**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, 2006
 
 o
              **TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF****THE
                  SECURITIES EXCHANGE ACT OF
                  1934**
 
 Commission
        file number 1-14012
  
 **EMERITUS
        CORPORATION**
 (Exact
        name of registrant as specified in its charter)
 
 WASHINGTON
              91-1605464(State
                  or other jurisdiction
              (I.R.S
                  Employerof
                  incorporation or organization)
              Identification
                  No.)
 
 3131
        Elliott Avenue, Suite 500
 Seattle,
        WA 98121
 (Address
        of principal executive offices)
 
 (206)
        298-2909
 (Registrant's
        telephone number, including area code)
 ____________________________
 
 Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days. Yes  þ  No  o
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
        (Check one):
 
 Large
        accelerated filer  o  Accelerated
        filer  þ  Non-accelerated
        filer  o
 
 Indicate
        by check mark whether the Registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act). Yes  o  No  þ
 
 As
        of
        July 31, 2006, there were  18,012,612 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, 2006, and
                  December 31, 2005
              2Condensed
                  Consolidated Statements of Operations for the Three
                  months and Six months ended June 30, 2006 and 2005
              3Condensed
                  Consolidated Statements of Cash Flows for the Six
                  months ended June 30, 2006 and 2005
              4Notes
                  to Condensed Consolidated Financial
                  Statements
              5**Item
                  2.**
              **Management's
                  Discussion and Analysis of Financial Condition
                  and Results of Operations**
              17**Item
                  3.**
              **Quantitative
                  and Qualitative Disclosures About Market
                  Risk**
              38**Item
                  4.**
              **Controls
                  and Procedures**
              38**Part
                  II. Other Information**Note:
              Items
                  2, 3, and 5 of Part II are omitted because they are not
                  applicable.**Item
                  1.**
              **Legal
                  Proceedings**
              39**Item
                  1A.**
              **Risk
                  Factors**
              39**Item
                  4.**
              **Submission
                  of Matters to a Vote of Security
                  Holders**
              40**Item
                  6.**
              **Exhibits**
              41**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,****2006**
              
              **2005**Current
                  Assets:Cash
                  and cash equivalents
              
              $
              30,073
              
              $
              56,413Short-term
                  investments
              
              
              1,633
              
              
              1,885Trade
                  accounts receivable, net of allowance of $796 and $744
              
              
              4,828
              
              
              4,604Other
                  receivables
              
              
              2,483
              
              
              2,297Tax
                  and maintenance escrows
              
              
              5,822
              
              
              6,579Prepaid
                  workers' compensation
              
              
              9,617
              
              
              7,542Other
                  prepaid expenses
              
              
              7,116
              
              
              6,791Total
                  current assets
              
              
              61,572
              
              
              86,111Property
                  and equipment, net of accumulated depreciation of $131,368 and
                  $109,035
              
              
              605,541
              
              
              619,146Property
                  held for development
              
              
              402
              
              
              402Notes
                  receivable and investments in affiliates
              
              
              3,326
              
              
              3,709Restricted
                  deposits
              
              
              10,870
              
              
              9,660Lease
                  and contract acquisition costs, net of amortization of $12,129
                  and
                  $10,487
              
              
              25,354
              
              
              27,167Other
                  assets, net
              
              
              13,710
              
              
              1,575Total
                  assets
              
              $
              720,775
              
              $
              747,770**LIABILITIES
                  AND SHAREHOLDERS' DEFICIT**Current
                  Liabilities:Current
                  portion of long-term debt
              
              $
              3,742
              
              $
              2,825Current
                  portion of capital lease and financing obligations
              
              
              20,620
              
              
              19,028Current
                  portion of convertible debentures
              
              
              -
              
              
              5,375Trade
                  accounts payable
              
              
              5,591
              
              
              7,070Accrued
                  employee compensation and benefits
              
              
              17,078
              
              
              17,372Accrued
                  interest
              
              
              1,350
              
              
              2,355Accrued
                  real estate taxes
              
              
              4,888
              
              
              6,478Accrued
                  professional and general liability
              
              
              11,737
              
              
              27,994Accrued
                  income taxes
              
              
              297
              
              
              4,649Other
                  accrued expenses
              
              
              8,003
              
              
              7,280Deferred
                  revenue
              
              
              8,936
              
              
              8,143Unearned
                  rental income
              
              
              7,874
              
              
              6,350Total
                  current liabilities
              
              
              90,116
              
              
              114,919Long-term
                  debt, less current portion
              
              
              84,452
              
              
              77,650Capital
                  lease and financing obligations, less current portion
              
              
              597,486
              
              
              607,677Convertible
                  debentures, less current portion
              
              
              26,575
              
              
              26,625Deferred
                  gain on sale of communities
              
              
              24,902
              
              
              26,009Deferred
                  rent
              
              
              5,996
              
              
              5,496Other
                  long-term liabilities
              
              
              2,034
              
              
              2,467Total
                  liabilities
              
              
              831,561
              
              
              860,843Commitments
                  and contingenciesShareholders'
                  Deficit:Preferred
                  stock, $.0001 par value. Authorized 5,000,000 shares, none
                  issuedCommon
                  stock, $.0001 par value. Authorized 40,000,000 shares; issued and
                  outstanding17,984,316
                  and 16,486,944 shares at June 30, 2006, and December 31, 2005,
                  respectively
              
              
              2
              
              
              2Additional
                  paid-in capital
              
              
              84,496
              
              
              79,321Accumulated
                  deficit
              
              
              (195,284
              )
              
              (192,396
              )Total
                  shareholders' deficit
              
              
              (110,786
              )
              
              (113,073
              )Total
                  liabilities and shareholders' deficit
              
              $
              720,775
              
              $
              747,770
 
 
 See
        accompanying Notes to Unaudited Condensed Consolidated Financial Statements
        and
        Management's
 Discussion
        and Analysis of Financial Condition and Results of Operations.
 
  **2**
 Table of
      Contents    **EMERITUS
                  CORPORATION****CONDENSED
                  CONSOLIDATED STATEMENTS OF OPERATIONS****(unaudited)****(In
                  thousands, except per share data)****Three
                  Months ended June 30,**
              
              **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Revenues:Community
                  revenue
              
              $
              101,571
              
              $
              94,030
              
              $
              200,466
              
              $
              186,517Other
                  service fees
              
              
              1,618
              
              
              1,772
              
              
              3,332
              
              
              3,480Management
                  fees
              
              
              484
              
              
              462
              
              
              941
              
              
              1,060Total
                  operating revenues
              
              
              103,673
              
              
              96,264
              
              
              204,739
              
              
              191,057Expenses:Community
                  operations (exclusive of depreciation and amortizationand
                  facility lease expense shown separately below)
              
              
              67,662
              
              
              61,942
              
              
              134,029
              
              
              122,347Texas
                  lawsuit settlement
              
              
              -
              
              
              -
              
              
              (12,207
              )
              
              -General
                  and administrative
              
              
              8,721
              
              
              7,857
              
              
              17,452
              
              
              15,190Depreciation
                  and amortization
              
              
              12,251
              
              
              11,513
              
              
              24,401
              
              
              22,800Facility
                  lease expense
              
              
              11,092
              
              
              10,388
              
              
              22,010
              
              
              20,124Total
                  operating expenses
              
              
              99,726
              
              
              91,700
              
              
              185,685
              
              
              180,461Operating
                  income from continuing operations
              
              
              3,947
              
              
              4,564
              
              
              19,054
              
              
              10,596Other
                  income (expense):Interest
                  income
              
              
              681
              
              
              205
              
              
              1,552
              
              
              436Interest
                  expense
              
              
              (12,475
              )
              
              (12,250
              )
              
              (24,206
              )
              
              (24,368
              )Gain
                  on sale of investment in Alterra Healthcare Corporation
              
              
              -
              
              
              21,323
              
              
              -
              
              
              21,323Equity
                  losses in unconsolidated joint ventures
              
              
              (396
              )
              
              (11
              )
              
              (492
              )
              
              (31
              )Other,
                  net
              
              
              562
              
              
              611
              
              
              1,158
              
              
              1,371Net
                  other income (expense)
              
              
              (11,628
              )
              
              9,878
              
              
              (21,988
              )
              
              (1,269
              )Income
                  (loss) from continuing operations before income taxes
              
              
              (7,681
              )
              
              14,442
              
              
              (2,934
              )
              
              9,327Provision
                  for income taxes
              
              
              100
              
              
              (974
              )
              
              90
              
              
              (1,089
              )Income
                  (loss) from continuing operations
              
              
              (7,581
              )
              
              13,468
              
              
              (2,844
              )
              
              8,238Loss
                  from discontinued operations (net of tax)
              
              
              (34
              )
              
              (4,111
              )
              
              (44
              )
              
              (2,920
              )Net
                  income (loss)
              
              
              (7,615
              )
              
              9,357
              
              
              (2,888
              )
              
              5,318Preferred
                  stock dividends
              
              
              -
              
              
              358
              
              
              -
              
              
              (599
              )Net
                  income (loss) to common shareholders
              
              $
              (7,615
              )
              $
              9,715
              
              $
              (2,888
              )
              $
              4,719Basic
                  income (loss) per common share:Continuing
                  operations
              
              $
              (0.42
              )
              $
              1.27
              
              $
              (0.17
              )
              $
              0.70Discontinued
                  operations
              
              
              -
              
              
              (0.38
              )
              
              -
              
              
              (0.27
              )$
              (0.42
              )
              $
              0.89
              
              $
              (0.17
              )
              $
              0.43Diluted
                  income (loss) per common share:Continuing
                  operations
              
              $
              (0.42
              )
              $
              0.73
              
              $
              (0.17
              )
              $
              0.47Discontinued
                  operations
              
              
              -
              
              
              (0.21
              )
              
              -
              
              
              (0.16
              )$
              (0.42
              )
              $
              0.52
              
              $
              (0.17
              )
              $
              0.31Weighted
                  average common shares outstanding :Basic
              
              
              17,927
              
              
              10,918
              
              
              17,481
              
              
              10,870Diluted
              
              
              17,927
              
              
              19,776
              
              
              17,481
              
              
              18,289
 See
        accompanying Notes to Unaudited Condensed Consolidated Financial Statements
        and
        Management's
 Discussion
        and Analysis of Financial Condition and Results of Operations.
 
  **3**
 Table of
      Contents    **EMERITUS
                  CORPORATION****CONDENSED
                  CONSOLIDATED STATEMENTS OF CASH FLOWS****(unaudited)****(In
                  thousands)****Six
                  Months Ended June 30,****2006**
              
              **2005**Cash
                  flows from operating activities:Net
                  income (loss)
              
              $
              (2,888
              )
              $
              5,318Adjustments
                  to reconcile net income (loss) to net cash provided by (used in)
                  operating
                  activities:Depreciation
                  and amortization
              
              
              24,401
              
              
              22,800Amortization
                  of deferred gain
              
              
              (1,107
              )
              
              (1,108
              )Gain
                  on sale of properties, net
              
              
              -
              
              
              (1,321
              )Gain
                  on sale of investment
              
              
              -
              
              
              (21,323
              )Impairment
                  of long-lived asset
              
              
              -
              
              
              4,028Amortization
                  of loan fees
              
              
              101
              
              
              241Preferred
                  stock conversion costs
              
              
              -
              
              
              265Equity
                  investment losses
              
              
              492
              
              
              31Stock
                  option compensation
              
              
              222
              
              
              -Other
              
              
              341
              
              
              415Changes
                  in operating assets and liabilities, net of acquisitions
              
              
              (25,584
              )
              
              (740
              )Net
                  cash provided by (used in) operating activities
              
              
              (4,022
              )
              
              8,606Cash
                  flows from investing activities:Acquisition
                  of property and equipment
              
              
              (6,439
              )
              
              (3,947
              )Acquisition
                  of assets in lease transactions
              
              
              -
              
              
              (406
              )Construction
                  expenditures - leased properties
              
              
              (1,982
              )
              
              (757
              )Management
                  and lease acquisition costs
              
              
              (8
              )
              
              (1,533
              )Payments
                  from affiliates and other managed communities
              
              
              606
              
              
              145Proceeds
                  from the sale of investment in Alterra, net
              
              
              -
              
              
              24,979Investment
                  in affiliates
              
              
              (136
              )
              
