLIDATED STATEMENTS OF CASH FLOWS****(unaudited)****(In
                  thousands)****Nine
                  Months Ended September 30,****2006**
              
              **2005**Cash
                  flows from operating activities:Net
                  loss
              
              $
              (9,322
              )
              $
              (6,251
              )Adjustments
                  to reconcile net loss to net cash provided by (used in) operating
                  activities:Depreciation
                  and amortization
              
              
              37,221
              
              
              34,427Amortization
                  of deferred gain
              
              
              (1,661
              )
              
              (1,661
              )Gain
                  on sale of properties, net
              
              
              -
              
              
              (1,321
              )Gain
                  on sale of investment
              
              
              -
              
              
              (21,323
              )Impairment
                  of long-lived asset
              
              
              -
              
              
              4,262Amortization
                  of loan fees
              
              
              191
              
              
              316Preferred
                  stock conversion costs
              
              
              -
              
              
              265Equity
                  investment (gains) losses
              
              
              630
              
              
              (2,277
              )Stock
                  option compensation
              
              
              2,205
              
              
              -Other
              
              
              611
              
              
              718Changes
                  in operating assets and liabilities, net of acquisitions
              
              
              (26,222
              )
              
              5,602Net
                  cash provided by operating activities
              
              
              3,653
              
              
              12,757Cash
                  flows from investing activities:Acquisition
                  of property and equipment
              
              
              (19,186
              )
              
              (5,595
              )Acquisition
                  of assets in lease transactions
              
              
              -
              
              
              (406
              )Construction
                  expenditures - leased properties
              
              
              (3,068
              )
              
              (1,263
              )Lease
                  and contract acquisition costs
              
              
              (2,801
              )
              
              (1,830
              )Payments
                  from (advances to) affiliates and other managed
                  communities
              
              
              402
              
              
              (106
              )Proceeds
                  from the sale of investment in Alterra, net
              
              
              -
              
              
              24,979Investment
                  in affiliates
              
              
              (590
              )
              
              1,293Collection
                  of notes receivable
              
              
              39
              
              
              -Net
                  cash provided by (used in) investing activities
              
              
              (25,204
              )
              
              17,072Cash
                  flows from financing activities:Proceeds
                  from sale of stock
              
              
              4,179
              
              
              583Increase
                  in restricted deposits
              
              
              (2,640
              )
              
              (1,982
              )Debt
                  issue and other financing costs
              
              
              (274
              )
              
              (795
              )Proceeds
                  from long-term borrowings and financings
              
              
              8,586
              
              
              32,226Repayment
                  of debenture
              
              
              (5,375
              )
              
              -Repayment
                  of long-term borrowings
              
              
              (2,551
              )
              
              (22,574
              )Repayment
                  of capital lease and financing obligations
              
              
              (13,904
              )
              
              (11,732
              )Tax
                  benefit of stock compensation
              
              
              1,325
              
              
              -Payment
                  of preferred dividend
              
              
              -
              
              
              (10,772
              )Net
                  cash used in financing activities
              
              
              (10,654
              )
              
              (15,046
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              (32,205
              )
              
              14,783Cash
                  and cash equivalents at the beginning of the period
              
              
              56,413
              
              
              10,748Cash
                  and cash equivalents at the end of the period
              
              $
              24,208
              
              $
              25,531Supplemental
                  disclosure of cash flow information -Cash
                  paid during the period for interest
              
              $
              38,166
              
              $
              37,600Non-cash
                  financing and investing activities:Accrued
                  and in-kind preferred stock dividends
              
              $
              -
              
              $
              599Debt
                  issued for acquisition of property and equipment
              
              $
              -
              
              $
              1,417Capital
                  lease and financing obligations
              
              $
              787
              
              $
              15,234Note
                  retirement
              
              $
              -
              
              $
              630Conversion
                  of convertible debentures
              
              $
              50
              
              $
              -Deferred
                  lease acquisition cost
              
              $
              179
              
              $
              -Reduction
                  in property held for sale and related deposit
              
              $
              -
              
              $
              7,891
 
 See
        accompanying Notes to Unaudited Condensed Consolidated Financial Statements
        and
        Management's
 Discussion
        and Analysis of Financial Condition and Results of Operations




**4**


Table
      of
      Contents





**EMERITUS
      CORPORATION**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





**Definitions**





Throughout
      Notes to Unaudited Condensed Consolidated Financial Statements certain terms
      are
      used repeatedly. In the interest of brevity, the full reference has been
      abbreviated to a single name or acronym. The following defines these abbreviated
      terms:





1.
            "FASB"
                refers to the Financial Accounting Standards
                Board.


2.
            "SFAS"
                refers to Statement of Financial Accounting
                Standards.


3.
            "SEC"
                refers to the Securities and Exchange
                Commission.


4.
            "REIT"
                means real estate investment trust.


5.
            "LIBOR"
                is the London Interbank Offering
                Rate.


6.
            "Mr.
                Baty" refers to Daniel R. Baty, the Company's chairman of the board
                of
                directors and chief executive officer.


7.
            "Triple-net
                lease" means a lease under which the lessee pays all operating expenses
                of
                the property, including taxes, licenses, utilities, maintenance,
                and
                insurance. The lessor receives a net rent.


8.
            "JEA"
                refers to JEA Senior Living, a
                non-affiliate.


9.
            "Fortress"
                refers to Fortress Investment Group LLC, a New York based private
                equity
                fund.


10.
            "LLC"
                refers to a limited liability
                company.


11.
            "NW"
                refers to NW Select LLC, an entity controlled by Mr.
                Baty.


12.
            "CPM"
                refers to Columbia Pacific Management, a group of entities controlled
                by
                Mr. Baty.


13.
            “SHP”
                refers to Senior Healthcare Partners, LLC, a pharmaceutical supply
                limited
                liability company.


14.
            "Saratoga"
                refers to a group of related companies, namely: Saratoga Partners
                IV, LP;
                Saratoga Management Company LLC, as Agent; and Saratoga Coinvestment
                IV,
                LLC.


15.
            "Series
                B Stock" refers to Series B Convertible Preferred
                Stock.


16.
            “Emeritrust”
                refers to two groups of communities (totaling 46 communities) that
                were
                managed by the Company starting in 1998. These communities were owned
                by
                two different investor groups in each of which Mr. Baty held a
                non-controlling interest. The composition of the groups has changed
                over
                time and most of the communities are now leased by the Company. Further
                details are available in the Company’s Forms 10-K for years prior to
                2006.





**Summary
      of Significant Accounting Policies and Use of Estimates**





The
      preparation of condensed consolidated financial statements requires Emeritus
      to
      make estimates and judgments that affect the reported amounts of assets,
      liabilities, revenues and expenses, and related disclosure of contingent assets
      and liabilities. On an ongoing basis, Emeritus evaluates its estimates,
      including those related to resident programs and incentives such as move-in
      fees, bad debts, investments, intangible assets, impairment of long-lived
      assets, income taxes, restructuring, long-term service contracts, contingencies,
      self-insured retention, insurance deductibles, health insurance, and litigation.
      Emeritus bases its estimates on historical experience and on various other
      assumptions that are believed to be reasonable under the circumstances, the
      results of which form the basis for making judgments about the carrying values
      of assets and liabilities that are not readily apparent from other sources.
      Actual results may differ from these estimates under different assumptions
      or
      conditions.





Emeritus
      believes that certain critical accounting policies are most significant to
      the
      judgments and estimates used in the preparation of its condensed consolidated
      financial statements. Revisions in such estimates are charged to income in
      the
      period in which the facts that give rise to the revision become known. A
      detailed discussion of the Company’s significant accounting policies and use of
      estimates is contained in the Company’s 2005 Form 10-K filed March 16, 2006.





**Basis
      of Presentation**





The
      unaudited interim financial information furnished herein, in the opinion of
      the
      Company's management, reflects all adjustments, consisting of only normally
      recurring adjustments, which are necessary to state fairly the condensed
      consolidated financial position as of September 30, 2006, and the results of
      operations, and cash flows of Emeritus for the three and nine month periods
      ended September 30, 2006 and 2005. The results of operations for the period
      ended September 30, 2006, are not necessarily indicative of the operating





**5**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


results
      for the full year. The Company presumes that those reading this interim
      financial information have read or have access to its 2005 audited consolidated
      financial statements and Management's Discussion and Analysis of Financial
      Condition and Results of Operations that are contained in the Company’s 2005
      Form 10-K filed March 16, 2006. Therefore, the Company has omitted footnotes
      and
      other disclosures herein, which are disclosed in the Form 10-K.





**Reclassifications**





Certain
      reclassifications have been made to the condensed consolidated financial
      statements to conform to the current period presentation, primarily relating
      to
      the impact of discontinued operations on prior periods.





**Stock-Based
      Compensation**





In
      December 2004, the FASB issued SFAS No. 123R. SFAS No. 123R is a revision of
      SFAS No. 123, as amended, Accounting for Stock-Based Compensation (‘SFAS No.
      123”), and supersedes Accounting Principals Board Opinion (“APB”) No. 25,
      Accounting for Stock Issued to Employees (“APB No. 25”). SFAS No. 123R
      eliminates the alternative to use the intrinsic value method of accounting
      that
      was provided in SFAS 123, which generally resulted in no compensation expense
      recorded in the financial statements related to the issuance of stock options
      or
      shares issued under the Company’s Employee Stock Purchase Plan (“ESP Plan”).
      SFAS No. 123R establishes fair value as the measurement objective in accounting
      for share-based payment arrangements and requires all companies to apply a
      fair-value-based measurement method in accounting for, generally, all
      share-based payment transactions with employees.





On
      January 1, 2006, the Company adopted SFAS No. 123R. The Company adopted SFAS
      No.
      123R using a modified prospective application, as permitted under SFAS No.
      123R.
      Accordingly, prior period amounts have not been restated. Under this
      application, the Company is required to record compensation expense for all
      awards granted after the date of adoption and for the unvested portion of
      previously granted awards that remain outstanding at the date of
      adoption.





Before
      the adoption of SFAS No. 123R, the Company applied APB Opinion No. 25 to account
      for stock-based awards. Under APB Opinion No. 25, the Company was not required
      to recognize compensation expense for the cost of stock options or shares issued
      under the Company’s ESP Plan. In accordance with the adoption of SFAS No. 123R,
      the Company recorded stock-based compensation expense for the cost of stock
      options and shares issued under the ESP Plan of approximately $2.0 million
      and
      $2.2 million for the three months and nine months ended September 30, 2006,
      respectively. For the three months and nine months ended September 30, 2005,
      the
      Company disclosed pro forma net loss and net loss per share as if compensation
      cost had been determined consistent with SFAS No. 123R.





With
      the
      adoption of SFAS No. 123R, the Company has recorded an expense for the unvested
      portion of awards granted before the adoption of SFAS No. 123R, options granted
      during the current year and for shares issued under the ESP Plan during the
      current year.





**6**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


The
      following table details the effect on net loss and loss per share had
      stock-based compensation expense been recorded in both the three and nine month
      periods ended September 30, 2006 and 2005, under SFAS No. 123R. The pro forma
      net loss and loss per share for the three months and nine months ended September
      30, 2006, are the same since stock-based compensation is calculated under the
      provisions of SFAS No. 123R.





**Three
                Months ended**
            
            **Nine
                Months ended****September
                30,**
            
            **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****(In
                thousands, except per share data )**Net
                loss to common shareholdersAs
                reported
            
            $
            (6,434
            )
            $
            (11,569
            )
            $
            (9,322
            )
            $
            (6,850
            )Add:
                Stock-based employee compensation expenseincluded
                in reported net loss
            
            
            1,984
            
            
            -
            
            
            2,205
            
            
            -Deduct:
                Stock-based employee compensationdetermined
                under fair value based method for all awards
            
            
            (1,984
            )
            
            (367
            )
            
            (2,205
            )
            
            (799
            )Pro
                forma
            
            $
            (6,434
            )
            $
            (11,936
            )
            $
            (9,322
            )
            $
            (7,649
            )Net
                loss per common share-
                basic and diluted:As
                reported
            
            $
            (0.36
            )
            $
            (0.71
            )
            $
            (0.53
            )
            $
            (0.54
            )Pro
                forma
            
            $
            (0.36
            )
            $
            (0.73
            )
            $
            (0.53
            )
            $
            (0.60
            )





In
      the
      first nine months of 2006, the adoption of SFAS No. 123R caused net loss to
      increase by $2.2 million and basic and diluted loss per share to increase by
      $.12 per share.





SFAS
      No.
      123R requires that stock-based compensation be recognized over the period from
      the date of grant to the date when the award is no longer contingent on the
      employee providing additional services (the “vesting period”). The Company’s
      stock incentive plans and the non-employee directors’ incentive plan provide
      that awards generally vest over a one to three year period. Any unexercised
      options expire between seven and ten years. The fair value of each grant is
      estimated as a single award and amortized into compensation expense over its
      vesting period. During the third quarter of 2006, the Company granted options
      to
      purchase 479,500 shares of common stock from the 2006 equity incentive
      plan.





The
      following table summarizes the Company’s stock option activity for the nine
      months ended September 30, 2006:




**2006****Shares**
            
            **Weighted-Average
                Exercise Price**
            
            **Aggregate
                Intrinsic Value ($000)**Outstanding
                at beginning of year
            
            
            1,349,381
            
            $
            3.81Granted
            
            
            524,500
            
            $
            18.81Exercised
            
            
            (257,869
            )
            $
            3.26Canceled
            
            
            (9,333
            )
            $
            7.09Outstanding
                at September 30, 2006
            
            
            1,606,679
            
            $
            8.77
            
            $
            16,128Options
                exercisable at September 30, 2006
            
            
            1,244,036
            
            $
            5.82
            
            $
            16,081Weighted-average
                fair value of options granted in second quarter 2006
            
            
            -
            
            $
            11.67Weighted-average
                fair value of options granted in third quarter 2006
            $
            10.17








**7**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents





The
      weighted average remaining contractual life was 6.3 years at September 30,
      2006,
      for stock options outstanding and exercisable. The total intrinsic value for
      stock options outstanding and exercisable was $16.1 million and $17.4 million
      at
      September 30, 2006 and 2005, respectively. The total intrinsic value for stock
      options exercised was $1.1 million and $1.4 million for the third quarter of
      2006 and 2005, respectively. The total intrinsic value for stock options
      exercised was $4.6 million and $2.1 million for the nine months ended September
      30, 2006 and 2005, respectively. The weighted-average fair value for the stock
      options granted on June 14, 2006, was $11.67 and $10.17 for those granted July
      25, 2006. As of September 30, 2006, there was $3.0 million of total unrecognized
      compensation expense related to unvested share-based compensation arrangements
      granted under the Plan. That expense is expected to be recognized over a
      weighted average period of two years.





The
      amount of cash received from the exercise of stock options was $841,000 and
      $440,000 in the first nine months of 2006 and 2005, respectively.





The
      Company estimates the fair value of its options using the Black-Scholes option
      value model, which is one of several methods that can be used to estimate option
      values. The Black-Scholes option valuation model was developed for use in
      estimating the fair value of traded options that have no vesting restrictions
      and are fully transferable. Option valuation models require the input of various
      assumptions, including the expected stock price volatility, risk-free interest
      rate, dividend yield, and forfeiture rate. The fair value of the stock options
      granted was estimated using a risk free rate that is the five year U.S. Treasury
      yield in effect at the time of grant. The expected life of the stock options
      granted (five years) was estimated using the historical exercise behavior of
      option holders. Expected volatility was based on historical volatility for
      a
      period equal to the stock option’s expected life, ending on the date of grant.
      Under SFAS 123R, forfeitures are estimated at the time of valuation and reduce
      expense ratably over the vesting period. The forfeiture rate, which was
      estimated at 10 percent of the shares awarded, is adjusted periodically based
      on
      the extent to which actual forfeitures differ, or are expected to differ, from
      the previous estimate. The Company's options have characteristics significantly
      different from those of traded options and changes in the various input
      assumptions can materially affect the fair value estimates. The fair value
      of
      options granted in the three months and nine months ended September 30, 2006
      and
      2005, were estimated at the date of grant using the following weighted average
      assumptions:





**Three
                Months Ended September 30,**
            
            **Nine
                Months Ended September 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Expected
                life from grant date (in years)
            5
            
            4
            
            5
            
            4Weighted
                average risk-free interest rate
            5.02%
            
            3.96%
            
            5.02%
                - 5.03%
            
            3.74%
                - 3.96%Weighted
                average volatility
            58.00%
            
            64.00%
            
            58.0%
                - 59.4%
            
            64.0%
                - 74.6%Dividend
                yield
            -
            
            -
            
            -
            
            -Weighted-average
                fair value of options
            $
                10.17
            
            $
                7.54
            
            $
                10.30
            
            $
                7.38




On
      June
      14, 2006, at the annual shareholders’ meeting, the 2006 Equity Incentive Plan
      was approved. The 2006 Plan authorizes the issuance of up to 1,000,000 shares
      of
      common stock for employees, non-employee directors, consultants, advisors and
      independent contractors. The plan allows for the granting of various types
      of
      awards, one of which is stock options that generally vest up to a three year
      period. Unless the terms of option grants specifically provide otherwise, any
      unexercised options expire no later than ten years. On July 25, 2006, 479,500
      stock options were granted under the 2006 Equity Incentive Plan, having terms
      of
      one third vesting immediately, and the remainder vesting over the next two
      years. These options will expire in seven years or on July 25, 2013. The Company
      has 169,000 shares of common stock authorized under the Amended and Restated
      Option Plan for Non Employee Directors that were available for issuance as
      of





**8**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


September
      30, 2006. Additional information about the Company’s stock plans is available in
      the Company’s 2005 Form 10-K and in its 2006 Definitive Proxy Statement Schedule
      14A filed with the SEC on May 1, 2006.





