**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 June 30, 2005
 
 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. [X] Yes [ ] No
 
 Indicate
        by check mark whether the Registrant is an accelerated filer (as defined
        in Rule
        12b-2 of the Act). [ ] Yes [X] No
 
 As
        of
        July 29, 2005, there were 16,250,698 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 June 30, 2005, and
                  December 31, 2004
              2Condensed
                  Consolidated Statements of Operations for the Three
                  Months and Six Months ended June 30, 2005 and 2004
              3Condensed
                  Consolidated Statements of Cash Flows for the Six
                  Months ended June 30, 2005 and 2004
              4Notes
                  to Condensed Consolidated Financial
                  Statements
              5**Item
                  2.**
              **Management's
                  Discussion and Analysis of Financial Condition
                  and Results of Operations**
              15**Item
                  3.**
              **Quantitative
                  and Qualitative Disclosures About Market
                  Risk**
              34**Item
                  4.**
              **Controls
                  and Procedures**
              34**Part
                  II. Other Information**Note:
              Items
                  2, 3, and 5 of Part II are omitted because they are not
                  applicable.**Item
                  1.**
              **Legal
                  Proceedings**
              36**Item
                  4.**
              **Submission
                  of Matters to a Vote of Security
                  Holders**
              37**Item
                  6.**
              **Exhibits**
              39**Signature**
              42
 
 
  
 Table
      of
      Contents **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****June
                  30,**
              
              **December
                  31,****2005**
              
              **2004**Current
                  Assets:Cash
                  and cash equivalents
              
              $
              27,363
              
              $
              10,748Short-term
                  investments
              
              
              1,665
              
              
              1,336Trade
                  accounts receivable, net of allowance of $822 and $841
              
              
              3,364
              
              
              3,982Other
                  receivables
              
              
              817
              
              
              2,270Prepaid
                  expenses and other current assets
              
              
              18,349
              
              
              18,317Property
                  held for sale
              
              
              -
              
              
              7,891Total
                  current assets
              
              
              51,558
              
              
              44,544Long-term
                  investments
              
              
              3,442
              
              
              6,884Property
                  and equipment, net
              
              
              621,968
              
              
              627,047Property
                  held for development
              
              
              807
              
              
              807Notes
                  receivable from and investments in affiliates
              
              
              3,635
              
              
              3,518Restricted
                  deposits
              
              
              9,388
              
              
              7,642Lease
                  acquisition costs, net
              
              
              26,719
              
              
              26,625Other
                  assets, net
              
              
              1,985
              
              
              2,571Total
                  assets
              
              $
              719,502
              
              $
              719,638**LIABILITIES
                  AND SHAREHOLDERS' DEFICIT**Current
                  Liabilities:Current
                  portion of long-term debt
              
              $
              2,656
              
              $
              4,133Current
                  portion of capital lease and financing obligations
              
              
              17,490
              
              
              15,479Trade
                  accounts payable
              
              
              4,681
              
              
              9,057Accrued
                  employee compensation and benefits
              
              
              15,527
              
              
              13,259Accrued
                  interest
              
              
              1,392
              
              
              1,547Accrued
                  real estate taxes
              
              
              4,426
              
              
              4,596Accrued
                  dividends on preferred stock
              
              
              -
              
              
              10,539Accrued
                  insurance liability
              
              
              25,713
              
              
              25,903Other
                  accrued expenses
              
              
              8,445
              
              
              7,952Deferred
                  revenue
              
              
              7,177
              
              
              6,516Unearned
                  rental income
              
              
              6,834
              
              
              8,227Deposit
                  on sales contract
              
              
              -
              
              
              9,212Total
                  current liabilities
              
              
              94,341
              
              
              116,420Long-term
                  debt, less current portion
              
              
              62,737
              
              
              50,528Capital
                  lease and financing obligations, less current portion
              
              
              619,225
              
              
              614,046Convertible
                  debentures
              
              
              32,000
              
              
              32,000Deferred
                  gain on sale of communities
              
              
              27,116
              
              
              28,517Deferred
                  rent
              
              
              4,966
              
              
              4,571Other
                  long-term liabilities
              
              
              2,107
              
              
              1,875Total
                  liabilities
              
              
              842,492
              
              
              847,957Commitments
                  and contingenciesShareholders'
                  Deficit:Preferred
                  stock, $.0001 par value. Authorized 5,000,000 shares.Series
                  B, Authorized 70,000 shares, issued and outstanding zero and 36,242
                  shares
                  atJune
                  30, 2005, and December 31, 2004, respectively
              
              
              -
              
              
              -Common
                  stock, $.0001 par value. Authorized 40,000,000 shares; issued and
                  outstanding16,243,606
                  and 10,811,531 shares at June 30, 2005, and December 31, 2004,
                  respectively
              
              
              2
              
              
              1Additional
                  paid-in capital
              
              
              76,388
              
              
              75,779Accumulated
                  deficit
              
              
              (199,380
              )
              
              (204,099
              )Total
                  shareholders' deficit
              
              
              (122,990
              )
              
              (128,319
              )Total
                  liabilities and shareholders' deficit
              
              $
              719,502
              
              $
              719,638
 See
        accompanying Notes to 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 June 30,**
              
              **Six
                  Months ended June 30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Revenues:Community
                  revenue
              
              $
              94,387
              
              $
              74,900
              
              $
              187,211
              
              $
              137,490Other
                  service fees
              
              
              1,777
              
              
              1,625
              
              
              3,491
              
              
              2,973Management
                  fees
              
              
              462
              
              
              1,196
              
              
              1,060
              
              
              2,829Total
                  operating revenues
              
              
              96,626
              
              
              77,721
              
              
              191,762
              
              
              143,292Expenses:Community
                  operations (exclusive of depreciation and amortizationand
                  facility lease expense shown separately below)
              
              
              62,277
              
              
              48,112
              
              
              123,037
              
              
              89,886General
                  and administrative
              
              
              7,857
              
              
              6,546
              
              
              15,190
              
              
              12,778Depreciation
                  and amortization
              
              
              11,569
              
              
              8,059
              
              
              22,912
              
              
              13,491Facility
                  lease expense
              
              
              10,388
              
              
              9,487
              
              
              20,125
              
              
              19,064Asset
                  impairment
              
              
              4,028
              
              
              -
              
              
              4,028
              
              
              -Total
                  operating expenses
              
              
              96,119
              
              
              72,204
              
              
              185,292
              
              
              135,219Operating
                  income from continuing operations
              
              
              507
              
              
              5,517
              
              
              6,470
              
              
              8,073Other
                  income (expense):Interest
                  income
              
              
              205
              
              
              134
              
              
              436
              
              
              287Interest
                  expense
              
              
              (12,308
              )
              
              (9,932
              )
              
              (24,485
              )
              
              (17,538
              )Other,
                  net
              
              
              21,924
              
              
              546
              
              
              22,664
              
              
              363Net
                  other income (expense)
              
              
              9,821
              
              
              (9,252
              )
              
              (1,385
              )
              
              (16,888
              )Income
                  (loss) from continuing operations before income taxes
              
              
              10,328
              
              
              (3,735
              )
              
              5,085
              
              
              (8,815
              )Provision
                  for income taxes
              
              
              (974
              )
              
              -
              
              
              (1,089
              )
              
              -Income
                  (loss) from continuing operations
              
              
              9,354
              
              
              (3,735
              )
              
              3,996
              
              
              (8,815
              )Income
                  from discontinued operations
              
              
              3
              
              
              117
              
              
              1,322
              
              
              175Net
                  income (loss)
              
              
              9,357
              
              
              (3,618
              )
              
              5,318
              
              
              (8,640
              )Preferred
                  stock dividends
              
              
              358
              
              
              (930
              )
              
              (599
              )
              
              (1,850
              )Net
                  income (loss) to common shareholders
              
              $
              9,715
              
              $
              (4,548
              )
              $
              4,719
              
              $
              (10,490
              )Basic
                  income (loss) per common share:Continuing
                  operations
              
              $
              0.89
              
              $
              (0.44
              )
              $
              0.31
              
              $
              (1.02
              )Discontinued
                  operations
              
              
              -
              
              
              0.01
              
              
              0.12
              
              
              0.02$
              0.89
              
              $
              (0.43
              )
              $
              0.43
              
              $
              (1.00
              )Diluted
                  income (loss) per common share:Continuing
                  operations
              
              $
              0.52
              
              $
              (0.44
              )
              $
              0.24
              
              $
              (1.02
              )Discontinued
                  operations
              
              
              -
              
              
              0.01
              
              
              0.07
              
              
              0.02$
              0.52
              
              $
              (0.43
              )
              $
              0.31
              
              $
              (1.00
              )Weighted
                  average common shares outstanding:Basic
              
              
              10,918
              
              
              10,610
              
              
              10,870
              
              
              10,460Diluted
              
              
              19,776
              
              
              10,610
              
              
              18,289
              
              
              10,460
 See
        accompanying Notes to 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)****Six
                  Months Ended June 30,****2005**
              
              **2004**Cash
                  flows from operating activities:Net
                  income (loss)
              
              $
              5,318
              
              $
              (8,640
              )Adjustments
                  to reconcile net income (loss) to net cash provided by operating
                  activities:Depreciation
                  and amortization
              
              
              22,912
              
              
              13,491Amortization
                  of deferred gain
              
              
              (1,108
              )
              
              (1,114
              )Gain
                  on sale of properties, net
              
              
              (1,321
              )
              
              -Gain
                  on sale of investment
              
              
              (21,323
              )
              
              -Impairment
                  of long-lived asset
              
              
              4,028
              
              
              -Amortization
                  of loan fees
              
              
              241
              
              
              635Preferred
                  stock conversion costs
              
              
              265
              
              
              -Equity
                  investment losses
              
              
              -
              
              
              794Other
              
              
              70
              
              
              211Changes
                  in operating assets and liabilities, net of acquisitions:
              
              
              (476
              )
              
              175Net
                  cash provided by operating activities
              
              
              8,606
              
              
              5,552Cash
                  flows from investing activities:Acquisition
                  of property and equipment
              
              
              (3,947
              )
              
              (1,775
              )Acquisition
                  of assets in lease transactions
              
              
              (406
              )
              
              (1,099
              )Sale
                  of property and equipment
              
              
              -
              
              
              226Construction
                  expenditures - leased properties
              
              
              (757
              )
              
              -Management
                  and lease acquisition costs
              
              
              (1,533
              )
              
              (5,340
              )Advances
                  to affiliates and other managed communities
              
              
              145
              
              
              (1,215
              )Sale
                  of investment in Alterra, net
              
              
              24,979
              
              
              -Investment
                  in affiliates
              
              
              (126
              )
              
              (285
              )Collection
                  of notes receivable
              
              
              -
              
              
              2,657Net
                  cash provided by (used in) investing activities
              
              
              18,355
              
              
              (6,831
              )Cash
                  flows from financing activities:Proceeds
                  from sale of stock under employee stock purchaseand
                  incentive plans, net
              
              
              244
              
              
              1,179Increase
                  in restricted deposits
              
              
              (1,746
              )
              
              (972
              )Debt
                  issue and other financing costs
              
              
              (631
              )
              
              34Proceeds
                  from short-term borrowing on bank line of credit
              
              
              -
              
              
              3,000Proceeds
                  from long-term borrowings
              
              
              32,226
              
              
              2,609Repayment
                  of long-term borrowings
              
              
              (21,999
              )
              
              (2,449
              )Repayment
                  of capital lease and financing obligations
              
              
              (7,668
              )
              
              (3,599
              )Payment
                  of preferred dividend
              
              
              (10,772
              )
              
              -Net
                  cash used in financing activities
              
              
              (10,346
              )
              
              (198
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              16,615
              
              
              (1,477
              )Cash
                  and cash equivalents at the beginning of the period
              
              
              10,748
              
              
              6,368Cash
                  and cash equivalents at the end of the period
              
              $
              27,363
              
              $
              4,891Supplemental
                  disclosure of cash flow information -Cash
                  paid during the period for interest
              
              $
              24,640
              
              $
              17,524Non-cash
                  financing and investing activities:Accrued
                  and in-kind preferred stock dividends
              
              $
              598
              
              $
              1,850Debt
                  issued for acquisition of property and equipment
              
              $
              1,135
              
              $
              -Capital
                  lease and financing obligations
              
              $
              14,858
              
              $
              148,000Reduction
                  in property held for sale and related deposit
              
              $
              7,891
              
              $
              -Note
                  retirement
              
              $
              (630
              )
              $
              -
 
 See
        accompanying Notes to 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 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **(unaudited)**
 
 **Definitions**
 
 Throughout
        Notes to 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"
                  refers to 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.
              "Alterra"
                  refers to Alterra Healthcare Corporation, a national assisted living
                  company headquartered in Milwaukee,
                  Wisconsin.
 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.
              "JEA"
                  refers to JEA Senior Living, a
                  non-affiliate.
 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.
              "N/A"
                  in a table means not applicable.
 17.
              "N/M"
                  in a table means not meaningful.
 
 **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 2004 Form 10-K filed March 31, 2005. The following
        critical accounting policy and estimates have not changed but have been updated
        for new events and information.
 
 ·
              The
                  Company's accounting policy regarding contingent liabilities is
                  to
                  recognize those obligations if they are probable and estimable
                  in
                  accordance with SFAS 5 based on management’s best estimate of the ultimate
                  outcome. If a legal judgment is rendered against the Company, then
                  Emeritus believes that it has a probable liability and it accrues
                  the full
                  amount of the judgment as the most likely estimate of the probable
                  loss
                  unless it is able to obtain a legal opinion that the ultimate settlement
                  will be different.
  **5**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents 
 **Recent
        Accounting Pronouncements and Proposed Statements**
 
 In
        December 2004, the FASB issued Statement of Financial Accounting Standards
        No.
        123 (revised 2004), *Share-Based
        Payment* (“SFAS
        No. 123R”) . This
        statement requires the Company to recognize expense for compensation cost
        related to share-based payments, including stock options and employee stock
        purchase plans, in its consolidated statement of operations. SFAS No. 123R
        would
        eliminate the Company’s ability to account for share-based awards to employees
        using Accounting Principles Board ("APB") Opinion 25, “ *Accounting
        for Stock Issued to Employees”* and
        would
        require that the transactions use a fair value method as of the grant
        date *.* SFAS
        No.
        123R addresses the accounting for transactions in which the Company receives
        employee services in exchange for equity instruments or liabilities that
        are
        based on the fair value of the Company’s equity instruments or that may be
        settled through the issuance of such equity instruments. On April 14, 2005,
        the
        SEC adopted a new rule that amends the compliance dates for SFAS No. 123R.
        Under
        the new rule, the Company is required to adopt SFAS No. 123R in the first
        quarter of fiscal 2006, beginning January 1, 2006. The Company has not yet
        determined the method of adoption or the effect of adopting SFAS No. 123R,
        and
        it has not determined whether the adoption will result in amounts that are
        similar to the current pro forma disclosures under SFAS No. 123. The Company
        is
        currently evaluating the impact of this statement on its financial
        statements.
 