              (126
              )Funds
                  held in escrow
              
              
              (10,834
              )
              
              -Collection
                  of notes receivable
              
              
              27
              
              
              -Net
                  cash provided by (used in) investing activities
              
              
              (18,766
              )
              
              18,355Cash
                  flows from financing activities:Proceeds
                  from sale of stock
              
              
              3,829
              
              
              244Increase
                  in restricted deposits
              
              
              (1,210
              )
              
              (1,746
              )Debt
                  issue and other financing costs
              
              
              (259
              )
              
              (631
              )Proceeds
                  from long-term borrowings and financings
              
              
              8,449
              
              
              32,226Repayment
                  of debenture
              
              
              (5,375
              )
              
              -Repayment
                  of long-term borrowings
              
              
              (982
              )
              
              (21,999
              )Repayment
                  of capital lease and financing obligations
              
              
              (9,078
              )
              
              (7,668
              )Tax
                  benefit of stock compensation
              
              
              1,074
              
              
              -Payment
                  of preferred dividend
              
              
              -
              
              
              (10,772
              )Net
                  cash used in financing activities
              
              
              (3,552
              )
              
              (10,346
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              (26,340
              )
              
              16,615Cash
                  and cash equivalents at the beginning of the period
              
              
              56,413
              
              
              10,748Cash
                  and cash equivalents at the end of the period
              
              $
              30,073
              
              $
              27,363Supplemental
                  disclosure of cash flow information -Cash
                  paid during the period for interest
              
              $
              25,211
              
              $
              24,640Non-cash
                  financing and investing activities:Accrued
                  and in-kind preferred stock dividends
              
              $
              -
              
              $
              599Debt
                  issued for acquisition of property and equipment
              
              $
              -
              
              $
              1,135Capital
                  lease and financing obligations
              
              $
              730
              
              $
              14,858Note
                  retirement
              
              $
              -
              
              $
              630Conversion
                  of convertible debentures
              
              $
              50
              
              $
              -Deferred
                  lease acquisition cost
              
              $
              179
              
              $
              -Reduction
                  in property held for sale and related deposit
              
              $
              -
              
              $
              7,891
 
 See
        accompanying Notes to Unaudited Condensed Consolidated Financial Statements
        and
        Management's
 Discussion
        and Analysis of Financial Condition and Results of Operations
  **4**
 Table of Contents   
 **EMERITUS
        CORPORATION**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 
 **Definitions**
 
 Throughout
        Notes to 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.
            "JEA"
                refers to JEA Senior Living, a
                non-affiliate. 9.
            "Saratoga"
                refers to a group of related companies, namely: Saratoga Partners
                IV, LP;
                Saratoga Management Company LLC, as Agent; and Saratoga Coinvestment
                IV,
                LLC. 10.
            "Series
                B Stock" refers to Series B Convertible Preferred
                Stock. 11.
            “Emeritrust”
                refers to two groups of communities (totaling 46 communities) that
                were
                managed by the Company starting in 1998. These communities were owned
                by
                two different investor groups in each of which Mr. Baty held a
                non-controlling interest. The composition of the groups has changed
                over
                time and most of the communities are now leased by the Company. Further
                details are available in the Company’s Forms 10-K for years prior to
                2006. 
 **Summary
        of Significant Accounting Policies and Use of Estimates**
 
 The
        preparation of condensed consolidated financial statements requires Emeritus
        to
        make estimates and judgments that affect the reported amounts of assets,
        liabilities, revenues and expenses, and related disclosure of contingent
        assets
        and liabilities. On an ongoing basis, Emeritus evaluates its estimates,
        including those related to resident programs and incentives such as move-in
        fees, bad debts, investments, intangible assets, impairment of long-lived
        assets, income taxes, restructuring, long-term service contracts, contingencies,
        self-insured retention, insurance deductibles, health insurance, and litigation.
        Emeritus bases its estimates on historical experience and on various other
        assumptions that are believed to be reasonable under the circumstances, the
        results of which form the basis for making judgments about the carrying values
        of assets and liabilities that are not readily apparent from other sources.
        Actual results may differ from these estimates under different assumptions
        or
        conditions.
 
 Emeritus
        believes that certain critical accounting policies are most significant to
        the
        judgments and estimates used in the preparation of its condensed consolidated
        financial statements. Revisions in such estimates are charged to income in
        the
        period in which the facts that give rise to the revision become known. A
        detailed discussion of the Company’s significant accounting policies and use of
        estimates is contained in the 2005 Form 10-K filed March 16, 2006.
 
 **Recent
        Accounting Pronouncements and Proposed Statements**
 
 In
        December 2004, the FASB issued SFAS 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 condensed consolidated statement of
        operations. SFAS No. 123R eliminates 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
        requires 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.
        The
        Company adopted SFAS No. 123R on January 1, 2006. The Company has adopted
        the
“modified prospective” method in
  **5**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   implementing
        SFAS No. 123R. Using this method has resulted in stock compensation expense
        amounts that are similar to prior pro forma disclosures.
 
 **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, 2006, and for the six months ended June 30, 2006
        and
        2005. The results of operations for the period ended June 30, 2006, 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 2005 audited consolidated financial statements and Management's
        Discussion and Analysis of Financial Condition and Results of Operations
        that
        are contained in the 2005 Form 10-K filed March 16, 2006. Therefore, the
        Company
        has omitted footnotes and other disclosures herein, which are disclosed in
        the
        Form 10-K.
 
 **Reclassifications**
 
 Certain
        reclassifications have been made to the condensed consolidated financial
        statements to conform to the current period presentation, primarily relating
        to
        the impact of discontinued operations on prior periods.
 
 **Stock-Based
        Compensation**
 
 In
        December 2004, the FASB issued SFAS No. 123R. SFAS No. 123R is a revision
        of
        SFAS No. 123, as amended, Accounting for Stock-Based Compensation (‘SFAS No.
        123”), and supersedes Accounting Principals Board Opinion (“APB”) No. 25,
        Accounting for Stock Issued to Employees (“APB No. 25”). SFAS No. 123R
        eliminates the alternative to use the intrinsic value method of accounting
        that
        was provided in SFAS 123, which generally resulted in no compensation expense
        recorded in the financial statements related to the issuance of stock options
        or
        shares issued under the Company’s Employee Stock Purchase Plan (“ESP Plan”).
        SFAS No. 123R establishes fair value as the measurement objective in accounting
        for share-based payment arrangements and requires all companies to apply
        a
        fair-value-based measurement method in accounting for, generally, all
        share-based payment transactions with employees.
 
 On
        January 1, 2006, the Company adopted SFAS No. 123R. The Company adopted SFAS
        No.
        123R using a modified prospective application, as permitted under SFAS No.
        123R.
        Accordingly, prior period amounts have not been restated. Under this
        application, the Company is required to record compensation expense for all
        awards granted after the date of adoption and for the unvested portion of
        previously granted awards that remain outstanding at the date of
        adoption.
 
 Before
        the adoption of SFAS No. 123R, the Company applied APB Opinion No. 25 to
        account
        for stock-based awards. Under APB Opinion No. 25, the Company was not required
        to recognize compensation expense for the cost of stock options or shares
        issued
        under the Company’s ESP Plan. In accordance with the adoption of SFAS No. 123R,
        the Company recorded stock-based compensation expense for the cost of stock
        options and shares issued under the ESP Plan of approximately $87,000 and
        $222,000 for the three months and six months ended June 30, 2006, respectively.
        For the three months and six months ended June 30, 2005, the Company disclosed
        pro forma net income (loss) and net income (loss) per share as if compensation
        cost had been determined consistent with SFAS No. 123R.
 
 With
        the
        adoption of SFAS No. 123R, the Company has recorded an expense for the unvested
        portion of awards granted before the adoption of SFAS No. 123R and for shares
        issued under the ESP Plan during the current year.
  **6**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   
 The
        following table details the effect on net income (loss) and earnings (loss)
        per
        share had stock-based compensation expense been recorded in both the three
        and
        six month periods ended June 30, 2006 and 2005, under SFAS No. 123R. The
        pro
        forma net loss and loss per share for the three months and six months ended
        June
        30, 2006, are the same since stock-based compensation is calculated under
        the
        provisions of SFAS No. 123R.
 
 
 **Three
                  Months ended**
              
              **Six
                  Months ended****June
                  30,**
              
              **June
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****(In
                  thousands, except per share data )**Net
                  income (loss) to commonshareholders:As
                  reported
              
              $
              (7,615
              )
              $
              9,715
              
              $
              (2,888
              )
              $
              4,719Add:
                  Stock-based employee compensation expenseincluded
                  in reported net income(loss)
              
              
              87
              
              
              -
              
              
              222
              
              
              -Deduct:
                  Stock-based employee compensationdetermined
                  under fair value based method for all awards
              
              
              (87
              )
              
              (287
              )
              
              (222
              )
              
              (432
              )Pro
                  forma
              
              $
              (7,615
              )
              $
              9,428
              
              $
              (2,888
              )
              $
              4,287Net
                  income (loss) per commonshare:As
                  reported - Basic
              
              $
              (0.42
              )
              $
              0.89
              
              $
              (0.17
              )
              $
              0.43Pro
                  forma - Basic
              
              $
              (0.42
              )
              $
              0.86
              
              $
              (0.17
              )
              $
              0.39As
                  reported - Diluted
              
              $
              (0.42
              )
              $
              0.52
              
              $
              (0.17
              )
              $
              0.31Pro
                  forma - Diluted
              
              $
              (0.42
              )
              $
              0.50
              
              $
              (0.17
              )
              $
              0.29
 
 
 In
        the
        first two quarters of 2006, the adoption of SFAS No. 123R caused net loss
        to
        increase by $222,000 and basic and diluted loss per share to each decrease
        by
        $.01 per share.
 
 SFAS
        No.
        123R requires that stock-based compensation be recognized over the period
        from
        the date of grant to the date when the award is no longer contingent on the
        employee providing additional services (the “vesting period”). The Company’s
        stock incentive plan and the non-employee directors’ incentive plan provide that
        awards generally vest over a one to three year period. Any unexercised options
        expire after ten years. The fair value of each grant is estimated as a single
        award and amortized into compensation expense over its vesting period. During
        the second quarter of 2006, the Company granted options to purchase 45,000
        shares of common stock from the director plan.
 
 
 [The
        rest
        of this page is intentionally left blank]
  **7**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   
 The
        following table summarizes the Company’s stock option activity for the first two
        quarters ended June 30, 2006:
 
 
 **2006****Shares**
              
              **Weighted-Average
                  Exercise Price**
              
              **Aggregate
                  Intrinsic Value ($000)**Outstanding
                  at beginning of year
              
              
              1,349,381
              
              $
              3.81Granted
              
              
              45,000
              
              $
              21.00Exercised
              
              
              (185,523
              )
              $
              3.26Canceled
              
              
              (667
              )
              $
              3.95Outstanding
                  at June 30, 2006
              
              
              1,208,191
              
              $
              4.53
              
              $
              17,175Options
                  exercisable at June 30, 2006
              
              
              1,163,191
              
              $
              3.90
              
              $
              17,276Weighted-average
                  fair value of options granted in 2006
              
              
              -
              
              $
              11.67
 
 
 The
        weighted average remaining contractual life was 6.3 years at June 30, 2006,
        for
        stock options outstanding and exercisable. The total intrinsic value for
        stock
        options outstanding and exercisable was $17.3 million and $14.9 million at
        June
        30, 2006 and 2005, respectively. The total intrinsic value for stock options
        exercised was $1.7 million and $388,000 for the first two quarters of 2006
        and
        2005, respectively. As of June 30, 2006, there was $526,000 of total
        unrecognized compensation expense related to unvested share-based compensation
        arrangements granted under the Plan. That expense is expected to be recognized
        over a weighted average period of one year.
 
 The
        amount of cash received from the exercise of stock options was $605,000 and
        $175,000 in the first two quarters of 2006 and 2005, respectively.
 