The
      Company offers eligible employees the option to purchase common stock of the
      Company under the ESP Plan at a 15% discount from the lower of the market price
      on the first trading date at the beginning of the current calendar quarter,
      or
      the last trading date of the current quarter. The Company issued 7,016 and
      17,827 shares of Common Stock under the ESP Plan during the three and nine
      months ended September 30, 2006, respectively. The purchase price of the shares
      was $18.36, $15.94, and $16.15 for the first, second, and third quarter of
      2006,
      respectively, which equals 85% of the market price on first or the last trading
      day of each quarter, whichever is less.





The
      following table shows the assumptions used in calculating the compensation
      expense for the ESP Plan shares issued during the quarter:








**Three
                Months Ended September 30,**
            
            **Nine
                Months Ended September 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Expected
                life from grant date (in months)
            
            
            3
            
            
            3
            
            
            3
            
            
            3Weighted
                average risk-free interest rate
            
            
            4.91
            %
            
            3.44
            %
            
            3.91%
                - 4.91
            %
            
            2.73%
                - 3.44
            %Weighted
                average volatility
            
            
            13.50
            %
            
            15.10
            %
            
            13.5%
                - 16.50
            %
            
            15.1%
                - 19.20
            %





**Emeritrust
      Transactions**





*Emeritrust Managed
      Communities* .
      For the
      nine months ended September 30, 2006, the Company managed five communities,
      which are owned by Mr. Baty, for a management fee equal to 5% of gross revenues.
      The agreement has been extended for one year and expires on June 30,
      2007. One of
      these communities was sold to an independent third party effective January
      1,
      2006, which the Company continued to manage until the new operator received
      licensure on March 20, 2006. Emeritus received management fees of approximately
      $119,000 and $129,000 for the three months ended September 30, 2006 and 2005,
      respectively, and approximately $348,000 and $385,000 for the nine months ended
      September 30, 2006 and 2005, respectively.





*Emeritrust
      Lease.* In
      September 2004, the Company completed the lease of 18 communities in the first
      phase of a transaction to lease up to 20 assisted living communities in 12
      states, with 1,824 units. These communities, which were owned by entities in
      which Mr. Baty had financial interests, were acquired by an independent REIT
      and
      were leased to the Company. One additional community was leased on March 31,
      2005, and the final community on September 1, 2005. The two additional
      communities are reported as operating leases with escalating rent payments,
      which are accounted for on a straight-line basis.





The
      initial cash lease payment for these two communities is approximately $2.5
      million per year based on 8.6% of the REIT’s investment basis of $29.0 million,
      with annual escalators to the extent the change in the consumer price index
      exceeds 0%, not to exceed 40 basis points during years two through four and
      30
      basis points thereafter, as calculated with respect to the REIT's investment
      basis in the properties. The two communities are covered by separate leases
      that
      include a 15-year original term, with one 15-year renewal option, triple-net
      provisions, and certain financial and other covenants. The Company has the
      right
      of first refusal to purchase the entire 20-community portfolio and Mr. Baty
      is
      personally guaranteeing the Company’s obligations under the leases. Mr. Baty
      receives, based on a prescribed formula, 50% of the positive cash flow of the
      20
      communities and is responsible for 50% of any negative cash flow, as defined
      in
      the cash flow sharing agreement. Under this arrangement, Mr. Baty paid the
      Company $145,000 and





**9**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


$403,000
      for the three and nine months ended September 30, 2006, respectively, and the
      Company paid Mr. Baty $78,000 and $514,000 for the three and nine months ended
      September 30, 2005, respectively.





*Other
      Emeritrust Transaction.* As part
      of an Emeritrust transaction in September 2003, the Company issued seven-year
      warrants to purchase 500,000 shares of its common stock at an exercise price
      of
      $7.60 per share to the original investors of some of the Emeritrust communities.
      Warrants representing 400,000 shares were exercised on February 3, 2006, and
      the
      Company received proceeds of approximately $3.0 million. On March 8, 2006,
      the Company issued 69,169 shares of common stock pursuant to the exercise of
      warrants to purchase the remaining 100,000 shares. The warrants representing
      the
      100,000 shares were exercised pursuant to a "net exercise" provision in which
      30,831 shares subject to the warrants were used to pay the exercise price of
      $760,000. The shares used to pay the exercise price were valued at $24.65 per
      share based on current market prices, as determined under the terms of the
      warrant agreement.





**Debt
      Restructuring**





In
      March
      2005, the Company completed a debt restructuring transaction that reduced the
      effective interest rate by approximately 2.75% on $21.4 million of debt and
      extended the maturity to March 2008.





Borrowings
      in 2003 had resulted in a $25.8 million leasehold mortgage loan, covering 32
      communities maturing on June 30, 2007, bearing interest at an initial rate
      of
      12.13% per annum, with periodic increases up to 13%, and requiring monthly
      payments of interest the first year and monthly payments of principal and
      interest, based on a 10-year amortization, thereafter. The Company elected
      to
      make a principal reduction of $6.0 million in August 2004. On March 2,
      2005, when the principal balance was $19.5 million, the loan was sold to
      Healthcare Realty Trust, Incorporated ("HRT") and modified. The loan, as
      modified, provides for monthly interest-only payments at 10% per annum and
      matures March 3, 2008 (the “HRT Loan”). The HRT Loan may not be prepaid
      without the lender's consent. The HRT Loan balance was increased to
      $21.4 million to repay other higher interest borrowings and cover the costs
      of the financing.





**Alterra
      Transactions**





In
      October 2003, the Company acquired an interest in an LLC that acquired Alterra
      for $7.7 million cash. The members of the LLC consisted of an affiliate of
      Fortress, NW, and the Company, with original ownership interests of 50%, 25%,
      and 25%, respectively. In June 2005, Fortress purchased 50% of the interest
      of
      both NW and Emeritus for $50 million in cash, $25 million each to NW and
      Emeritus. The Company recorded a gain of $21.3 million in the condensed
      consolidated statement of operations in the second quarter ended June 30, 2005,
      as a result of this transaction. In November 2005, the Company sold its
      remaining interest in Alterra through the public offering of Brookdale Senior
      Living, Inc. (“Brookdale”) and recorded a gain of approximately $34.1 million in
      the fourth quarter of 2005. The Company has no further ownership interest in
      Brookdale or any of its subsidiaries.





**CPM/JEA
      Transactions**





On
      March
      1, 2005, the Company entered into leases with a REIT covering the final two
      communities of the CPM/JEA lease transactions for which the first stage was
      completed in April 2004. One community had previously been managed by the
      Company. The leases expire March 31, 2019, with three 5-year renewal options.
      The initial year lease rate is 9% of the REIT’s investment of approximately
      $14.3 million, which results in initial annual rent of approximately $1.3
      million, with fixed escalators of the lesser of four times the change in the
      consumer price index or 3%. These leases are accounted for as capital leases,
      which resulted in additions to property and equipment and capital lease and
      financing obligations totaling approximately $14.6 million.





In
      September 2006, the Company completed an early termination of its third party
      management agreement with JEA. This third party management agreement was entered
      into in April 2004 as part of the original





**10**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


transaction
      and entitled JEA to a monthly management fee of 5% of the gross revenues of
      the
      nine communities and a termination payment of $100,000 per year for a period
      of
      ten years after the termination of the management agreement. Also as part of
      the
      original sales transaction in April 2004, JEA was entitled to an earn-out
      payment of up to $2.0 million based on the improvement in the net operating
      income of the communities during the three-year period after the closing. As
      part of the early termination agreement, the Company and JEA agreed to a
      one-time payment of $594,000 in lieu of paying out the termination fee over
      ten
      years and agreed that the Company would pay the earn-out payment of $2.0
      million. JEA will also forego the remaining six months of management fees.
      Over
      the term of the management agreement, the Company accrued approximately $444,000
      of the management termination fee up to September 2006, the early termination
      date. The Company recorded an additional accrual of approximately $150,000
      in
      the third quarter of 2006 to accrue for the full termination fee obligation
      of
      $594,000.





**Arkansas
      Acquisition**





On
      December 1, 2005, the Company acquired three communities located in Arkansas,
      with a capacity of 253 units, for approximately $17.8 million. The Company
      financed $15.9 million of the purchase price through a mortgage financing with
      GE Capital. The debt matures in December 2012, bears interest at 6.95% per
      annum, and has monthly payments based on a 25-year amortization. No prepayment
      of the loan is allowed. This loan agreement was modified in June 2006, to
      cross-collateralize this loan with the GE Capital loan as discussed under the
      Arbor Place Acquisition caption below.





**Arbor
      Place Acquisition**





Emeritus
      entered into a series of agreements to purchase a 100-unit assisted living
      community in Everett, Washington, for approximately $11.0 million in July 2006,
      from an entity in which Mr. Baty had a 50% financial interest and which the
      Company previously managed. The Company financed $8.0 million of the purchase
      price through a mortgage financing with GE Capital. The debt matures in June
      2013, bears interest at 7.229% per annum, and has monthly payments based on
      a
      25-year amortization. No prepayment of the loan is allowed. The loan is
      cross-collateralized with the GE Capital loan discussed under the Arkansas
      Acquisition caption above.





**Senior
      Med Transaction**





In
      January 2000, Emeritus acquired a 30% equity interest in SHP for an investment
      of approximately $2.2 million ($1.8 million initial investment plus $356,000
      in
      subsequent contributions). The Company currently carries the investment at
      approximately $1.7 million after recording its equity share of income (losses)
      in SHP since the acquisition. SHP provides pharmacy services to senior housing
      residents under the trade name “Senior Med.” The remaining 70% of SHP is owned
      by MD Network, LLC, which is not affiliated with the Company.





In
      September 2005, SHP entered into an agreement with Walgreen Company (“Walgreen”)
      to sell substantially all of the business assets of SHP for cash, assumption
      of
      certain liabilities and an ownership interest in Senior Med, LLC, an entity
      created specifically for this transaction (“Walgreen Transaction”). SHP
      continues to maintain a 33.3% interest in Senior Med, LLC. The operating
      agreement for this transaction contains an option to purchase by Walgreen,
      and a
      put and call provision for Walgreen and SHP, by which Walgreen could obtain
      the
      remaining SHP interest in Senior Med. Should this provision be exercised, the
      Company’s remaining interest in SHP would be acquired by Walgreen at a price
      based upon a multiple of revenues as defined in the operating agreement. The
      agreement also contains a non-compete agreement, which prevents Emeritus from
      providing pharmacy services to the assisted living industry in the U.S., in
      any
      manner, for a period of 18 months after Emeritus ceases to hold any ownership
      interest in SHP. The Walgreen Transaction resulted in an indirect ownership
      interest by Emeritus of approximately 9.5% in Senior Med, LLC. Emeritus
      recognized equity earnings of $2.3 million and $2.4 million in its condensed
      consolidated statements of operations in the line item entitled “Equity earnings
      (losses) in unconsolidated





**11**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


joint
      ventures” for the three and nine months ended September 30, 2005, respectively,
      received cash distributions of $2.3 million related to the Walgreen Transaction
      in 2005, and made a cash contribution of $380,000 in the third quarter of 2006.
      We recognized equity losses of $102,000 and $509,000 in our condensed
      consolidated statements of operations in the line item entitled “Equity earnings
      (losses) in unconsolidated joint ventures” for the three and nine months ended
      September 30, 2006, respectively.





**Sale
      of Communities**





On
      November 1, 2004, the Company sold a single community located in Issaquah,
      Washington, for cash and assumption of liabilities totaling $9.6 million. Since
      the Company had a continuing involvement in the community until such time as
      the
      buyer was granted a license to operate the community, which occurred on January
      7, 2005, the Company deferred recognition of the sale and associated gain until
      the first quarter of 2005. The Company recorded a gain of $1.3 million related
      to this sale in discontinued operations for the nine months ended September
      30,
      2005. In December 2005, the Company sold a community in Las Vegas, Nevada,
      and
      reclassified prior period operating results to discontinued operations in the
      condensed consolidated statements of operations. The Company recorded an
      impairment loss of approximately $4.3 million related to the Las Vegas community
      in the second and third quarters of 2005, which is included in discontinued
      operations for the nine months ended September 30, 2005.





**Series
      B Stock**





On
      June 30, 2005, the Company entered into an agreement with Saratoga that
      provided for the conversion of the Series B Stock held by Saratoga upon the
      payment by the Company of accrued and unpaid cash dividends on the Series B
      Stock, in the amount of $10.8 million. The Company borrowed $10.8 million
      from a REIT at 10% per annum for a term of three years in order to pay the
      accumulated cash dividends of the Series B Stock. Upon the payment of the
      dividends on June 30, 2005, Saratoga converted all of the outstanding
      Series B Stock into 5,365,746 shares of common stock. Preferred stock
      dividends of $957,000 were recorded for the three months ended March 31, 2005,
      consisting of cash dividends of $591,000 and in-kind dividends of $366,000.
      For
      accounting purposes, the Company had accrued a liability of $11.1 million,
      which
      included approximately $358,000 that represented a straight-line dividend
      accrual that was reversed upon closing of this stock transaction. As part of
      the
      agreement, no dividends were required to be paid for the second quarter of
      2005.
      Thus, the preferred dividends for the nine months ended September 30, 2005,
      amounted to $599,000.





The
      Series B Stock owned by Saratoga consisted of 36,970 shares with a stated
      value of $1,000 per share, of which 30,000 shares were issued in December 1999
      for a price of $30.0 million and 6,970 shares were issued as dividends of
      additional Series B Stock since December 1999. Additionally, the Company issued
      to Saratoga seven-year warrants to purchase 1,000,000 shares of common stock
      at
      an exercise price of $4.30 per share on August 31, 2000, which was subsequently
      adjusted to $4.20 per share due to dilutive stock option transactions, as
      provided in the warrant agreement. On
      March 6, 2006, the Company issued 829,597 shares of common stock pursuant
      to the exercise of the warrants. The shares were purchased by the holders of
      the
      warrants pursuant to a "net exercise" provision of the warrants in which 170,403
      shares subject to the warrants were used to pay the exercise price of
      $4.2 million. The shares used to pay the exercise price were valued at
      $24.65 per share based on current market prices, as determined under the terms
      of the warrants.





**Convertible
      Debentures**





In
      November 2005, the Company completed an offer to exchange its outstanding 6.25%
      Convertible Subordinated Debentures due 2006 for new 6.25% Convertible
      Subordinated Debentures due 2008. Of the $32.0 million principal amount of
      outstanding debentures, $26.6 million was exchanged in the exchange offer.
      Debentures in the aggregate principally amount of $5.4 million remained
      outstanding and were paid at maturity on January 3, 2006. The terms of the
      original debentures and the new debentures are substantially the same, except
      that the maturity of the new debentures is July 1, 2008, instead of
      January 1, 2006, and the





**12**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


new
      debentures cannot be redeemed at the Company’s election. Interest on the new
      debentures is payable semiannually on January 1 and July 1 of each year. The
      new
      debentures are unsecured and subordinated to all other indebtedness of the
      Company. In February 2006, $50,000 of face value of the new debentures was
      converted into 2,272 shares of common stock. The new debentures are convertible
      into common stock at the rate of $22 per share, which equates to 1,207,955
      shares of common stock, at September 30, 2006.





Of
      the
      remaining $26.6 million of debentures outstanding, $20.8 million are owned
      by
      directors and officers or their affiliates. Saratoga Partners, two of whose
      representatives are directors, own $5.0 million of the debentures. Affiliates
      of
      Daniel R. Baty, the Company’s chief executive officer and a director, and
      Stanley L. Baty, a director, own $15.8 million of the debentures.





**Loss
      Per Share**





The
      capital structure of Emeritus includes convertible debentures and stock options.
      In addition, the capital structure included common stock warrants in prior
      periods, which were exercised in February and March 2006. Basic net loss per
      share is computed based on the weighted average shares outstanding and excludes
      any potential dilution. Net loss per share is computed based on the weighted
      average number of shares outstanding plus dilutive potential common shares.
      Options and warrants are included under the “treasury stock method” to the
      extent they are dilutive. Certain shares issuable upon the exercise of stock
      options and warrants and conversion of convertible debentures have been excluded
      from the computation because the effect of their inclusion would be
      anti-dilutive.