 **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, results of operations, and cash flows of
        Emeritus as of June 30, 2005, and for the three and six months ended June
        30,
        2005 and 2004. The results of operations for the period ended June 30, 2005,
        are
        not necessarily indicative of the operating results for the full year. The
        Company presumes that those reading this interim financial information have
        read
        or have access to its 2004 audited consolidated financial statements and
        Management's Discussion and Analysis of Financial Condition and Results of
        Operations that are contained in the 2004 Form 10-K filed March 31, 2005.
        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 consolidated financial statements
        to
        conform to the current period presentation.
 
 [The
        rest
        of this page is intentionally left blank]
  **6**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of Contents   **Stock-Based
        Compensation**
 
 The
        Company applies APB Opinion No. 25, *Accounting
        for Stock Issued to Employees* and
        related interpretations in measuring compensation costs for its stock option
        plans. The Company discloses pro forma net income (loss) and net income (loss)
        per share as if compensation cost had been determined consistent with SFAS
        No.
        123, *Accounting
        for Stock-Based Compensation* .
 
 Had
        compensation costs for the Company’s stock option plan been determined pursuant
        to SFAS 123, the Company’s pro forma net income (loss) and pro forma net income
        (loss) per share would have been as follows:
 
 **Three
                  Months ended**
              
              **Six
                  Months ended****June
                  30,**
              
              **June
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****(In
                  thousands, except per share data )**Net
                  income (loss) to common shareholders:As
                  reported
              
              $
              9,715
              
              $
              (4,548
              )
              $
              4,719
              
              $
              (10,490
              )Add:
                  Stock-based employee compensation expenseincluded
                  in reported net income (loss)
              
              
              -
              
              
              -
              
              
              -
              
              
              -Deduct:
                  Stock-based employee compensationdetermined
                  under fair value based method for all awards
              
              
              (287
              )
              
              (341
              )
              
              (432
              )
              
              (619
              )Pro
                  forma
              
              $
              9,428
              
              $
              (4,889
              )
              $
              4,287
              
              $
              (11,109
              )Net
                  income (loss) per common share:As
                  reported - Basic
              
              $
              0.89
              
              $
              (0.43
              )
              $
              0.43
              
              $
              (1.00
              )Pro
                  forma - Basic
              
              $
              0.86
              
              $
              (0.46
              )
              $
              0.39
              
              $
              (1.06
              )As
                  reported - Diluted
              
              $
              0.52
              
              $
              (0.43
              )
              $
              0.31
              
              $
              (1.00
              )Pro
                  forma - Diluted
              
              $
              0.50
              
              $
              (0.46
              )
              $
              0.29
              
              $
              (1.06
              )
 
 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
        highly
        subjective assumptions, including the expected stock price volatility. The
        Company's options have characteristics significantly different from those
        of
        traded options and changes in the subjective input assumptions can materially
        affect the fair value estimates. The fair value of options granted and employee
        purchase plan shares in the three months and six months ended June 30, 2005
        and
        2004, were estimated at the date of grant using the following weighted average
        assumptions:
  **Three
                  Months**
              
              **Six
                  Months****Ended**
              
              **Ended****June
                  30,**
              
              **June
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Expected
                  life from grant date (in years)
              
              
              4
              
              
              4
              
              
              4
              
              
              4Weighted
                  average risk-free interest rate
              
              
              3.79
              %
              
              3.52
              %
              
              3.79
              %
              
              3.52
              %Weighted
                  average volatility
              
              
              70.19
              %
              
              90.72
              %
              
              70.19
              %
              
              90.72
              %Dividend
                  yield
              
              
              -
              
              
              -
              
              
              -
              
              
              -Weighted
                  average fair value (per share)
              
              $
              7.37
              
              $
              4.18
              
              $
              7.37
              
              $
              4.18
 
  **7**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents 
 **Emeritrust
        Transactions**
 
 Beginning
        in 1999, the Company managed 25 communities under arrangements with a
        related investor group (Emeritrust) that involved (i) payment of management
        fees
        to the Company (ii) options for the Company to purchase the communities at
        a
        price determined by a formula, and (iii) obligations to fund operating losses
        of
        certain communities.
  *Emeritrust I
        Communities Management.* During the period from 2000 to 2004, the arrangements were modified several
        times, the options to purchase and funding obligation were terminated, and
        the
        number of communities covered declined to 21. Effective January 2, 2004,
        the
        management fee arrangement provided for a flat fee of 5% of gross revenues.
        The
        term currently expires March 31, 2006, subject to termination by either
        party on 90 days notice. On September 30, 2004, 16 communities were leased
        pursuant to leases discussed below and five communities, which are now owned
        by
        Mr. Baty, continue to be managed by the Company. The Company received management
        fees of approximately $129,000 and $583,000 for the three months ended June
        30,
        2005 and 2004, respectively, and $256,000 and $1.2 million for the six months
        ended June 30, 2005 and 2004, respectively.
 
 *Emeritrust
        I Communities Lease.* On
        September 30, 2004, the Company completed the first phase of a transaction
        to
        lease (Baty/REIT 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 for an investment
        of approximately $170.8 million and are being leased to the Company. The
        Company
        completed the lease on the first 18 communities on September 30, 2004, which
        included 17 new communities and one existing lease, and an additional community
        lease on March 31, 2005, and anticipates the remaining community will close
        during the third quarter 2005. Of the communities included in this lease,
        16
        were part of the communities referred to above and in past filings with the
        SEC
        as the “Emeritrust I communities” and are capital leases.
 
 The
        single community lease completed on March 31, 2005, is leased by the Company
        from the REIT pursuant to a lease agreement with a 15-year term, with one
        15-year renewal option. This lease has been accounted for as an operating
        lease
        with straight-lined rent payments.
 
 The
        initial lease payment for the facilities that have closed (18 capital leases
        and
        one operating lease) is approximately $14.0 million per year, with inflators
        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
        initial lease payment is expected to increase by $691,000 per year when the
        remaining facility closes. All of the leases are triple-net leases. The new
        leases are cross-defaulted and cross-collateralized with all of the Company's
        other leases and loans relating to other communities owned by the REIT and
        contain certain financial and other covenants. The Company has the right
        of
        first refusal to purchase these leased communities and Mr. Baty is personally
        guaranteeing its obligations under the lease. Mr. Baty will receive, based
        on a
        prescribed formula, 50% of the positive cash flow of the 20 communities and
        will
        be responsible for 50% of any negative cash flow. In the fourth quarter of
        2004,
        the first quarter under this arrangement, Mr. Baty received $200,000 as
        consideration. Mr. Baty received $229,000 and $374,000 in the three months
        and
        six months ended June 30, 2005, respectively.
 
 **Debt
        Consolidation**
 
 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,
        extended the maturity to March 2008, and improved annual cash flows and earnings
        by approximately $1.6 million and $550,000, respectively, exclusive of
        transaction charges, as further described below.
 
 The
        REIT
        that financed the Emeritrust II transaction discussed in the Company’s 2004
        Form 10-K already held $6.8 million of the Company's leasehold mortgage debt
        that matured in March 2005 and bore interest at 12% per annum, commencing
        March
        2002 with periodic increases up to 13% per annum. This REIT also provided
        $7.5
        million in leasehold mortgage financing incurred to support the Series A
        Preferred Stock
  **8**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents repurchase
        in August 2003. On September 30, 2003, these two financings, together
        with
        the $11.5 million leasehold mortgage financing related to the Emeritrust
        II
        communities, were consolidated into a single $25.8 million leasehold mortgage
        financing, covering the 32 communities and maturing on June 30, 2007. The
        debt
        bore interest at an initial rate of 12.13% per annum with periodic increases
        up
        to 13%. The consolidated loan required 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 on August 2, 2004. The balance on the note as of March 2, 2005,
        was
        approximately $19.5 million.
 
 On
        March 2, 2005, this 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 loan may
        not be
        prepaid without the lender's consent.
 
 In
        connection with the loan modification, HRT also extended an additional $1.8
        million to the Company on the same terms as the restated loan from HRT to
        pay
        off certain transaction cost advances related to communities acquired in
        April
        2004 that matured in March 2006 and had an interest rate of 12.0%, which
        would
        have increased to 12.5% in April 2005. In addition, in connection with this
        loan
        modification, the Company paid approximately $126,000 in closing costs, which
        is
        included in the $21.4 million of debt mentioned above.
 
 **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. Through January 31, 2004, the investment in Alterra
        was
        structured as an ownership interest in an LLC, which is a pass-through entity
        for tax purposes, similar to a limited partnership. Under generally accepted
        accounting principles, the Company used the equity method of accounting for
        its
        LLC membership interest and recorded a portion of Alterra's results of
        operations in its financial statements. As a consequence, equity losses of
        approximately $794,000 are included in the condensed consolidated statement
        of
        operations for the first half of 2004, under the caption “Other, net,” which
        represents the Company's portion of Alterra's net loss for December 2003
        and
        January 2004.
 
 The
        LLC
        made an election to be treated as a corporation for tax purposes effective
        January 31, 2004, and is no longer a pass-through entity. As a result of
        this
        election, on February 1, 2004, the Company began accounting for Alterra
        on
        a cost basis under APB 18 “The Equity Method of Accounting for Investments in
        Common Stock.”
 
 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 parties entered
        into a
        Membership Interest Purchase Agreement (the “Agreement”) whereby, concurrent
        with the sale and purchase of the membership interests, the parties entered
        into
        an Amended and Restated LLC Agreement (the “Amended LLC”). The resulting
        membership interests of Fortress, NW, and the Company is 75%, 12.5%, and
        12.5%,
        respectively. The Company recorded a gain of $21.3 million in Other, net
        in the
        condensed consolidated statement of operations for the three months ended
        June
        30, 2005, as a result of this transaction. The estimated income tax effect
        of
        this gain is approximately $835,000.
 
 Under
        the
        Amended LLC, the Company agreed to provide an indirect guarantee of an
        obligation of Alterra. The primary guarantor is an affiliate of Fortress
        (the
“Affiliate”). The Affiliate has agreed to guarantee the proposed purchase by
        Alterra of six properties that are currently operated by Alterra under a
        lease
        agreement with Omega Healthcare Investors. The Company agreed to pay its
        proportional membership interest (12.5%) of any amount that the Affiliate
        is
        required to pay under the guarantee, not to exceed $2,550,000. The gain was
        reduced by the fair value of the guarantee which was determined to be
        $200,000.
  **9**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents 
 **CPM-JEA
        Transactions**
 
 In
        March
        2005, the Company entered into agreements 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 the Company and is located
        in
        Richland, Washington. This community offers assisted living services and
        was
        part of the CPM group. The second community located in Lubbock, Texas, offers
        memory loss services and is a part of the JEA group of communities. It is
        new to
        the Company's portfolio. Both facilities are under separate leases with the
        independent REIT, each with a maturity date of March 31, 2019, with three
        5-year
        renewal options. The lease rate is 9% with fixed inflators of the lesser
        of four
        times the change in the consumer price index or 3%. The base rent as of June
        30,
        2005, for these two leases is approximately $107,000 per month. Due to certain
        subjective default clauses in the lease and remedies, which allow for
        acceleration of all unpaid rents in the event of default, these leases have
        been
        accounted for as capital leases, which resulted in additions to property
        and
        equipment and capital lease and financing obligations totaling approximately
        $14.6 million.
 
 **Sale
        of Community**
 
 On
        November 1, 2004, the Company sold a single community located in Issaquah,
        Washington, for cash and assumption of liabilities for a total of $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 that point. The Company recorded a gain of $1.3 million related
        to
        this sale in "Income from discontinued operations" in its condensed consolidated
        statements of operations for the six months ended June 30, 2005.
 
 **Preferred
        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 approximately $10.8 million. Also on June 30,
        2005, the Company borrowed $10.8 million from a REIT and used the
        proceeds
        to pay the accrued and unpaid cash dividends on the Series B Stock;
        upon
        such payment, Saratoga converted all of the outstanding Series B Stock
        to
        common stock in accordance with the agreement.
 
 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 the balance were issued as dividends
        of
        additional Series B Stock. In accordance with the agreement referred to above
        and as described below, the Series B Stock was converted into 5,365,747
        shares of common stock.
 
 The
        Series B Stock was entitled to receive quarterly dividends in a combination
        of
        cash and additional shares of Series B Stock. The initial rate for the dividend
        was 6% of the stated value of $1,000 per share, of which 2% was payable in
        cash
        and 4% was payable in additional Series B Stock. Starting in January 2004,
        the
        dividend rate moved to 7%, of which 3% was payable in cash and 4% in Series
        B
        Stock. The Series B Stock provided for an “arrearage rate” if the cash portion
        of the dividend was not paid, increasing the cash portion of the dividend
        to 7%.
        The arrearage rate became effective in October 2000, thus accruing dividends
        at
        an 11% rate, 7% in cash and 4% in additional shares of Series B Stock. The
        Company had issued the additional Series B Stock dividends on a quarterly
        basis
        on the first day of the month after the end of each quarter. However, the
        cash
        portion of the dividend had not been paid since 2000, which resulted in an
        accumulated liability of approximately $10.8 million as of March 31, 2005.
        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. No interest
        was required to be accrued on the unpaid cash dividends. In
        addition, in connection with the conversion, the Company paid $265,000 in
        legal
        and professional fees.
 
 The
        Company borrowed $10.8 million from a REIT at 10% per annum for a term of
        three
        years in order to pay the unpaid cash dividends of the Series B Preferred
        Stock.
        Monthly note payments of interest-only are
  **10**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents due
        in
        arrears on the first day of each month. The note is due in full on June 30,
        2008, with no prepayments allowed prior to January 1, 2007, and only upon
        at
        least 9 months prior written notice. The $10.8 million note contains provisions
        that modify one multi-community and four individual community leases with
        the
        REIT covering 12 properties. The loan requires collateral in the form of
        a
        letter of credit issued by a bank or a cash deposit of $1.0 million with
        the
        REIT. The Company deposited $1.0 million with the REIT at closing, which
        was
        recorded as a restricted deposit in the accompanying balance sheet.
 