 The
        Company estimates the fair value of its options using the Black-Scholes option
        value model, which is one of several methods that can be used to estimate
        option
        values. The Black-Scholes option valuation model was developed for use in
        estimating the fair value of traded options that have no vesting restrictions
        and are fully transferable. Option valuation models require the input of
        various
        assumptions, including the expected stock price volatility, risk-free interest
        rate, dividend yield, and forfeiture rate. The fair value of the stock options
        granted was estimated using a risk free rate that is the five year U.S. Treasury
        yield in effect at the time of grant. The expected life of the stock options
        granted (five years) was estimated using the historical exercise behavior
        of
        option holders. Expected volatility was based on historical volatility for
        a
        period equal to the stock option’s expected life, ending on the date of grant.
        Under SFAS 123R, forfeitures are estimated at the time of valuation and reduce
        expense ratably over the vesting period. The forfeiture rate, which was
        estimated at 10 percent of the shares awarded, is adjusted periodically based
        on
        the extent to which actual forfeitures differ, or are expected to differ,
        from
        the previous estimate. The Company's options have characteristics significantly
        different from those of traded options and changes in the various input
        assumptions can materially affect the fair value estimates. The fair value
        of
        options granted in the three months and six months ended June 30, 2006 and
        2005,
        were estimated at the date of grant using the following weighted average
        assumptions:
  **8**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   
 **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Expected
                  life from grant date (in years)
              
              
              5
              
              
              4
              
              
              5
              
              
              4Weighted
                  average risk-free interest rate
              
              
              5.03
              %
              
              3.79
              %
              
              5.03
              %
              
              3.79
              %Weighted
                  average volatility
              
              
              59.40
              %
              
              70.19
              %
              
              59.40
              %
              
              70.19
              %Dividend
                  yield
              
              
              -
              
              
              -
              
              
              -
              
              
              -Weighted
                  average fair value (per share)
              
              $
              11.67
              
              $
              7.37
              
              $
              11.67
              
              $
              7.37
 
 
 On
        June
        14, 2006, at the annual shareholders’ meeting, the 2006 Equity Incentive Plan
        was approved. The 2006 Plan authorizes the issuance of up to 1,000,000 share
        of
        common stock for employees, non-employee directors, consultants, advisors
        and
        independent contractors. The plan allows for the granting of various types
        of
        awards, one of which is stock options that generally vest over a three year
        period. Any unexercised options expire after ten years. No options or awards
        have been granted under the 2006 Equity Incentive Plan.  The
        Company has 169,000 shares of common stock authorized under the Amended and
        Restated Option Plan for Non Employee Directors that were available for issuance
        as of June 30, 2006.
 
 The
        Company offers eligible employees the option to purchase common stock of
        the
        Company under the ESP Plan at a 15% discount from the lower of the market
        price
        on the first trading date at the beginning of the current calendar quarter,
        or
        the last trading date of the current quarter. The Company issued 5,882 and
        10,811 shares of Common Stock during the three and six months ended June
        30,
        2006, under the Employee
        Stock Purchase Plan ,
        respectively. The purchase price of the shares was $18.36 and $15.94 for
        the
        first and second quarter of 2006, respectively, which equals 85% of the market
        price on the last trading day of each quarter.
 
 The
        following table shows the assumptions used in calculating the compensation
        expense for the Employee Stock Purchase Plan shares issued during the quarter:
 
 
 **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Expected
                  life from grant date (in months)
              
              
              3
              
              
              3
              
              
              3
              
              
              3Weighted
                  average risk-free interest rate
              
              
              4.50
              %
              
              3.08
              %
              
              3.91%
                  - 4.50
              %
              
              2.73%
                  - 3.08
              %Weighted
                  average volatility
              
              
              16.50
              %
              
              19.20
              %
              
              13.5%
                  - 16.50
              %
              
              19.20
              %
 
 **Emeritrust
        Transactions**
 
 *Emeritrust Managed
        Communities* .
        For the
        six months ended June 30, 2006, the Company managed five communities, which
        are
        owned by Mr. Baty, for a management fee equal to 5% of gross revenues. The
        agreement expired on June 30, 2006 but has been extended for one
        year. One of
        these communities was sold to an independent third party effective January
        1,
        2006, which the Company continued to manage until the new operator received
        licensure on March 20, 2006. Emeritus received management fees of approximately
        $116,000 and $129,000 for the three months ended June 30, 2006 and 2005,
        respectively, and approximately $229,000 and $256,000 for the six months
        ended
        June 30, 2006 and 2005, respectively.
  *Emeritrust
        Lease.*In September 2004, the Company completed the lease of 18 communities
        in the first phase of a transaction to lease up to 20 assisted living
        communities in 12 states, with 1,824 units. These communities, which were
        owned
        by entities in which Mr. Baty had financial interests, were acquired by an
  **9**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   independent
          REIT and were leased to the Company. One additional community was leased
          on
          March 31,
 
 The
        initial cash lease payment for these two communities is approximately $2.5
        million per year based on 8.6% of the REIT’s investment basis of $29.0 million,
        with annual 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 two communities are covered by separate leases
        that
        include a 15-year original term, with one 15-year renewal option, triple-net
        provisions, and certain financial and other covenants. The Company has the
        right
        of first refusal to purchase the entire 20-community portfolio and Mr. Baty
        is
        personally guaranteeing the Company’s obligations under the leases. Mr. Baty
        receives, based on a prescribed formula, 50% of the positive cash flow of
        the 20
        communities and is responsible for 50% of any negative cash flow, as defined
        in
        the cash flow sharing agreement. Under this arrangement, Mr. Baty paid the
        Company $89,000 and $258,000 for the three and six months ended June 30,
        2006,
        respectively, and the Company paid Mr. Baty $191,000 and $435,000 for the
        three
        and six months ended June 30, 2005, respectively.
 
 *Other
        Emeritrust Transaction.* As part
        of an Emeritrust transaction in September 2003, the Company issued seven-year
        warrants to purchase 500,000 shares of its common stock at an exercise price
        of
        $7.60 per share to the original investors of some of the Emeritrust communities.
        Warrants representing 400,000 shares were exercised on February 3, 2006,
        and the
        Company received proceeds of approximately $3.0 million. On March 8, 2006,
        the Company issued 69,169 shares of common stock pursuant to the exercise
        of
        warrants to purchase the remaining 100,000 shares. The warrants representing
        the
        100,000 shares were exercised pursuant to a "net exercise" provision in which
        30,831 shares subject to the warrants were used to pay the exercise price
        of
        $760,000. The shares used to pay the exercise price were valued at $24.65
        per
        share based on current market prices, as determined under the terms of the
        warrant agreement.
 
 **Debt
        Restructuring**
 
 In
        March
        2005, the Company completed a debt restructuring transaction that reduced
        the
        effective interest rate by approximately 2.75% on $21.4 million of debt and
        extended the maturity to March 2008.
 
 Borrowings
        in 2003 had resulted in a $25.8 million leasehold mortgage loan, covering
        32
        communities maturing on June 30, 2007, bearing interest at an initial rate
        of
        12.13% per annum, with periodic increases up to 13%, and requiring monthly
        payments of interest the first year and monthly payments of principal and
        interest, based on a 10-year amortization, thereafter. The Company elected
        to
        make a principal reduction of $6.0 million in August 2004. On March 2,
        2005, when the principal balance was $19.5 million, the loan was sold to
        Healthcare Realty Trust, Incorporated ("HRT") and modified. The loan, as
        modified, provides for monthly interest-only payments at 10% per annum and
        matures March 3, 2008 (the “HRT Loan”). The HRT Loan may not be prepaid
        without the lender's consent. The HRT Loan balance was increased to
        $21.4 million to repay other higher interest borrowings and cover the costs
        of the financing.
 
 **Alterra
        Transactions**
 
 In
        October 2003, the Company acquired an interest in an LLC that acquired Alterra
        for $7.7 million cash. The members of the LLC consisted of an affiliate of
        Fortress, NW, and the Company, with original ownership interests of 50%,
        25%,
        and 25%, respectively. In June 2005, Fortress purchased 50% of the interest
        of
        both NW and Emeritus for $50 million in cash, $25 million each to NW and
        Emeritus. The Company recorded a gain of $21.3 million in the condensed
        consolidated statement of operations for the second quarter ended June 30,
        2005,
        as a result of this transaction. In November 2005, the Company sold its
        remaining interest in Alterra through the public offering of Brookdale Senior
        Living, Inc. (“Brookdale”). The Company has no further ownership interest in
        Brookdale or any of its subsidiaries.
  **10**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   
 **CPM/JEA
        Transactions**
 
 On
        March
        1, 2005, the Company entered into leases with a REIT covering the final two
        communities of the CPM/JEA lease transactions for which the first stage was
        completed in April 2004. One community had previously been managed by the
        Company. The leases expire March 31, 2019, with three 5-year renewal options.
        The initial year lease rate is 9% of the REIT’s investment of approximately
        $14.3 million, which results in initial annual rent of approximately $1.3
        million, with fixed inflators of the lesser of four times the change in the
        consumer price index or 3%. These leases are accounted for as capital leases,
        which resulted in additions to property and equipment and capital lease and
        financing obligations totaling approximately $14.6 million.
 
 **Arkansas
        Acquisition**
 
 On
        December 1, 2005, the Company acquired three communities located in Arkansas,
        with a capacity of 253 units, for approximately $17.8 million. The Company
        financed $15.9 million of the purchase price through mortgage financing with
        GE
        Capital. The debt matures in December 2012, bears interest at 6.95% per annum,
        and has monthly payments based on a 25-year amortization. No prepayment of
        the
        loan is allowed. This loan agreement was modified in June 2006, to
        cross-collateralize this loan with the GE Capital loan as discussed under
        the
        Arbor Place Acquisition caption below.
 
 **Arbor
        Place Acquisition**
 
 Emeritus
        has entered into a series of agreements to purchase a 100-unit assisted living
        community in Everett, Washington, for approximately $11.0 million effective
        July
        2006, from an entity in which Mr. Baty has a 50% financial interest and which
        the Company currently manages. The Company will finance $8.0 million of the
        purchase price with GE Capital. The loan agreement closed in June 2006, and
        is
        reflected in the condensed consolidated balance sheet as of June 30, 2006.
        The
        loan proceeds and $3.0 million in Emeritus funding are held by the escrow
        agent
        at June 30, 2006, pending closing of the transaction in July 2006. The debt
        matures in June 2013, bears interest at 7.229% per annum, and has monthly
        payments based on a 25-year amortization. No prepayment of the loan is allowed.
        The loan is cross-collateralized with the GE Capital loan discussed under
        the
        Arkansas Acquisition caption above.
 
 **Sale
        of Communities**
 
 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 the first quarter of 2005. The Company recorded a gain of $1.3
        million related to this sale in discontinued operations in its condensed
        consolidated statements of operations for the six months ended June 30, 2005.
        In
        December 2005, the Company sold a community in Las Vegas, Nevada, and
        reclassified prior period operating results to discontinued operations in
        the
        condensed consolidated statements of operations. The Company recorded an
        impairment loss of approximately $4.0 million related to the Las Vegas community
        in the second quarter of 2005, which is reflected in discontinued operations
        for
        the three and six months ended June 30, 2005.
 
 **Series
        B Stock**
 
 On
        June 30, 2005, the Company entered into an agreement with Saratoga that
        provided for the conversion of the Series B Stock held by Saratoga upon the
        payment by the Company of accrued and unpaid cash dividends on the Series B
        Stock, in the amount of $10.8 million. The Company borrowed $10.8 million
        from a REIT at 10% per annum for a term of three years in order to pay the
        accumulated cash dividends of the Series B Stock. Upon the payment of the
        dividends on June 30, 2005, Saratoga converted all of the outstanding
        Series B Stock into 5,365,746 shares of common stock. Preferred stock
        dividends of $957,000 were recorded
  **11**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   for
        the
        three months ended March 31, 2005, consisting of cash dividends of $591,000
        and
        in-kind dividends of $366,000. For accounting purposes, the Company had accrued
        a liability of $11.1 million, which included approximately $358,000 that
        represented a straight-line dividend accrual that was reversed upon closing
        of
        this stock transaction. As part of the agreement, no dividends were required
        to
        be paid for the second quarter of 2005. Thus, the preferred dividends for
        the
        six months ended June 30, 2005, amounted to $599,000.
 