The
      following table summarizes those that are excluded in each period because they
      are anti-dilutive (in thousands):





**Three
                Months ended**
            
            **Nine
                Months ended****September
                30,**
            
            **September,
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Convertible
                Debentures(1)
            
            
            1,208
            
            
            1,455
            
            
            1,208
            
            
            1,455Options
            
            
            1,607
            
            
            1,477
            
            
            1,607
            
            
            1,477Warrants
                - Senior Housing Partners I, L.P.(2)
            
            
            -
            
            
            500
            
            
            -
            
            
            500Warrants
                - Saratoga Partners(3)
            
            
            -
            
            
            1,000
            
            
            -
            
            
            1,0002,815
            
            
            4,432
            
            
            2,815
            
            
            4,432(1)Approximately
                $5.4 million principal amount paid at maturity on January 3, 2006.(2)Exercised
                in February and March 2006.(3)Exercised
                in March 2006.





**Comprehensive
      Loss**





Comprehensive
      loss is the same as net loss to common shareholders for the three-month and
      nine-month periods ended September 30, 2006 and 2005.




**Liquidity**
 
 As
        of
        September 30, 2006, the Company has a working capital deficit of $34.3 million.
        The Company is able to operate in the position of a working capital deficit
        because revenues are collected more quickly, often in advance, than obligations
        are required to be paid. This can result in a low level of current assets
        to the
        extent cash has been deployed in business development opportunities or to
        pay
        down long-term liabilities. Along those lines, the working capital deficit
        includes $15.7 million of deferred revenue and unearned rental income. The
        level
        of current liabilities is not expected to change year to year in such a way
        as
        to require the use of significant cash, except for debt maturities of $80.7
        million due in 2008.


**13**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


The
        Company has incurred significant losses since its inception and has an
        accumulated deficit of $201.7 million as of September 30, 2006. The Company
        believes these losses have resulted from its early emphasis on expansion,
        financing costs arising from multiple financing and refinancing transactions
        related to this expansion, occupancy rates remaining lower for longer periods
        than anticipated, and depreciation expense primarily from multiple capital
        and
        financing leases.
 
 Cash
        provided by operating activities was $3.7 million for the nine months ended
        September 30, 2006. The primary components of cash provided by operating
        activities for this period was $37.2 million of depreciation and amortization
        and $2.2 million in non-cash stock compensation (due to implementation of
        SFAS
        123R), partially offset by a net change in operating assets and liabilities
        of
        $26.2 million, amortization of deferred gain of $1.7 million, and $9.3 million
        of net loss from operations. The $26.2 million use of cash related to operating
        assets and liabilities is primarily comprised of the following:
 
 **Significant
                  components of changes in operating assets and
                  liabilities:****Nine
                  Months Ended September 30,****2006**
              
              **2005**Reduction
                  of Texas settlement liability accruals, including interest
              
              $
              (12,973
              )
              $
              -Payment
                  of Texas Settlement
              
              
              (5,600
              )
              
              -Refund
                  of court bond related to Texas Settlement
              
              
              1,725
              
              
              -Federal
                  tax refund receivable, related to 2005 overpayment
              
              
              (1,043
              )
              
              -Federal
                  tax deposits, principally related to the Alterra transaction
                  gain
              
              
              (4,200
              )
              
              -Professional
                  and general liability accrual adjustment
              
              
              (1,700
              )
              
              5,008Workers
                  compensation accrual adjustment
              
              
              (2,021
              )
              
              (736
              )Payment
                  of semi-annual debenture interest
              
              
              (1,830
              )
              
              (2,000
              )Payment
                  of annual insurance premiums
              
              
              (8,655
              )
              
              (8,098
              )Federal
                  tax refund receivable, related to 2006 loss carryback
              
              
              (2,258
              )
              
              -Texas
                  Medicaid settlement accrual
              
              
              1,272
              
              
              -All
                  other activity, net
              
              
              11,061
              
              
              11,428Net
                  change in operating assets and liabilities
              
              $
              (26,222
              )
              $
              5,602
 
 The
        Texas
        settlement impact of $16.8 million, the federal tax deposits of $4.2 million
        related to the Alterra transaction gain, and the federal tax refunds of $3.3
        million, partially offset by the Texas Medicaid accrual of $1.3 million,
        a total
        of $23.0 million for 2006, are expected to be non-recurring items.
 
 The
        revenue per unit exceeded the Company’s targeted growth from the comparable
        period in the prior year and the weighted average occupancy rate was 84.8%
        for
        both the first nine months of 2006 and 2005. In order to keep improving
        occupancy and rates, the Company will continue to focus on marketing
        initiatives, programs that address resident mix, and on property improvements
        and other community level enhancements to attract additional long-term
        residents. The Company’s occupancy rate has reflected an increased trend from
        84.2% on December 31, 2005 to 87.0% on September 30, 2006, the last day of
        each
        fiscal quarter. Management believes that these initiatives will continue
        to have
        a positive impact on operating performance over time.
 
 In
        February 2005, a San Antonio, Texas, jury found one of the Company’s assisted
        living communities negligent in the care of a resident. The jury awarded
        a
        verdict against the Company in the amount of $1.5 million in compensatory
        damages and $18.0 million in punitive damages. The Company appealed the verdict
        and posted a deposit of $1.7 million in order to stay the proceedings. In
        March
        2006, the Company settled the case for $5.6 million and the deposit was
        refunded, with interest, in April 2006. In the fourth quarter of 2004, the
        Company recorded an additional liability accrual of $18.7 million and
        accrued $766,000 of interest
 **14**
 **EMERITUS
                CORPORATION**
 **NOTES
                TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
  Table
          of
          Contents
 on
        the
        judgment in 2005. In the first quarter of 2006, the Company reduced the accrued
        interest by $766,000 and the liability accrual recorded in 2004 by $12.2
        million.
 
 In
        March
        2006, the Company received a request for documents from the Office of the
        Attorney General of Texas, in connection with its inquiry into compliance
        with certain Medicaid regulations at six of the Company’s communities in Texas
        that participate in the Community Based Alternative program of the Texas
        Department of Aging and Disability.  Participation in the program requires
        eligible rooms to have an area equipped with a sink, refrigerator, cooking
        appliance, adequate space for food preparation, and storage space for utensils
        and supplies.  An audit by the department revealed that some of
        the rooms used for residents in the program did not have some or all of
        those items.  The Company addressed the State's concerns raised in the
        audits and all rooms were equipped with the above regulatory requirements
        as of April 2006, at a cost of approximately $618,000.
  The
        Company began settlement discussions with the attorney general's
        office in late May 2006 to resolve the matter.  Initially,
        the attorney general’s office sought $6.6 million, which equates to
        three times the total amount of all payments made to the Company by the State
        of
        Texas since the inception of its Medicaid contract, plus interest and attorney
        fees.  The Company responded in July 2006, advising the attorney general’s
        office that all the services for which Medicaid could, and did, lawfully
        pay
        were provided to the program residents despite the absence of some of
        the kitchen items.  Accordingly, recovery of the total of all payments to
        the Company was unjustified.  The letter advised the attorney general's
        office that the absence of the required items during the period of
        non-compliance was valued at $176,000.  In August 2006, the Company offered
        to settle the matter for $500,000 and recorded a liability in that amount
        as of
        June 30, 2006. In September 2006, the attorney general’s office responded to our
        August 2006 letter with an offer to settle the matter for $3.6 million. The
        amount was based on the difference between the rate originally paid to the
        Company by the State, and the lower non-apartment rate available under the
        State
        Medicaid program, which was calculated at $1.1 million. The total settlement
        offer includes additional interest, attorney fees, and $2.3 million in treble
        damages. In October 2006, the Company responded to the attorney general’s office
        with an offer to settle the matter for approximately $1.3 million, which
        is
        equal to the attorney general’s offer less the $2.3 million in treble damages.
        The Company recorded an additional liability of $772,000 in the third quarter
        of
        2006, for a total accrued liability of $1.3 million as of September 30, 2006.
        The discussions are continuing.
 
 While
        the
        Company believes it has incurred a liability in this matter, the range of
        possible outcomes is wide and the ultimate resolution is not readily
        determinable.  Accordingly, the Company has recorded a $1.3 million
        liability as of September 30, 2006, as its best estimate of the ultimate
        outcome.  The Company will assess its liability as discussions continue and
        will make adjustments, if any, to its recorded liability as more information
        becomes available.
 
 At
        the
        beginning of 2005, the Company had outstanding $32.0 million principal amount
        of
        6.25% convertible subordinated debentures that matured January 1, 2006. Of
        the
        full principal amount, $5.4 million was paid at maturity in January 2006.
        Pursuant to an exchange offer completed by the Company in November 2005,
        the
        remaining $26.6 million principal amount of debentures were replaced with
        new
        6.25% convertible subordinated debentures that are due July 1, 2008. Of the
        $26.6 million, $20.8 million is owned by directors and officers or their
        affiliates.
 
 The
        cash
        flows from operating activities have not always been sufficient to pay all
        of
        the Company’s long-term obligations and the Company has been dependent upon
        third party financing or disposition of assets to fund operations. The Company
        cannot guarantee that, if necessary in the future, such transactions will
        be
        available timely or at all, or on terms attractive to the Company.
 
 The
        Company has refinanced substantially all of its debt obligations, extending
        the
        maturities of such financings to dates beyond October 2007, at which time
        the
        Company will need to refinance or otherwise repay the obligations. Many of
        the
        Company's debt instruments and leases contain "cross-default"
        provisions
 **15**
 **EMERITUS
                CORPORATION**
 **NOTES
                TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table
          of
          Contents
 pursuant
        to which a default under one obligation can cause a default under one or
        more
        other obligations to the same lender or lessor. Such cross-default provisions
        affect the majority of the Company’s properties. Accordingly, any event of
        default could cause a material adverse effect on the Company's financial
        condition if such debt or leases are cross-defaulted. At September 30, 2006,
        the
        Company was non-compliant with one or more covenants in certain of the leases
        and mortgages, but obtained waivers from the owners and lenders that expire
        on
        October 1, 2007. The Company was required to make additional security deposits
        of $1.1 million and $2.2 million during the three and nine month periods
        ending
        September 30, 2006, respectively, related to the Company’s non-compliance with
        debt and lease covenants.
 
 As
        discussed below under the caption “Subsequent Event,” the Company expects to
        make an additional cash contribution in 2006 of approximately $4.2 million
        relating to the Company’s investment in a joint venture.
 
 Based
        on
        the Company’s current operating initiatives and its current cash position,
        management believes that the Company will be able to generate positive operating
        cash flows or will have adequate cash for all necessary investing and financing
        activities including required debt service and capital expenditures for at
        least
        the next twelve months.




**Discontinued
      Operations**





In
      August
      2004, the Company sold a facility in Scottsdale, Arizona to an unrelated third
      party. In September 2004, the Company committed to sell a community in Issaquah,
      Washington. The community was sold on November 1, 2004, but was not recognized
      as a sale until the first quarter of 2005 due to continuing involvement in
      the
      community through that period. In December 2005, the Company sold a community
      in
      Las Vegas, Nevada. All of these transactions qualify for discontinued operations
      treatment under SFAS No. 144 and the results of discontinued operations for
      both
      current and prior periods is reported as a separate line item in the condensed
      consolidated statements of operations.





The
      following table shows the revenues and net income (loss) for the discontinued
      operations (in thousands):





**Three
                Months ended**
            
            **Nine
                Months ended****September
                30,**
            
            **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Total
                revenue:**Issaquah
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            -Scottsdale
            
            
            -
            
            
            -
            
            
            -
            
            
            -Las
                Vegas
            
            
            -
            
            
            345
            
            
            -
            
            
            1,049Total
            
            $
            -
            
            $
            345
            
            $
            -
            
            $
            1,049**Net
                income (loss):**Issaquah
            
            $
            -
            
            $
            -
            
            $
            1
            
            $
            1,319Scottsdale
            
            
            -
            
            
            -
            
            
            (19
            )
            
            3Las
                Vegas
            
            
            (6
            )
            
            (328
            )
            
            (32
            )
            
            (4,570
            )Total
            
            $
            (6
            )
            $
            (328
            )
            $
            (50
            )
            $
            (3,248
            )








**16**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**


Table
      of
      Contents


**Subsequent
      Event**





On
      October 10, 2006, the Company entered into a Limited Liability Company Agreement
      (the “Joint Venture Agreement”) with Blackstone Real Estate Acquisitions
      (“BREA”), pursuant to which the Company and BREA have formed a joint venture
      that will operate under the name of BREA Emeritus, LLC (the "Joint Venture").
      The purpose of the Joint Venture is to acquire and operate a portfolio of
      twenty-five assisted living and Alzheimer’s/dementia care communities, including
      one skilled nursing facility. The portfolio consists of 1,990 units. The Company
      owns a 19% interest in the Joint Venture and is the Administrative Member.
      The
      Company made an initial contribution to the Joint Venture in the amount of
      $2.85
      million in proportion to its ownership interest. Additional capital
      contributions may be required by BREA to meet the financial obligations of
      the
      Joint Venture. The Joint Venture Agreement provides for cash distributions
      from
      the Joint Venture to BREA and the Company generally in accordance with their
      ownership interests, but the Company is entitled to distributions at increasing
      levels in excess of its ownership percentage if certain portfolio performance
      criteria are achieved and provides the Company the right of first opportunity
      in
      the event that BREA desires to sell all or any of the properties, or its
      membership interest in the Joint Venture. The Joint Venture Agreement prohibits
      the Company from transferring its interest in the Joint Venture without BREA's
      consent. The Company, as Administrative Member, is responsible for the
      day-to-day operations of the Joint Venture. However, BREA has final authority
      on
      major decisions affecting the Joint Venture. Pursuant to Management Agreements
      between the Joint Venture and the Company relating to the portfolio properties,
      the Company will manage the portfolio for a fee equal to 5% of revenues
      generated from the properties. The Joint Venture Agreement provides BREA with
      the right to terminate these management agreements if certain performance
      benchmarks are not met. BREA may also terminate the Company as Administrative
      Member for certain reasons, including gross negligence or willful misconduct,
      bankruptcy, termination of the management agreements, and failure to provide
      effective management of the Joint Venture.





On
      October 11, 2006, the Joint Venture entered into a Purchase and Sale Agreement
      ("Purchase Agreement") to acquire a portfolio of twenty-five assisted living
      and
      Alzheimer’s/dementia care communities from Pita General Corporation and AHC
      Tenant, Inc. for a purchase price of $190.0 million, plus transaction costs.
      The
      Purchase Agreement contains representations and warranties by the parties that
      are customary for transactions of this nature. The closing of the transaction
      is
      contingent upon the satisfaction of certain conditions that are customary for
      transactions of this nature. The joint venture has provided a deposit in the
      amount of $15.0 million which, subject to certain conditions, is non-refundable.
      It is expected that the transaction will be completed within 60
      days.





On
      October 24, 2006, the Joint Venture signed a commitment letter with GE Capital
      Corporation (“GECC”) to provide financing up to the lesser of $167.0 million or
      85% of the appraised value of the properties, of which approximately $10.0
      million will be used to establish capital expenditure and interest expense
      reserves.





The
      Company expects to make additional contributions to the joint venture in 2006
      of
      approximately $4.2 million, in proportion to its ownership interest, upon
      closing of the acquisition of the portfolio of properties described above.
      The
      Company expects to account for this investment under the equity method of
      accounting.











**17**


Table
      of
      Contents


**Item
      2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
      CONDITION** **AND** **RESULTS
      OF OPERATIONS**





Forward-Looking
      Statements





“Safe
      Harbor” Statement under the Private Securities Litigation Reform Act of 1995: A
      number of the matters and subject areas discussed in this report that are not
      historical or current facts deal with potential future circumstances,
      operations, and prospects. The discussion of such matters and subject areas
      is
      qualified by the inherent risks and uncertainties surrounding future
      expectations generally, and also may materially differ from our actual future
      experience as a result of such factors as: the effects of competition and
      economic conditions on the occupancy levels in our communities; our ability
      under current market conditions to maintain and increase our resident charges
      in
      accordance with our rate enhancement programs without adversely affecting
      occupancy levels; increases in interest costs as a result of re-financings;
      our
      ability to control community operation expenses, including insurance and utility
      costs, without adversely affecting the level of occupancy and the level of
      resident charges; our ability to generate cash flow sufficient to service our
      debt and other fixed payment requirements; our ability to find sources of
      financing and capital on satisfactory terms to meet our cash requirements to
      the
      extent that they are not met by operations, and other uncertainties related
      to
      professional liability claims. We have attempted to identify, in context,
      certain of the factors that we currently believe may cause actual future
      experience and results to differ from our current expectations regarding the
      relevant matter or subject area. These and other risks and uncertainties are
      detailed in our reports filed with the SEC, including our Annual Reports on
      Form
      10-K.





**Definitions**





Throughout
      this filing certain terms are used repeatedly. In the interest of brevity,
      the
      full reference has been abbreviated to a single name or acronym. The following
      defines these abbreviated terms:





1.
            "FASB"
                refers to the Financial Accounting Standards
                Board.


2.
            "SFAS"
                refers to Statement of Financial Accounting
                Standards.


3.
            "SEC"
                refers to the Securities and Exchange
                Commission.


4.
            "REIT"
                means real estate investment trust.


5.
            "LIBOR"
                is the London Interbank Offering
                Rate.


6.
            "Mr.
                Baty" refers to Daniel R. Baty, the Company's chairman of the board
                of
                directors and chief executive officer.


7.
            "Triple-net
                lease" means a lease under which the lessee pays all operating expenses
                of
                the property, including taxes, licenses, utilities, maintenance,
                and
                insurance. The lessor receives a net rent.