 **Convertible
        Debentures**
 
 The
        Company has $32.0 million of 6.25% convertible subordinated debentures (the
        “Debentures”) that are due January 1, 2006 .
        The
        Debentures are convertible
        into common stock at the rate of $22 per share, which equates to an aggregate
        of
        approximately 1,454,545 shares of the Company’s common stock .
        Interest on the Debentures is payable semiannually on January 1 and July
        1 of
        each year. The Debentures are unsecured and subordinated to all other
        indebtedness of the Company.
 
 The
        Debentures are subject to redemption by the Company at any time, as a whole
        or
        in part, at a redemption price of 100% of the principal amount.
 
 Of
        the
        $32.0 million of Debentures, $21.5 million are owned by directors and officers
        or their affiliates. Saratoga, two of whose representatives are directors,
        own
        $5.0 million of the Debentures. Affiliates of Mr. Baty and Stanley L. Baty,
        a
        director, own $15.8 million of the Debentures and another executive officer
        owns
        $660,000.
 
 On
        July
        6, 2005, the Company announced that it intended to commence an offer to exchange
        (the "Exchange Offer") its 6.25% Convertible Subordinated Debentures due
        2006
        (the "Outstanding Debentures") for new convertible subordinated debentures
        (the
        "New Debentures"). The New Debentures will have the same terms as the
        Outstanding Debentures, except that (i) the principal amount and all accrued
        interest of New Debentures will be paid on June 30, 2008, and all
        other
        dates that are determined by or relate to the maturity date of the Debentures
        will be adjusted accordingly; (ii) the Company will have no right of redemption
        prior to maturity, as provided in the Outstanding Debentures; and (iii) the
        interest rate paid under the New Debentures will be 8.0%, commencing on the
        day
        following the issuance thereof.
 
 On
        June
        30, 2005, the Company entered into an Agreement (an "Agreement") with Columbia
        Select, L.P. and Catalina General, L.P. (collectively, the "Baty Entities"),
        and
        Saratoga. The Agreement provides that if at the expiration of the Exchange
        Offer
        any Outstanding Debentures have not been exchanged for New Debentures, then
        Saratoga and the Baty Entities will purchase a principal amount of New
        Debentures ("Additional New Debentures") equal to the principal amount of
        Outstanding Debentures that have not been exchanged, excluding any Outstanding
        Debentures that have not been exchanged by any of Saratoga or the Baty Entities.
        The Agreement provides that Saratoga, as a group, will purchase 24% of any
        Additional New Debentures and the Baty Entities, as a group, will purchase
        76%
        of any Additional New Debentures, unless Saratoga and the Baty Entities agree
        on
        a different allocation of purchase. The purchase of the Additional New
        Debentures, if required, would take place on December 30, 2005. If the Baty
        Entities or Saratoga do not exchange any of their Outstanding Debentures,
        they
        are obligated to purchase New Debentures on December 30, 2005, equal to the
        principal amount of Debentures that were not exchanged. Proceeds from the
        New
        Debentures will be used to repay any of the Outstanding Debentures not
        exchanged, and as a result, the Debentures are classified as a long-term
        liability due to the Company’s ability and intent to refinance the Debentures on
        a long-term basis.
 
 The
        Baty
        Entities are affiliated with Mr. Baty, who beneficially owns approximately
        28.5%
        of the Company's common stock. Saratoga beneficially owns approximately 33.0%
        of
        the Company's common stock and is represented on the Company's board by two
        directors. Together Mr. Baty and Saratoga beneficially own approximately
        65% of
        Outstanding Debentures.
 
 The
        forgoing description of the Agreement does not purport to be complete and
        is
        qualified in its entirety by reference to the Agreement, which was filed
        as
        Exhibit 10.1 to a Form 8-K filed with the SEC on July 7, 2005.
  **11**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents 
 **Earnings
        (Loss) Per Share**
 
 The
        capital structure of Emeritus includes convertible debentures, common stock
        warrants, and stock options and up until June 30, 2005, included redeemable
        convertible preferred stock. Basic net income per share is computed based
        on
        weighted average shares outstanding and excludes any potential dilution.
        Diluted
        net income 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 and preferred stock 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**
              
              **Six
                  Months ended****June
                  30,**
              
              **June
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Convertible
                  Debentures
              
              
              -
              
              
              1,455
              
              
              1,455
              
              
              1,455Options
              
              
              55
              
              
              1,657
              
              
              55
              
              
              1,657Warrants
                  - Senior Housing Partners I, L.P.
              
              
              -
              
              
              500
              
              
              -
              
              
              500Warrants
                  - Saratoga Partners
              
              
              -
              
              
              1,000
              
              
              -
              
              
              1,000Series
                  B Preferred(1)
              
              
              -
              
              
              5,157
              
              
              -
              
              
              5,15755
              
              
              9,769
              
              
              1,509
              
              
              9,769(1)Converted
                  to common June 30, 2005.
 
 Dilutive
        potential common shares and adjustments to net income (loss) to common
        shareholders arising under the assumed conversion into common stock of the
        convertible debentures are included under the "if-converted method".
 
 [The
        rest
        of this page is intentionally left blank]
  **12**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents 
 The
        following table summarizes the computation of basic and diluted net income
        (loss) per common share amounts presented in the accompanying condensed
        consolidated statements of operations (in thousands, except per share amounts):
 **Three
                    Months ended**
                
                **Six
                    Months ended****June
                    30,**
                
                **June
                    30,****2005**
                
                **2004**
                
                **2005**
                
                **2004**Basic:Numerator
                    for basic net income (loss) per share:Net
                    income (loss) to common shareholders
                
                $
                9,715
                
                $
                (4,548
                )
                $
                4,719
                
                $
                (10,490
                )Denominator
                    for basic net income (loss) per share:Weighted
                    average number of common shares outstanding
                
                
                10,918
                
                
                10,610
                
                
                10,870
                
                
                10,460Basic
                    net income (loss) per share
                
                $
                0.89
                
                $
                (0.43
                )
                $
                0.43
                
                $
                (1.00
                )Diluted:Numerator
                    for diluted net income (loss) per share:Net
                    income (loss) to common shareholders
                
                $
                9,715
                
                $
                (4,548
                )
                $
                4,719
                
                $
                (10,490
                )Assumed
                    conversion of convertible debentures
                
                
                500
                
                
                -
                
                
                -
                
                
                -Assumed
                    conversion of Series B Preferred
                
                
                -
                
                
                -
                
                
                957$
                10,215
                
                $
                (4,548
                )
                $
                5,676
                
                $
                (10,490
                )Denominator
                    for diluted net income (loss) per share:Weighted
                    average number of common shares outstanding
                
                
                10,918
                
                
                10,610
                
                
                10,870
                
                
                10,460Assumed
                    exercise of options and warrants
                
                
                2,037
                
                
                -
                
                
                2,053
                
                
                -Assumed
                    conversion of convertible debentures
                
                
                1,455
                
                
                -
                
                
                -
                
                
                -Assumed
                    conversion of Series B Preferred
                
                
                5,366
                
                
                -
                
                
                5,366
                
                
                -19,776
                
                
                10,610
                
                
                18,289
                
                
                10,460Diluted
                    net income (loss) per share
                
                $
                0.52
                
                $
                (0.43
                )
                $
                0.31
                
                $
                (1.00
                )
  
 **Comprehensive
        Income (Loss** **)**
 
 Comprehensive
        income (loss) is the same as net income (loss) to common shareholders for
        the
        three-month and six-month periods ended June 30, 2005 and 2004,
        respectively.
 **Asset
        Impairment**
 
 In
        June
        2005, the Company determined that the carrying amount of a facility in Las
        Vegas, Nevada, was not recoverable from expected undiscounted cash flows
        generated from the use of the asset and thus recorded an impairment loss
        of $4.0
        million for the three months ended June 30, 2005, and accordingly, the carrying
        value was reduced to estimated fair value based on appraised value and a
        letter
        of intent from a pending sale.
 
 **Liquidity** ****
 
 The
        Company has incurred significant operating losses since its inception and
        has a
        working capital deficit of $42.8 million , although
        $14.0 million of this deficit represents deferred revenue and unearned rental
        income .
        In
        addition, due to the adverse judgment against the Company as described under
        “Legal Proceedings,” an additional reserve was recorded in the fourth quarter of
        2004 for $18.7 million in
  **13**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 Continued
 (unaudited)
 Table
      of
      Contents accordance
        with the Company's self-insured pool agreement. The Company believes there
        are
        substantial grounds for an appeal and that the damage award was not justified
        by
        the facts or the law in the case presented. The Company has appealed the
        verdict
        and on March 16, 2005, posted funds in the amount of $1.7 million in order
        to
        stay the proceedings while the appellate process runs its course, which could
        be
        anywhere from 18 months to three years. The Company will not be required
        to pay
        additional amounts until the appeal and further litigation is completed or
        the
        case is settled. At times in the past, the Company has been dependent upon
        third-party financing or disposition of assets to fund operations. If such
        transactions are necessary in the future, Emeritus cannot guarantee that
        they
        will be available on a timely basis, on terms attractive to the Company,
        or at
        all.
 
 Throughout
        2002 and continuing through the second quarter of 2005, the Company refinanced
        substantially all of its debt obligations, extending the maturities of such
        financings to dates beyond June 30, 2006, or thereafter, 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
        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 6 owned assisted living properties and 157
        properties operated under leases. 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 June 30, 2005, the Company complied with all
        such
        covenants.
 
 Management
        believes that the Company will be able to sustain positive operating cash
        flow
        on an annual basis and will have adequate cash or the ability to obtain adequate
        financing for all necessary investing and financing activities including
        required debt service and capital expenditures through at least June 30,
        2006.
 
 **Discontinued
        Operations**
 
 On
        August
        9, 2004, the Company sold an owned facility (“Scottsdale Royale”) to an
        unrelated third party. Due to certain legal requirements of resident
        notification, the Company leased the property back from the third party through
        August 31, 2004. In addition, on September 30, 2004, the Company committed
        to
        sell another owned facility (“Hearthside of Issaquah”), which under SFAS No. 144 *“Accounting
        for the Impairment or Disposal of Long-Lived Assets,* ”
        qualified as an asset held for sale. A current asset of $7.9 million was
        recorded on the Company's financial statements and the Company discontinued
        depreciating the asset as of September 30, 2004. Hearthside of Issaquah 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.
        Both
        transactions qualify for discontinued operations treatment under SFAS No.
        144
        and the results of discontinued operations is reported as a separate line
        item
        in the condensed consolidated statement of operations.
 
 The
        following table shows the revenues and net income (loss) for the discontinued
        operations (in thousands):
 
 **Three
                  months ended**
              
              **Six
                  months ended****June
                  30,**
              
              **June
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****Total
                  revenue:**Hearthside
                  of Issaquah
              
              $
              -
              
              $
              884
              
              $
              -
              
              $
              1,726Scottsdale
                  Royale
              
              
              -
              
              
              113
              
              
              -
              
              
              235Total
              
              $
              -
              
              $
              997
              
              $
              -
              
              $
              1,961**Net
                  income (loss):**Hearthside
                  of Issaquah
              
              $
              -
              
              $
              135
              
              $
              1,319
              
              $
              214Scottsdale
                  Royale
              
              
              3
              
              
              (18
              )
              
              3
              
              
              (39
              )Total
              
              $
              3
              
              $
              117
              
              $
              1,322
              
              $
              175
 
 
  **14**
 Table
      of
      Contents 
 **Item
        2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
        CONDITION****AND****RESULTS
        OF OPERATIONS**
 
 **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"
                  refers to 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.
              "Alterra"
                  refers to Alterra Healthcare Corporation, a national assisted living
                  company headquartered in Milwaukee,
                  Wisconsin.
 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.
              "JEA"
                  refers to JEA Senior Living, a non-affiliate.
 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.
              "N/A"
                  in a table means not applicable.
 17.
              "N/M"
                  in a table means not meaningful.
 
 **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 limited further growth and in
        1999
        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 adjust 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 environmental
        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. In 2000 and 2001,
  
 **15**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents we
        operated approximately 130 communities, but in 2002 and 2003, we increased
        that
        to 180 and 175 communities, respectively. From the end of 2000 to the end
        of
        2003, the communities we managed decreased from 69 to 47 and the owned and
        leased communities increased from 61 to 128, reflecting our increasing
        confidence in the assisted living industry, stabilization of managed properties,
        and the availability of capital. In 2004, managed communities further declined
        to 17 and owned and leased communities increased to 164. In the first two
        quarters of 2005, managed communities declined to 15 and owned and leased
        communities increased to 167. Throughout 2004 and continuing in 2005, we
        continue to review acquisition or lease opportunities.
 
 In
        March
        2005, we completed the lease of three additional communities, two of which
        we
        had previously managed.
 
 The
        following table sets forth a summary of our property interests:
 
 
 **As
                  of June 30,**
              
              **As
                  of December 31,**
              
              **As
                  of June 30,****2005**
              
              **2004**
              
              **2004****Buildings**
              
              **Units**
              
              **Buildings**
              
              **Units**
              
              **Buildings**
              
              **Units**Owned
              6
              
              454
              
              6
              
              454
              
              19
              
              1,813Leased
                  (1 )
              161
              
              12,820
              
              158
              
              12,589
              
              127
              
              9,579Consolidated
                  Portfolio
              167
              
              13,274
              
              164
              
              13,043
              
              146
              
              11,392Managed/Admin
                  Services (2)
              14
              
              1,467
              
              16
              
              1,668
              
              35
              
              3,417Joint
                  Venture/Partnership
              1
              
              140
              
              1
              
              140
              
              1
              
              140Operated
                  Portfolio
              182
              
              14,881
              
              181
              
              14,851
              
              182
              
              14,949Percentage
                  increase (decrease) (3)
              0.6%
              
              0.2%
              
              3.4%
              
              0.0%
              
              4.0%
              
              0.7%
 
 --------
 (1)
        Of
        the leased communities at June 30, 2005, 76 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 15 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.
 (2)
        One
        managed building was shut down and sold March 12, 2004, we discontinued
        management of one facility on September 30, 2004 and one on July 1,
        2005.
 (3)  The
        percentage increase (decrease) indicates the change from the prior year,
        or, in
        the case of June 30, 2005 and 2004, from the end of the prior year.
 