 The
        Series B Stock owned by Saratoga consisted of 36,970 shares with a stated
        value of $1,000 per share, of which 30,000 shares were issued in December
        1999
        for a price of $30.0 million and 6,970 shares were issued as dividends of
        additional Series B Stock since December 1999. Additionally, the Company
        issued
        to Saratoga seven-year warrants to purchase 1,000,000 shares of common stock
        at
        an exercise price of $4.30 per share on August 31, 2000, which was subsequently
        adjusted to $4.20 due to dilutive stock option transactions. On
        March 6, 2006, the Company issued 829,597 shares of common stock pursuant
        to the exercise of the warrants. The shares were purchased by the holders
        of the
        warrants pursuant to a "net exercise" provision of the warrants in which
        170,403
        shares subject to the warrants were used to pay the exercise price of
        $4.2 million. The shares used to pay the exercise price were valued at
        $24.65 per share based on current market prices, as determined under the
        terms
        of the warrants.
 
 **Convertible
        Debentures**
 
 In
        November 2005, the Company completed an offer to exchange its outstanding
        6.25%
        Convertible Subordinated Debentures due 2006 for new 6.25% Convertible
        Subordinated Debentures due 2008. Of the $32.0 million principal amount of
        outstanding debentures, $26.6 million were exchanged in the exchange offer.
        The
        remaining $5.4 million principal amount of outstanding debentures continued
        outstanding and was paid at maturity on January 3, 2006. The terms of the
        existing debentures and the new debentures are substantially the same, except
        that the maturity of the new debentures is July 1, 2008, instead of
        January 1, 2006, and the new debentures cannot be redeemed at the Company’s
        election. Interest on the new debentures is payable semiannually on January
        1
        and July 1 of each year. The new debentures are unsecured and subordinated
        to
        all other indebtedness of the Company. In February 2006, $50,000 of face
        value
        of the new debentures was converted into 2,272 shares of common stock. The
        new
        debentures are convertible into common stock at the rate of $22 per share,
        which
        equates to 1,207,955 shares of common stock.
 
 Of
        the
        remaining $26.6 million of debentures outstanding, $20.8 million are owned
        by
        directors and officers or their affiliates. Saratoga Partners, two of whose
        representatives are directors, own $5.0 million of the debentures. Affiliates
        of
        Daniel R. Baty, the Company’s chief executive officer and a director, and
        Stanley L. Baty, a director, own $15.8 million of the debentures.
 
 **Income
        (Loss) Per Share**
 
 The
        capital structure of Emeritus includes convertible debentures and stock options
        and until June 30, 2005, included redeemable convertible preferred stock.
        In
        addition, the capital structure included common stock warrants in periods
        prior
        to the current quarter, which were exercised in February and March 2006.
        Basic
        net income (loss) per share is computed based on the weighted average shares
        outstanding and excludes any potential dilution. Diluted net income (loss)
        per
        share is computed based on the weighted average number of shares outstanding
        plus dilutive potential common shares. Options and warrants are included
        under
        the “treasury stock method” to the extent they are dilutive. Certain shares
        issuable upon the exercise of stock options and warrants and conversion of
        convertible debentures and preferred stock have been excluded from the
        computation because the effect of their inclusion would be
        anti-dilutive.
  **12**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   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,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Convertible
                  Debentures(1)
              
              
              1,208
              
              
              -
              
              
              1,208
              
              
              1,455Options
              
              
              1,208
              
              
              55
              
              
              1,208
              
              
              55Warrants
                  - Senior Housing Partners I, L.P.(2)
              
              
              -
              
              
              -
              
              
              -
              
              
              -Warrants
                  - Saratoga Partners(3)
              
              
              -
              
              
              -
              
              
              -
              
              
              -Series
                  B Preferred(4)
              
              
              -
              
              
              -
              
              
              -
              
              
              -2,416
              
              
              55
              
              
              2,416
              
              
              1,510(1)Approximately
                  $5.4 million principal amount paid at maturity on January 3, 2006.(2)Exercised
                  in February and March 2006.(3)Exercised
                  in March 2006.(4)Converted
                  to common stock in June 2005.
 
 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 data):
  **Three
                  Months ended**
              
              **Six
                  Months ended****June
                  30,**
              
              **June
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Basic:Numerator
                  for basic net income (loss) per share:Net
                  income (loss) to common shareholders
              
              $
              (7,615
              )
              $
              9,715
              
              $
              (2,888
              )
              $
              4,719Denominator
                  for basic net income (loss) per share:Weighted
                  average number of common shares outstanding
              
              
              17,927
              
              
              10,918
              
              
              17,481
              
              
              10,870Basic
                  net income (loss) per share
              
              $
              (0.42
              )
              $
              0.89
              
              $
              (0.17
              )
              $
              0.43Diluted:Numerator
                  for diluted net income (loss) per share:Net
                  income (loss) to common shareholders
              
              $
              (7,615
              )
              $
              9,715
              
              $
              (2,888
              )
              $
              4,719Assumed
                  conversion of convertible debentures
              
              
              -
              
              
              500
              
              
              -
              
              
              -Assumed
                  conversion of Series B Preferred
              
              
              -
              
              
              -
              
              
              -
              
              
              957$
              (7,615
              )
              $
              10,215
              
              $
              (2,888
              )
              $
              5,676Denominator
                  for diluted net income (loss) per share:Weighted
                  average number of common shares outstanding
              
              
              17,927
              
              
              10,918
              
              
              17,481
              
              
              10,870Assumed
                  exercise of options and warrants
              
              
              -
              
              
              2,037
              
              
              -
              
              
              2,053Assumed
                  conversion of convertible debentures
              
              
              -
              
              
              1,455
              
              
              -
              
              
              -Assumed
                  conversion of Series B Preferred
              
              
              -
              
              
              5,366
              
              
              -
              
              
              5,36617,927
              
              
              19,776
              
              
              17,481
              
              
              18,289Diluted
                  net income (loss) per share
              
              $
              (0.42
              )
              $
              0.52
              
              $
              (0.17
              )
              $
              0.31
  **13**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents  
 **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, 2006 and 2005.
  **Liquidity** ****
 
 As
        of
        June 30, 2006, the Company has a working capital deficit of $28.5 million.
        The
        Company is able to operate in the position of a working capital deficit because
        revenues are collected more quickly, often in advance, than obligations are
        required to be paid. This can result in a low level of current assets to
        the
        extent cash has been deployed in business development opportunities or to
        pay
        down long-term liabilities. Along those lines, the working capital deficit
        includes $16.8 million of deferred revenue and unearned rental income and
        the
        level of current liabilities is not expected to change year to year in such
        a
        way as to require the use of significant cash, except for debt maturities
        of
        $81.2 million due in 2008.
 
 The
        Company has incurred significant losses since its inception and has an
        accumulated deficit of $195.3 million as of June 30, 2006. The Company believes
        these losses have resulted from its early emphasis on expansion, financing
        costs
        arising from multiple financing and refinancing transactions related to this
        expansion, occupancy rates remaining lower for longer periods than anticipated,
        and depreciation expense, a non-cash charge, primarily from multiple capital
        and
        financing leases.
 
 Cash
        used
        in operating activities was $4.0 million for the six months ended June 30,
        2006.
        The primary components of cash used in operating activities for this period
        was
        a net change in operating assets and liabilities of $25.6 million, amortization
        of deferred gain of $1.1 million, and $2.9 million of net loss from operations,
        partially offset by $24.4 million of depreciation and amortization. The $25.6
        million use of cash related to operating assets and liabilities is primarily
        comprised of the following:
 
 
 **Significant
                  components of changes in operating assets and
                  liabilities:****Six
                  Months Ended June 30,****2006**
              
              **2005**Reduction
                  of Texas settlement liability accruals, including interest
              
              $
              (12,973
              )
              $
              -Payment
                  of Texas Settlement
              
              
              (5,600
              )
              
              -Federal
                  tax deposits, principally related to the Alterra transaction
                  gain
              
              
              (4,200
              )
              
              -Payment
                  of semi-annual debenture interest
              
              
              (1,000
              )
              
              (1,000
              )Initial
                  payment of annual insurance premiums
              
              
              (6,785
              )
              
              (5,371
              )Tax
                  benefit of stock compensation
              
              
              (1,074
              )
              
              -Texas
                  Medicaid accrual
              
              
              500
              
              
              -All
                  other activity, net
              
              
              5,548
              
              
              5,631Net
                  change in operating assets and liabilities
              
              $
              (25,584
              )
              $
              (740
              )
 
 The
        Texas
        settlement impact of $18.6 million and the federal tax deposits of $4.2 million
        related to the Alterra transaction gain, partially offset by the Texas Medicaid
        accrual of $500,000, a total of $22.3 million, are non-recurring items. The
        insurance payment difference between years is due to a change in payment
        arrangements and the variance will even out over the course of the
        year.
 
 While
        the
        revenue per unit exceeded our Company’s targeted growth from the comparable
        period in the prior year, the weighted average occupancy rate decreased by
        0.5
        percentage points to 84.2% for the first two quarters of 2006 from 84.7%
        for the
        first two quarters of 2005. The Company is responding to this occupancy decline
        through increased marketing initiatives, programs that address resident mix
        and
        a focus on
  **14**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents  property
        improvements and other community level enhancements to attract additional
        long-term residents. The Company’s occupancy rate has reflected an increased
        trend from 84.2% on December 31, 2005 to 85.9% on June 30, 2006, the last
        day of
        each fiscal quarter. Management believes that these initiatives will continue
        to
        have a positive impact on operating performance over time.
 
 In
        February 2005, a San Antonio, Texas, jury found one of the Company’s assisted
        living communities negligent in the care of a resident. The jury awarded
        a
        verdict against the Company in the amount of $1.5 million in compensatory
        damages and $18.0 million in punitive damages. The Company appealed the verdict
        and posted a deposit of $1.7 million in order to stay the proceedings. In
        March
        2006, the Company settled the case for $5.6 million and the deposit was
        refunded, with interest, in April 2006. In the fourth quarter of 2004, the
        Company recorded an additional liability accrual of $18.7 million and
        accrued $766,000 of interest on the judgment in 2005. In the first two quarters
        of 2006, the Company reduced the accrued interest by $766,000 and the liability
        accrual recorded in 2004 by $12.2 million.
 In
          March
          2006, the Company received a request for documents from the Office of the
          Attorney General of Texas, in connection with its inquiry into compliance
          with certain Medicaid regulations at six of the Company’s communities in Texas
          that participate in the Community Based Alternative program of the Texas
          Department of Aging and Disability.  Participation in the program requires
          eligible rooms to have an area equipped with a sink, refrigerator, cooking
          appliance, adequate space for food preparation, and storage space for utensils
          and supplies.  An audit by the department revealed that some of
          the rooms used for residents in the program did not have some or all of
          those items.  The Company addressed the State's concerns raised in the
          audits and all rooms were equipped with the above regulatory requirements
          as of April 10, 2006, at a cost of approximately $618,000.
  The
          Company began settlement discussions with the attorney general's
          office in late May 2006 to resolve the matter.  Initially,
          the attorney general’s office sought $6.6 million, which equates to
          three times the total amount of all payments made to the Company by the
          State of
          Texas since the inception of its Medicaid contract, plus interest and attorney
          fees.  The Company responded in July 2006, advising the attorney general’s
          office that all the services for which Medicaid could, and did, lawfully
          pay
          were provided to the program residents despite the absence of some of
          the kitchen items.  Accordingly, recovery of the total of all payments to
          the Company was unjustified.  The letter advised the attorney general's
          office that the absence of the required items during the period of
          non-compliance was valued at $176,000.  In August 2006, the Company offered
          to settle the matter for $500,000. The discussions are continuing.
  While
          the
          Company believes it has incurred a liability in this matter, the range
          of
          possible outcomes is wide and the ultimate resolution is not readily
          determinable.  Accordingly, the Company has recorded a liability in the
          amount of $500,000 as of June 30, 2006, as its best estimate of the ultimate
          outcome.  The Company will assess its liability as discussions continue and
          will make adjustments, if any, to its recorded liability as more information
          becomes available to it.
 At
        the
        beginning of 2005, the Company had outstanding $32.0 million principal amount
        of
        6.25% convertible subordinated debentures that matured January 1, 2006. Of
        the
        full principal amount, $5.4 million was paid at maturity in January 2006.
        Pursuant to an exchange offer completed by the Company in November 2005,
        the
        remaining $26.6 million principal amount of debentures were replaced with
        new
        6.25% convertible subordinated debentures that are due July 1, 2008. Of the
        $26.6 million, $20.8 million is owned by directors and officers or their
        affiliates.
 