8.
            "JEA"
                refers to JEA Senior Living, a
                non-affiliate.


9.
            "Fortress"
                refers to Fortress Investment Group LLC, a New York based private
                equity
                fund.


10.
            "LLC"
                refers to a limited liability
                company.


11.
            "NW"
                refers to NW Select LLC, an entity controlled by Mr.
                Baty.


12.
            "CPM"
                refers to Columbia Pacific Management, a group of entities controlled
                by
                Mr. Baty.


13.
            “SHP”
                refers to Senior Healthcare Partners, LLC, a pharmaceutical supply
                limited
                liability company.


14.
            "Saratoga"
                refers to a group of related companies, namely: Saratoga Partners
                IV, LP;
                Saratoga Management Company LLC, as Agent; and Saratoga Coinvestment
                IV,
                LLC.


15.
            "Series
                B Stock" refers to Series B Convertible Preferred
                Stock.


16.
            “Emeritrust”
                refers to two groups of communities (totaling 46 communities) that
                were
                managed by us starting in 1998. These communities were owned by two
                different investor groups in each of which Mr. Baty held a non-controlling
                interest. The composition of the groups has changed over time and
                most of
                the communities are now leased by us. Further details are available
                in our
                Forms 10-K for years prior to 2006







**18**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents


Overview





Emeritus
      is a Washington corporation organized by Mr. Baty and two other founders in
      1993. In November 1995, we completed our initial public offering.





From
      1995
      through 1998, we expanded rapidly through acquisition and internal development
      and by December 31, 1999, operated 129 assisted living communities with
      11,726 units. We believe, however, that during this expansion, the assisted
      living industry became overbuilt in certain regions, creating an environment
      characterized by slower than planned occupancy and rate growth. As a result
      of
      these difficult operating circumstances, we deliberately slowed down our growth
      rate. In 1999, we began an increasing focus, first, on raising our occupancy
      and
      later, on operating efficiencies and cost controls as well as implementing
      a
      systematic rate enhancement program.





We
      believe that the health of the assisted living industry is currently improving
      and that opportunities are developing to improve occupancy and to increase
      rates. The assisted living industry is experiencing increased regulation
      (varying by state), increased insurance costs, and limited availability of
      capital for smaller local and regional operators. In this type of environment,
      we believe that we will continue to witness consolidation of smaller local
      and
      regional operators into the larger national operators. Because of these
      circumstances, we have been able to complete several acquisitions or leases
      in
      the last two years.  In addition, our
      size
      and ability to respond to negative industry or market conditions such as
      insurance availability and costs has attracted capital resources to allow us
      to
      convert communities we managed to communities we now lease. Going forward,
      we
      will attempt to identify additional acquisition or lease opportunities. From
      the
      end of 2000 to the end of 2005, the communities we managed decreased from 69
      to
      14 and the owned and leased communities increased from 61 to 170, reflecting
      our
      increasing confidence in the assisted living industry, stabilization of managed
      properties, and the availability of capital. By the end of the third quarter
      of
      2006, managed communities had decreased to 11 and owned and leased communities
      increased to 171.





The
      following table sets forth a summary of our property interests:





**As
                of September 30,**
            
            **As
                of December 31,**
            
            **As
                of September 30,****2006**
            
            **2005**
            
            **2005****Buildings**
            
            **Units**
            
            **Buildings**
            
            **Units**
            
            **Buildings**
            
            **Units**Owned
                (1)
            10
            
            808
            
            9
            
            707
            
            6
            
            454Leased
                (2 )
            161
            
            12,821
            
            161
            
            12,805
            
            162
            
            12,921Consolidated
                Portfolio
            171
            
            13,629
            
            170
            
            13,512
            
            168
            
            13,375Managed/Admin
                Services (3)
            10
            
            1,134
            
            13
            
            1,443
            
            13
            
            1,443Joint
                Venture/Partnership
            1
            
            140
            
            1
            
            140
            
            1
            
            140Operated
                Portfolio
            182
            
            14,903
            
            184
            
            15,095
            
            182
            
            14,958Percentage
                increase (decrease) (4)
            (1.1%)
            
            (1.3%)
            
            1.7%
            
            1.6%
            
            0.6%
            
            0.7%




(1)
      Owned
      communities increased due to the acquisition of three communities in Arkansas
      in
      December 2005 and one community in Washington acquired in July
      2006.


(2)
      Of
      the 161 leased communities at September 30, 2006, 77 are accounted for as
      operating leases, in which the assets and liabilities of the communities are
      not
      included in our condensed consolidated balance sheet and 70 are accounted for
      as
      capital leases, in which a long-term asset and corresponding liability is
      established on our balance sheet. The remaining 14 leased communities are
      reflected in our condensed consolidated financial statements as owned
      communities because of accounting requirements related to sale-leaseback
      accounting, notwithstanding the legal sale of the communities and their
      subsequent leasing by us.


(3)
      We
      discontinued management of one facility in July 2005, one in January 2006,
      one
      in March 2006, and another in April 2006. We began managing another facility
      in
      January 2006.


(4)  The
      percentage increase (decrease) indicates the change from the prior year, or,
      in
      the case of September 30, 2006 and 2005, from the end of the prior year.





**19**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents


Two
      of
      the important factors affecting our financial results are the rates we charge
      our residents and the occupancy levels we achieve in our communities. We rely
      primarily on our residents' ability to pay our charges for services from their
      own or familial resources and expect that we will do so for the foreseeable
      future. Although care in an assisted living community is typically less
      expensive than in a skilled nursing facility, we believe that generally only
      seniors with income or assets meeting or exceeding the regional median can
      afford to reside in our communities. In this context, we must be sensitive
      to
      our residents' financial circumstances and remain aware that rates and occupancy
      are often interrelated.





In
      evaluating the rate component, we generally rely on the average monthly revenue
      per unit, computed by dividing the total revenue for a particular period by
      the
      average number of occupied units for the same period. In evaluating the
      occupancy component, we generally rely on an average occupancy rate, computed
      by
      dividing the average units occupied during a particular period by the average
      number of units available during the period. We evaluate these and other
      operating components for our consolidated portfolio, which includes the
      communities we own and lease, and our operating portfolio, which also includes
      the communities we manage.





In
      our
      consolidated portfolio, our average monthly revenue per unit for the nine months
      ended September 30, 2006, increased to $3,094 from $2,948 for the same period
      in
      2005. This change represents an increase of $146 or 5.0%. For the third quarter
      of 2006, our average monthly revenue per unit was $3,124 as compared to $3,096
      for the second quarter of 2006. This change represents an increase of $28 or
      0.9%. This level of increase is primarily due to repositioning several of our
      acquired communities over the past year to be more rate-competitive and to
      establish a new presence in their respective markets.





In
      our
      consolidated portfolio, our average occupancy rate was 84.8% for both the nine
      months ended September 30, 2006 and 2005. For the third quarter of 2006, our
      average occupancy rate increased to 86.0% as compared to 84.6% for the second
      quarter of 2006. In late 2005, we experienced what we believe to be a temporary
      decline in occupancy, which we believe was largely related to the detailed
      review of all aspects of our operations in response to the Texas verdict that
      was announced early in 2005. The review resulted in more conservative admission
      and discharge policies to insure our services were more than adequate to care
      for the more fragile residents in our communities. We also believe this
      occupancy decline has bottomed out as evidenced by an increase in our occupancy
      from 84.2% on December 31, 2005, to 87.0% on September 30, 2006, the last day
      of
      each fiscal quarter. We continue to evaluate the factors of rate and occupancy
      to find the optimum balance.





We
      have
      incurred operating losses since our inception in 1993, and as of September
      30,
      2006, we had an accumulated deficit of approximately $201.7 million. We believe
      that these losses have resulted from our early emphasis on expansion, financing
      costs arising from multiple financing and refinancing transactions related
      to
      this expansion, occupancy rates remaining lower for longer periods than we
      anticipated, and depreciation expense, primarily from multiple capital and
      financing leases.





**Significant
      Transactions**





In
      2004
      and continuing in 2005, we substantially increased the number of communities
      we
      lease, reduced the number of communities we manage, and, in connection with
      these changes, increased and restructured portions of our long-term financing
      obligations. The transactions associated with these developments are summarized
      below.





*Emeritrust
      Transactions*





*Emeritrust Managed
      Communities* .
      For the
      nine months ended September 30, 2006, we managed five communities, which are
      owned by Mr. Baty, for a management fee equal to 5% of gross revenues. The
      agreement has been extended for one year and expires on June 30, 2007. One
      of
      these communities was sold to an independent third party effective January
      1,
      2006, which we continued to manage until the new operator





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received
      licensure on March 20, 2006. We received management fees of approximately
      $119,000 and $129,000 for the three months ended September 30, 2006 and 2005,
      respectively, and approximately $348,000 and $385,000 for the nine months ended
      September 30, 2006 and 2005, respectively.





*Emeritrust
      Lease.* As
      further described in the Notes to Unaudited Condensed Consolidated Financial
      Statements, in September 2004, we completed the lease of 18 communities in
      the
      first phase of a transaction to lease up to 20 assisted living communities
      in 12
      states, with 1,824 units. These communities, which were owned by entities in
      which Mr. Baty had financial interests, were acquired by an independent REIT
      and
      were leased to us. One additional community was leased on March 31, 2005, and
      the final community on September 1, 2005. The two additional communities are
      reported as operating leases with escalating rent payments, which are accounted
      for on a straight-line basis, resulting in an increase in facility lease expense
      of approximately $147,000 and $1.2 million for the three and nine months ended
      September 30, 2006, respectively.





Mr.
      Baty
      personally guarantees our obligation under the leases. Mr. Baty receives, based
      on a prescribed formula, 50% of the positive cash flow of the 20 communities
      and
      is responsible for 50% of any negative cash flow, as defined in the cash flow
      sharing agreement. Under this arrangement, Mr. Baty paid us $145,000 and
      $403,000 for the three and nine months ended September 30, 2006, respectively,
      and we paid Mr. Baty $78,000 and $514,000 for the three and nine months ended
      September 30, 2005, respectively.





*Other
      Emeritrust Transaction.* As part
      of an Emeritrust transaction in September 2003, we issued seven-year warrants
      to
      purchase 500,000 shares of our common stock at an exercise price of $7.60 per
      share to the original investors of some of the Emeritrust communities. Warrants
      representing 400,000 shares were exercised on February 3, 2006, and we received
      proceeds of approximately $3.0 million. On March 8, 2006, we issued 69,169
      shares of common stock pursuant to the exercise of warrants to purchase the
      remaining 100,000 shares. The warrants representing the 100,000 shares were
      exercised pursuant to a "net exercise" provision in which 30,831 shares subject
      to the warrants were used to pay the exercise price of $760,000. The shares
      used
      to pay the exercise price were valued at $24.65 per share based on current
      market prices, as determined under the terms of the warrant agreement.





*Debt
      Restructuring*





As
      further described in the Notes to Unaudited Condensed Consolidated Financial
      Statements, in March 2005, we completed a debt restructuring transaction that
      reduced the effective interest rate by approximately 2.75% on $21.4 million
      of
      debt and extended the maturity to March 2008. The loan, as modified, provides
      for monthly interest-only payments at 10% per annum and matures March 3,
      2008. The original note had escalating interest rates, which were accounted
      for
      on a straight-line basis. Upon completion of the debt restructuring, we reversed
      $134,000 of the straight-line interest accrual. The new debt has resulted in
      a
      decrease in interest expense of approximately $117,000 for the nine months
      ended
      September 30, 2006. Due to the reversal of the accrued interest in 2005, the
      impact from this transaction on reported interest expense was not significant
      for the comparable nine month periods ended September 30, 2006 and 2005.





*Alterra
      Transactions*





In
      October 2003, we acquired an interest in an LLC that acquired Alterra for $7.7
      million cash. The members of the LLC consisted of an affiliate of Fortress,
      NW,
      and us, with original ownership interests of 50%, 25%, and 25%, respectively.
      In
      June 2005, Fortress purchased 50% of the interest of both NW and us for $50
      million in cash, $25 million each to NW and us. We recorded a gain of $21.3
      million in the condensed consolidated statement of operations for the second
      quarter ended June 30, 2005, as a result of this transaction. In November 2005,
      we sold our remaining interest in Alterra through the public offering of
      Brookdale Senior Living, Inc. (“Brookdale”) and recorded a gain of approximately
      $34.1 million in the fourth quarter of 2005. We have no further ownership
      interest in Brookdale or any of its subsidiaries.





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*CPM/JEA
      Transactions*





As
      further described in the Notes to Unaudited Condensed Consolidated Financial
      Statements, on March 1, 2005, we entered into leases with a REIT covering the
      final two communities of the CPM/JEA lease transactions for which the first
      stage was completed in April 2004. One community had been previously managed
      by
      us. These leases are accounted for as capital leases, which resulted in
      additions to property and equipment and capital lease and financing obligations
      totaling approximately $14.6 million, and resulted in an increase in interest
      expense of $124,000 and depreciation expense of $186,000 for the nine months
      ended September 30, 2006, respectively. The impact from this transaction on
      the
      three months ended September 30, 2006, as compared to the prior year period
      was
      not significant.





In
      September 2006, we completed an early termination of our third party management
      agreement with JEA. This third party management agreement was entered into
      in
      April 2004 as part of the original transaction and entitled JEA to a monthly
      management fee of 5% of the gross revenues of the nine communities and a
      termination payment of $100,000 per year for a period of ten years after the
      termination of the management agreement. Also, as part of the original sales
      transaction in April 2004, JEA was entitled to an earn-out payment of up to
      $2.0
      million based on the improvement in the net operating income of the communities
      during the three-year period after the closing. As a part of the early
      termination agreement, the parties have agreed to a one-time payment of $594,000
      in lieu of paying out the termination fee over ten years and agreed that we
      would pay the earn-out payment of $2.0 million. JEA will also forego the
      remaining six months of management fees. Over the term of the management
      agreement, we had accrued approximately $444,000 of the management termination
      fee up to September 2006, the early termination date. We recorded an additional
      accrual of approximately $150,000 in the third quarter of 2006 to accrue for
      the
      full termination fee obligation of $594,000.





*Arkansas
      Acquisition*





On
      December 1, 2005, we acquired three communities located in Arkansas, with a
      capacity of 253 units, for approximately $17.8 million. We financed $15.9
      million of the purchase price through mortgage a financing with GE Capital.
      The
      debt matures in December 2012, bears interest at 6.95% per annum, and has
      monthly payments based on a 25-year amortization. No prepayment of the loan
      is
      allowed. This transaction resulted in an increase in interest expense of
      $295,000 and $879,000 and an increase in depreciation expense of $358,000 and
      $1.1 million for the three and nine months ended September 30, 2006,
      respectively. This loan agreement was modified in June 2006, to
      cross-collateralize this loan with the GE Capital loan as discussed under the
      Arbor Place Acquisition caption below.





*Arbor
      Place Acquisition*





We
      entered into a series of agreements to purchase a 100-unit assisted living
      community in Everett, Washington, for approximately $11.0 million in July 2006,
      from an entity in which Mr. Baty had a 50% financial interest and which we
      previously managed. We financed $8.0 million of the purchase price through
      a
      mortgage financing with GE Capital. The debt matures in June 2013, bears
      interest at 7.229% per annum, and has monthly payments based on a 25-year
      amortization. No prepayment of the loan is allowed. This transaction resulted
      in
      an increase in interest expense of $158,000 and an increase in depreciation
      of
      $214,000 for the three and nine months ended September 30, 2006. The loan is
      cross-collateralized with the GE Capital loan discussed under the Arkansas
      Acquisition caption above.





*Senior
      Med Transaction*





In
      January 2000, we acquired a 30% equity interest in SHP for an investment of
      approximately $2.2 million ($1.8 million initial investment plus $356,000 in
      subsequent contributions). We currently carry the investment at approximately
      $1.7 million after recording our equity share of income (losses) in SHP since
      the





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acquisition.
      SHP provides pharmacy services to senior housing residents under the trade
      name
“Senior Med.” The remaining 70% of SHP is owned by MD Network, LLC, which is not
      affiliated with us.





In
      September 2005, SHP entered into an agreement with Walgreen Company (“Walgreen”)
      to sell substantially all of the business assets of SHP for cash, assumption
      of
      certain liabilities and an ownership interest in Senior Med, LLC, an entity
      created specifically for this transaction (“Walgreen Transaction”). SHP
      continues to maintain a 33.3% interest in Senior Med, LLC. The operating
      agreement for this transaction contains an option to purchase by Walgreen,
      and a
      put and call provision for Walgreen and SHP, by which Walgreen could obtain
      the
      remaining SHP interest in Senior Med, LLC. Should this provision be exercised,
      our remaining interest in SHP would be acquired by Walgreen at a price based
      upon a multiple of revenues as defined in the operating agreement. The agreement
      also contains a non-compete agreement, which prevents us from providing pharmacy
      services to the assisted living industry in the U.S., in any manner, for a
      period of 18 months after we cease to hold any ownership interest in SHP. The
      Walgreen Transaction resulted in an indirect ownership interest by us of
      approximately 9.5% in Senior Med, LLC. We recognized equity earnings of $2.3
      million and $2.4 million in our condensed consolidated statements of operations
      in the line item entitled “Equity earnings (losses) in unconsolidated joint
      ventures” for the three and nine months ended September 30, 2005, respectively,
      and received cash distributions of $2.3 million related to the Walgreen
      Transaction in 2005, and made a cash contribution of $380,000 in the third
      quarter of 2006. We recognized equity losses of $102,000 and $509,000 in our
      condensed consolidated statements of operations in the line item entitled
“Equity earnings (losses) in unconsolidated joint ventures” for the three and
      nine months ended September 30, 2006, respectively.