 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 determined on a daily basis for the same
        period. In evaluating the occupancy component, we generally rely on an average
        occupancy rate, computed by dividing the average units occupied, determined
        on a
        daily basis, during a particular period by the average number of units
        available, determined on a daily basis, during the period. We evaluate these
        and
        other operating components for our consolidated portfolio, which includes
        the
  **16**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 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 six
        months
        ended June 30, 2005, increased to $2,915 from $2,840 for the same period
        in
        2004. This change represents an increase of $75 or 2.6%. In our consolidated
        portfolio, our average monthly revenue per unit for the three months ended
        June
        30, 2005, increased to $2,928 from $2,902 for the three months ended March
        31,
        2005. This change represents an increase of $26 or 0.9%. This level of increase
        is partially 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 addition, increased competition in certain locations
        has
        prevented us from raising rates to the extent we otherwise would have desired.
 
 In
        our
        consolidated portfolio, our average occupancy rate increased to 84.7% for
        the
        six months ended June 30, 2005, from 79.7% for the six months ended June
        30,
        2004. In our consolidated portfolio, our average occupancy rate increased
        to
        84.4% for the three months ended June 30, 2005, from 80.8% for the three
        months
        ended June 30, 2004 For the first quarter of 2005, our average occupancy
        rate
        was 85.0%. We believe that this increase in occupancy rates reflects
        industry-wide factors, such as the declining supply of vacant units as well
        as
        our own actions and policies. 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 June 30,
        2005,
        we had an accumulated deficit of approximately $199.4 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, and occupancy rates remaining lower for longer periods than we
        anticipated.
 
 **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*
 
 Beginning
        in 1999, we managed 25 communities under arrangements with a related investor
        group (Emeritrust) that involved (i) payment of management fees to us (ii)
        options for us to purchase the communities at a price determined by a formula,
        and (iii) obligations to fund operating losses of certain
        communities.
  *Emeritrust I
        Communities Management.* During the period from 2000 to 2004, the arrangements were modified several
        times, the options to purchase and funding obligation were terminated, and
        the
        number of communities covered declined to 21. Effective January 2, 2004,
        the
        management fee arrangement provided for a flat fee of 5% of gross revenues.
        The
        term currently expires March 31, 2006, subject to termination by either
        party on 90 days notice. On September 30, 2004, 16 communities were
        leased
        pursuant to leases discussed below and five communities, which are now owned
        by
        Mr. Baty, continue to be managed by us. We received management fees of
        approximately $129,000 and $583,000 for the three months ended June 30, 2005
        and
        2004, respectively, and $256,000 and $1.2 million for the six months ended
        June
        30, 2005 and 2004 respectively.
 
 *Emeritrust
        I Communities Lease.* On
        September 30, 2004, we completed the first phase of a transaction to lease
        (Baty/REIT 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 for an investment
        of
        approximately $170.8 million and are being leased to us. We
  **17**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents completed
        the lease on the first 18 communities on September 30, 2004, which included
        17
        new communities and one existing lease, and an additional community lease
        on
        March 31, 2005, and anticipate the remaining community will close during
        the
        third quarter 2005. Of the communities included in this lease, 16 were part
        of
        the communities referred to above and in past filings with the SEC as the
        “Emeritrust I communities” and are capital leases.
 
 The
        single community lease completed on March 31, 2005, is leased by us from
        the
        REIT pursuant to a lease agreement with a 15-year term, with one 15-year
        renewal
        option. This lease has been accounted for as an operating lease with
        straight-lined rent payments.
 
 The
        initial lease payment for the facilities that have closed (18 capital leases
        and
        one operating lease) is approximately $14.0 million per year, with inflators
        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
        initial lease payment is expected to increase by $691,000 per year when the
        remaining facility closes. All of the leases are triple-net leases. The new
        leases are cross-defaulted and cross-collateralized with all of our other
        leases
        and loans relating to other communities owned by the REIT and contain certain
        financial and other covenants. We have the right of first refusal to purchase
        these leased communities and Mr. Baty is personally guaranteeing our obligations
        under the lease. Mr. Baty will receive, based on a prescribed formula, 50%
        of
        the positive cash flow of the 20 communities and will be responsible for
        50% of
        any negative cash flow. In the fourth quarter of 2004, the first quarter
        under
        this arrangement, Mr. Baty received $200,000 as consideration. Mr. Baty received
        $229,000 and $374,000 in the three months and six months ended June 30, 2005,
        respectively.
 
 *Debt
        Consolidation*
 
 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, extended the
        maturity to March 2008, and improved annual cash flows and earnings by
        approximately $1.6 million and $550,000, respectively, exclusive of transaction
        charges, as further described below.
 
 The
        REIT
        that financed the Emeritrust II transaction discussed in our 2004
        Form 10-K
        already held $6.8 million of our leasehold mortgage debt that matured in
        March
        2005 and bore interest at 12% per annum, commencing March 2002 with periodic
        increases up to 13% per annum. This REIT also provided $7.5 million in leasehold
        mortgage financing incurred to support the Series A Preferred Stock
        repurchase in August 2003. On September 30, 2003, these two financings,
        together with the $11.5 million leasehold mortgage financing related to the
        Emeritrust II communities, were consolidated into a single $25.8 million
        leasehold mortgage financing covering the 32 communities and maturing on
        June
        30, 2007. The debt bore interest at an initial rate of 12.13% per annum with
        periodic increases up to 13%. The consolidated loan required monthly payments
        of
        interest the first year and monthly payments of principal and interest, based
        on
        a 10-year amortization, thereafter. We elected to make a principal reduction
        of
        $6.0 million on August 2, 2004. The balance on the note as of March 2, 2005,
        was
        approximately $19.5 million.
 
 On
        March 2, 2005, this 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 loan may
        not be
        prepaid without the lender's consent.
 
 In
        connection with the loan modification, HRT also extended an additional $1.8
        million to us on the same terms as the restated loan from HRT to pay off
        certain
        transaction cost advances related to communities acquired in April 2004 that
        matured in March 2006 and had an interest rate of 12.0%, which would have
        increased to 12.5% in April 2005. In addition, in connection with this loan
        modification, we paid approximately $126,000 in closing costs, which is included
        in the $21.4 million of debt mentioned above.
  **18**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents *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.  Through
        January 31, 2004, the investment in Alterra was structured as an ownership
        interest in an LLC, which is a pass-through entity for tax purposes, similar
        to
        a limited partnership. Under generally accepted accounting principles, we
        used
        the equity method of accounting for our LLC membership interest and recorded
        a
        portion of Alterra's results of operations in our financial statements. As
        a
        consequence, equity losses of approximately $794,000 are included in the
        condensed consolidated statement of operations for the first half of 2004,
        under
        the caption “Other, net,” which represents our portion of Alterra's net loss for
        December 2003 and January 2004.
 
 The
        LLC
        made an election to be treated as a corporation for tax purposes effective
        January 31, 2004, and is no longer a pass-through entity. As a result of
        this
        election, on February 1, 2004, we began accounting for Alterra on
        a cost
        basis under APB 18 “The Equity Method of Accounting for Investments in Common
        Stock.”
 
 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 us. The parties entered into
        a
        Membership Interest Purchase Agreement (the “Agreement”) whereby, concurrent
        with the sale and purchase of the membership interests, the parties entered
        into
        an Amended and Restated LLC Agreement (the “Amended LLC”). The resulting
        membership interests of Fortress, NW, and us is 75%, 12.5%, and 12.5%,
        respectively. We recorded a gain of $21.3 million in Other, net in the condensed
        consolidated statement of operations for the three months ended June 30,
        2005,
        as a result of this transaction. The estimated income tax effect of this
        gain is
        approximately $835,000.
 
 Under
        the
        Amended LLC, we agreed to provide an indirect guarantee of an obligation
        of
        Alterra. The primary guarantor is an affiliate of Fortress (the “Affiliate”).
        The Affiliate has agreed to guarantee the proposed purchase by Alterra of
        six
        properties that are currently operated by Alterra under a lease agreement
        with
        Omega Healthcare Investors. We agreed to pay our proportional membership
        interest (12.5%) of any amount that the Affiliate is required to pay under
        the
        guarantee, not to exceed $2,550,000. The gain was reduced by the fair value
        of
        the guarantee which was determined to be $200,000.
 
 *CPM-JEA
        Transactions*
 
 In
        March
        2005, we entered into agreements 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 and is located in
        Richland, Washington. This community offers assisted living services and
        was
        part of the CPM group. The second community located in Lubbock, Texas, offers
        memory loss services and is a part of the JEA group of communities. It is
        new to
        our portfolio. Both facilities are under separate leases with the independent
        REIT, each with a maturity date of March 31, 2019, with three 5-year renewal
        options. The lease rate is 9% with fixed inflators of the lesser of four
        times
        the change in the consumer price index or 3%. The base rent as of June 30,
        2005,
        for these two leases is approximately $107,000 per month. Due to certain
        subjective default clauses in the lease and remedies, which allow for
        acceleration of all unpaid rents in the event of default, these leases have
        been
        accounted for as capital leases, which resulted in additions to property
        and
        equipment and capital lease and financing obligations totaling approximately
        $14.6 million.
 
 *Sale
        of Community*
 
 On
        November 1, 2004, we sold a single community located in Issaquah, Washington,
        for cash and assumption of liabilities for a total of $9.6 million. Since
        we 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,
  **19**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 2005,
        we
        deferred recognition of the sale and associated gain until that point. We
        recorded a gain of $1.3 million related to this sale in "Income from
        discontinued operations" in our condensed consolidated statements of operations
        for the six months ended June 30, 2005.
  *Series
        B Preferred 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
        by
        us of accrued and unpaid cash dividends on the Series B Stock, in
        the
        amount of approximately $10.8 million. Also on June 30, 2005,
        we
        borrowed $10.8 million from a REIT and used the proceeds to pay the
        accrued
        and unpaid cash dividends on the Series B Stock; upon such payment,
        Saratoga converted all of the outstanding Series B Stock to common
        stock in
        accordance with the agreement.
 
 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 the balance were issued as dividends
        of
        additional Series B Stock. In accordance with the agreement referred to above
        and as described below, the Series B Stock was converted into 5,365,747
        shares of common stock.
 
 The
        Series B Stock was entitled to receive quarterly dividends in a combination
        of
        cash and additional shares of Series B Stock. The initial rate for the dividend
        was 6% of the stated value of $1,000 per share, of which 2% was payable in
        cash
        and 4% was payable in additional Series B Stock. Starting in January 2004,
        the
        dividend rate moved to 7%, of which 3% was payable in cash and 4% in Series
        B
        Stock. The Series B Stock provided for an “arrearage rate” if the cash portion
        of the dividend was not paid, increasing the cash portion of the dividend
        to 7%.
        The arrearage rate became effective in October 2000, thus accruing dividends
        at
        an 11% rate, 7% in cash and 4% in additional shares of Series B Stock. We
        had
        issued the additional Series B Stock dividends on a quarterly basis on the
        first
        day of the month after the end of each quarter. However, the cash portion
        of the
        dividend had not been paid since 2000, which resulted in an accumulated
        liability of approximately $10.8 million as of March 31, 2005. For accounting
        purposes, we 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. No interest was required
        to
        be accrued on the unpaid cash dividends. In
        addition, in connection with the conversion, we paid $265,000 in legal and
        professional fees.
 
 We
        borrowed $10.8 million from a REIT at 10% per annum for a term of three years
        in
        order to pay the unpaid cash dividends of the Series B Preferred Stock. Monthly
        note payments of interest-only are due in arrears on the first day of each
        month. The note is due in full on June 30, 2008, with no prepayments allowed
        prior to January 1, 2007, and only upon at least 9 months prior written notice.
        The $10.8 million note contains provisions that modify one multi-community
        and
        four individual community leases with the REIT covering 12 properties. The
        loan
        requires collateral in the form of a letter of credit issued by a bank or
        a cash
        deposit of $1.0 million with the REIT. We deposited $1.0 million with the
        REIT
        at closing, which was recorded as a restricted deposit in the accompanying
        balance sheet.
 
 *Convertible
        Debentures*
 
 We
        have
        $32.0 million of 6.25% convertible subordinated debentures (the “Debentures”)
        that are due January 1, 2006. The Debentures are convertible into common
        stock
        at the rate of $22 per share, which equates to an aggregate of approximately
        1,454,545 shares of our common stock. Interest on the Debentures is payable
        semiannually on January 1 and July 1 of each year. The Debentures are unsecured
        and subordinated to all our other indebtedness.
 
 The
        Debentures are subject to redemption by us at any time, as a whole or in
        part,
        at a redemption price of 100% of the principal amount.
  **20**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents Of
        the
        $32.0 million of Debentures, $21.5 million are owned by directors and officers
        or their affiliates. Saratoga, two of whose representatives are directors,
        own
        $5.0 million of the Debentures. Affiliates of Mr. Baty and Stanley L. Baty,
        a
        director, own $15.8 million of the Debentures and another executive officer
        owns
        $660,000.
 
 On
        July
        6, 2005, we announced our intention to commence an offer to exchange (the
        "Exchange Offer") our 6.25% Convertible Subordinated Debentures due 2006
        (the
        "Outstanding Debentures") for new convertible subordinated debentures (the
        "New
        Debentures"). The New Debentures will have the same terms as the Outstanding
        Debentures, except that (i) the principal amount and all accrued interest
        of New
        Debentures will be paid on June 30, 2008, and all other dates that
        are
        determined by or relate to the maturity date of the Debentures will be adjusted
        accordingly; (ii) we will have no right of redemption prior to maturity,
        as
        provided in the Outstanding Debentures; and (iii) the interest rate paid
        under
        the New Debentures will be 8.0%, commencing on the day following the issuance
        thereof.
 
 On
        June
        30, 2005, we entered into an Agreement (an "Agreement") with Columbia Select,
        L.P. and Catalina General, L.P. (collectively, the "Baty Entities"), and
        Saratoga. The Agreement provides that if at the expiration of the Exchange
        Offer
        any Outstanding Debentures have not been exchanged for New Debentures, then
        Saratoga and the Baty Entities will purchase a principal amount of New
        Debentures ("Additional New Debentures") equal to the principal amount of
        Outstanding Debentures that have not been exchanged, excluding any Outstanding
        Debentures that have not been exchanged by any of Saratoga or the Baty Entities.
        The Agreement provides that Saratoga, as a group, will purchase 24% of any
        Additional New Debentures and the Baty Entities, as a group, will purchase
        76%
        of any Additional New Debentures, unless Saratoga and the Baty Entities agree
        on
        a different allocation of purchase. The purchase of the Additional New
        Debentures, if required, would take place on December 30, 2005. If the Baty
        Entities or Saratoga do not exchange any of their Outstanding Debentures,
        they
        are obligated to purchase New Debentures on December 30, 2005, equal to the
        principal amount of Debentures that were not exchanged. Proceeds from the
        New
        Debentures will be used to repay any of the Outstanding Debentures not
        exchanged, and as a result, the Debentures are classified as a long-term
        liability due to our ability and intent to refinance the Debentures on a
        long-term basis.
 