 The
        cash
        flows from operating activities have not always been sufficient to pay all
        of
        the Company’s long-term obligations and the Company has been dependent upon
        third party financing or disposition of assets to fund operations. The Company
        cannot guarantee that, if necessary in the future, such transactions will
        be
        available timely or at all, or on terms attractive to the Company.
 
 **15**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 Table of Contents   The
          Company refinanced substantially all of its debt obligations, extending
          the
          maturities of such financings to dates beyond July 2007, at which time
          the
          Company will need to refinance or otherwise repay the obligations. Many
          of the
          Company's debt instruments and leases contain "cross-default" provisions
          pursuant to which a default under one obligation can cause a default under
          one
          or more other obligations to the same lender or lessor. Such cross-default
          provisions affect the majority of the Company’s properties. Accordingly, any
          event of default could cause a material adverse effect on the Company's
          financial condition if such debt or leases are cross-defaulted. At June
          30,
          2006, the Company was in violation of one or more covenants in certain
          of the
          leases and mortgages, but obtained waivers from the owners that expire
          on July
          1, 2007.
 
 Management
          believes that the Company will be able to generate positive operating cash
          flows
          or will have adequate cash for all necessary investing and financing activities
          including required debt service and capital expenditures for at least the
          next
          twelve months.
 **Discontinued
        Operations**
 
 In
        August
        2004, the Company sold a facility in Scottsdale, Arizona to an unrelated
        third
        party. In September 2004, the Company committed to sell a community in Issaquah,
        Washington. The community was sold on November 1, 2004, but was not recognized
        as a sale until the first quarter of 2005 due to continuing involvement in
        the
        community through that period. In December 2005, the Company sold a community
        in
        Las Vegas, Nevada. All of these transactions qualify for discontinued operations
        treatment under SFAS No. 144 and the results of discontinued operations for
        both
        current and prior periods is reported as a separate line item in the condensed
        consolidated statements of operations.
 
 The
        following table shows the revenues and net income for the discontinued
        operations (in thousands):
 
 
 **Three
                  Months ended**
              
              **Six
                  Months ended****June
                  30,**
              
              **June
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****Total
                  revenue:**Issaquah
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -Scottsdale
              
              
              -
              
              
              -
              
              
              -
              
              
              -Las
                  Vegas
              
              
              -
              
              
              362
              
              
              -
              
              
              704Total
              
              $
              -
              
              $
              362
              
              $
              -
              
              $
              704**Net
                  income (loss):**Issaquah
              
              $
              1
              
              $
              (1
              )
              $
              1
              
              $
              1,319Scottsdale
              
              
              (19
              )
              
              3
              
              
              (19
              )
              
              3Las
                  Vegas
              
              
              (16
              )
              
              (4,113
              )
              
              (26
              )
              
              (4,242
              )Total
              
              $
              (34
              )
              $
              (4,111
              )
              $
              (44
              )
              $
              (2,920
              )
 
 
 [The
        rest
        of this page is intentionally left blank]
 
 
 
  **16**
 **EMERITUS
              CORPORATION**
 **NOTES
              TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 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.
            "JEA"
                refers to JEA Senior Living, a non-affiliate. 9.
            "Saratoga"
                refers to a group of related companies, namely: Saratoga Partners
                IV, LP;
                Saratoga Management Company LLC, as Agent; and Saratoga Coinvestment
                IV,
                LLC. 10.
            "Series
                B Stock" refers to Series B Convertible Preferred
                Stock. 11.
            “Emeritrust”
                refers to two groups of communities (totaling 46 communities) that
                were
                managed by us starting in 1998. These communities were owned by two
                different investor groups in each of which Mr. Baty held a non-controlling
                interest. The composition of the groups has changed over time and
                most of
                the communities are now leased by us. Further details are available
                in our
                Forms 10-K for years prior to 2006. 
 **Overview**
 
 Emeritus
        is a Washington corporation organized by Mr. Baty and two other founders
        in
        1993. In November 1995, we completed our initial public offering.
 
 From
        1995
        through 1998, we expanded rapidly through acquisition and internal development
        and by December 31, 1999, operated 129 assisted living communities with
        11,726 units. We believe, however, that during this expansion, the assisted
        living industry became overbuilt in certain regions, creating an environment
        characterized by slower than planned occupancy and rate growth. As a result
        of
        these difficult operating circumstances, we deliberately slowed down our
        growth
        rate. In 1999, we began an increasing focus, first, on raising our occupancy
        and
        later, on operating efficiencies and cost controls as well as implementing
        a
        systematic rate enhancement program.
 
 We
        believe that the health of the assisted living industry is currently improving
        and that opportunities are developing to improve occupancy and to increase
        rates. The assisted living industry is experiencing increased regulation
        (varying by state), increased insurance costs, and limited availability of
        capital for smaller local and regional operators. In this type of environment,
        we believe that we will continue to witness consolidation of smaller local
        and
        regional operators into the larger national operators. Because of these
        circumstances, we have been able to complete several acquisitions or leases
        in
        the last two years. In addition, our size and ability to respond to negative
        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. From the end of 2000 to the end of 2005, the communities
        we managed decreased from 69 to 14 and the owned and leased communities
        increased from 61 to 170, reflecting our increasing confidence in the assisted
        living industry, stabilization of managed properties, and the availability
        of
        capital. By the end of the second quarter of 2006,
  **17**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  managed
        communities had decreased to 12 and owned and leased communities remained
        at
        170. We will continue to review acquisition or lease opportunities.
 
 The
        following table sets forth a summary of our property interests:
 
 **As
                    of June 30,**
                
                **As
                    of December 31,**
                
                **As
                    of June 30,****2006**
                
                **2005**
                
                **2005****Buildings**
                
                **Units**
                
                **Buildings**
                
                **Units**
                
                **Buildings**
                
                **Units**Owned
                    (1)
                9
                
                707
                
                9
                
                707
                
                6
                
                454Leased
                    (2 )
                161
                
                12,821
                
                161
                
                12,805
                
                161
                
                12,820Consolidated
                    Portfolio
                170
                
                13,528
                
                170
                
                13,512
                
                167
                
                13,274Managed/Admin
                    Services (3)
                11
                
                1,235
                
                13
                
                1,443
                
                14
                
                1,467Joint
                    Venture/Partnership
                1
                
                140
                
                1
                
                140
                
                1
                
                140Operated
                    Portfolio
                182
                
                14,903
                
                184
                
                15,095
                
                182
                
                14,881Percentage
                    increase (decrease) (4)
                (1.1%)
                
                (1.3%)
                
                1.7%
                
                1.6%
                
                0.6%
                
                0.2%
  (1)
        Owned
        communities increased in December 2005 due to the acquisition of three
        communities in Arkansas.
 (2)
        Of
        the leased communities at June 30, 2006, 77 are accounted for as operating
        leases, in which the assets and liabilities of the communities are not included
        in our condensed consolidated balance sheet and 70 are accounted for as capital
        leases, in which a long-term asset and corresponding liability is established
        on
        our balance sheet. The remaining 14 leased communities are reflected in our
        condensed consolidated financial statements as owned communities because
        of
        accounting requirements related to sale-leaseback accounting, notwithstanding
        the legal sale of the communities and their subsequent leasing by us.
 (3)
        We
        discontinued management of one facility in July 2005, one in January 2006,
        one
        in March 2006, and another in April 2006. We began managing another facility
        in
        January 2006.
 (4)  The
        percentage increase indicates the change from the prior year, or, in the
        case of
        June 30, 2006 and 2005, 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 for the same period. In evaluating the
        occupancy component, we generally rely on an average occupancy rate, computed
        by
        dividing the average units occupied during a particular period by the average
        number of units available during the period. We evaluate these and other
        operating components for our consolidated portfolio, which includes the
        communities we own and lease, and our operating portfolio, which also includes
        the communities we manage.
 
 In
        our
        consolidated portfolio, our average monthly revenue per unit for the six
        months
        ended June 30, 2006, increased to $3,065 from $2,915 for the same period
        in
        2005. This change represents an increase of $150 or 5.1%. For the second
        quarter
        of 2006, our average monthly revenue per unit was $3,083 as compared to $3,046
        for the first quarter of 2006. This change represents an increase of $37
        or
        1.2%. 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.
  **18**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  
 In
        our
        consolidated portfolio, our average occupancy rate decreased to 84.2% for
        the
        six months ended June 30, 2006, from 84.7% for the six months ended June
        30,
        2005. For the second quarter of 2006, our average occupancy rate increased
        to
        84.6% as compared to 83.9% for the first quarter of 2006. We believe the
        decline
        in occupancy over 2005 was largely related to the detailed review of all
        aspects
        of our operations in response to the Texas verdict that was announced early
        in
        2005. The review resulted in more conservative admission and discharge policies
        to insure our services were more than adequate to care for the residents
        in our
        communities. We also believe this occupancy decline has bottomed out as
        evidenced by an increase in our occupancy from 84.2% on December 31, 2005,
        to
        85.9% on June 30, 2006, the last day of each fiscal quarter. We continue
        to
        evaluate the factors of rate and occupancy to find the optimum
        balance.
 
 We
        have
        incurred operating losses since our inception in 1993, and as of June 30,
        2006,
        we had an accumulated deficit of approximately $195.3 million. We believe
        that
        these losses have resulted from our early emphasis on expansion, financing
        costs
        arising from multiple financing and refinancing transactions related to this
        expansion, occupancy rates remaining lower for longer periods than we
        anticipated, and depreciation expense, a non-cash charge, primarily from
        multiple capital and financing leases.
 
 **Significant
        Transactions**
 
 In
        2004
        and continuing in 2005, we substantially increased the number of communities
        we
        lease, reduced the number of communities we manage, and, in connection with
        these changes, increased and restructured portions of our long-term financing
        obligations. The transactions associated with these developments are summarized
        below.
 
 *Emeritrust
        Transactions*
 
 *Emeritrust Managed
        Communities* .
        For the
        year ended December 31, 2005, we managed five communities, which are owned
        by
        Mr. Baty, for a management fee equal to 5% of gross revenues. The agreement
        expired on June 30, 2006 but has been extended for one year. One of these
        communities was sold to an independent third party effective January 1, 2006,
        which we continued to manage until the new operator received licensure on
        March
        20, 2006. We received management fees of approximately $116,000 and $129,000
        for
        the three months ended June 30, 2006 and 2005, respectively, and approximately
        $229,000 and $256,000 for the six months ended June 30, 2006 and 2005,
        respectively.
 
 *Emeritrust
        Lease.* As
        further described in the Notes to the Condensed Consolidated Financial
        Statements, in September 2004, we completed the lease of 18 communities in
        the
        first phase of a transaction to lease up to 20 assisted living communities
        in 12
        states, with 1,824 units. These communities, which were owned by entities
        in
        which Mr. Baty had financial interests, were acquired by an independent REIT
        and
        were leased to us. One additional community was leased on March 31, 2005,
        and
        the final community on September 1, 2005. The two additional communities
        are
        reported as operating leases with escalating rent payments, which are accounted
        for on a straight-line basis, resulting in an increase in facility lease
        expense
        of approximately $220,000 and $1.0 million for the three and six months ended
        June 30, 2006, respectively.
 
 Mr.
        Baty
        personally guarantees our obligation under the leases. Mr. Baty receives,
        based
        on a prescribed formula, 50% of the positive cash flow of the 20 communities
        and
        is responsible for 50% of any negative cash flow, as defined in the cash
        flow
        sharing agreement. Under this arrangement, Mr. Baty paid us $89,000 and $258,000
        for the three and six months ended June 30, 2006, respectively, and we paid
        Mr.
        Baty $191,000 and $435,000 for the three and six months ended June 30, 2005,
        respectively.
 
 *Other
        Emeritrust Transaction.* As part
        of an Emeritrust transaction in September 2003, we issued seven-year warrants
        to
        purchase 500,000 shares of our common stock at an exercise price of $7.60
        per
        share to the original investors of some of the Emeritrust communities. Warrants
        representing 400,000 shares were exercised on February 3, 2006, and we received
        proceeds of approximately $3.0 million. On March 8, 2006,
  **19**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  we
        issued
        69,169 shares of common stock pursuant to the exercise of warrants to purchase
        the remaining 100,000 shares. The warrants representing the 100,000 shares
        were
        exercised pursuant to a "net exercise" provision in which 30,831 shares subject
        to the warrants were used to pay the exercise price of $760,000. The shares
        used
        to pay the exercise price were valued at $24.65 per share based on current
        market prices, as determined under the terms of the warrant agreement.
 