*Sale
      of Communities* **





As
      further described in the Notes to Unaudited Condensed Consolidated Financial
      Statements, we recorded a gain of $1.3 million in January 2005 related to the
      sale of a community located in Issaquah, Washington, which is included in
      discontinued operations for the nine months ended September 30, 2005. In
      December 2005, we sold a community in Las Vegas, Nevada and recorded a loss
      of
      approximately $4.3 million related to this community in the second and third
      quarters of 2005, which is included in discontinued operations for the nine
      months ended September 30, 2005.





*Series
      B Stock*





On
      June 30, 2005, we entered into an agreement with Saratoga that provided for
      the conversion of the Series B Stock held by Saratoga upon the payment of
      all accrued and unpaid cash dividends in the amount of $10.8 million. We
      borrowed $10.8 million from a REIT at 10% per annum for a term of three years
      in
      order to pay the accumulated cash dividends of the Series B Stock, resulting
      in
      an increase in interest expense of approximately $536,000 for the nine months
      ended September 30, 2006. The difference in interest costs for the three month
      periods ending September 30, 2006 and 2005 is not significant since the debt
      was
      in place for both periods. Upon the payment of the dividends on June 30, 2005,
      Saratoga converted all of the outstanding Series B Stock into 5,365,746
      shares of common stock. Preferred stock dividends of $957,000 were recorded
      for
      the three months ended March 31, 2005, consisting of cash dividends of $591,000
      and in-kind dividends of $366,000. For accounting purposes, we had accrued
      a
      dividend payable liability of $11.1 million, which included approximately
      $358,000 that represented a straight-line dividend accrual that was reversed
      upon closing of this stock transaction in the second quarter of 2005. As part
      of
      the agreement, no dividends were required to be paid for the second quarter
      of
      2005. Thus, the preferred dividends for the nine months ended September 30,
      2005, amounted to $599,000.





We
      had
      also issued to Saratoga seven-year warrants to purchase 1,000,000 shares of
      common stock at an exercise price of $4.30 per share on August 31, 2000, which
      was subsequently adjusted to $4.20 per share due to dilutive stock option
      transactions, as provided in the warrant agreement. On
      March 6, 2006, we issued 829,597 shares of common stock pursuant to the
      exercise of the warrants. The shares were purchased by the holders of the
      warrants pursuant to a "net exercise" provision of the warrants in which 170,403
      shares subject





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to
      the
      warrants were used to pay the exercise price of $4.2 million. The shares
      used to pay the exercise price were valued at $24.65 per share based on current
      market prices, as determined under the terms of the warrants. We received no
      cash proceeds from this transaction.





*Convertible
      Debentures*





In
      November 2005, we completed an offer to exchange our outstanding 6.25%
      Convertible Subordinated Debentures due 2006 for new 6.25% Convertible
      Subordinated Debentures due 2008. In the exchange offer, $26.6 million of the
      $32.0 million principal amount of outstanding debentures were exchanged.
      Debentures in the aggregate principal amount of $5.4 million remained
      outstanding and were paid at maturity on January 3, 2006. The terms of the
      original debentures and the new debentures are substantially the same, except
      that the maturity of the new debentures is July 1, 2008, instead of
      January 1, 2006, and the new debentures cannot be redeemed at our election.
      Interest on the new debentures is payable semiannually on January 1 and July
      1
      of each year. The new debentures are unsecured and subordinated to all of our
      other indebtedness. In February 2006, $50,000 of face value of the new
      debentures were converted into 2,272 shares of common stock. The new debentures
      are convertible into common stock at the rate of $22 per share, which equates
      to
      1,207,955 shares of common stock, at September 30, 2006.





Of
      the
      remaining $26.6 million of debentures outstanding, $20.8 million are owned
      by
      directors and officers or their affiliates. Saratoga Partners, two of whose
      representatives are directors, own $5.0 million of the debentures. Affiliates
      of
      Daniel R. Baty, our chief executive officer and a director, and Stanley L.
      Baty,
      a director, own $15.8 million of the debentures.





*Subsequent
      Event*





On
      October 10, 2006, we entered into a Limited Liability Company Agreement (the
      “Joint Venture Agreement”) with Blackstone Real Estate Acquisitions (“BREA”),
      pursuant to which we and BREA have formed a joint venture that will operate
      under the name of BREA Emeritus, LLC (the "Joint Venture"). The purpose of
      the
      Joint Venture is to acquire and operate a portfolio of twenty-five assisted
      living and Alzheimer’s/dementia care communities, including one skilled nursing
      facility. The portfolio consists of 1,990 units. We own a 19% interest in the
      Joint Venture and are the Administrative Member. We made an initial contribution
      to the Joint Venture in the amount of $2.85 million in proportion to our
      ownership interest. Additional capital contributions may be required by BREA
      to
      meet the financial obligations of the Joint Venture. The Joint Venture Agreement
      provides for cash distributions from the Joint Venture to BREA and us generally
      in accordance with each party’s ownership interests, but we are entitled to
      distributions at increasing levels in excess of our ownership percentage if
      certain portfolio performance criteria are achieved. The Joint Venture Agreement
      provides us the right of first opportunity in the event that BREA desires to
      sell all or any of the properties, or its membership interest in the Joint
      Venture. The Joint Venture Agreement prohibits us from transferring our interest
      in the Joint Venture without BREA's consent. We, as Administrative Member,
      are
      responsible for the day-to-day operations of the Joint Venture. However, BREA
      has final authority on major decisions affecting the Joint Venture. Pursuant
      to
      Management Agreements between the Joint Venture and us relating to the portfolio
      properties, we will manage the portfolio for a fee equal to 5% of revenues
      generated from the properties. The Joint Venture Agreement provides BREA with
      the right to terminate these management agreements if certain performance
      benchmarks are not met. BREA may also terminate us as Administrative Member
      for
      certain reasons, including gross negligence or willful misconduct, bankruptcy,
      termination of the management agreements, and failure to provide effective
      management of the Joint Venture.





On
      October 11, 2006, the Joint Venture entered into a Purchase and Sale Agreement
      ("Purchase Agreement") to acquire a portfolio of twenty-five assisted living
      and
      Alzheimer’s/dementia care communities from Pita General Corporation and AHC
      Tenant, Inc. for a purchase price of $190.0 million, plus transaction costs.
      The
      Purchase Agreement contains representations and warranties by the parties that
      are customary for transactions of this nature. The closing of the transaction
      is
      contingent upon the satisfaction of certain





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conditions
      that are customary for transactions of this nature. The joint venture has
      provided a deposit in the amount of $15.0 million which, subject to certain
      conditions, is non-refundable. It is expected that the transaction will be
      completed within 60 days.





On
      October 24, 2006, the Joint Venture signed a commitment letter with GE Capital
      Corporation (“GECC”) to provide financing up to the lesser of $167.0 million or
      85% of the appraised value of the properties, of which approximately $10.0
      million will be used to establish capital expenditure and interest expense
      reserves.





We
      expect
      to make additional contributions to the joint venture in 2006 of approximately
      $4.2 million, in proportion to our ownership interest, upon closing of the
      acquisition of the portfolio of properties described above. We expect to account
      for this investment under the equity method of accounting.











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The
      following table shows the changes in buildings from December 31, 2004, through
      September 30, 2006, including those transactions described above:





**Month**
            
            **Owned**
            
            **Leased**
            
            
            
            **Consolidated**
            
            **Managed**
            
            **Total****December
                31, 2004**
            
            
            
            
            
            **6**
            
            
            **158**
            
            
            
            
            
            **164**
            
            
            **17**
            
            
            **181**Richland
                Gardens
            
            
            Mar-05
            
            
            **-**
            
            
            1
            
            
            **1**
            
            
            1
            
            
            (1
            )
            
            -Quail
                Ridge
            
            
            Mar-05
            
            
            **-**
            
            
            1
            
            
            **1**
            
            
            1
            
            
            **-**
            
            
            1Wilburn
                Gardens
            
            
            Mar-05
            
            
            **-**
            
            
            1
            
            
            
            
            
            1
            
            
            (1
            )
            
            -**March
                31, 2005**
            
            
            
            
            
            **6**
            
            
            **161**
            
            
            
            
            
            **167**
            
            
            **15**
            
            
            **182****-**
            
            
            
            
            
            
            
            
            **-**
            
            
            
            
            
            **-**
            
            
            **-**
            
            
            **-****June
                30, 2005**
            
            
            
            
            
            **6**
            
            
            **161**
            
            
            
            
            
            **167**
            
            
            **15**
            
            
            **182**Regent
                Court of Kent - disposition
            
            
            Jul-05
            
            
            **-**
            
            
            **-**
            
            
            
            
            
            **-**
            
            
            (1
            )
            
            (1
            )Hunter's
                Glen - Missoula
            
            
            Sep-05
            
            
            **-**
            
            
            1
            
            
            
            
            
            1
            
            
            -
            
            
            1**September
                30, 2005**
            
            
            
            
            
            **6**
            
            
            **162**
            
            
            
            
            
            **168**
            
            
            **14**
            
            
            **182**Arkansas
                Transaction
            
            
            Dec-05
            
            
            3
            
            
            **-**
            
            
            
            
            
            3
            
            
            **-**
            
            
            3Concorde
                - disposition
            
            
            Dec-05
            
            
            **-**
            
            
            (1
            )
            
            **2**
            
            
            (1
            )
            
            **-**
            
            
            (1
            )**December
                31, 2005**
            
            
            
            
            
            **9**
            
            
            **161**
            
            
            
            
            
            **170**
            
            
            **14**
            
            
            **184**Isle
                at Emerald Court
            
            
            Jan-06
            
            
            **-**
            
            
            **-**
            
            
            
            
            
            **-**
            
            
            1
            
            
            1Park
                Lane - disposition
            
            
            Jan-06
            
            
            **-**
            
            
            **-**
            
            
            
            
            
            **-**
            
            
            (1
            )
            
            (1
            )La
                Villita - disposition
            
            
            Mar-06
            
            
            **-**
            
            
            **-**
            
            
            
            
            
            **-**
            
            
            (1
            )
            
            (1
            )**March
                31, 2006**
            
            
            
            
            
            **9**
            
            
            **161**
            
            
            
            
            
            **170**
            
            
            **13**
            
            
            **183**Emerald
                Estates - disposition
            
            
            Apr-06
            
            
            **-**
            
            
            **-**
            
            
            
            
            
            **-**
            
            
            (1
            )
            
            (1
            )**June
                30, 2006**
            
            
            
            
            
            **9**
            
            
            **161**
            
            
            
            
            
            **170**
            
            
            **12**
            
            
            **182**Arbor
                Place
            
            
            Jul-06
            
            
            1
            
            
            **-**
            
            
            
            
            
            1
            
            
            (1
            )
            
            -**September
                30, 2006**
            
            
            
            
            
            **10**
            
            
            **161**
            
            
            
            
            
            **171**
            
            
            **11**
            
            
            **182****1**These leases are accounted for as capital leases in our condensed
                consolidated financial statements.**2**Concorde was reflected in our condensed consolidated financial statements
                as an owned community because of accountingrequirements
                related to sale-leaseback accounting.





**Results
        of Operations**
 
 **Summary
        of Significant Accounting Policies and Use of Estimates**
 
 Our
        discussion and analysis of our financial condition and results of operations
        are
        based upon our unaudited condensed consolidated financial statements, which
        have
        been prepared in accordance with accounting principles generally accepted
        in the
        United States. The preparation of these financial statements requires us
        to make
        estimates and judgments that affect the reported amounts of assets, liabilities,
        revenues and expenses, and related disclosure of contingent assets and
        liabilities. On an ongoing basis, we evaluate our estimates, including those
        related to resident programs and incentives such as move-in fees, bad debts,
        investments, intangible assets, impairment of long-lived assets, income taxes,
        restructuring, long-term service contracts, contingencies, self-insured
        retention, insurance deductibles, health insurance, and litigation. We base
        our
        estimates on historical experience and on various other assumptions that
        are
        believed to be reasonable under the circumstances, the results of which form
        the
        basis for making judgments about the carrying values of assets and liabilities
        that are not readily apparent from other sources. Actual results may differ
        from
        these estimates under different assumptions or
        conditions.





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We
      believe that certain critical accounting policies are most significant to the
      judgments and estimates used in the preparation of our condensed consolidated
      financial statements. Revisions in such estimates are charged to income in
      the
      period in which the facts that give rise to the revision become known. A
      detailed discussion of our significant accounting policies and use of estimates
      is contained in our 2005 Form 10-K filed March 16, 2006.





**Common-size
      Statements of Operations and Period-to-Period Percentage
      Change**





The
      following table sets forth, for the periods indicated, certain items from our
      condensed consolidated statements of operations as a percentage of total
      revenues and the percentage change of the dollar amounts from period to
      period.





**Period-to-Period****Percentage****Change****Percentage
                of Revenues**
            
            **Fav
                / (Unfav)****Three
                Months**
            
            **Nine
                Months****Three
                Months ended**
            
            **Nine
                Months ended**
            
            **ended**
            
            **ended****September
                30,**
            
            **September
                30,**
            
            **September
                30,**
            
            **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**
            
            **2006-2005**
            
            **2006-2005**Revenues:
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %
            
            10.1
            %
            
            8.1
            %Expenses:Community
                operations*
            
            
            65.0
            
            
            70.3
            
            
            65.3
            
            
            66.2
            
            
            (1.8
            )
            
            (6.8
            )Texas
                lawsuit settlement
            
            
            -
            
            
            -
            
            
            (3.9
            )
            
            -
            
            
            N/AGeneral
                and administrative
            
            
            9.7
            
            
            8.5
            
            
            8.9
            
            
            8.1
            
            
            (25.8
            )
            
            (18.7
            )Depreciation
                and amortization
            
            
            11.9
            
            
            11.9
            
            
            11.9
            
            
            11.9
            
            
            (10.3
            )
            
            (8.1
            )Facility
                lease expense
            
            
            10.5
            
            
            10.8
            
            
            10.7
            
            
            10.6
            
            
            (6.8
            )
            
            (8.5
            )Total
                operating expenses
            
            
            97.1
            
            
            101.5
            
            
            92.9
            
            
            96.8
            
            
            (5.3
            )
            
            (3.8
            )Operating
                income (loss) from continuing operations
            
            
            2.9
            
            
            (1.5
            )
            
            7.1
            
            
            3.2
            
            
            N/A
            
            
            141.9Other
                income (expense)Interest
                income
            
            
            0.7
            
            
            0.5
            
            
            0.7
            
            
            0.3
            
            
            69.4
            
            
            161.7Interest
                expense
            
            
            (11.7
            )
            
            (13.4
            )
            
            (11.8
            )
            
            (13.0
            )
            
            3.6
            
            
            1.7Gain
                on sale of investment in Alterra Healthcare Corporation
            
            
            -
            
            
            -
            
            
            -
            
            
            7.4
            
            
            N/A
            
            
            (100.0
            )Equity
                earnings (losses) in unconsolidated joint ventures
            
            
            (0.1
            )
            
            2.4
            
            
            (0.2
            )
            
            0.8
            
            
            (105.9
            )
            
            (127.7
            )Other,
                net
            
            
            0.5
            
            
            0.6
            
            
            0.6
            
            
            0.7
            
            
            (5.6
            )
            
            (13.4
            )Net
                other expense
            
            
            (10.6
            )
            
            (9.9
            )
            
            (10.7
            )
            
            (3.8
            )
            
            (17.8
            )
            
            (205.0
            )Loss
                from continuing operationsbefore
                income taxes
            
            
            (7.7
            )
            
            (11.4
            )
            
            (3.6
            )
            
            (0.6
            )
            
            25.3
            
            
            (527.2
            )Provision
                for income taxes
            
            
            1.7
            
            
            (0.1
            )
            
            0.6
            
            
            (0.4
            )
            
            N/A
            
            
            N/ALoss
                from continuing operations
            
            
            (6.0
            )
            
            (11.5
            )
            
            (3.0
            )
            
            (1.0
            )
            
            42.8
            
            
            (208.8
            )Loss
                from discontinued operations (net of tax)
            
            
            -
            
            
            (0.3
            )
            
            -
            
            
            (1.2
            )
            
            98.2
            
            
            98.5Net
                loss
            
            
            (6.0
            %)
            
            (11.8
            %)
            
            (3.0
            %)
            
            (2.2
            %)
            
            44.4
            %
            
            (49.1
            %)*
                exclusive of depreciation and amortization and facility lease expense
                shown separately below











**27**
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**Comparison
      of the three months ended September 30, 2006 and 2005**





**Total
      Operating Revenues:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Community
                revenue
            
            **$**
            **105,394**
            
            $
            95,357
            
            $
            10,037
            
            
            10.5
            %Other
                service fees
            
            
            **1,537**
            
            
            1,698
            
            
            (161
            )
            
            (9.5
            %)Total
                community revenues
            
            
            **106,931**
            
            
            97,055
            
            
            9,876
            
            
            10.2
            %Management
                fees
            
            
            **380**
            
            
            455
            
            
            (75
            )
            
            (16.5
            %)Total
                operating revenues
            
            **$**
            **107,311**
            
            $
            97,510
            
            $
            9,801
            
            
            10.1
            %





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D**Average
                monthly revenue per occupied unit
            
            **$**
            **3,124**
            
            $
            2,980
            
            $
            144
            
            
            4.8
            %Average
                occupancy rate
            
            
            **86.0**
            **%**
            
            84.7
            %
            
            
            
            
            1.3
            
            
            ppt*





*
      percentage points





Of
      the
      increase in revenues of $9.8 million for the three months ended September 30,
      2006, compared to the three months ended September 30, 2005, the acquisition
      of
      five additional communities since July 1, 2005, accounted for approximately
      $2.6
      million. Of the remaining increase of $7.2 million, approximately $4.8 million
      was due to increases in the average monthly revenue per unit and approximately
      $2.4 million was due to an increase in occupancy, including an increase of
      $254,000 from the reopening of our Biloxi community that was temporarily closed
      due to hurricane damage in 2005.