 The
        Baty
        Entities are affiliated with Mr. Baty, who beneficially owns approximately
        28.5%
        of our common stock. Saratoga beneficially owns approximately 33.0% of our
        common stock and is represented on our board by two directors. Together Mr.
        Baty
        and Saratoga beneficially own approximately 65% of Outstanding
        Debentures.
 
 The
        forgoing description of the Agreement does not purport to be complete and
        is
        qualified in its entirety by reference to the Agreement, which was filed
        as
        Exhibit 10.1 to a Form 8-K filed with the SEC on July 7, 2005.
 
  **21**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents The
        following table shows the changes in buildings from December 31, 2003, through
        June 30, 2005, including those transactions described above:
  **Month**
                
                **Owned**
                
                **Leased**
                
                
                
                **Consolidated**
                
                **Managed**
                
                **Total****December
                    31, 2003**
                
                
                
                
                
                **19**
                
                
                **109**
                
                
                
                
                **128**
                
                
                **47**
                
                
                **175**Madison
                    Glen - disposition
                
                
                Mar-04
                
                
                -
                
                
                -
                
                
                
                
                -
                
                
                (1
                )
                
                (1
                )**March
                    31, 2004**
                
                
                
                
                
                **19**
                
                
                **109**
                
                
                
                
                **128**
                
                
                **46**
                
                
                **174**CPM-JEA
                    transactions
                
                
                Apr-04
                
                
                -
                
                
                16
                
                **1**
                
                
                16
                
                
                (8
                )
                
                8Autumn
                    Ridge
                
                
                Jun-04
                
                
                -
                
                
                1
                
                **1**
                
                
                1
                
                
                (1
                )
                
                -The
                    Terrace
                
                
                Jun-04
                
                
                -
                
                
                1
                
                **1**
                
                
                1
                
                
                (1
                )
                
                -**June
                    30, 2004**
                
                
                
                
                
                **19**
                
                
                **127**
                
                
                
                
                **146**
                
                
                **36**
                
                
                **182**HCP
                    Transaction - sale-leaseback
                
                
                Jul-04
                
                
                (11
                )
                
                11
                
                **2**
                
                
                -
                
                
                -
                
                
                -Scottsdale
                    Royale - sold
                
                
                Aug-04
                
                
                (1
                )
                
                -
                
                
                
                
                (1
                )
                
                -
                
                
                (1
                )Baty/REIT
                    Lease
                
                
                Sep-04
                
                
                -
                
                
                17
                
                **1**
                
                
                17
                
                
                (17
                )
                
                -**September
                    30, 2004**
                
                
                
                
                
                **7**
                
                
                **155**
                
                
                
                
                **162**
                
                
                **19**
                
                
                **181**Manor
                    at Essington
                
                
                Oct-04
                
                
                -
                
                
                1
                
                **1**
                
                
                1
                
                
                -
                
                
                1Arbor
                    Gardens at Corona
                
                
                Oct-04
                
                
                -
                
                
                1
                
                **1**
                
                
                1
                
                
                -
                
                
                1Willows
                    at York - disposition
                
                
                Oct-04
                
                
                -
                
                
                -
                
                
                
                
                -
                
                
                (1
                )
                
                (1
                )Loyalton
                    of Cape May
                
                
                Oct-04
                
                
                -
                
                
                1
                
                **1**
                
                
                1
                
                
                (1
                )
                
                -Hearthside
                    of Issaquah - disposition
                
                
                Nov-04
                
                
                (1
                )
                
                -
                
                
                
                
                (1
                )
                
                -
                
                
                (1
                )**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**
 1  These
          leases are accounted for as capital leases in our condensed consolidated
          statements.
 2  These
          11
          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.
 **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 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, health insurance, and litigation. We base our estimates on historical
        experience and on various other assumptions that are
  **22**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 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.
 
 Our
        significant accounting policies and use of estimates are delineated in the
        Notes
        to the Condensed Consolidated Financial Statements under the heading "Summary
        of
        Significant Accounting Policies and Use of Estimates."
 
 **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**
              
              **Six
                  Months****Three
                  Months ended**
              
              **Six
                  Months ended**
              
              **ended**
              
              **ended****June
                  30,**
              
              **June
                  30,**
              
              **June
                  30,**
              
              **June
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**
              
              **2005-2004**
              
              **2005-2004**Revenues:
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              24.3
              %
              
              33.8
              %Expenses:Community
                  operations*
              
              
              64.4
              
              
              61.9
              
              
              64.2
              
              
              62.8
              
              
              (29.4
              )
              
              (36.9
              )General
                  and administrative
              
              
              8.1
              
              
              8.4
              
              
              7.9
              
              
              8.9
              
              
              (20.0
              )
              
              (18.9
              )Depreciation
                  and amortization
              
              
              12.0
              
              
              10.4
              
              
              11.9
              
              
              9.4
              
              
              (43.6
              )
              
              (69.8
              )Facility
                  lease expense
              
              
              10.8
              
              
              12.2
              
              
              10.5
              
              
              13.3
              
              
              (9.5
              )
              
              (5.6
              )Asset
                  impairment
              
              
              4.2
              
              
              -
              
              
              2.1
              
              
              -
              
              
              N/A
              
              
              N/ATotal
                  operating expenses
              
              
              99.5
              
              
              92.9
              
              
              96.6
              
              
              94.4
              
              
              (33.1
              )
              
              (37.0
              )Operating
                  income from continuing operations
              
              
              0.5
              
              
              7.1
              
              
              3.4
              
              
              5.6
              
              
              (90.8
              )
              
              (19.9
              )Other
                  income (expense)Interest
                  income
              
              
              0.2
              
              
              0.2
              
              
              0.2
              
              
              0.2
              
              
              53.0
              
              
              51.9Interest
                  expense
              
              
              (12.7
              )
              
              (12.8
              )
              
              (12.7
              )
              
              (12.2
              )
              
              (23.9
              )
              
              (39.6
              )Other,
                  net
              
              
              22.7
              
              
              0.7
              
              
              11.8
              
              
              0.3
              
              
              N/M
              
              
              N/MNet
                  other expense
              
              
              10.2
              
              
              (11.9
              )
              
              (0.7
              )
              
              (11.7
              )
              
              N/A
              
              
              N/AIncome
                  (loss) from continuing operationsbefore
                  income taxes
              
              
              10.7
              
              
              (4.8
              )
              
              2.7
              
              
              (6.1
              )
              
              N/A
              
              
              N/AProvision
                  for income taxes
              
              
              (1.0
              )
              
              -
              
              
              (0.6
              )
              
              -
              
              
              N/A
              
              
              N/AIncome
                  (loss) from continuing operations
              
              
              9.7
              
              
              (4.8
              )
              
              2.1
              
              
              (6.1
              )
              
              N/A
              
              
              N/AIncome
                  (loss) from discontinued operations
              
              
              -
              
              
              0.1
              
              
              0.7
              
              
              0.1
              
              
              97.4
              
              
              (655.4
              )Net
                  income (loss)
              
              
              9.7
              %
              
              (4.7
              %)
              
              2.8
              %
              
              (6.0
              %)
              
              N/A
              
              
              N/A*
                  exclusive of depreciation and amortization and facility lease expense
                  shown separately below
 
  **23**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 
 Comparison
        of the three months ended June 30, 2005 and 2004
 
 *Total
        Operating Revenues:* Total
        operating revenues for the three months ended June 30, 2005, increased by
        $18.9
        million to $96.6 million from $77.7 million for the comparable period in
        2004,
        or 24.3%.
 
 Community
        revenue and other service fees increased by approximately $19.6 million in
        the
        three months ended June 30, 2005, compared to the three months ended June
        30,
        2004, or 25.7%. This increase was primarily due to additional revenue related
        to
        the acquisition or lease of 25 communities from April 1, 2004, to June 30,
        2005.
        Of the 25 communities, we had formerly managed 22. These communities represent
        a
        revenue increase of approximately $15.3 million in the second quarter of
        2005.
        The remaining increase of $4.3 million, or 5.6% was primarily due to an increase
        in occupancy and average revenue per unit of previously operated
        communities.
 
 The
        average occupancy rate for all communities for the three months ended June
        30,
        2005, increased 3.6 percentage points to 84.4% from 80.8%. The occupancy
        rate
        grew from marketing initiatives in existing communities and from the acquisition
        or leasing of additional communities with higher occupancy levels than existing
        communities. Average community monthly revenue per unit for all communities
        was
        $2,928 for the second quarter of 2005 compared to $2,894 for the comparable
        quarter of 2004, an increase of approximately $34 per occupied unit, or
        1.2%.
 
 Management
        fee income decreased by approximately $734,000 to $462,000 for the three
        months
        ended June 30, 2005, from $1.2 million for the three months ended June 30,
        2004.
        This decrease was primarily due to 22 communities now leased in the second
        quarter of 2005 that were managed in the same quarter of the prior year.
 
 *Community
        Operations:* Community operating expenses for the three months ended June 30, 2005, increased
        by $14.2 million to $62.3 million from $48.1 million in the second quarter
        of
        2004, or 29.4%. The change was primarily due to the acquisition or lease
        of 25
        communities referred to above, which accounted for approximately $9.8 million
        of
        the increased expense. The remaining increase of $4.4 million, or 9.1%, was
        attributable to a number of factors. Census-based increases to staffing,
        raw
        food costs, utilities, and supplies accounted for $1.7 million and increased
        facility maintenance costs accounted for $600,000 of the increase. Also included
        in this increase is a one-time medication dispensing cost of $120,000. The
        comparison between the two quarters also reflects a $400,000 net favorable
        effect in 2004 of credits relating to employee benefit and workers' compensation
        programs, partially offset by increases in liability insurance accruals.
        The
        balance is comprised of general increases in operating costs, including
        community management personnel, real estate taxes, and contracted services.
        On a
        cost per resident basis, our operating expenses increased 1.9 percent. Community
        operating expenses as a percentage of total operating revenue increased to
        64.4%
        in the second quarter of 2005 from 61.9% in the second quarter of
        2004.
 
 *General
        and Administrative:* General
        and administrative (G&A) expenses for the three months ended June 30, 2005,
        increased $1.3 million to $7.8 million from $6.5 million for the comparable
        period in 2004, or 20.0%. As a percentage of total operating revenues, G&A
        expenses decreased to 8.1% for the three months ended June 30, 2005, compared
        to
        8.4% for the three months ended June 30, 2004, primarily as a result of
        increased revenue arising from the acquisition or lease of communities referred
        to above. Of the increase, approximately $550,000 is related to costs associated
        with the conversion of Series B Preferred Stock, project costs relating
        to
        initial compliance with internal controls requirements under the Sarbanes-Oxley
        Act of 2002, and an adjustment in 2004 decreasing our incentive compensation
        accrual. Of the remaining increase of approximately $750,000, the most
        significant factors were staffing additions, primarily associated with regional
        functions of sales and marketing and risk prevention, as well as routine
        compensation increases for all personnel. Other factors included accounting
        and
        other fees associated with increased corporate governance requirements.
  **24**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 
 *Depreciation
        and Amortization:* Depreciation
        and amortization for the three months ended June 30, 2005, was $11.6 million
        compared to $8.1 million for the comparable period in 2004. The increase
        is
        primarily the result of depreciation resulting from capital lease treatment
        associated with the leasing of 24 additional communities since April 1, 2004
        (primarily the Baty/REIT transactions announced September 30, 2004). In 2005,
        depreciation and amortization represented 12.0% of total operating revenues,
        compared to 10.4% for the same period in 2004.
 
 *Facility
        Lease Expense* :
        Facility lease expense for the three months ended June 30, 2005, was $10.4
        million compared to $9.5 million for the comparable period of 2004, representing
        an increase of $901,000, or 9.5%. The change was primarily due to the operating
        lease of a single community discussed under Emeritrust I communities lease,
        which accounted for approximately $575,000 of the increase, partially offset
        by
        one lease that was changed from an operating lease to a capital lease in
        September 2004. Of the remaining increase,  $349,000 was primarily
        attributable to performance-based lease inflators of existing operating leases.
        We leased 76 communities under operating leases as of June 30, 2005 and 2004.
        Facility lease expense as a percentage of revenues was 10.8% for the three
        months ended June 30, 2005, and 12.2% for the three months ended June 30,
        2004.
        The decrease is primarily a result of increased revenues.
 
 *Asset
        Impairment:* Asset
        impairment for the three months ended June 30, 2005, was $4.0 million. The
        impairment is related to a facility in Las Vegas, Nevada, in which we determined
        that the carrying amount was not recoverable from expected undiscounted cash
        flows generated from the use of the asset, and accordingly, the carrying
        value
        was reduced to estimated fair value.
  *Interest
        Income:* Interest
        income for the three months ended June 30, 2005, was $205,000 versus $134,000
        for the same period of 2004, an increase of $71,000. This increase was primarily
        attributable to interest earned on collateral funds placed with our workers'
        compensation insurance carrier.
 
 *Interest
        Expense:* Interest
        expense for the three months ended June 30, 2005, was $12.3 million compared
        to
        $9.9 million for the comparable period of 2004, an increase of $2.4 million,
        or
        23.9%. Of
        this
        amount, $2.0 million resulted from capital lease treatment on the Emeritrust
        I
        communities’ lease involving 18 facilities completed on September 30, 2004, and
        $544,000 resulted from the capital lease treatment of the CPM/JEA communities’
        lease involving 23 communities, completed from April 1, 2004, through the
        second
        quarter of 2005. As a
        percentage of total operating revenues, interest expense decreased to 12.7%
        in
        the second quarter of 2005 from 12.8% for the second quarter of
        2004.
 
 *Other,
        net:* Other,
        net for the three months ended June 30, 2005, was approximately $21.9 million
        of
        income compared to $546,000 of income for the comparable period in 2004.
        The
        $21.9 million income for the current year quarter is primarily the result
        of the
        gain on sale of our interest in Alterra of $21.3 million and amortization
        of
        deferred gains of approximately $554,000. The $546,000 income in the second
        quarter of 2004 is primarily the result of the amortization of deferred gains
        of
        approximately $518,000.
 