 *Debt
        Restructuring*
 
 As
        further described in the Notes to the Condensed Consolidated Financial
        Statements, in March 2005, we completed a debt restructuring transaction
        that
        reduced the effective interest rate by approximately 2.75% on $21.4 million
        of
        debt and extended the maturity to March 2008. The loan, as modified, provides
        for monthly interest-only payments at 10% per annum and matures March 3,
        2008.
 
 *Alterra
        Transactions*
 
 In
        October 2003, we acquired an interest in an LLC that acquired Alterra for
        $7.7
        million cash. The members of the LLC consisted of an affiliate of Fortress,
        NW,
        and us, with original ownership interests of 50%, 25%, and 25%, respectively.
        In
        June 2005, Fortress purchased 50% of the interest of both NW and us for $50
        million in cash, $25 million each to NW and us. We recorded a gain of $21.3
        million in the condensed consolidated statement of operations for the second
        quarter ended June 30, 2005, as a result of this transaction. In November
        2005,
        we sold our remaining interest in Alterra through the public offering of
        Brookdale Senior Living, Inc. (“Brookdale”). We have no further ownership
        interest in Brookdale or any of its subsidiaries.
 
 *CPM/JEA
        Transactions*
 
 As
        further described in the Notes to the Condensed Consolidated Financial
        Statements, on March 1, 2005, we entered into leases with a REIT covering
        the
        final two communities of the CPM/JEA lease transactions for which the first
        stage was completed in April 2004. One community had been previously managed
        by
        us. These leases are accounted for as capital leases, which resulted in
        additions to property and equipment and capital lease and financing obligations
        totaling approximately $14.6 million, and resulting in an increase in interest
        expense of $130,000 and depreciation expense of $182,000 for the six months
        ended June 30, 2006, respectively. The impact from this transaction on the
        three
        months ended June 30, 2006, as compared to the prior year period was not
        significant.
 
 *Arkansas
        Acquisition*
 
 On
        December 1, 2005, we acquired three communities located in Arkansas, with
        a
        capacity of 253 units, for approximately $17.8 million. We financed $15.9
        million of the purchase price through mortgage financing with GE Capital.
        The
        debt matures in December 2012, bears interest at 6.95% per annum, and has
        monthly payments based on a 25-year amortization. No prepayment of the loan
        is
        allowed. This transaction resulted in an increase in interest expense of
        $294,000 and $584,000 and an increase in depreciation expense of $352,000
        and
        $695,000 for the three and six months ended June 30, 2006, respectively.
        This
        loan agreement was modified in June 2006, to cross-collateralize this loan
        with
        the GE Capital loan as discussed under the Arbor Place Acquisition caption
        below.
 
 *Arbor
        Place Acquisition*
 
 We
        have
        entered into a series of agreements to purchase a 100-unit assisted living
        community in Everett, Washington, for approximately $11.0 million effective
        July
        2006, from an entity in which Mr. Baty has a 50% financial interest and which
        we
        currently manage. We financed $8.0 million of the purchase price with GE
        Capital. The loan agreement closed in June 2006, and is reflected in the
        condensed consolidated balance sheet as of June 30, 2006. The loan proceeds
        of
        $8.0 million and $3.0 million of our funds are held by the
  **20**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  escrow
        agent at June 30, 2006, pending closing of the transaction in July 2006.
        The
        debt matures in June 2013, bears interest at 7.229% per annum, and has monthly
        payments based on a 25-year amortization. No prepayment of the loan is allowed.
        The loan is cross-collateralized with the GE Capital loan discussed under
        the
        Arkansas Acquisition caption above.
 
 *Sale
        of Communities* **
 
 As
        further described in the Notes to the Condensed Consolidated Financial
        Statements, we recorded a gain of $1.3 million in January 2005 related to
        the
        sale of a community located in Issaquah, Washington, which is included in
        discontinued operations in our condensed consolidated statements of operations
        for the six months ended June 30, 2005. In December 2005, we sold a community
        in
        Las Vegas, Nevada and recorded a loss of approximately $4.0 million related
        to
        this community in the second quarter of 2005, which is reflected in discontinued
        operations for the three and six months ended June 30, 2005.
 
 *Series
        B Stock*
 
 On
        June 30, 2005, we entered into an agreement with Saratoga that provided for
        the conversion of the Series B Stock held by Saratoga upon the payment of
        all accrued and unpaid cash dividends in the amount of $10.8 million. We
        borrowed $10.8 million from a REIT at 10% per annum for a term of three years
        in
        order to pay the accumulated cash dividends of the Series B Stock, resulting
        in
        an increase in interest expense of approximately $270,000 and $536,000 for
        the
        three and six months ended June 30, 2006, respectively. Upon the payment
        of the
        dividends on June 30, 2005, Saratoga converted all of the outstanding
        Series B Stock into 5,365,746 shares of common stock. Preferred stock
        dividends of $957,000 were recorded for the three months ended March 31,
        2005,
        consisting of cash dividends of $591,000 and in-kind dividends of $366,000.
        For
        accounting purposes, we had accrued a dividend payable liability of $11.1
        million, which included approximately $358,000 that represented a straight-line
        dividend accrual that was reversed upon closing of this stock transaction
        in the
        second quarter of 2005. As part of the agreement, no dividends were required
        to
        be paid for the second quarter of 2005. Thus, the preferred dividends for
        the
        six months ended June 30, 2005, amounted to $599,000.
 
 We
        had
        also issued to Saratoga seven-year warrants to purchase 1,000,000 shares
        of
        common stock at an exercise price of $4.30 per share on August 31, 2000,
        which
        was subsequently adjusted to $4.20 due to dilutive stock option transactions. On
        March 6, 2006, we issued 829,597 shares of common stock pursuant to the
        exercise of the warrants. The shares were purchased by the holders of the
        warrants pursuant to a "net exercise" provision of the warrants in which
        170,403
        shares subject to the warrants were used to pay the exercise price of
        $4.2 million. The shares used to pay the exercise price were valued at
        $24.65 per share based on current market prices, as determined under the
        terms
        of the warrants. We received no cash proceeds from this
        transaction.
 
 *Convertible
        Debentures*
 
 In
        November 2005, we completed an offer to exchange our outstanding 6.25%
        Convertible Subordinated Debentures due 2006 for new 6.25% Convertible
        Subordinated Debentures due 2008. In the exchange offer, $26.6 million of
        the
        $32.0 million principal amount of outstanding debentures were exchanged.
        The
        remaining $5.4 million principal amount of outstanding debentures continued
        outstanding and was paid at maturity on January 3, 2006. The terms of the
        existing debentures and the new debentures are substantially the same, except
        that the maturity of the new debentures is July 1, 2008, instead of
        January 1, 2006, and the new debentures cannot be redeemed at our election.
        Interest on the new debentures is payable semiannually on January 1 and July
        1
        of each year. The new debentures are unsecured and subordinated to all of
        our
        other indebtedness. In February 2006, $50,000 of face value of the new
        debentures was converted into 2,272 shares of common stock. The new debentures
        are convertible into common stock at the rate of $22 per share, which equates
        to
        1,207,955 shares of common stock.
  **21**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  
 Of
        the
        remaining $26.6 million of debentures outstanding, $20.8 million are owned
        by
        directors and officers or their affiliates. Saratoga Partners, two of whose
        representatives are directors, own $5.0 million of the debentures. Affiliates
        of
        Daniel R. Baty, our chief executive officer and a director, and Stanley L.
        Baty,
        a director, own $15.8 million of the debentures.
 
  The
        following table shows the changes in buildings from December 31, 2004, through
        June 30, 2006, including those transactions described above:
  
 
 **Month**
              
              **Owned**
              
              **Leased**
              
              
              
              **Consolidated**
              
              **Managed**
              
              **Total****December
                  31, 2004**
              
              
              
              
              
              **6**
              
              
              **158**
              
              
              
              
              
              **164**
              
              
              **17**
              
              
              **181**Richland
                  Gardens
              
              
              Mar-05
              
              
              **-**
              
              
              1
              
              
              **1**
              
              
              1
              
              
              (1
              )
              
              -Quail
                  Ridge
              
              
              Mar-05
              
              
              **-**
              
              
              1
              
              
              **1**
              
              
              1
              
              
              **-**
              
              
              1Wilburn
                  Gardens
              
              
              Mar-05
              
              
              **-**
              
              
              1
              
              
              
              
              
              1
              
              
              (1
              )
              
              -**March
                  31, 2005**
              
              
              
              
              
              **6**
              
              
              **161**
              
              
              
              
              
              **167**
              
              
              **15**
              
              
              **182****-**
              
              
              
              
              
              
              
              
              **-**
              
              
              
              
              
              **-**
              
              
              **-**
              
              
              **-****June
                  30, 2005**
              
              
              
              
              
              **6**
              
              
              **161**
              
              
              
              
              
              **167**
              
              
              **15**
              
              
              **182**Regent
                  Court of Kent - disposition
              
              
              Jul-05
              
              
              **-**
              
              
              **-**
              
              
              
              
              
              **-**
              
              
              (1
              )
              
              (1
              )Hunter's
                  Glen - Missoula
              
              
              Sep-05
              
              
              **-**
              
              
              1
              
              
              
              
              
              1
              
              
              -
              
              
              1**September
                  30, 2005**
              
              
              
              
              
              **6**
              
              
              **162**
              
              
              
              
              
              **168**
              
              
              **14**
              
              
              **182**Arkansas
                  Transaction
              
              
              Dec-05
              
              
              3
              
              
              **-**
              
              
              
              
              
              3
              
              
              **-**
              
              
              3Concorde
                  - disposition
              
              
              Dec-05
              
              
              **-**
              
              
              (1
              )
              
              **2**
              
              
              (1
              )
              
              **-**
              
              
              (1
              )**December
                  31, 2005**
              
              
              
              
              
              **9**
              
              
              **161**
              
              
              
              
              
              **170**
              
              
              **14**
              
              
              **184**Isle
                  at Emerald Court
              
              
              Jan-06
              
              
              **-**
              
              
              **-**
              
              
              
              
              
              **-**
              
              
              1
              
              
              1Park
                  Lane - disposition
              
              
              Jan-06
              
              
              **-**
              
              
              **-**
              
              
              
              
              
              **-**
              
              
              (1
              )
              
              (1
              )La
                  Villita - disposition
              
              
              Mar-06
              
              
              **-**
              
              
              **-**
              
              
              
              
              
              **-**
              
              
              (1
              )
              
              (1
              )**March
                  31, 2006**
              
              
              
              
              
              **9**
              
              
              **161**
              
              
              
              
              
              **170**
              
              
              **13**
              
              
              **183**Emerald
                  Estates - disposition
              
              
              Apr-06
              
              
              **-**
              
              
              **-**
              
              
              
              
              
              **-**
              
              
              (1
              )
              
              (1
              )**June
                  30, 2006**
              
              
              
              
              
              **9**
              
              
              **161**
              
              
              
              
              
              **170**
              
              
              **12**
              
              
              **182****1**These leases are accounted for as capital leases in our condensed
                  consolidated financial statements.**2**Concorde was reflected in our condensed consolidated financial
                  statements
                  as an owned community because of accountingrequirements
                  related to sale-leaseback accounting.
 
   **22**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  **Results
        of Operations**
 
 **Summary
        of Significant Accounting Policies and Use of Estimates**
 
 Our
        discussion and analysis of our financial condition and results of operations
        are
        based upon our unaudited condensed consolidated financial statements, which
        have
        been prepared in accordance with accounting principles generally accepted
        in the
        United States. The preparation of these financial statements requires us
        to make
        estimates and judgments that affect the reported amounts of assets, liabilities,
        revenues and expenses, and related disclosure of contingent assets and
        liabilities. On an ongoing basis, we evaluate our estimates, including those
        related to resident programs and incentives such as move-in fees, bad debts,
        investments, intangible assets, impairment of long-lived assets, income taxes,
        restructuring, long-term service contracts, contingencies, self-insured
        retention, health insurance, and litigation. We base our estimates on historical
        experience and on various other assumptions that are believed to be reasonable
        under the circumstances, the results of which form the basis for making
        judgments about the carrying values of assets and liabilities that are not
        readily apparent from other sources. Actual results may differ from these
        estimates under different assumptions or conditions.
 