While
      our
      occupancy rate grew more slowly than we anticipated, we have experienced an
      upward pattern in our occupancy rate from 85.9% on June 30, 2006, to 87.0%
      on
      September 30, 2006, the last day of each fiscal quarter. We will continue our
      efforts to build our occupancy through increased marketing initiatives, programs
      that address resident mix and a focus on property improvements and other
      community-level enhancements to attract additional long-term residents and
      increase occupancy while maintaining growth in average monthly revenue per
      unit.
      We believe that these initiatives will continue to have a positive impact on
      operating performance over time.





**Community
      Operations:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Community
                operations
            
            **$**
            **69,763**
            
            $
            68,539
            
            $
            1,224
            
            
            1.8
            %As
                a percent of revenue
            
            
            **65.0**
            **%**
            
            70.3
            %
            
            
            
            
            (5.3
            )
            
            ppt





A
      significant factor impacting the change in community operating expense between
      the periods was a $5.0 million adjustment to our professional and general
      liability insurance accrual. We recorded an additional $5.0 million professional
      and general liability insurance accrual in the third quarter ended September
      30,
      2005, to reflect the settlement experience of claims closed during the third
      quarter of 2005, primarily from





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claims
      originating in 2003 and 2004, and to reflect an updated estimate of ultimate
      losses for all years from 2002 to September 30, 2005, based upon an actuarial
      valuation report.





Another
      major factor impacting the change in community operating expenses between the
      periods was a reduction in workers’ compensation expense of $2.0 million and
      $736,000 in the third quarter of 2006 and 2005, respectively, for a net change
      of $1.3 million, due to revised estimates of our ultimate exposure under our
      workers’ compensation programs. The adjustment in the third quarter of 2006 was
      based upon an actuarial valuation report.





Exclusive
      of the professional and general liability insurance and workers’ compensation
      adjustments mentioned above, the increase would have been approximately $7.5
      million. Approximately $1.6 million of the increase in community operating
      expense resulted from the addition of five new communities. Of the remaining
      increase of $5.9 million, approximately $3.7 million was primarily due to
      increases in labor-related costs and approximately $942,000 was due to increases
      in utilities and repairs and maintenance expenses. In addition, increases of
      approximately $741,000 were from increases in various operating costs, primarily
      food costs, management fees, marketing, professional services, and bad debt
      expense. Also, an additional accrual of $772,000 was recorded in the third
      quarter of 2006 related to the Texas Medicaid dispute discussed under “Legal
      Proceedings” contributed to the increase.  Included
      in the changes above are losses of approximately $750,000 related to hurricanes
      Katrina and Rita in 2005.





**General
      and Administrative:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**General
                and administrative
            
            **$**
            **10,380**
            
            $
            8,250
            
            $
            2,130
            
            
            25.8
            %As
                a percent of revenue
            
            
            **9.7**
            **%**
            
            8.5
            %
            
            
            
            
            1.2
            
            
            ppt





The
      increase in G&A expenses of $2.1 million was primarily related to staffing
      costs for regional and corporate overhead positions of approximately $315,000,
      non-cash stock option compensation expenses of approximately $2.0 million (due
      to implementation of SFAS 123R), and legal fees of $332,000, primarily relating
      to the Texas Medicaid dispute as discussed under “Legal Proceedings.” In
      addition, our accounting and consulting fees decreased by $521,000, primarily
      because project costs in 2006 related to compliance work for internal control
      requirements under the Sarbanes-Oxley Act of 2002 declined from expense levels
      in 2005.





**Depreciation
      and Amortization:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Depreciation
                and amortization
            
            **$**
            **12,820**
            
            $
            11,627
            
            $
            1,193
            
            
            10.3
            %As
                a percent of revenue
            
            
            **11.9**
            **%**
            
            11.9
            %
            
            
            
            
            .0
            
            
            ppt





The
      increase is primarily the result of increased depreciation and amortization
      expense of $572,000 related to the December 2005 acquisition of three Arkansas
      communities and the July 2006 acquisition of one Washington community, as well
      as from leasehold improvement depreciation on capital expenditures to improve
      our properties.





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**Facility
      Lease Expense:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Facility
                lease expense
            
            **$**
            **11,254**
            
            $
            10,534
            
            $
            720
            
            
            6.8
            %As
                a percent of revenue
            
            
            **10.5**
            **%**
            
            10.8
            %
            
            
            
            
            (.3
            )
            
            ppt





The
      increase in facility lease expense of $720,000 was partially due to the
      operating lease of two new communities discussed under the caption “Significant
      Transactions - Emeritrust Lease,” which accounted for approximately $147,000 of
      the increase. The remaining increase of $573,000 was primarily attributable
      to
      lease terms that provide for periodic increases in rent. We leased 77
      communities under operating leases as of September 30, 2006 and 2005.





**Interest
      Income:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Interest
                income
            
            **$**
            **759**
            
            $
            448
            
            $
            311
            
            
            69.4
            %As
                a percent of revenue
            
            
            **0.7**
            **%**
            
            0.5
            %
            
            
            
            
            .2
            
            
            ppt





The
      increase in interest income of $311,000 was primarily attributable to interest
      earned on investments of cash that was received in the sale of our ownership
      interest in Alterra and interest income earned on restricted
      deposits.





**Interest
      Expense:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Interest
                expense
            
            **$**
            **12,581**
            
            $
            13,049
            
            $
            (468
            )
            
            (3.6
            %)As
                a percent of revenue
            
            
            **11.7**
            **%**
            
            13.4
            %
            
            
            
            
            (1.7
            )
            
            ppt





The
      decrease in interest expense of $468,000 for the third quarter of 2006 as
      compared to the comparable period in 2005 is primarily due to a decrease of
      $563,000 related to an interest accrual we recorded in connection with the
      Texas
      judgment in 2005, a decline in interest expense of approximately $358,000
      primarily from the pay down of principal balances over the past year, offset
      by
      increases in interest expense of $453,000 from three new Arkansas communities
      acquired in December 2005 and from the new Washington community acquired in
      July
      2006. Excluding the interest accrual related to the lawsuit settlement, interest
      expense was 12.8% of total operating revenues for the nine months ended
      September 30, 2005.








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**Equity
      earnings (losses) in unconsolidated joint ventures:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Equity
                earnings (losses) inunconsolidated
                joint ventures
            
            **$**
            **(138**
            **)**
            $
            2,328
            
            $
            (2,466
            )
            
            (105.9
            %)As
                a percent of revenue
            
            
            **(0.1**
            **%)**
            
            2.4
            %
            
            
            
            
            (2.5
            )
            
            ppt





The
      decrease in equity earnings (losses) in unconsolidated joint ventures of $2.5
      million is primarily from equity losses in Senior Healthcare Partners, LLC
      for
      the three months ended September 30, 2006, as compared to equity earnings in
      the
      comparable quarter of the prior year, as further explained under “Senior Med
      Transaction.”





**Other,
      net:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Other,
                net
            
            **$**
            **561**
            
            $
            594
            
            $
            (33
            )
            
            (5.6
            %)As
                a percent of revenue
            
            
            **0.5**
            **%**
            
            0.6
            %
            
            
            
            
            (.1
            )
            
            ppt





Other,
      net primarily reflects the amortization of deferred gains of $554,000 for both
      periods presented.





**Income
      taxes:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Provision
                for income taxes
            
            **$**
            **(1,877**
            **)**
            $
            122
            
            $
            (1,999
            )
            
            (1,638.5
            %)As
                a percent of revenue
            
            
            **(1.7**
            **%)**
            
            0.1
            %
            
            
            
            
            (1.8
            )
            
            ppt





The
      provision for income taxes for the quarter ended September 30, 2006, includes
      a
      tax benefit of $823,000 for the proportionate share of the estimated tax refund,
      exclusive of the $251,000 of tax benefit related to employee stock option
      exercises, from the expected carry back of tax losses for 2006 to offset taxable
      income in 2005, an adjustment of approximately $1.1 million to our estimated
      2005 federal tax liability to the final federal tax return filed during the
      quarter, and an accrual for estimated state income and franchise tax
      liabilities. Other than the loss carry back benefit discussed above, no benefit
      has been recognized for our net deferred tax assets as management does not
      believe it is more likely than not that the deferred tax assets will be
      realized.  The provision for income taxes for the quarter ended September
      30, 2005, is principally due to federal and state income tax liabilities on
      taxable income from the equity earnings on the Senior Med transaction and
      federal and state income and franchise tax liabilities on operating income
      after
      adding back financial accounting for leases and other timing and permanent
      differences between financial accounting and tax.





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**Net Loss
      and Property-Related Expense:** **





In
      comparing the net loss for the three months ended September 30, 2006 and
      2005, it is important to consider our property-related expenses, which include
      depreciation and amortization, facility lease expense, and interest expense
      that
      are directly related to our communities, and which include capital lease
      accounting treatment, finance accounting treatment, or straight-line accounting
      treatment of rent escalators for many of our leases. These accounting treatments
      all result in greater property-related expense than actual lease payments made
      in the early years of the affected leases and less property-related expense
      than
      actual lease payments made in later years, as detailed in the tables
      below.





**Detail
                of property-related expenses from lease accounting
                treatment:****Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)****Total
                property-related expense:**Depreciation
                and amortization
            
            **$**
            **12,820**
            
            $
            11,627
            
            $
            1,193
            
            
            10.3
            %Facility
                lease expense
            
            
            **11,254**
            
            
            10,534
            
            
            720
            
            
            6.8
            %Interest
                expense
            
            
            **12,581**
            
            
            13,049
            
            
            (468
            )
            
            (3.6
            %)Total
                property-related expense
            
            **$**
            **36,655**
            
            $
            35,210
            
            $
            1,445
            
            
            4.1
            %**Property-related
                expenses from lease accounting treatment:**Depreciation
                and amortization
            
            **$**
            **9,724**
            
            $
            9,748
            
            $
            (24
            )
            
            (0.2
            %)Interest
                expense
            
            
            **10,288**
            
            
            10,590
            
            
            (302
            )
            
            (2.9
            %)Straight-line
                lease expense
            
            
            **222**
            
            
            255
            
            
            (33
            )
            
            (12.9
            %)Operating
                lease expense
            
            
            **11,032**
            
            
            10,279
            
            
            753
            
            
            7.3
            %Total
                property-related lease expense
            
            
            **31,266**
            
            
            30,872
            
            
            394
            
            
            1.3
            %Actual
                lease payments
            
            
            **(26,146**
            **)**
            
            (24,659
            )
            
            (1,487
            )
            
            6.0
            %Expense
                in excess of lease payments
            
            **$**
            **5,120**
            
            $
            6,213
            
            $
            (1,093
            )
            
            (17.6
            %)





Our
      property-related expense associated with our leases exceeded our actual lease
      payments by $5.1 million and $6.2 million for the three months ended September
      30, 2006 and 2005, respectively. While the impact of lease accounting declined
      by $1.1 million in the current year quarter from the comparable quarter last
      year due to the normal reversal of the timing differences, the total impact
      in
      both periods is significant to our overall operating results. It should be
      noted
      that, notwithstanding the effects of lease accounting treatment, the actual
      lease payments required under most of our leases will continue to increase
      annually and, as a result, we will need to improve our results from community
      operations to cover these increases.





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**Loss
      from Discontinued Operations:**





**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Loss
                from discontinued operations,net
                of tax benefit
            
            **$**
            **(6**
            **)**
            $
            (328
            )
            $
            322
            
            
            (98.2
            %)As
                a percent of revenue
            
            
            **-**
            
            
            0.3
            %
            
            
            
            
            (0.3
            )
            
            ppt





The
      loss
      from discontinued operations for the three months ended September 30, 2005,
      is
      due to the sale of a facility in Nevada.








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**Comparison
      of the nine months ended September 30, 2006 and 2005**





**Total
      Operating Revenues:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Community
                revenue
            
            **$**
            **305,860**
            
            $
            281,873
            
            $
            23,987
            
            
            8.5
            %Other
                service fees
            
            
            **4,869**
            
            
            5,178
            
            
            (309
            )
            
            (6.0
            %)Total
                community revenues
            
            
            **310,729**
            
            
            287,051
            
            
            23,678
            
            
            8.2
            %Management
                fees
            
            
            **1,321**
            
            
            1,517
            
            
            (196
            )
            
            (12.9
            %)Total
                operating revenues
            
            **$**
            **312,050**
            
            $
            288,568
            
            $
            23,482
            
            
            8.1
            %





Of
      the
      increase in revenues of $23.5 million for the nine months ended September 30,
      2006, compared to the nine months ended September 30, 2005, the acquisition
      of
      eight additional communities since December 31, 2004, accounted for
      approximately $8.8 million. The increase in existing communities of $14.7
      million was primarily due to increases in the average monthly revenue per unit,
      including an offsetting decrease of $497,000 from the temporary closure of
      our
      Biloxi community due to hurricane damage.





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D**Average
                monthly revenue per occupied unit
            
            **$**
            **3,094**
            
            $
            2,948
            
            $
            146
            
            
            5.0
            %Average
                occupancy rate
            
            
            **84.8**
            **%**
            
            84.8
            %
            
            
            
            
            .0
            
            
            ppt





While
      our
      occupancy rate remained flat from the comparable prior period, we have
      experienced an upward pattern in our occupancy rate from 84.2% on December
      31,
      2005, to 87.0% on September 30, 2006, the last day of each fiscal quarter.
      We
      will continue our efforts to build our occupancy through increased marketing
      initiatives, programs that address resident mix and a focus on property
      improvements and other community-level enhancements to attract additional
      long-term residents and increase occupancy while maintaining growth in average
      monthly revenue per unit. We believe that these initiatives will continue to
      have a positive impact on operating performance over time.





The
      decrease in management fee income of approximately $196,000 for the first nine
      months of 2006 as compared to the same period in 2005 was primarily due to
      the
      reduction in management contracts since December 31, 2004.





**Community
      Operations:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Community
                operations
            
            **$**
            **203,792**
            
            $
            190,887
            
            $
            12,905
            
            
            6.8
            %As
                a percent of revenue
            
            
            **65.3**
            **%**
            
            66.2
            %
            
            
            
            
            (.9
            )
            
            ppt





Community
      operations expense excludes a $12.2 million reduction in our professional
      and general liability insurance accrual that resulted from the settlement of
      a
      lawsuit for an amount less than the original accrual for the action, which
      is
      shown as a separate line item on the condensed consolidated statement of
      operations






**34**


Table
      of
      Contents




and
      is
      further discussed under “Legal Proceedings.” Excluding this adjustment,
      community operations expense increased $12.9 million, or 6.8%. However, if
      we
      also exclude the $5.0 million professional and general liability insurance
      adjustment and the net $1.3 million workers’ compensation adjustment discussed
      in the three month comparison above, community operations expense would have
      increased $19.2 million, or 10.3%. Approximately $5.3 million of this increase
      was from the addition of eight new communities. Of the remaining increase of
      $13.9 million in community operations expense approximately $9.3 million was
      increased staffing costs and approximately $2.6 million was due to increases
      in
      utilities and repairs and maintenance expenses. The remaining difference was
      due
      to increases of $2.0 million in various other operating costs, primarily
      marketing, food costs, property taxes, bad debts, supplies, telephone, and
      management fees as well as an accrual of approximately $1.3 million related
      to
      the Texas Medicaid dispute discussed under “Legal Proceedings,” offset by a
      decrease in professional liability insurance costs of approximately $1.6
      million, due principally from a $1.7 million expense reduction recorded in
      the
      second quarter of 2006 to recognize favorable settlements on several specific
      claims.