 *Income
        taxes:* The
        provision for income taxes of $974,000 for the three months ended June 30,
        2005,
        was principally due the estimated income tax effect of the gain on sale of
        Alterra ($835,000) and to Federal alternative minimum tax and state income
        and
        franchise tax liabilities on operating income after adding back financial
        accounting for leases. At June 30, 2005 and 2004, we have a 100% valuation
        allowance on our deferred tax assets.
 
 *Net
        Income (Loss) and Property-Related Expense:* In
        comparing the net income for 2005 and the net loss for 2004, 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
  **25**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 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.
 
 The
        net
        income reflected in our consolidated statement of operations for the three
        months ended June 30, 2005, was $9.4 million. Our property-related expense
        for
        this period was $34.3 million, of which $30.8 million was associated with
        our
        leases due to the effects of lease accounting referred to above. Our actual
        capital, finance and operating lease payments during this period were $24.6
        million. Correspondingly, the net loss of $3.6 million for the three months
        ended June 30, 2004, reflected property-related expense of $27.5 million,
        of
        which $21.5 million was associated with our leases. Our actual capital, finance,
        and operating lease payments for the three months ended June 30, 2005, were
        $17.7 million. The increase in total property-related expense is due primarily
        to the acquisition and lease of 25 additional communities since April 1, 2004. The amount by which the
        property-related expense associated with our leases exceeded our actual lease
        payments was $6.2 million for the three months ended June 30, 2005, compared
        to
        $3.8 million for the three months ended June 30, 2004, an increase of $2.4
        million. This increase is primarily attributable to capital lease accounting
        treatment of leases for 24 of the 25 communities referred to above and the
        finance lease treatment of 11 communities which were in a sales-leaseback
        transaction in July 2004. 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
        increase our revenues and our results from community operations to cover
        these
        increases.
 
 *Income
        from Discontinued Operations:* Income
        from discontinued operations for the three months ended June 30, 2005, was
        approximately $3,000 compared to $117,000 for the comparable period in 2004.
 
 *Preferred
        dividends:* For the
        three months ended June 30, 2005 and 2004, preferred dividends totaled
        approximately ($358,000) and $930,000, respectively. The preferred dividends
        for
        the three months ended June 30, 2005, were negative because the Series B
        Stock
        was converted to common stock on June 30, 2005, and the previously accrued
        dividends due to straight-lining were reversed upon conversion.
 
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              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
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      Contents 
 Comparison
        of the six months ended June 30, 2005 and 2004
 
 *Total
        Operating Revenues:* Total
        operating revenues for the six months ended June 30, 2005, increased by $48.5
        million to $191.8 million from $143.3 million for the comparable period in
        2004,
        or 33.8%.
 
 Community
        revenue and other service fees increased by approximately $50.2 million in
        the
        six months ended June 30, 2005, compared to the six months ended June 30,
        2004,
        or 35.8%. This increase was primarily due to additional revenue related to
        the
        acquisition or lease of 41 communities from January 1, 2004, to June 30,
        2005.
        Of the 41 communities, we had formerly managed 30. These communities represent
        a
        revenue increase of approximately $40.7 million in the first two quarters
        of
        2005. The remaining increase of $9.5 million, or 6.8%, was primarily due
        to an
        increase in occupancy and average revenue per unit of previously operated
        communities.
 
 The
        average occupancy rate for all communities for the six months ended June
        30,
        2005, increased 5.0 percentage points to 84.7% from 79.7%. The occupancy
        rate
        grew from marketing initiatives in existing communities and from the acquisition
        or leasing of additional communities with higher occupancy levels than existing
        communities. Average community monthly revenue per unit for all communities
        was
        $2,915 for the first two quarters of 2005 compared to $2,840 for the comparable
        quarters of 2004, an increase of approximately $75 per occupied unit, or
        2.6%.
 
 Management
        fee income decreased by approximately $1.7 million to $1.1 million for the
        six
        months ended June 30, 2005, from $2.8 million for the six months ended June
        30,
        2004. This decrease was primarily due to 30 communities now leased in the
        first
        two quarters of 2005 that were managed for a portion of same quarters of
        the
        prior year.
 
 *Community
        Operations:* Community operating expenses for the six months ended June 30, 2005, increased
        by $33.1 million to $123.0 million from $89.9 million for the first two quarters
        of 2004, or 36.9%. The change was primarily due to the acquisition or lease
        of
        41 communities referred to above, which accounted for approximately $26.3
        million of the increased expense. The remaining increase of $6.8 million,
        or
        7.6%, was attributable to a number of factors. Census-based increases to
        staffing, raw food costs, utilities, and supplies accounted for $3.1 million
        and
        increased facility maintenance costs accounted for $1.0 million of the increase.
        Also included in this increase is a one-time medication dispensing cost of
        $120,000. The comparison between the first six months of 2005 and the first
        six
        months of 2004 also reflects a $400,000 net favorable effect in 2004 of credits
        relating to employee benefit and workers' compensation programs, partially
        offset by increases in liability insurance accruals. The balance is comprised
        of
        general increases in operating costs, including community management personnel,
        real estate taxes, and contracted services. On a cost per resident basis,
        our
        community operating expenses were flat with the prior year period. Community
        operating expenses as a percentage of total operating revenue increased to
        64.2%
        for the first two quarters of 2005 from 62.8% for the first two quarters
        of
        2004.
 
 *General
        and Administrative:* General
        and administrative (G&A) expenses for the six months ended June 30, 2005,
        increased $2.4 million to $15.2 million from $12.8 million for the comparable
        period in 2004, or 18.9%. As a percentage of total operating revenues, G&A
        expenses decreased to 7.9% for the six months ended June 30, 2005, compared
        to
        8.9% for the six months ended June 30, 2004, primarily as a result of increased
        revenue arising from the acquisition or lease of communities referred to
        above.
        Of the increase, approximately $700,000 is related to costs associated with
        the
        conversion of Series B Preferred Stock, project costs related to initial
        compliance with internal controls requirements under the Sarbanes-Oxley Act
        of
        2002, and an adjustment in 2004 decreasing our incentive compensation
        accrual. Of the remaining increase of approximately $1.7 million, the most
        significant factors were staffing additions, primarily associated with regional
        functions of sales and marketing and risk prevention as well as routine
        compensation increases for all personnel. Other factors included accounting
        and
        other fees associated with increased corporate governance requirements.
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              RESULTS OF OPERATIONS - CONTINUED**
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 *Depreciation
        and Amortization:* Depreciation
        and amortization for the six months ended June 30, 2005, was $22.9 million
        compared to $13.5 million for the comparable period in 2004. The increase
        is
        primarily the result of depreciation resulting from capital lease treatment
        associated with the leasing of 40 additional communities since December 31,
        2003 (primarily the CPM/JEA transactions announced April 1, 2004,
        and the
        Baty/REIT transactions announced September 30, 2004). In 2005, depreciation
        and
        amortization represented 11.9% of total operating revenues, compared to 9.4%
        for
        the same period in 2004.
 
 *Facility
        Lease Expense* :
        Facility lease expense for the six months ended June 30, 2005, was $20.1
        million
        compared to $19.1 million for the comparable period of 2004, representing
        an
        increase of $1.0 million, or 5.6%. The change was primarily due to the operating
        lease of a single community discussed under Emeritrust I communities lease,
        which accounted for approximately $580,000 of the increase, partially offset
        by
        one lease that was changed from an operating lease to a capital lease in
        September 2004. Of the remaining increase, $505,000 was primarily attributable
        to performance-based lease inflators of existing operating leases. We leased
        76
        communities under operating leases as of June 30, 2005 and 2004. Facility
        lease
        expense as a percentage of revenues was 10.5% for the six months ended June
        30,
        2005, and 13.3% for the six months ended June 30, 2004. The decrease is
        primarily a result of increased revenues.
 
 *Asset
        Impairment:* Asset
        impairment for the six months ended June 30, 2005, was $4.0 million. The
        impairment is related to a facility in Las Vegas, Nevada, in which we determined
        that the carrying amount was not recoverable from expected undiscounted cash
        flows generated from the use of the asset, and accordingly, the carrying
        value
        was reduced to estimated fair value.
  *Interest
        Income:* Interest
        income for the six months ended June 30, 2005, was $436,000 versus $287,000
        for
        the same period of 2004, an increase of $149,000. This increase was primarily
        attributable to interest earned on collateral funds placed with our workers'
        compensation insurance carrier.
 
 *Interest
        Expense:* Interest
        expense for the six months ended June 30, 2005, was $24.5 million compared
        to
        $17.5 million for the comparable period of 2004 an increase of $7.0 million,
        or
        39.6%. Of this amount, $4.1 million resulted from capital lease treatment
        on the
        Emeritrust I communities’ lease involving 18 facilities completed on September
        30, 2004, and $3.0 million resulted from the capital lease treatment of the
        CPM/JEA communities’ lease involving 23 communities, completed from April 1,
        2004, through the second quarter of 2005. In addition, $119,000 in loan fees
        was
        extinguished as a part of the modification of an existing note (see Debt
        Consolidation for details). As a percentage of total operating revenues,
        interest expense increased to 12.7% for the first two quarters of 2005 from
        12.2% for the first two quarters of 2004.
 
 *Other,
        net:* Other,
        net for the six months ended June 30, 2005, was approximately $22.7 million
        of
        income compared to $363,000 of income for the comparable period in 2004.
        The
        $22.7 million income for the current year quarter is primarily the result
        of the
        gain on sale of our interest in Alterra of $21.3 million and amortization
        of
        deferred gains of approximately $1.1 million. The $363,000 income for the
        first
        two quarters of 2004 is primarily the result of the amortization of deferred
        gains of approximately $1.1 million, partially offset by our portion of
        Alterra’s net loss for December 2003 and January 2004 (discussed above under
“Alterra Transactions”) totaling $794,000.
 
 *Income
        taxes:* The
        provision for income taxes of $1.1 million for the six months ended June
        30,
        2005, was principally due to the estimated income tax effect of the gain
        on sale
        of Alterra ($835,000) and Federal alternative minimum tax and state income
        and
        franchise tax liabilities on operating income after adding back financial
        accounting for leases. At June 30, 2005 and 2004, we have a 100% valuation
        allowance on our deferred tax assets.
 
 *Net
        Income (Loss) and Property-Related Expense:* In
        comparing the net income for 2005 and the net loss for 2004, 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
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              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
      of
      Contents 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.
 
 The
        net
        income reflected in our consolidated statement of operations for the six
        months
        ended June 30, 2005, was $5.3 million. Our property-related expense for this
        period was $67.5 million, of which $60.6 million was associated with our
        leases
        due to the effects of lease accounting referred to above. Our actual capital,
        finance and operating lease payments during this period were $48.5 million.
        Correspondingly, the net loss of $8.6 million for the six months ended June
        30,
        2004, reflected property-related expense of $50.1 million, of which $38.4
        million was associated with our leases. Our actual capital, finance, and
        operating lease payments for the six months ended June 30, 2005, were $32.4
        million. The increase in total property-related expense is due primarily
        to the
        acquisition and lease of 41 additional communities since December 31,
        2003.
        The amount by which the property-related expense associated with our leases
        exceeded our actual lease payments was $12.1 million for the six months ended
        June 30, 2005, compared to $6.0 million for the six months ended June 30,
        2004,
        an increase of $6.1 million. This increase is primarily attributable to capital
        lease accounting treatment of leases for 40 of the 41 communities referred
        to
        above and the finance lease treatment of 11 communities which were in a
        sales-leaseback transaction in July 2004. It should be remembered 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 increase our revenues and our results from
        community operations to cover these increases.
 
 *Income
        from Discontinued Operations:* Income
        from discontinued operations for the six months ended June 30, 2005, was
        approximately $1.3 million compared to $175,000 for the comparable period
        in
        2004. The income for the first two quarters of 2005 was the recognition of
        the
        previously deferred gain on the sale of one community in 2004. We 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. Thus,
        we
        deferred recognition of the sale and associated gain of $1.3 million until
        that
        point and recorded the related assets at December 31, 2004, as held for sale.
 
 *Preferred
        dividends:* For the
        six months ended June 30, 2005 and 2004, preferred dividends totaled
        approximately $599,000 and $1.9 million, respectively. The preferred dividends
        for the six months ended June 30, 2005, were lower because the Series B Stock
        was converted to common stock on June 30, 2005, no dividends were required
        to be
        accrued for the second quarter based on the terms of the agreement, and the
        previously accrued dividends due to straight-lining were reversed upon
        conversion and offset against the dividends from the first quarter.
 
 
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              RESULTS OF OPERATIONS - CONTINUED**
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 *Same
        Community Comparison*
 
 We
        operated 125 communities, which we have operated continuously since January
        1,
        2004, and define as "Same Communities.". The following table sets forth a
        comparison of same community results of operations, excluding general and
        administrative expenses, for the three months ended June 30, 2005 and
        2004.
 
 **Three
                  Months ended June 30,****(In
                  thousands)****Dollar**
              
              **%
                  Change****2005**
              
              **2004**
              
              **Change**
              
              **Fav
                  / (Unfav)**Revenue
              
              $
              68,887
              
              $
              65,038
              
              $
              3,849
              
              
              5.9
              %Community
                  operations *
              
              
              (44,685
              )
              
              (41,029
              )
              
              (3,656
              )
              
              (8.9
              )Community
                  operating income
              
              
              24,202
              
              
              24,009
              
              
              193
              
              
              0.8Depreciation
                  & amortization
              
              
              (5,520
              )
              
              (5,477
              )
              
              (43
              )
              
              (0.8
              )Facility
                  lease expense
              
              
              (9,624
              )
              
              (9,275
              )
              
              (349
              )
              
              (3.8
              )Operating
                  income
              
              
              9,058
              
              
              9,257
              
              
              (199
              )
              
              (2.1
              )Interest
                  expense, net
              
              
              (6,901
              )
              
              (7,039
              )
              
              138
              
              
              2.0Operating
                  income after interest expense
              
              $
              2,157
              
              $
              2,218
              
              $
              (61
              )
              
              (2.8
              %)*
                  exclusive of depreciation and amortization and facility lease expense
                  shown separately below
 
 These
        125
        communities represented $68.9 million or 71.3% of our total revenue of $96.6
        million for the second quarter of 2005. Same community revenues increased
        by
        $3.8 million or 5.9% for the quarter ended June 30, 2005, from the same period
        in 2004. This increase was primarily due to improvements in occupancy. Occupancy
        increased 3.7 percentage points to 83.2% for the three months ended June
        30,
        2005 from 79.5% for the three months ended June 30, 2004. Average revenue
        per
        occupied unit increased by $41 per month or 1.5% for the three months ended
        June
        30, 2005, as compared to the three months ended June 30, 2004.
 