 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,****2006**
              
              **2005**
              
              **2006**
              
              **2005**
              
              **2006-2005**
              
              **2006-2005**Revenues:
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              7.7
              %
              
              7.2
              %Expenses:Community
                  operations*
              
              
              65.3
              
              
              64.3
              
              
              65.5
              
              
              64.0
              
              
              (9.2
              )
              
              (9.5
              )Texas
                  lawsuit settlement
              
              
              -
              
              
              -
              
              
              (6.0
              )
              
              -
              
              
              N/AGeneral
                  and administrative
              
              
              8.4
              
              
              8.2
              
              
              8.5
              
              
              8.0
              
              
              (11.0
              )
              
              (14.9
              )Depreciation
                  and amortization
              
              
              11.8
              
              
              12.0
              
              
              11.9
              
              
              11.9
              
              
              (6.4
              )
              
              (7.0
              )Facility
                  lease expense
              
              
              10.7
              
              
              10.8
              
              
              10.8
              
              
              10.5
              
              
              (6.8
              )
              
              (9.4
              )Total
                  operating expenses
              
              
              96.2
              
              
              95.3
              
              
              90.7
              
              
              94.4
              
              
              (8.8
              )
              
              (2.9
              )Operating
                  income from continuing operations
              
              
              3.8
              
              
              4.7
              
              
              9.3
              
              
              5.6
              
              
              (13.5
              )
              
              79.8Other
                  income (expense)Interest
                  income
              
              
              0.7
              
              
              0.2
              
              
              0.8
              
              
              0.2
              
              
              232.2
              
              
              256.0Interest
                  expense
              
              
              (12.0
              )
              
              (12.7
              )
              
              (11.9
              )
              
              (12.8
              )
              
              (1.8
              )
              
              0.7Gain
                  on sale of investment in Alterra Healthcare Corporation
              
              
              -
              
              
              22.2
              
              
              -
              
              
              11.2
              
              
              (100.0
              )
              
              (100.0
              )Equity
                  losses in unconsolidated joint ventures
              
              
              (0.4
              )
              
              -
              
              
              (0.2
              )
              
              -
              
              
              N/A
              
              
              N/AOther,
                  net
              
              
              0.5
              
              
              0.6
              
              
              0.6
              
              
              0.7
              
              
              (8.0
              )
              
              (15.5
              )Net
                  other income (expense)
              
              
              (11.2
              )
              
              10.3
              
              
              (10.7
              )
              
              (0.7
              )
              
              (217.7
              )
              
              (1,632.7
              )Income
                  (loss) from continuing operationsbefore
                  income taxes
              
              
              (7.4
              )
              
              15.0
              
              
              (1.4
              )
              
              4.9
              
              
              (153.2
              )
              
              (131.5
              )Provision
                  for income taxes
              
              
              0.1
              
              
              (1.0
              )
              
              -
              
              
              (0.6
              )
              
              N/A
              
              
              N/AIncome
                  (loss) from continuing operations
              
              
              (7.3
              )
              
              14.0
              
              
              (1.4
              )
              
              4.3
              
              
              (156.3
              )
              
              (134.5
              )Loss
                  from discontinued operations (net of tax)
              
              
              -
              
              
              (4.3
              )
              
              -
              
              
              (1.5
              )
              
              99.2
              
              
              98.5Net
                  income (loss)
              
              
              (7.3
              %)
              
              9.7
              %
              
              (1.4
              %)
              
              2.8
              %
              
              (181.4
              )
              
              (154.3
              %)*
                  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, 2006 and 2005**
 
 **Total
        Operating Revenues:**
 
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Community
                  revenue
              
              **$**
              **101,571**
              
              $
              94,030
              
              $
              7,541
              
              
              8.0
              %Other
                  service fees
              
              
              **1,618**
              
              
              1,772
              
              
              (154
              )
              
              (8.7
              %)Total
                  community revenues
              
              
              **103,189**
              
              
              95,802
              
              
              7,387
              
              
              7.7
              %Management
                  fees
              
              
              **484**
              
              
              462
              
              
              22
              
              
              4.8
              %Total
                  operating revenues
              
              **$**
              **103,673**
              
              $
              96,264
              
              $
              7,409
              
              
              7.7
              %
 
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D**Average
                  monthly revenue per occupied unit
              
              **$**
              **3,083**
              
              $
              2,928
              
              $
              155
              
              
              5.3
              %Average
                  occupancy rate
              
              
              **84.6**
              **%**
              
              84.4
              %
              
              
              
              
              .2
              
              ppt*
 
 *
        percentage points
 
 Of
        the
        increase in community revenue and other service fees of $7.4 million for
        the
        three months ended June 30, 2006, compared to the three months ended June
        30,
        2005, the acquisition of four additional communities since July 1, 2005,
        accounted for approximately $2.0 million. The increase in existing communities
        of $5.4 million was primarily due to increases in the average monthly revenue
        per unit, which accounted for approximately $5.6 million of the increase,
        partially offset by a reduction in revenues of $238,000 from the temporary
        closure of our Biloxi community due to hurricane damage.
 
 While
        our
        occupancy rate grew more slowly than budgeted, we have experienced more recent
        growth in our occupancy rate from 85.0% on March 31, 2006, to 85.9% on June
        30,
        2006, the last day of each fiscal quarter. We will continue our efforts to
        build
        our occupancy through increased marketing initiatives, programs that address
        resident mix and a focus on property improvements and other community-level
        enhancements to attract additional long-term residents and increase occupancy
        while maintaining growth in average monthly revenue per unit. We believe
        that
        these initiatives will continue to have a positive impact on operating
        performance over time.
 
 **Community
        Operations:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Community
                  operations
              
              **$**
              **67,662**
              
              $
              61,942
              
              $
              5,720
              
              
              9.2
              %As
                  a percent of revenue
              
              
              **65.3**
              **%**
              
              64.3
              %
              
              
              
              
              1.0
              
              ppt
 
 Approximately
        $1.4 million of the increase in community operating expense of $5.7 million
        was
        from the addition of four new communities. Of the remaining increase of $4.3
        million approximately $3.5 million was primarily due to increases in
        labor-related costs, $2.0 million from increases in various operating costs,
  **24**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  primarily
        utilities, facility repairs and maintenance costs, marketing expenses, and
        property taxes, as well as an accrual of $500,000 related to the Texas Medicaid
        dispute as discussed under “Legal Proceedings,”offset by a decrease in
        professional liability insurance costs of $1.7 million.
 
 **General
        and Administrative:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**General
                  and administrative
              
              **$**
              **8,721**
              
              $
              7,857
              
              $
              864
              
              
              11.0
              %As
                  a percent of revenue
              
              
              **8.4**
              **%**
              
              8.2
              %
              
              
              
              
              .2
              
              ppt
 
 The
        increase in G&A expenses of $864,000 was primarily related to staffing costs
        for regional and corporate overhead positions of approximately $244,000,
        non-cash stock option compensation expenses of $87,000, approximately $246,000
        in other employee benefit and recruiting expenses, and legal fees of $613,000,
        primarily as a result of the Texas Medicaid dispute as discussed under “Legal
        Proceedings.” In addition, our accounting and consulting fees decreased by
        $435,000, primarily from direct project costs in 2005 related to initial
        compliance work for internal control requirements under the Sarbanes-Oxley
        Act
        of 2002.
 
 **Depreciation
        and Amortization:**
 
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Depreciation
                  and amortization
              
              **$**
              **12,251**
              
              $
              11,513
              
              $
              738
              
              
              6.4
              %As
                  a percent of revenue
              
              
              **11.8**
              **%**
              
              12.0
              %
              
              
              
              
              (.2
              )
              ppt
 
 The
        increase is primarily the result of the depreciation and amortization related
        to
        the December 2005 acquisition of three Arkansas communities and leasehold
        improvement depreciation from capital expenditures to improve our properties.
 
 **Facility
        Lease Expense:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Facility
                  lease expense
              
              **$**
              **11,092**
              
              $
              10,388
              
              $
              704
              
              
              6.8
              %As
                  a percent of revenue
              
              
              **10.7**
              **%**
              
              10.8
              %
              
              
              
              
              (.1
              )
              ppt
 
 The
        increase in facility lease expense of $704,000 was partially due to the
        operating lease of one new community discussed under Emeritrust Lease, which
        accounted for approximately $220,000 of the increase. The remaining increase
        of
        $484,000 was primarily attributable to annual lease inflators and
        increases in the LIBOR rate from existing operating leases (see
        Item
        3 - Market Risk).We leased 77 and 76 communities under operating leases as of June
        30,
        2006 and 2005, respectively.
  **25**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  
 **Interest
        Income:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Interest
                  income
              
              **$**
              **681**
              
              $
              205
              
              $
              476
              
              
              232.2
              %As
                  a percent of revenue
              
              
              **0.7**
              **%**
              
              0.2
              %
              
              
              
              
              .5
              
              ppt
 
 The
        increase in interest income of $476,000 was primarily attributable to interest
        earned on investments of cash that was received in the sale of our ownership
        interest in Alterra and interest income earned on restricted
        deposits.
 
 **Interest
        Expense:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Interest
                  expense
              
              **$**
              **12,475**
              
              $
              12,250
              
              $
              225
              
              
              1.8
              %As
                  a percent of revenue
              
              
              **12.0**
              **%**
              
              12.7
              %
              
              
              
              
              (0.7
              )
              ppt
 
 The
        increase in interest expense of $225,000 for the second quarter of 2006 as
        compared to the comparable period in 2005 is primarily due to an increase
        in
        interest expense of $294,000 from three new Arkansas communities acquired
        in
        December 2005 and interest expense of $270,000 on the new $10.8 million loan
        related to our Series B Stock conversion in June 2005, offset by a decline
        in
        interest expense from the pay down of principal balances over the past year.
 
 **Other,
        net:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Other,
                  net
              
              **$**
              **562**
              
              $
              611
              
              $
              (49
              )
              
              (8.0
              %)As
                  a percent of revenue
              
              
              **0.5**
              **%**
              
              0.6
              %
              
              
              
              
              (.1
              )
              ppt
 
 Other,
        net primarily reflects the amortization of deferred gains of $554,000 for
        both
        periods presented.
 
 **Income
        taxes:**
 
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Provision
                  for income taxes
              
              **$**
              **(100**
              **)**
              $
              974
              
              $
              (1,074
              )
              
              (110.3
              %)As
                  a percent of revenue
              
              
              **(0.1**
              **%)**
              
              1.0
              %
              
              
              
              
              (1.1
              )
              ppt
 
  **26**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  The
        provision for income taxes for the quarter ended June 30, 2006, includes
        a tax
        benefit of $110,000 for the proportionate share of the estimated tax refund,
        exclusive of the tax benefit related to employee stock option exercises,
        from
        the expected carry back of tax losses for 2006 to offset taxable income in
        2005,
        and an accrual for estimated state income and franchise tax liabilities. No
        benefit has been recognized for the Company’s expected 2006 operating loss or
        net deferred tax assets at the beginning of the year, beyond the carryback
        amount, as management does not believe it is more likely than not that the
        deferred tax assets will be realized.  The provision for income taxes for
        the quarter ended June 30, 2005, is principally due to Federal and state
        income
        tax liabilities on taxable income from the gain on sale of our Alterra
        investment.
 
 **Net
        Income (Loss) and Property-Related Expense:** **
 
 In
        comparing the net income (loss) for the three months ended June 30, 2006
        and
        2005, it is important to consider our property-related expenses, which include
        depreciation and amortization, facility lease expense, and interest expense
        that
        are directly related to our communities, and which include capital lease
        accounting treatment, finance accounting treatment, or straight-line accounting
        treatment of rent escalators for many of our leases. These accounting treatments
        all result in greater property-related expense than actual lease payments
        made
        in the early years of the affected leases and less property-related expense
        than
        actual lease payments made in later years, as detailed in the tables
        below.
 