**General
      and Administrative:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**General
                and administrative
            
            **$**
            **27,832**
            
            $
            23,440
            
            $
            4,392
            
            
            18.7
            %As
                a percent of revenue
            
            
            **8.9**
            **%**
            
            8.1
            %
            
            
            
            
            .8
            
            
            ppt





The
      increase in G&A expenses of $4.4 million was primarily related to staffing
      costs for regional and corporate overhead positions of approximately $1.3
      million, non-cash stock option compensation expenses of $2.2 million (due to
      implementation of SFAS 123R), and legal fees of $1.1 million, primarily as
      a
      result of the Texas Medicaid dispute discussed under “Legal Proceedings,”
partially offset by a decrease in accounting and consulting fees of $400,000,
      primarily from direct project costs in 2005 related to initial compliance work
      for internal control requirements under the Sarbanes-Oxley Act of
      2002.





**Depreciation
      and Amortization:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Depreciation
                and amortization
            
            **$**
            **37,221**
            
            $
            34,427
            
            $
            2,794
            
            
            8.1
            %As
                a percent of revenue
            
            
            **11.9**
            **%**
            
            11.9
            %
            
            
            
            
            .0
            
            
            ppt





The
      increase is primarily the result of increased depreciation and amortization
      expense of $1.5 million related to the December 2005 acquisition of three
      Arkansas communities, the acquisition of two communities under capital leases
      in
      March 2005, the July 2006 acquisition of one Washington community, as well
      as to
      leasehold improvement depreciation on capital expenditures to improve our
      properties.







**35**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents


**Facility
        Lease Expense:**
 
 **Nine
                  Months ended September 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Facility
                  lease expense
              
              **$**
              **33,264**
              
              $
              30,658
              
              $
              2,606
              
              
              8.5
              %As
                  a percent of revenue
              
              
              **10.7**
              **%**
              
              10.6
              %
              
              
              
              
              .1
              
              
              ppt


The
      increase in facility lease expense of $2.6 million was primarily due to the
      operating lease of two new communities discussed under Emeritrust Lease, which
      accounted for approximately $1.2 million of the increase. The remaining increase
      of $1.4 million was primarily attributable to lease terms that provide for
      periodic increases in rent. We leased 77 communities under operating leases
      as
      of September 30, 2006 and 2005.





**Interest
      Income:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Interest
                income
            
            **$**
            **2,311**
            
            $
            883
            
            $
            1,428
            
            
            161.7
            %As
                a percent of revenue
            
            
            **0.7**
            **%**
            
            0.3
            %
            
            
            
            
            .4
            
            
            ppt





The
      increase in interest income of $1.4 million was primarily attributable to
      interest earned on investments of cash that was received in the sale of our
      ownership interest in Alterra and interest income earned on restricted
      deposits.





**Interest
      Expense:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Interest
                expense
            
            **$**
            **36,787**
            
            $
            37,417
            
            $
            (630
            )
            
            (1.7
            %)As
                a percent of revenue
            
            
            **11.8**
            **%**
            
            13.0
            %
            
            
            
            
            (1.2
            )
            
            ppt





The
      decrease in interest expense of $630,000 for the first nine months of 2006
      as
      compared to the comparable period in 2005 was primarily due to the 2006 reversal
      of an interest accrual of $766,000 previously recorded for the settlement of
      a
      lawsuit, of which $563,000 is reflected in interest expense for the first nine
      months of 2005, as described under “Legal Proceedings.” Interest expense
      increased by $699,000 after adjusting for the settlement impact noted above.
      This increase is primarily due to an increase in interest expense of $879,000
      relating to debt financing associated with three new Arkansas communities
      acquired in December 2005, $124,000 relating to two new communities under
      capital leases acquired in March 2005, $536,000 from the new $10.8 million
      loan
      we entered into in connection with our Series B Stock conversion in June 2005,
      offset by a decline in interest expense from the pay down of principal balances
      over the past year. Excluding the interest accrual and reversal related to
      the
      lawsuit settlement, interest expense was 12.0% and 12.8% of total operating
      revenues for the nine months ended September 30, 2006 and 2005,
      respectively.










**36**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
        of
        Contents
  **Equity
        earnings (losses) in unconsolidated joint ventures:**
 
 **Nine
                  Months ended September 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Equity
                  earnings (losses) inunconsolidated
                  joint ventures
              
              **$**
              **(630**
              **)**
              $
              2,277
              
              $
              (2,907
              )
              
              (127.7
              %)As
                  a percent of revenue
              
              
              **(0.2**
              **%)**
              
              0.8
              %
              
              
              
              
              (1.0
              )
              
              ppt


The
      decrease in equity earnings (losses) in unconsolidated joint ventures of $2.9
      million is primarily from equity losses in Senior Healthcare Partners, LLC
      for
      the nine months ended September 30, 2006, as compared to equity earnings in
      the
      comparable period of the prior year, as further explained under “Senior Med
      Transaction.”





**Other,
      net:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Other,
                net
            
            **$**
            **1,719**
            
            $
            1,986
            
            $
            (267
            )
            
            (13.4
            %)As
                a percent of revenue
            
            
            **0.6**
            **%**
            
            0.7
            %
            
            
            
            
            (.1
            )
            
            ppt





The
      amortization of deferred gains of approximately $1.7 million is reflected in
      Other, net for both periods presented.





**Income
      taxes:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Provision
                for income taxes
            
            **$**
            **(1,967**
            **)**
            $
            1,211
            
            $
            (3,178
            )
            
            (262.4
            %)As
                a percent of revenue
            
            
            **(0.6**
            **%)**
            
            0.4
            %
            
            
            
            
            (1.0
            )
            
            ppt





The
      provision for income taxes for the nine months ended September 30, 2006,
      includes a tax benefit of $933,000 for the proportionate share of the estimated
      tax refund, exclusive of the $1.3 million of tax benefit related to employee
      exercises of stock options, from the expected carry back of 2006 tax losses
      to
      offset taxable income in 2005, an adjustment of approximately $1.1 million
      to
      our estimated 2005 federal tax liability to the final federal tax return filed
      during the quarter, and an accrual for estimated state income and franchise
      tax
      liabilities. Other than the loss carry back benefit discussed above, no benefit
      has been recognized for the Company’s net deferred tax assets as management does
      not believe it is more likely than not that the deferred tax assets will be
      realized. The provision for income taxes for the nine months ended September
      30,
      2005, is principally due to federal and state income and franchise tax
      liabilities on operating income after adding back financial accounting for
      leases and other timing and permanent differences between financial accounting
      and tax, and from the gain on sale of our Alterra and Senior Med
      investments.








**37**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents


**Net Loss
        and Property-Related Expense:** **
 
 In
        comparing the net loss for the nine months ended September 30, 2006 and
        2005, it is important to consider our property-related expenses, which include
        depreciation and amortization, facility lease expense, and interest expense
        that
        are directly related to our communities, and which include capital lease
        accounting treatment, finance accounting treatment, or straight-line accounting
        treatment of rent escalators for many of our leases. These accounting treatments
        all result in greater property-related expense than actual lease payments
        made
        in the early years of the affected leases and less property-related expense
        than
        actual lease payments made in later years, as detailed in the tables
        below.
  **Detail
                  of property-related expenses from lease accounting
                  treatment:****Nine
                  Months ended September 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)****Total
                  property-related expense:**Depreciation
                  and amortization
              
              **$**
              **37,221**
              
              $
              34,427
              
              $
              2,794
              
              
              8.1
              %Facility
                  lease expense
              
              
              **33,264**
              
              
              30,658
              
              
              2,606
              
              
              8.5
              %Interest
                  expense
              
              
              **36,787**
              
              
              37,417
              
              
              (630
              )
              
              (1.7
              %)Total
                  property-related expense
              
              **$**
              **107,272**
              
              $
              102,502
              
              $
              4,770
              
              
              4.7
              %**Property-related
                  expenses from lease accounting treatment:**Depreciation
                  and amortization
              
              **$**
              **29,149**
              
              $
              29,152
              
              $
              (3
              )
              
              (0.0
              %)Interest
                  expense
              
              
              **31,046**
              
              
              31,683
              
              
              (637
              )
              
              (2.0
              %)Straight-line
                  lease expense
              
              
              **734**
              
              
              651
              
              
              83
              
              
              12.7
              %Operating
                  lease expense
              
              
              **32,530**
              
              
              30,008
              
              
              2,522
              
              
              8.4
              %Total
                  property-related lease expense
              
              
              **93,459**
              
              
              91,494
              
              
              1,965
              
              
              2.1
              %Actual
                  lease payments
              
              
              **(77,481**
              **)**
              
              (72,717
              )
              
              (4,764
              )
              
              6.6
              %Expense
                  in excess of lease payments
              
              **$**
              **15,978**
              
              $
              18,777
              
              $
              (2,799
              )
              
              (14.9
              %)


Our
      property-related expense associated with our leases exceeded our actual lease
      payments by $16.0 million and $18.8 million for the nine months ended September
      30, 2006 and 2005, respectively. While the impact of lease accounting declined
      by $2.8 million in the first nine months of the current year from the comparable
      period last year due to the normal reversal of the timing differences, the
      total
      impact in both periods is significant to our overall operating results. It
      should be noted that, notwithstanding the effects of lease accounting treatment,
      the actual lease payments required under most of our leases will continue to
      increase annually and, as a result, we will need to improve our results from
      community operations to cover these increases.







**38**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents


**Loss
        from Discontinued Operations:**
 
 **Nine
                  Months ended September 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Loss
                  from discontinued operations,net
                  of tax benefit
              
              **$**
              **(50**
              **)**
              $
              (3,248
              )
              $
              3,198
              
              
              (98.5
              %)As
                  a percent of revenue
              
              
              **-**
              
              
              1.2
              %
              
              
              
              
              (1.2
              )
              
              ppt
 
 The
        loss
        from discontinued operations for the nine months ended September 30, 2005,
        reflects an impairment loss of approximately $4.3 million from the sale of
        a
        facility in Nevada, partially offset by a gain of approximately $1.3 million
        from the sale of a facility in Washington.


**Preferred
      dividends:**





**Nine
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands, except percentages)**Preferred
                dividends
            
            **$**
            **-**
            
            $
            599
            
            $
            (599
            )
            
            (100.0
            %)As
                a percent of revenue
            
            
            **-**
            
            
            0.2
            %
            
            
            
            
            (0.2
            )
            
            ppt





*Preferred
      dividends:* For the
      nine months ended September 30, 2005, preferred dividends totaled $599,000.
      The
      Series B Stock was converted to common stock on June 30, 2005. The preferred
      dividends of $957,000 in the first quarter of 2005 were offset by the second
      quarter reversal of $358,000 in excess accrued dividends from the straight-line
      accounting treatment of scheduled dividend rate increases.








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 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents





**Same
      Community Comparison**





Of
      our
      171 communities, we have operated 162 communities continuously since January
      1,
      2005, and define these as "Same Communities." Since our Biloxi community
      suffered significant damage from Katrina and was out of operation for
      approximately nine months, we have excluded it from this comparison. In
      addition, the analysis below excludes general and administrative expenses.
      The
      following table sets forth a comparison of same community results of operations
      for the three months ended September 30, 2006 and 2005.





**Three
                Months ended September 30,****(In
                thousands)****$****D**
            
            **%****D****2006**
            
            **2005**
            
            **Fav
                / (Unfav)**
            
            **Fav
                / (Unfav)**Revenue
            
            $
            100,945
            
            $
            94,145
            
            $
            6,800
            
            
            7.2
            %Community
                operations *
            
            
            (65,687
            )
            
            (65,891
            )
            
            204
            
            
            0.3Community
                operating income
            
            
            35,258
            
            
            28,254
            
            
            7,004
            
            
            24.8Depreciation
                & amortization
            
            
            (11,611
            )
            
            (11,231
            )
            
            (380
            )
            
            (3.4
            )Facility
                lease expense
            
            
            (10,068
            )
            
            (9,449
            )
            
            (619
            )
            
            (6.6
            )Operating
                income
            
            
            13,579
            
            
            7,574
            
            
            6,005
            
            
            79.3Interest
                expense, net
            
            
            (10,967
            )
            
            (11,342
            )
            
            375
            
            
            3.3Operating
                income (loss) after interest expense
            
            $
            2,612
            
            $
            (3,768
            )
            $
            6,380
            
            
            N/A*
                exclusive of depreciation and amortization and facility lease expense
                shown separately below





These
      162
      communities represented $100.9 million or 94.1% of our total revenue of $107.3
      million for the third quarter of 2006. The increase in same community revenues
      of $6.8 million was primarily due to improvements in average revenue per
      occupied unit, which accounted for approximately $5.4 million of the increase
      in
      revenue and the increase in occupancy, which accounted for approximately $1.4
      million.





The
      table
      below shows the amounts and changes in average monthly revenue per occupied
      unit
      and occupancy rates:




**Three
                Months ended September 30,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D**Average
                monthly revenue per occupied unit
            
            **$**
            **3,125**
            
            $
            2,955
            
            $
            170
            
            
            5.7
            %Average
                occupancy rate
            
            
            **85.8**
            **%**
            
            84.5
            %
            
            
            
            
            1.3
            
            
            ppt





A
      significant factor in explaining the minor increase in community operating
      expense of $204,000 was a $5.0 million adjustment to our professional and
      general liability insurance accrual in the quarter ended September 30, 2005,
      of
      which approximately $4.6 million related to the Same Communities. We recorded
      an
      additional $5.0 million professional and general liability insurance accrual
      to
      reflect the settlement experience of claims closed in the third quarter of
      2005,
      primarily from claims originating in 2003 and 2004, and to reflect an updated
      estimate of ultimate losses for all years from 2002 to September 30, 2005,
      based
      upon an actuarial valuation report.





Another
      major factor impacting the change in community operating expense between the
      periods was a reduction in workers’ compensation expense of approximately $1.8
      million and $677,000 in the third quarter of 2006 and 2005, respectively, for
      a
      net change of $1.1 million due to revised estimates of our ultimate exposure
      under our workers’ compensation programs. The adjustment in the third quarter of
      2006 was based upon an actuarial valuation report.





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 **AND
            RESULTS OF OPERATIONS - CONTINUED**


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      of
      Contents





Exclusive
      of the general and professional liability insurance and worker’s compensation
      adjustments mentioned above, community operating expenses would have increased
      approximately $5.6 million primarily from increased costs for direct care labor
      and related employee taxes and benefits of $3.9 million. The increase also
      reflects increased utilities and facility repair and maintenance expenses of
      $909,000. The remaining increase of approximately $748,000 is primarily
      comprised of other general operating expenses of the communities, including
      food
      costs, marketing, property taxes, bad debts, supplies, and similar community
      operating expenses.





Property-related
      expenses (depreciation and amortization, facility lease expense, and interest
      expense, net of interest income) increased by approximately $624,000, which
      primarily reflects the effect of lease terms that provide for periodic increases
      in rent and an increase in depreciation from increased capital expenditures
      to
      improve our properties, offset by an increase in interest income on restricted
      deposits, and a decrease in interest expense due to the pay down of principal
      balances.





Operating
      income (loss) after interest expense increased from a loss of $3.8 million
      to
      income of $2.6 million for a total improvement of $6.4 million from the
      comparable period of 2005 as a result of the changes discussed above. Exclusive
      of the general and professional liability insurance and workers’ compensation
      adjustments noted above, the improvement in operating results would be
      approximately $661,000. We will continue our efforts to build our occupancy
      through increased marketing initiatives, programs that address resident mix
      and
      a focus on property improvements and other community-level enhancements to
      attract additional long-term residents and increase occupancy while maintaining
      growth in average monthly revenue per unit. We believe that these initiatives
      will continue to have a positive impact on operating performance over time.




**Liquidity
        and Capital Resources**
 
 For
        the
        nine months ended September 30, 2006, net cash provided by operating activities
        was $3.7 million. The primary components of cash provided by operating
        activities for this period were depreciation and amortization of $37.2 million
        and non-cash stock option compensation of $2.2 million (due to implementation
        of
        SFAS 123R), partially offset by a net change in operating assets and liabilities
        of $26.2 million, amortization of deferred gain of $1.7 million, and $9.3
        million of net loss from operations. The $26.2 million use of cash related
        to
        operating assets and liabilities is primarily comprised of those items detailed
        in the following table. For the nine months ended September 30, 2005, net
        cash
        provided by operating activities was $12.8 million. The primary components
        of
        operating cash provided by operating activities for this period were
        depreciation and amortization of $34.4 million, $4.3 million from the impairment
        of long-lived asset, and the net change in operating assets and liabilities
        of
        $5.6 million, partially offset by the gain on sale of our investment in Alterra
        and Senior Med of $23.6 million, the net gain on sale of properties of $1.3
        million, the amortization of deferred gain of $1.7 million, and $6.3
        million  of
        net
        loss from operations.