 Community
        operating expenses increased approximately $3.7 million primarily from increased
        costs for direct care labor, related employee taxes and benefits, maintenance
        of
        facilities, food costs, utilities, and supplies. Property-related expenses
        (depreciation and amortization, facility lease expense, and interest expense,
        net) increased by approximately $254,000, which reflects primarily the effect
        of
        rent escalators in operating leases, which are in part performance based,
        the
        impact of changing one community from an operating lease to a capital lease
        at a
        higher financing rate, increasing depreciation and amortization, and a reduction
        in interest resulting from partial repayment of debt in August 2004 and a
        lower
        interest rate on that debt commencing in March 2005. Operating income after
        interest expense decreased $61,000.
 
 **Liquidity
        and Capital Resources**
 
 For
        the
        six months ended June 30, 2005, net cash provided by operating activities
        was
        $8.6 million. The primary components of cash provided by operating activities
        were net income, depreciation and amortization of $22.9 million, the asset
        impairment of $4.0 million, the amortization of loan fees of $241,000, and
        the
        preferred stock conversion costs of $265,000, partially offset by the gain
        on
        sale of investment in Alterra of $21.3 million, recognition of deferred gain
        on
        sale of property, plant and equipment of $1.3 million, the net increase in
        other
        operating assets and liabilities of $476,000, and amortization of deferred
        gain
        of $1.1 million. For the six months ended June 30, 2004, net cash provided
        by
        operating activities was $5.6 million. The primary components of operating
        cash
        provided by operating activities for the six months ended June 30, 2004,
        were
        depreciation and amortization of $13.5 million,  the
        amortization of loan fees of $635,000,  the
        net
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 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 Table
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        in other operating assets and liabilities of $175,000, and an adjustment
        for the
        Alterra equity investment loss of $794,000, partially offset by the amortization
        of deferred gain of $1.1 million and net loss.
 
 Net
        cash
        provided by investing activities amounted to $18.4 million for the six months
        ended June 30, 2005, and was comprised primarily of the sale of our investment
        in Alterra of $25.0 million and a decrease in our advances to affiliates
        and
        other managed communities of $145,000, partially offset by the acquisition
        of
        property and equipment of $3.9 million, management and lease acquisition
        cost of
        $1.5 million, construction expenditures for leased properties of $757,000,
        acquisition of assets in lease transactions of $406,000, and investment in
        affiliates of $126,000. Net cash used in investing activities amounted to
        $6.8
        million for the six months ended June 30, 2004, and was comprised primarily
        of
        an expenditure for management and lease acquisition costs of approximately
        $5.3
        million, purchases of approximately $1.8 million of various property and
        equipment, advances to affiliates and other managed communities of $1.2 million,
        acquisition of assets in lease transactions of $1.1 million, and investments
        in
        affiliates of $285,000, partially offset by collection of a note receivable
        of
        $2.7 million and proceeds from the sale of property and equipment of $226,000
        .
 
 For
        the
        six months ended June 30, 2005, net cash used in financing activities was
        $10.3
        million, primarily from long-term debt repayments of $22.0 million, payment
        of
        preferred dividends on Series B Stock of $10.8 million, repayment of capital
        lease and financing obligations of $7.7 million, an increase in restricted
        deposits of $1.7 million, and debt issuance and other financing costs of
        $631,000, partially offset by proceeds from long-term borrowings and financings
        of $32.2 million and proceeds from sale of stock under employee stock purchase
        and incentive plans of $244,000. For the six months ended June 30, 2004,
        net
        cash used in financing activities was $198,000, primarily from repayment
        of
        capital lease and financing obligations of $3.6 million, repayment of long-term
        borrowings of $2.4 million, and increases in restricted deposits of $972,000,
        partially offset by proceeds from short-term borrowing on bank line of credit
        of
        $3.0 million, proceeds from long-term borrowings and financings of $2.6 million,
        proceeds from sale of stock under employee stock purchase and incentive plans
        of
        $1.2 million, and a decrease in debt issuance and other financing costs of
        $34,000.
 
 We
        have
        incurred significant operating losses since our inception and have a working
        capital deficit of $42.8 million, although $14.0 million represents deferred
        revenue and unearned rental income. Additionally, due to the adverse judgment
        against us as described under “Legal Proceedings,” an additional reserve was
        recorded in the fourth quarter of 2004 for $18.7 million in accordance with
        our
        self-insured pool agreement. We believe there are substantial grounds for
        an
        appeal and that the damage award was not justified by the facts or the law
        in
        the case presented. We have appealed the verdict and on March 16, 2005, we
        posted funds in the amount of $1.7 million in order to stay the proceedings
        while the appellate process runs its course, which could be anywhere from
        18
        months to three years. We will not be required to pay additional amounts
        until
        the appeal and further litigation is completed or the case is settled. At
        times
        in the past, we have been dependent upon third-party financing or disposition
        of
        assets to fund operations. If such transactions are necessary in the future,
        we
        cannot guarantee that they will be available on a timely basis, on terms
        attractive to us, or at all.
 
 Throughout
        2004 and continuing through the second quarter of 2005, we refinanced
        substantially all of our debt obligations, extending the maturities of such
        financings to dates beyond June 30, 2006, and thereafter, 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 6 owned assisted living properties and 157 properties operated
        under leases. Accordingly, any event of default could cause a material adverse
        effect on our financial condition if such debt or leases are cross-defaulted. At
        June
        30, 2005, we complied with all such covenants.
 
 Management
        believes that we will be able to sustain positive operating cash flow on
        an
        annual basis and will have adequate cash or the ability to obtain adequate
        financing for all necessary investing and financing activities including
        required debt service and capital expenditures through at least June 30,
        2006.
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 Table
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 The
        following table summarizes our contractual obligations at June 30, 2005,
        (in
        thousands):
 
 
 **Principal
                  Payments Due by Period****Less
                  than**
              
              
              
              
              
              **After
                  5****Contractual
                  Obligations**
              
              **Total**
              
              **1
                  year**
              
              **1-3
                  years**
              
              **4-5
                  years**
              
              **years**Long-term
                  debt, including current portion
              
              $
              65,393
              
              $
              2,656
              
              $
              4,378
              
              $
              54,851
              
              $
              3,508Capital
                  lease and financing obligations including current portion
              
              
              636,715
              
              
              17,490
              
              
              44,488
              
              
              58,446
              
              
              516,291Operating
                  leases
              
              
              337,260
              
              
              38,865
              
              
              79,927
              
              
              82,243
              
              
              136,225Convertible
                  debentures*
              
              
              32,000
              
              
              -
              
              
              32,000
              
              
              -
              
              
              -$
              1,071,368
              
              $
              59,011
              
              $
              160,793
              
              $
              195,540
              
              $
              656,024
 
 *
        These
        principal payments are predicated on the refinancing of the debentures to
        become
        due June 30, 2008, as described above.
 
 
 
 The
        following table summarizes interest on our contractual obligations at June
        30,
        2005, (in thousands):
 
 
 **Interest
                  Due by Period****Less
                  than**
              
              
              
              
              
              **After
                  5****Contractual
                  Obligations**
              
              **Total**
              
              **1
                  year**
              
              **1-3
                  years**
              
              **4-5
                  years**
              
              **years**Long-term
                  debt
              
              $
              16,392
              
              $
              5,394
              
              $
              9,644
              
              $
              992
              
              $
              362Capital
                  lease and financing obligations
              
              
              388,673
              
              
              41,969
              
              
              80,228
              
              
              73,775
              
              
              192,701Convertible
                  debentures*
              
              
              7,120
              
              
              2,000
              
              
              5,120
              
              
              -
              
              
              -$
              412,185
              
              $
              49,363
              
              $
              94,992
              
              $
              74,767
              
              $
              193,063
 
 *
        The
        interest payments due in less than one year are based upon the current interest
        rate of 6.25% and the interest payments due in 1-3 years are based upon the
        rate
        of 8% for the new debentures to be issued upon refinancing of the current
        debentures, and are included even though they are not yet contractual
        obligations.
 
 
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              RESULTS OF OPERATIONS - CONTINUED**
 Table
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 **Impact
        of Inflation**
 
 To
        date,
        inflation has not had a significant impact on us. 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.
 
 **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 operation, and final resolution of the adverse
        Texas jury verdict 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 and Quarterly Reports
        Form
        10-Q.
 
 
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        rest
        of this page is intentionally left blank]
 
 
  **33**
 Table
      of
      Contents **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 June 30, 2005, we had no variable rate borrowings.
        However, we do have certain operating lease obligations based on LIBOR, subject
        to a LIBOR floor ranging from 2.0% to 2.5%. As LIBOR rates increase above
        the
        current level, we will be exposed to higher lease expense costs. As of June
        30,
        2005, the LIBOR rate was 3.3%. If LIBOR interest rates were to average 2%
        more,
        our annual facility lease expense and net loss would increase by approximately
        $1.1 million. This amount is determined by considering the impact of
        hypothetical interest rates on these operating lease obligations as of June
        30,
        2005, and does not consider changes in the actual level of borrowings or
        operating lease obligations that may occur subsequent to June 30, 2005. 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******
 
 *Evaluation
        of disclosure controls and procedures*
 
 The
        Company maintains a set of disclosure controls and procedures and internal
        controls designed to ensure that information required to be disclosed in
        its
        filings under the Securities Exchange Act of 1934 is recorded, processed,
        summarized, and reported within the time periods specified in the SEC’s rules
        and forms. Disclosure controls and procedures include controls and procedures
        designed to ensure that information required to be disclosed by us in reports
        we
        file or submit under the Exchange Act is accumulated and communicated to
        our
        management, including our chief executive officer and chief financial officer,
        as appropriate, to allow timely decisions regarding disclosure. It should
        be
        noted that any system of controls, however well designed and operated, can
        provide only reasonable, and not absolute, assurance that the objectives
        of the
        system are met.
 
 Our
        current management, with the participation of our chief executive officer
        and
        chief financial officer, has evaluated the effectiveness of our disclosure
        controls and procedures as of June 30, 2005, which included an evaluation
        of
        disclosure controls and procedures applicable to the period covered by the
        filing of this periodic report. Based on this evaluation, our chief executive
        officer and chief financial officer have concluded that our disclosure controls
        and procedures were effective as of June 30, 2005.
 
 The
        certifications of our chief executive officer and chief financial officer
        required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002
        are
        attached as exhibits to this Form 10-Q.
 
 *Changes
        in internal controls over financial reporting*
 
 In
        our
        Form 10K dated December 31, 2004, the Company 's management identified several
        issues relating to improvement of our internal controls over financial
        reporting. Since that time, we have implemented various changes to our internal
        controls responding to these issues, as follows:
  ·
              Have
                  hired accounting personnel with experience, skills, and knowledge
                  relating
                  to complex leasing and financing transactions and direct involvement
                  in
                  the review and accounting evaluation of such
                  transactions;
  ·
              Have
                  included internal personnel and outside accounting consultants,
                  if
                  necessary, early in a transaction to obtain additional guidance
                  as to the
                  application of generally accepted accounting principles to a proposed
                  transaction;
  ·
              Have
                  established clear responsibilities for our real estate personnel
                  and
                  accounting personnel and increased the formal interaction, responsibility
                  and coordination between such
                  personnel;
  **34**
 Table
      of
      Contents  
  ·
              Have
                  documented the review, analysis, and related conclusions with respect
                  to
                  complex leasing transactions;
  ·
              Senior
                  accounting personnel and the chief accounting officer review such
                  transactions in order to evaluate, document, and approve their
                  accounting
                  treatment.
  
 Management
        believes these changes to be effective, and has evaluated the effectiveness
        of
        the Company's internal controls through June 30, 2005, and will continue
        to do
        so and make additional changes as appropriate. No additional changes have
        been
        made since filing the Form 10-Q dated March 31, 2005, filed with the SEC
        on May
        13, 2005.
 
 
 
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        rest
        of this page is intentionally left blank]
 
  **35**
 Table
      of
      Contents  **PART
        II. OTHER INFORMATION**
 
 **Items
        2, 3, 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.
        Reserves for these claims have been accrued 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.
 
 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
        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 believe that this verdict is unjust, that there are substantial
        grounds for an appeal, and that the damage award was not justified by the
        facts
        or the law in the case presented by the plaintiff. We have appealed the verdict
        based on significant legal errors we believe occurred at the trial. We have
        posted funds in the amount of $1.7 million in order to stay the proceedings
        while the appellate process runs its course, which could be anywhere from
        18
        months to three years. We will not be required to pay additional amounts
        until
        the appeal and further litigation is completed or the case is settled. We
        have
        recorded a liability for the amount of the verdict on our consolidated balance
        sheet for the year ended December 31, 2004, with a corresponding charge on
        our
        consolidated statements of operations for the year then ended.
 
 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 seeks, on behalf of residents of these
        facilities located in California, to recover move-in or preadmission fees
        that
        have been paid over the past three years as well as certain penalties. We
        are
        defending this action vigorously and have entered into a joint defense agreement
        with other operators in California. We believe recent court rulings in the
        case
        have significantly eroded the viability of the plaintiff’s action.
 
 There
        have been no further developments in these cases since we filed our 2004
        Form
        10-K with the SEC on March 31, 2005. A discussion of our general and
        professional liability is contained in the same 2004 Form 10-K under
        "Significant Accounting Policies and Use of Estimates."
 
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        rest
        of this page is intentionally left blank]
  **36**
 Table
      of
      Contents 
 **Item
        4.****Submission
        of Matters to a Vote of Security Holders**
 
 (a)
              The
                  Annual Meeting of Shareholders was held on June 15,
                  2005.
 
 (b)
              All
                  director nominees listed in the proxy statement were elected at
                  the
                  meeting.
  **Nominees
        for Election**
  **Class
        III Directors (terms to expire in 2008)**
 
 Daniel
        R.
        Baty
 Bruce
        L.
        Busby
 Charles
        P. Durkin, Jr.
 
 **Class
        II Director (term to expire 2007)**
 
 Stanley
        L. Baty
 
  **Continuing
        Directors**
 
 **Class
        II Directors (terms to expire 2007)**
 
 Raymond
        R. Brandstrom
 T.
        Michael Young
 
 **Class
        I Directors (terms to expire in 2006)**
 
 Patrick
        Carter
 David
        W.
        Niemiec
 
 [The
        rest
        of this page is intentionally left blank]
 
  **37**
 Table
      of
      Contents 
 (c
        ) The
        following matters voted upon at the meeting received the number of votes
        set
        forth below:
 
 ·
              Election
                  of Directors
 ·
              Ratification
                  of Independent Public Accountants
 ·
              An
                  amendment to the Emeritus Corporation Amended and Restated Stock
                  Option
                  Plan for Non Employee Directors (the "Plan") to increase the number
                  of
                  shares authorized for issuance under the Plan by an additional
                  200,000
                  shares, from 150,000 to 350,000 shares.
 