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**41**
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            RESULTS OF OPERATIONS - CONTINUED**


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      Contents


**Significant
                  components of changes in operating assets and
                  liabilities:****Nine
                  Months Ended September 30,****2006**
              
              **2005**Reduction
                  of Texas settlement liability accruals, including interest
              
              $
              (12,973
              )
              $
              -Payment
                  of Texas Settlement
              
              
              (5,600
              )
              
              -Refund
                  of court bond related to Texas Settlement
              
              
              1,725
              
              
              -Federal
                  tax refund receivable, related to 2005 overpayment
              
              
              (1,043
              )
              
              -Federal
                  tax deposits, principally related to the Alterra transaction
                  gain
              
              
              (4,200
              )
              
              -Professional
                  and general liability accrual adjustment
              
              
              (1,700
              )
              
              5,008Workers
                  compensation accrual adjustment
              
              
              (2,021
              )
              
              (736
              )Payment
                  of semi-annual debenture interest
              
              
              (1,830
              )
              
              (2,000
              )Payment
                  of annual insurance premiums
              
              
              (8,655
              )
              
              (8,098
              )Federal
                  tax refund receivable, related to 2006 loss carryback
              
              
              (2,258
              )
              
              -Texas
                  Medicaid settlement accrual
              
              
              1,272
              
              
              -All
                  other activity, net
              
              
              11,061
              
              
              11,428Net
                  change in operating assets and liabilities
              
              $
              (26,222
              )
              $
              5,602
 
 The
        Texas
        settlement impact of $16.8 million, the federal tax deposits of $4.2 million
        related to the Alterra transaction gain, and the federal tax refunds of $3.3
        million, partially offset by the Texas Medicaid accrual of $1.3 million,
        a total
        of $23.0 million for 2006, are expected to be non-recurring items.
 
 For
        the
        nine months ended September 30, 2006, cash used in investing activities was
        $25.2 million. The activities that used cash include $22.3 million for the
        acquisition of property and equipment and management and lease acquisition
        costs
        of $2.8 million. Net cash provided by investing activities amounted to $17.1
        million for the nine months ended September 30, 2005, and was comprised
        primarily of proceeds from the sale of the Alterra investment of $25.0 million,
        partially offset by lease acquisition costs of approximately $1.8 million,
        and
        acquisitions of various property and equipment of approximately $7.3
        million.
 
 For
        the
        nine months ended September 30, 2006, net cash used in financing activities
        was
        $10.7 million. Activities resulting in a net cash decrease include $13.9
        million
        for repayment of capital lease and financing obligations, $7.9 million for
        repayment of borrowings, and $2.6 million for the increase in restricted
        deposits, partially offset by proceeds from the Arbor Place debt of $8.0
        million, proceeds from the issuance of common stock of approximately $4.2
        million, and approximately $1.3 million from the tax benefit of stock
        compensation. For the nine months ended September 30, 2005, net cash used
        in
        financing activities was $15.0 million, consisting primarily of $1.1 million
        net
        repayment of long-term borrowings, repayment of capital lease and financing
        obligations of $11.7 million and restricted deposits of $2.0 million. We
        borrowed $32.2 million to refinance debt of $21.4 million and to pay accumulated
        preferred dividends of $10.8 million during the nine months ended September
        30,
        2005.
 
 As
        of
        September 30, 2006, we had a working capital deficit of $34.3 million. We
        are
        able to operate in the position of a working capital deficit because revenues
        are collected more quickly, often in advance, than obligations are required
        to
        be paid. This can result in a low level of current assets to the extent cash
        has
        been deployed in business development opportunities or to pay down long-term
        liabilities. Along those lines, the working capital deficit includes $15.7
        million of deferred revenue and unearned rental income. The level of current
        liabilities is not expected to change year to year in such a way as to require
        the use of significant cash, except for debt maturities of $80.7 million
        scheduled to be due in 2008.
 
 We
        have
        incurred significant losses since our inception and have an accumulated deficit
        of $201.7 million as of September 30, 2006. We believe these losses have
        resulted from our early emphasis on expansion, financing costs arising from
        multiple financing and refinancing transactions related to this expansion,


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            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
      of
      Contents


occupancy
        rates remaining lower for longer periods than anticipated, and depreciation
        expense primarily from multiple capital and financing leases.
 
 In
        February 2005, a San Antonio, Texas, jury found one of our assisted living
        communities negligent in the care of a resident. The jury awarded a verdict
        against us in the amount of $1.5 million in compensatory damages and $18.0
        million in punitive damages. We appealed the verdict and posted a deposit
        of
        $1.7 million in order to stay the proceedings. In March 2006, we settled
        the
        case for $5.6 million and the deposit was refunded to us, with interest,
        in
        April 2006. In the fourth quarter of 2004, we recorded an additional liability
        accrual of $18.7 million and accrued $766,000 of interest on the judgment
        in 2005. In the first quarter of 2006, we reduced the accrued interest by
        $766,000 and the liability accrual recorded in 2004 by $12.2
        million.
 
 We
        refinanced substantially all of our debt obligations, extending the maturities
        of such financings to dates beyond October 2007, at which time we will need
        to
        refinance or otherwise repay the obligations. Many of our debt instruments
        and
        leases contain “cross-default” provisions pursuant to which a default under one
        obligation can cause a default under one or more other obligations to the
        same
        or other lenders or lessors. Such cross-default provisions affect the majority
        of our properties. Accordingly, any event of default could cause a material
        adverse effect on our financial condition if such debt or leases are
        cross-defaulted. At September 30, 2006, we were non-compliant with one or
        more
        covenants in certain of the leases and mortgages, but obtained waivers from
        the
        owners and lenders that expire on October 1, 2007. We were required to make
        additional security deposits of $1.1 million and $2.2 million during the
        three
        and nine month periods ending September 30, 2006, respectively, related to
        our
        non-compliance with debt and lease covenants.
 
 As
        discussed above under the caption “Subsequent Event,” we expect to make an
        additional cash contribution of approximately $4.2 million in 2006 relating
        to
        our investment in a joint venture.
 
 Based
        on
        our current operating initiatives and our current cash position, management
        believes that we will be able to generate positive operating cash flow, or
        will
        have adequate cash reserves, or the ability to obtain adequate financing
        to
        cover any potential operating shortfalls and necessary investing and financing
        activities, including required debt service and capital expenditures for
        at
        least the next twelve months.
 
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        rest
        of this page is intentionally left blank]





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            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**


Table
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      Contents


The
      following table summarizes our contractual obligations at September 30, 2006,
      (in thousands):





**Principal
                and Lease Payments Due by Period****After
                5****Contractual
                Obligations**
            
            **Total**
            
            **1
                year**
            
            **2-3
                years**
            
            **4-5
                years**
            
            **years**Long-term
                debt, including current portion
            
            $
            86,821
            
            $
            2,858
            
            $
            56,791
            
            $
            4,870
            
            $
            22,302Capital
                lease and financing obligations, including current portion
            
            
            613,279
            
            
            21,429
            
            
            53,121
            
            
            68,202
            
            
            470,527Operating
                leases
            
            
            308,893
            
            
            41,038
            
            
            83,648
            
            
            81,546
            
            
            102,661Convertible
                debentures
            
            
            26,575
            
            
            -
            
            
            26,575
            
            
            -
            
            
            -$
            1,035,568
            
            $
            65,325
            
            $
            220,135
            
            $
            154,618
            
            $
            595,490





The
      following table summarizes interest on our contractual obligations at September
      30, 2006, (in thousands):








**Interest
                Due by Period****After
                5****Contractual
                Obligations**
            
            **Total**
            
            **1
                year**
            
            **2-3
                years**
            
            **4-5
                years**
            
            **years**Long-term
                debt
            
            $
            21,684
            
            $
            7,490
            
            $
            8,249
            
            $
            3,810
            
            $
            2,135Capital
                lease and financing obligations
            
            
            334,642
            
            
            40,346
            
            
            76,138
            
            
            68,467
            
            
            149,691Convertible
                debentures
            
            
            3,322
            
            
            1,661
            
            
            1,661
            
            
            -
            
            
            -$
            359,648
            
            $
            49,497
            
            $
            86,048
            
            $
            72,277
            
            $
            151,826











**Impact
      of Inflation**





To
      date,
      inflation has not had a significant impact on us except for recent increases
      in
      utility costs, which increased approximately 10.2% per occupied unit for the
      nine months ended September 30, 2006, as compared to the comparable period
      of
      the prior year. However, inflation could affect our future revenues and
      operating income due to our dependence on the senior resident population, most
      of whom rely on relatively fixed incomes to pay for our services. The monthly
      charges for a resident's unit and assisted living services are influenced by
      the
      location of the community and local competition. Our ability to increase
      revenues in proportion to increased operating expenses may be limited. To the
      extent we rely upon governmental reimbursement programs, we have a limited
      ability to increase rates. In pricing our services, we attempt to anticipate
      inflation levels, but there can be no assurance that we will be able to respond
      to inflationary pressures in the future.





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              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**


Table
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**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk**





Our
      earnings are affected by changes in interest rates as a result of our short-term
      and long-term borrowings. At September 30, 2006, we had no variable rate
      borrowings. However, we do have certain operating lease obligations based on
      LIBOR, with a LIBOR cap of approximately 5.3%. As of September 30, 2006, the
      LIBOR rate was at the 5.3% cap and we currently have no variable rate exposure
      for additional lease expense. This analysis does not consider changes in the
      actual level of borrowings or operating lease obligations that may occur
      subsequent to September 30, 2006. This analysis also does not consider the
      effects of the reduced level of overall economic activity that could exist
      in
      such an environment, nor does it consider actions that management might be
      able
      to take with respect to our financial structure to mitigate the exposure to
      such
      a change.





**Item
      4. Controls and Procedures** ****





(a) *Evaluation
      of disclosure controls and procedures.*





Our
      chief
      executive officer and our chief financial officer, after evaluating the
      effectiveness of our “disclosure controls and procedures” (as defined in Rules
      13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period
      covered by this quarterly report, have concluded that, as of that date, our
      disclosure controls and procedures were effective.





*(b)*
            *Changes
                in internal controls*





We
      also
      carried out an evaluation of the internal control over financial reporting
      to
      determine whether any changes occurred during the period covered by this report.
      Based on such evaluation, there has been no change in our internal control
      over
      financial reporting that occurred during the most recently completed fiscal
      quarter ended September 30, 2006, that materially affected, or is reasonably
      likely to materially affect, our internal control over financial reporting.











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      rest
      of this page is intentionally left blank]








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Table
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      Contents


**PART
      II. OTHER INFORMATION**





**Items
      2, 3, 4, and 5 are not applicable.**





**Item
      1. Legal Proceedings**





From
      time
      to time, we are subject to lawsuits and other matters in the normal course
      of
      business, including claims related to general and professional liability.
      Accruals for these claims have been based upon actuarial and/or estimated
      exposure, taking into account self-insured retention or deductibles, as
      applicable. While we cannot predict the results with certainty, except as noted
      below, we do not believe that any liability from any such lawsuits or other
      matters will have a material effect on our financial position, results of
      operations, or liquidity. A discussion of our general and professional liability
      is contained in our 2005 Form 10-K under "Significant Accounting Policies and
      Use of Estimates."





In
      February 2005, a San Antonio, Texas, jury found one of our assisted living
      communities negligent in the care of a resident. The jury awarded a verdict
      against us in the amount of $1.5 million in compensatory damages and $18.0
      million in punitive damages. The verdict was in connection with an action that
      alleged negligence brought by the relatives of a resident at one of our assisted
      living facilities. We appealed the verdict and posted $1.7 million in order
      to
      stay the proceedings while the appellate process ran its course, or until the
      case was otherwise resolved. We recorded an additional liability accrual of
      $18.7 million in the fourth quarter of 2004 and accrued interest of $766,000
      on
      the unpaid judgment at the rate of 5% per annum during 2005. In March 2006,
      we
      settled the action for $5.6 million. In the first quarter of 2006, we reduced
      the accrued interest by $766,000 and the liability accrual recorded in 2004
      by
      $12.2 million. The deposit with the court, including interest, was refunded
      in
      April 2006.





In
      February 2004, the California Public Interest Research Group brought an action
      against owners and operators of assisted living communities and senior housing
      facilities including us. The action sought, on behalf of residents of these
      facilities located in California, to recover move-in or preadmission fees that
      had been paid over the past three years as well as certain penalties. We
      defended this action vigorously and entered into a joint defense agreement
      with
      other operators in California. We believed recent court rulings in the case
      significantly eroded the viability of the plaintiff’s action. In September 2006,
      we settled this action for a nominal amount and agreed to provide a letter
      to
      the on-site manager of our licensed Residential Care Facilities that directs
      the
      manager to comply with the California Health and Safety Code Section 1569.881,
      by making the admission agreement available to the public upon request and
      posting it within the public view.





In
      March
      2006, we received a request for documents from the Office of the Attorney
      General of Texas, in connection with its inquiry into compliance with
      certain Medicaid regulations at six of our communities in Texas that participate
      in the Community Based Alternative program of the Texas Department of Aging
      and
      Disability.  Participation in the program requires eligible rooms to have
      an area equipped with a sink, refrigerator, cooking appliance, adequate space
      for food preparation, and storage space for utensils and supplies.  An
      audit by the department revealed that some of the rooms used for
      residents in the program did not have some or all of those items. We
      addressed the State's concerns raised in the audits and all rooms were equipped
      with the above regulatory requirements as of April 2006, at a cost of
      approximately $618,000.




We
      began
      settlement discussions with the attorney general's office in late May
      2006 to resolve the matter.  Initially, the attorney general’s office
      sought $6.6 million, which equates to three times the total amount of all
      payments made to us by the State of Texas since the inception of our Medicaid
      contract, plus interest and attorney fees.  We responded in July 2006,
      advising the attorney general’s office that all the services for which Medicaid
      could, and did, lawfully pay were provided to the program residents despite
      the absence of some of the kitchen items.  Accordingly, recovery of
      the total of all payments made to us was unjustified.  The letter advised
      the attorney general's office that the absence of the required items during
      the period of non-compliance was valued at $176,000.  In August 2006, we
      offered to settle the matter for $500,000. In September 2006, the attorney
      general’s office responded to our August 2006 letter with an offer to settle for
      $3.6 million. This amount was based on the difference between the rate
      originally paid to us by the State, and the lower non-apartment rate available
      under the State Medicaid program, which was calculated at $1.1 million. The
      total





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Table
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      Contents


settlement
      offer includes additional interest, attorney fees, and $2.3 million in treble
      damages. In October 2006, we responded to the attorney general’s office with an
      offer to settle for $1.3 million, which is equal to the State’s offer of $3.6
      million less the $2.3 million in treble damages. The discussions are
      continuing.





While
      we
      believe we have incurred a liability in this matter, the range of possible
      outcomes is wide and the ultimate resolution is not readily determinable. 
Accordingly, we have recorded an increase to our liability of $772,000 in the
      third quarter of 2006, in addition to $500,000 recorded in the second quarter
      of
      2006, as our best estimate of the ultimate outcome.  We will assess our
      liability as discussions continue and will make adjustments, if any, to our
      recorded liability as more information becomes available to us.





**Item
      1A. Risk Factors**





In
      addition to the other information set forth in this report, you should carefully
      consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual
      Report on Form 10-K for the year ended December 31, 2005, which could materially
      affect our business, financial condition or future results. The risks described
      in our Annual Report on Form 10-K are not the only risks facing our Company.
      Additional risks and uncertainties not currently known to us or that we
      currently deem to be immaterial also may materially adversely affect our
      business, financial condition and/or operating results.





**Item
      6. Exhibits**





**Footnote****Number**
            
            **Description**
            
            **Number****10.87**
            
            **Arbor
                Place Acquisition on July 1, 2006 of one 100 unit
                community**10.87.1
            LOAN
                AGREEMENT between ESC ARBOR PLACE, LLC, a Washington limited liability
                company and GENERALELECTRIC
                CAPITAL CORPORATION and THE OTHER FINANCIAL INSTITUTIONS WHO ARE
                OR
                HEREAFTERBECOME
                PARTIES TO THIS AGREEMENT Dated as of June 30, 2006
            
            (2)10.87.2
            PURCHASE
                and SALE AGREEMENT (Arbor Place)
            
            (4)**10.9**
            
            **2006
                Equity Incentive Plan**
            
            (1)10.90.1
            Stock
                Option Grant Notice/Stock Option Agreement under the Emeritus Corporation
                2006 Equity Incentive Plan
            
            (3)31.1
            
            
            Certification
                of Periodic Reports31.1.1
            Certification
                Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                302 of
                the Sarbanes-Oxley Actof
                2002 for Daniel R. Baty dated November 7, 2006.
            
            (4)31.1.2
            Certification
                Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                302 of
                the Sarbanes-Oxley Actof
                2002 for Raymond R. Brandstrom dated November 7, 2006.
            
            (4)32.1
            
            
            Certification
                of Periodic Reports32.1.1
            Certification
                Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Actof
                2002 for Daniel R. Baty dated November 7, 2006.
            
            (4)32.1.2
            Certification
                Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Actof
                2002 for Raymond R. Brandstrom dated November 7, 2006.
            
            (4)





Footnotes:(1)
            Incorporated
                by reference to the indicated exhibit filed with the Company's Definitive
                Proxy Statement on ScheduleDEF
                14A on May 1, 2006.(2)
            Incorporated
                by reference to the indicated exhibit filed with the Company's Second
                Quarter Report on Form 10-Q(File
                No. 1-14012) on August 8, 2006.(3)
            Filed
                as an exhibit to a Form 8-K filed on November 3, 2006, and incorporated
                herein by reference.(4)
            Filed
                herewith.











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**SIGNATURE**





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








Dated:
                November 7, 2006
            EMERITUS
                CORPORATION(Registrant)/s/
                Raymond R. BrandstromRaymond
                R. Brandstrom, Vice President of Finance,Chief
                Financial Officer, and Secretary








**48**