 
 **Election
                  of Directors:****Abstain
                  or****Name**
              
              **For**
              
              **Against**
              
              **Broker
                  Non-vote**Daniel
                  R. Baty
              
              15,341,111
              
              -
              
              378,862Bruce
                  L. Busby
              
              15,344,178
              
              
              
              375,795Charles
                  P. Durkin, Jr.
              
              15,293,212
              
              -
              
              426,761Stanley
                  L. Baty
              
              15,292,445
              
              -
              
              427,528**Ratification
                  of Independent Public Accountants:****For**
              
              **Against**
              
              **Abstain**
              
              **Other
                  Non-vote**15,715,906
              
              2,229
              
              1,838
              
              -**Approval
                  of an Amendment to the Stock Option Plan****for
                  Nonemployee Directors****For**
              
              **Against**
              
              **Abstain**
              
              **Other
                  Non-vote**11,899,299
              
              642,844
              
              18,518
              
              3,159,312
 
 (d)
        Not
        applicable.
 
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        rest
        of this page is intentionally left blank]
 
  **38**
 Table
      of
      Contents 
 **Item
        6.  Exhibits**
 
  **Footnote****Number**
                
                **Description**
                
                **Number**4.6
                
                Agreement
                    Regarding 6.25% Convertible Subordinated Debenture due 2006 entered
                    into
                    as of June 30, 2005 is between EmeritusCorporation
                    (the "Company"), Saratoga Partners IV, LP, Saratoga Management
                    Company
                    LLC, Saratoga Coinvestment IV LLC(collectively,
                    the "Saratoga Entities"), Columbia Select, L.P. and Catalina
                    General, L.P.
                    (collectively, the "Baty Entities").
                
                (10)**10.53**
                
                **Emeritrust
                    II communities**10.53.19
                Second
                    Amended and Restated Loan Agreement between Healthcare Realty
                    Trust and
                    EmeritusCorporation
                    and dated as of March 3, 2005.
                
                (2)10.53.20
                Second
                    Amended and Restated Note**between
                    Emeritus Corporation and Healthcare Realty TrustIncorporated
                    and dated as of March 3, 2005.
                
                (2)10.53.21
                Loan
                    Purchase Agreement among Healthcare Realty Trust Incorporated,
                    Health Care
                    REIT, Inc., andEmeritus
                    Corporation and dated as of March 3, 2005.
                
                (2)10.53.22
                Intercreditor
                    Agreement between Health Care REIT, Inc. and Healthcare Realty
                    Trust
                    Incorporated anddated
                    as of March 3, 2005.
                
                (2)10.53.23
                First
                    Amendment to Amended and Restated Master Lease Agreement dated
                    as of June
                    22nd, 2005 by and among Health Care Reit,Inc.,
                    HCRI Mississippi Properties, Inc, HCRI Massachusetts Properties
                    Trust II,
                    and HCRI Texas Properties, LTD, as Landlord andEmeritus
                    Corporation as Tenant
                
                (12)**10.68**
                
                **Kingsley
                    Place at Alexandria, Louisiana; Kingsley Place at Lake Charles,
                    Louisiana;
                    Kingsley Place at Lafayette,****Louisiana;
                    Kingsley Place of Shreveport, Louisiana; Kingsley Place of Henderson,
                    Texas; Kingsley Place at Oakwell****Farms,
                    Texas; Kingsley Place at the Medical Center, Texas; Kingsley
                    Place at
                    Stonebridge, Texas. The following****agreements
                    are representative of those executed in connection with these
                    properties:**10.68.25
                Third
                    Amendment to Lease Agreement (Henderson, TX) dated as of June
                    30, 2005 by
                    and between HRAcquisition
                    of San Antonio, LTD ("Lessor"), ESC IV, LP ("Lessee") and Emeritus
                    Corporation and Daniel RBaty
                    (collectively "Guarantor")
                
                (12)10.68.26
                Third
                    Amendment to Lease Agreement (Mckinney, TX) dated as of June
                    30, 2005 by
                    and between HRAcquisition
                    of San Antonio, LTD ("Lessor"), ESC IV, LP ("Lessee") and Emeritus
                    Corporation and Daniel RBaty
                    (collectively "Guarantor")
                
                (12)10.68.27
                Third
                    Amendment to Lease Agreement (Oakwell, TX) dated as of June 30,
                    2005 by
                    and between HRAcquisition
                    of San Antonio, LTD ("Lessor"), ESC IV, LP ("Lessee") and Emeritus
                    Corporation and Daniel RBaty
                    (collectively "Guarantor")
                
                (12)10.68.28
                Third
                    Amendment to Lease Agreement (San Antonio, TX) dated as of June
                    30, 2005
                    by and between HRAcquisition
                    of San Antonio, LTD ("Lessor"), ESC IV, LP ("Lessee") and Emeritus
                    Corporation and Daniel RBaty
                    (collectively "Guarantor")
                
                (12)**10.75**
                
                **Loyalton
                    of Bloomsburg, Pennsylvania; Loyalton of Creekview, Pennsylvania;
                    Loyalton
                    of Harrisburg, Pennsylvania;****Loyalton
                    of Danville, Virginia; Loyalton of Harrisonburg, Virginia; Loyalton
                    of
                    Roanoke, Virginia; Loyalton of****Greensboro,
                    North Carolina; Loyalton of Ravenna, Ohio. The following agreements
                    are
                    representative of those****executed
                    in connection with these properties:**10.75.35
                First
                    Amendment to Lease Agreement dated as of June 30, 2005 by and
                    between HR
                    Acquisition I Corporation, HRAcquisition
                    of Pennsylvania, Inc, and HRT Holdings, Inc ("Lessor") and Emeritus
                    Corporation ("Lessee")
                
                (12)**10.77**
                
                **The
                    Palms at Loma Linda, California, The Springs at Oceanside, California,
                    The
                    Fairways of Augusta, Kansas,****Liberal
                    Springs, Kansas, Loyalton of Broadmoor, Colorado. The following
                    agreements
                    are representative of those****executed
                    in connection with this property:**10.77.6
                Membership
                    Interest Purchase Agreement, dated as of June 29, 2005, by and
                    among NW
                    Select LLC, EmeritusCorporation
                    ("Emeritus" and together with NW Select, the "Sellers", and each
                    individually, a "Seller"), FIT-ALTInvestor
                    LLC, ("Buyer"), and Brookdale Senior Living Inc.,
                    ("Newco")
                
                (8)10.77.7
                Stockholders
                    and Voting Agreement made as of June 29, 2005, by and among Brookdale
                    Senior Living Inc.,FIT-ALT
                    Investor LLC, Emeritus Corporation, and NW Select LLC
                
                (8)
  **39**
 Table
          of Contents
 **Footnote****Number**
                
                **Description**
                
                **Number**
 10.77.8
                Amended
                    and Restated Limited Liability Company Agreement of FEBC-ALT
                    Investors
                    LLC, made as ofJune
                    29, 2005 by and among, FIT-ALT Investors LLC, as a Class A Member,
                    and NW
                    Select LLC, and EmeritusCorporation,
                    as the Class B Members, and the Company
                
                (8)**10.79**
                
                **Loyalton
                    of Folsom, California; The Lakes, Florida; Canterbury Woods,
                    Massachusetts; Beckett Meadows,****Texas;
                    Creekside, Texas; Oak Hollow, Texas; Pinehurst, Texas; Stonebridge,
                    Texas,
                    Desert Springs, Texas;****Austin
                    Gardens, California; Kingsley Place Shreveport, Louisiana; Silverleaf
                    Manor, Mississippi;****Pine
                    Meadow, Mississippi; Pines of Goldsboro, North Carolina; Loyalton
                    of
                    Rockford, Illinois;****Charleston
                    Gardens, West Virginia; Arbor Gardens at Corona, California;
                    and Manor at
                    Essington, Illinois;****Quail
                    Ridge, Lubbock, Texas; Richland Gardens, Richland,
                    Washington.****The
                    following agreements are representative of those executed in
                    connection
                    with these properties:**10.79.10
                Lease
                    dated March 1, 2005 between QR Lubbock Texas Properties, L.P.,
                    a Texas
                    Limited Partnership ("Landlord"),and
                    ESC IV, LP, a Washington Limited Partnership (doing business
                    in the State
                    of Texas as Texas - ESC IV, L.P.(“Tenant”).
                
                (7)10.79.11
                Guaranty
                    of Lease executed as of March 1, 2005, by Emeritus Corporation,
                    a
                    Washington Corporation ("Guarantor")in
                    favor of QR Lubbock Texas Properties, L.P., a Texas Limited Partnership
                    ("Landlord")
                
                (7)10.79.12
                Lease
                    dated February 25, 2005 to be effective as of March 1, 2005 (the
                    "Effective Date") between BIP SUB I,Inc.,
                    a Delaware Corporation ("Landlord"), and Emeritus Corporation,
                    a
                    Washington Corporation ("Tenant").
                
                (7)**10.83**
                
                **Barrington
                    Place, Lecanto, Florida; Bellaire Place, Greenville, South Carolina;
                    Brookside Estates, Middleberg****Heights,
                    Ohio; Dowlen Oaks, Beaumont, Texas; Eastman Estates, Longview,
                    Texas; Elm
                    Grove, Hutchinson,****Kansas;
                    Emeritus Estates, Ogden, Utah; Gardens at White Chapel, Newark,
                    Delaware;
                    Harbor Pointe Shores,****Ocean
                    Shores, Washington; Hunters Glen, Missoula, Montana; Lakeridge
                    Place,
                    Wichita Falls, Texas;****Meadowlands
                    Terrace, Waco, Texas; Myrtlewood Estates, San Angelo, Texas;
                    Pavilion at
                    Crossing Pointe,****Orlando,
                    Florida; Seville Estates, Amarillo, Texas; Saddleridge Lodge,
                    Midland,
                    Texas; Springtree, Sunrise,****Florida;
                    The Terrace, Grand Terrace, California; Wilburn Gardens, Fredericksburg,
                    Virginia; Woodmark****at
                    Summit Ridge, Reno, Nevada.**10.83.6
                Lease
                    Agreement between HCRI Wilburn Gardens Properties, LLC
                    and Emeritus
                    Corporation dated March 31, 2005.
                
                (7)**10.84**
                
                **Real
                    Property Purchase and Sale Agreement made and entered into as
                    of May 20,
                    2005, by and between Pioneer****Health
                    Management Corporation ("Buyer"), and Emeritus Corporation ("Seller")
                    Green Valley Land Sale**
                
                (12)**10.85**
                
                **Agreement
                    Regarding Series B Convertible Preferred Stock entered into as
                    of June 30,
                    2005 between Emeritus****Corporation,
                    Saratoga Partners IV, LP, Saratoga Management Company LLC and****Saratoga
                    Coinvestment IV LLC. Exhibit 4.7**
                
                (12)10.85.1
                Loan
                    Agreement made and entered into effective as of June 30, 2005
                    between
                    Emeritus Corporation andHealthcare
                    Realty Trust Incorporated
                
                (12)10.85.2
                $10,800,000
                    Promissory Note between Emeritus Corporation ("Borrower") and
                    Healthcare
                    Realty TrustIncorporated
                    ("Lender")
                
                (12)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 August 12, 2005.
                
                (12)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 August 12, 2005.
                
                (12)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 August 12, 2005.
                
                (12)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 August 12, 2005.
                
                (12)99.1
                
                
                Press
                    Releases91.1.1
                Press
                    Release dated February 25, 2005, announcing the results of a
                    jury verdict
                    and plans to appeal.
                
                (1)91.1.2
                Press
                    Release dated March 3, 2005, announcing a $21.4 million
                    refinance.
                
                (2)99.1.3
                Press
                    Release dated March 31, 2005, reports on fourth quarter and year
                    2004
                    results.
                
                (3)99.1.4
                Press
                    Release dated May 13, 2005, reports on first quarter
                    results.
                
                (4)99.1.5
                Press
                    Release dated June 29, 2005, Announcement of sale of Alterra
                    interest
                
                (8)99.1.6
                Press
                    Release dated July 5, 2005, Announcement of the conversion of
                    Series B
                    preferred stock
                
                (9)99.1.7
                Press
                    Release dated July 6, 2005, Announcement Intention to Commence
                    Offer To
                    Exchange Convertible Debentures
                (10)99.1.8
                Press
                    Release dated August 15, 2005, reports on second quarter
                    results.
                
                (11)
 
  **40**
 Table
      of
      Contents 
 Footnotes:(1)
              Filed
                  as an exhibit to a Form 8-K filed on February 25, 2005, and incorporated
                  herein by reference.(2)
              Filed
                  as an exhibit to a Form 8-K filed on March 9, 2005, and incorporated
                  herein by reference.(3)
              Filed
                  as an exhibit to a Form 8-K filed on April 1, 2005, and incorporated
                  herein by reference.(4)
              Filed
                  as an exhibit to a Form 8-K filed on May 13, 2005, and incorporated
                  herein
                  by reference.(5)
              Filed
                  as an exhibit to a Form 10-Q filed on May 13, 2005, and incorporated
                  herein by reference.(6)
              Filed
                  as an exhibit to a Form 8-K filed on August 9, 2005, and incorporated
                  herein by reference.(7)
              Filed
                  as an exhibit to a Form 10-Q filed on May 12, 2005, and incorporated
                  herein by reference.(8)
              Filed
                  as an exhibit to a Form 8-K filed on July 1, 2005, and incorporated
                  herein
                  by reference.(9)
              Filed
                  as an exhibit to a Form 8-K filed on July 7, 2005, and incorporated
                  herein
                  by reference.(10)
              Filed
                  as an exhibit to a Form 8-K filed on July 7, 2005, and incorporated
                  herein
                  by reference.(11)
              Filed
                  as an exhibit to a Form 8-K filed on August 15, 2005, and incorporated
                  herein by reference.(12)
              Filed
                  herewith.
 
 
 
 
  **41**
 Table
      of
      Contents 
 
 **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:
                  August 15, 2005
              **EMERITUS
                  CORPORATION**(Registrant)/s/
                  Raymond R. BrandstromRaymond
                  R. Brandstrom, Vice President of Finance,Chief
                  Financial Officer, and Secretary
 
 **42**