 
 **Detail
                  of property-related expenses from lease accounting
                  treatment:****Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)****Total
                  property-related expense:**Depreciation
                  and amortization
              
              **$**
              **12,251**
              
              $
              11,513
              
              $
              738
              
              
              6.4
              %Facility
                  lease expense
              
              
              **11,092**
              
              
              10,388
              
              
              704
              
              
              6.8
              %Interest
                  expense
              
              
              **12,475**
              
              
              12,250
              
              
              225
              
              
              1.8
              %Total
                  property-related expense
              
              **$**
              **35,818**
              
              $
              34,151
              
              $
              1,667
              
              
              4.9
              %**Property-related
                  expenses from lease accounting treatment:**Depreciation
                  and amortization
              
              **$**
              **9,727**
              
              $
              9,786
              
              $
              (59
              )
              
              (0.6
              %)Interest
                  expense
              
              
              **10,359**
              
              
              10,650
              
              
              (291
              )
              
              (2.7
              %)Straight-line
                  lease expense
              
              
              **264**
              
              
              278
              
              
              (14
              )
              
              (5.0
              %)Operating
                  lease expense
              
              
              **10,828**
              
              
              10,110
              
              
              718
              
              
              7.1
              %Total
                  property-related lease expense
              
              
              **31,178**
              
              
              30,824
              
              
              354
              
              
              1.1
              %Actual
                  lease payments
              
              
              (25,847
              )
              
              (24,393
              )
              
              (1,454
              )
              
              6.0
              %Expense
                  in excess of lease payments
              
              **$**
              **5,331**
              
              $
              6,431
              
              $
              (1,100
              )
              
              (17.1
              %)
 
 Our
        property-related expense associated with our leases exceeded our actual lease
        payments by $5.3 million and $6.4 million for the three months ended June
        30,
        2006 and 2005, respectively. While the impact of lease accounting declined
        by
        $1.1 million in the current year quarter from the comparable quarter last
        year
        due to the normal reversal of the timing differences, the total impact in
        both
        periods is significant to our overall operating results. It should be noted
        that, notwithstanding the effects of lease accounting treatment, the actual
        lease payments required under most of our leases will continue to increase
        annually and, as a result, we will need to improve our results from community
        operations to cover these increases.
  **27**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  **Income
        (Loss) from Discontinued Operations:**
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Income
                  (loss) from discontinued operations,net
                  of tax benefit
              
              **$**
              **(34**
              **)**
              $
              (4,111
              )
              $
              4,077
              
              
              (99.2
              %)As
                  a percent of revenue
              
              
              **-**
              
              
              4.3
              %
              
              
              
              
              (4.3
              )
              ppt
 
 The
        loss
        from discontinued operations for the three months ended June 30, 2005, reflects
        an impairment loss of approximately $4.0 million from the sale of a facility
        in
        Nevada.
 
 **Preferred
        dividends:**
 
 
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Preferred
                  dividends
              
              **$**
              **-**
              
              $
              (358
              )
              $
              358
              
              
              (100.0
              %)As
                  a percent of revenue
              
              
              **-**
              
              
              (0.4
              %)
              
              
              
              
              0.4
              
              ppt
 
 *Preferred
        dividends:* The
        preferred dividends in 2005, were negative because the Series B Stock was
        converted to common stock on June 30, 2005, and the excess accrued dividends
        due
        to straight-line accounting treatment of scheduled dividend rate increases
        were
        reversed upon conversion of the Series B Stock.
 
 
 [The
        rest
        of this page is intentionally left blank]
  **28**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  **Comparison
        of the six months ended June 30, 2006 and 2005**
 
 **Total
        Operating Revenues:**
 
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Community
                  revenue
              
              **$**
              **200,466**
              
              $
              186,517
              
              $
              13,949
              
              
              7.5
              %Other
                  service fees
              
              
              **3,332**
              
              
              3,480
              
              
              (148
              )
              
              (4.3
              %)Total
                  community revenues
              
              
              **203,798**
              
              
              189,997
              
              
              13,801
              
              
              7.3
              %Management
                  fees
              
              
              **941**
              
              
              1,060
              
              
              (119
              )
              
              (11.2
              %)Total
                  operating revenues
              
              **$**
              **204,739**
              
              $
              191,057
              
              $
              13,682
              
              
              7.2
              %
 
 
 Of
        the
        increase in community revenue and other service fees of $13.8 million for
        the
        six months ended June 30, 2006, compared to the six months ended June 30,
        2005,
        the acquisition of seven additional communities since December 31, 2004,
        accounted for approximately $6.1 million. The increase in existing communities
        of $7.7 million was primarily due to increases in the average monthly revenue
        per unit, which accounted for approximately $10.6 million, partially offset
        by a
        decrease in the average occupancy rate, which resulted in a reduction of
        revenues from the comparable quarters of 2005 of approximately $2.1 million
        and
        the remaining reduction of $750,000 from the temporary closure of our Biloxi
        community due to hurricane damage.
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D**Average
                  monthly revenue per occupied unit
              
              **$**
              **3,065**
              
              $
              2,915
              
              $
              150
              
              
              5.1
              %Average
                  occupancy rate
              
              
              **84.2**
              **%**
              
              84.7
              %
              
              
              
              
              (.5
              )
              ppt
 
 While
        our
        occupancy rate declined from the comparable prior period, we have experienced
        a
        more recent growth in our occupancy rate from 84.2% on December 31, 2005,
        to
        85.9% on June 30, 2006, the last day of each fiscal quarter. We will continue
        our efforts to build our occupancy through increased marketing initiatives,
        programs that address resident mix and a focus on property improvements and
        other community-level enhancements to attract additional long-term residents
        and
        increase occupancy while maintaining growth in average monthly revenue per
        unit.
        We believe that these initiatives will continue to have a positive impact
        on
        operating performance over time.
 
 The
        decrease in management fee income of approximately $119,000 for the first
        two
        quarters of 2006 as compared to 2005 was primarily due to the reduction in
        management contracts since December 31, 2004.
 
 **Community
        Operations:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Community
                  operations
              
              **$**
              **134,029**
              
              $
              122,347
              
              $
              11,682
              
              
              9.5
              %As
                  a percent of revenue
              
              
              **65.5**
              **%**
              
              64.0
              %
              
              
              
              
              1.5
              
              ppt
 
  **29**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  Community
        operations expense excludes a $12.2 million reduction in our professional
        and general liability insurance accrual that resulted from the settlement
        of a
        lawsuit for an amount less than the original accrual for the action, which
        is
        shown as a separate line item on the condensed consolidated statement of
        operations and is further discussed under “Legal Proceedings.” Excluding this
        adjustment, community operations expense increased $11.7 million, or 9.5%.
        Approximately $4.1 million of this increase was from the addition of seven
        new
        communities. Of the remaining increase of $7.6 million in community operations
        expense approximately $5.7 million was increased staffing costs and
        approximately $1.7 million was due to increases in utilities and repairs
        and
        maintenance. The remaining difference was due to a decrease in professional
        liability insurance costs of approximately $1.7 million and increases of
        $1.4
        million in various other operating costs, primarily marketing and property
        taxes, as well as an accrual of $500,000 related to the Texas Medicaid dispute
        as discussed under “Legal Proceedings.”
 
 **General
        and Administrative:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**General
                  and administrative
              
              **$**
              **17,452**
              
              $
              15,190
              
              $
              2,262
              
              
              14.9
              %As
                  a percent of revenue
              
              
              **8.5**
              **%**
              
              8.0
              %
              
              
              
              
              .5
              
              ppt
 
 The
        increase in G&A expenses of $2.3 million was primarily related to staffing
        costs for regional and corporate overhead positions of approximately $639,000,
        non-cash stock option compensation expenses of $222,000, approximately $396,000
        in other employee benefit and recruiting expenses, and legal fees of $804,000,
        primarily as a result of the Texas Medicaid dispute as discussed under “Legal
        Proceedings.” In addition, our accounting and consulting fees increased by
        $128,000.
 
 **Depreciation
        and Amortization:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Depreciation
                  and amortization
              
              **$**
              **24,401**
              
              $
              22,800
              
              $
              1,601
              
              
              7.0
              %As
                  a percent of revenue
              
              
              **11.9**
              **%**
              
              11.9
              %
              
              
              
              
              .0
              
              ppt
 
 The
        increase is primarily the result of the depreciation and amortization related
        to
        the December 2005 acquisition of three Arkansas communities, the acquisition
        of
        two communities under capital leases in March 2005, and leasehold improvement
        depreciation from capital expenditures to improve our properties.
 
 **Facility
        Lease Expense:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Facility
                  lease expense
              
              **$**
              **22,010**
              
              $
              20,124
              
              $
              1,886
              
              
              9.4
              %As
                  a percent of revenue
              
              
              **10.8**
              **%**
              
              10.5
              %
              
              
              
              
              .3
              
              ppt
 
 The
        increase in facility lease expense of $1.9 million was primarily due to the
        operating lease of two new communities discussed under Emeritrust Lease,
        which
        accounted for approximately $1.0 million of the
  **30**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  increase.
        The remaining increase of $886,000 was primarily attributable to annual lease
        inflators and increases in the LIBOR rate from existing operating leases
(see
        Item
        3 - Market Risk).  We leased 77 and 76 communities under operating
        leases as of June 30, 2006 and 2005, respectively.
 
 **Interest
        Income:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Interest
                  income
              
              **$**
              **1,552**
              
              $
              436
              
              $
              1,116
              
              
              256.0
              %As
                  a percent of revenue
              
              
              **0.8**
              **%**
              
              0.2
              %
              
              
              
              
              .6
              
              ppt
 
 The
        increase in interest income of $1.1 million was primarily attributable to
        interest earned on investments of cash that was received in the sale of our
        ownership interest in Alterra and interest income earned on restricted
        deposits.
 
 **Interest
        Expense:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Interest
                  expense
              
              **$**
              **24,206**
              
              $
              24,368
              
              $
              (162
              )
              
              (0.7
              %)As
                  a percent of revenue
              
              
              **11.9**
              **%**
              
              12.8
              %
              
              
              
              
              (0.9
              )
              ppt
 
 The
        decrease in interest expense of $162,000 for the first two quarters of 2006
        as
        compared to the comparable period in 2005 was primarily due to the reduction
        of
        the interest accrual of $766,000 previously recorded for the settlement of
        a
        lawsuit as described under “Legal Proceedings.” Interest expense increased by
        $604,000 after adjusting for the settlement impact noted above. This increase
        is
        primarily due to an increase in interest expense from three new Arkansas
        communities acquired in December 2005, two new communities under capital
        leases
        acquired in March 2005, the new $10.8 million loan related to our Series
        B Stock
        conversion in June 2005, offset by a decline in interest expense from the
        pay
        down of principal balances over the past year. Excluding the reduction in
        the
        interest accrual related to the lawsuit settlement, interest expense was
        12.2%
        of total operating revenues for the six months ended June 30, 2006.
 
 **Other,
        net:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Other,
                  net
              
              **$**
              **1,158**
              
              $
              1,371
              
              $
              (213
              )
              
              (15.5
              %)As
                  a percent of revenue
              
              
              **0.6**
              **%**
              
              0.7
              %
              
              
              
              
              (.1
              )
              ppt
 
 The
        amortization of deferred gains of approximately $1.1 million is reflected
        in
        Other, net for both periods presented.
  **31**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  **Income
        taxes:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Provision
                  for income taxes
              
              **$**
              **(90**
              **)**
              $
              1,089
              
              $
              (1,179
              )
              
              (108.3
              %)As
                  a percent of revenue
              
              
              **-**
              
              
              0.6
              %
              
              
              
              
              (0.6
              )
              ppt
 
 The
        provision for income taxes for the two quarters ended June 30, 2006, includes
        a
        tax benefit of $110,000 for the proportionate share of the estimated tax
        refund,
        exclusive of the tax benefit related to employee exercises of stock options,
        from the expected carry back of 2006 tax losses to offset taxable income
        in
        2005, and an accrual for estimated state income and franchise tax
        liabilities.  No benefit has been recognized for the Company’s expected
        2006 operating loss or net deferred tax assets at the beginning of the year,
        beyond the carryback amount, as management does not believe it is more
        likely than not that the deferred tax assets will be realized. The provision
        for
        income taxes for the two quarters ended June 30, 2005, is principally due
        to
        Federal and state income tax liabilities on taxable income from the gain
        on sale
        of our Alterra investment.
 
 **Net
        Income (Loss) and Property-Related Expense:** **
 
 In
        comparing the net income (loss) for the six months ended June 30, 2006 and
        2005,
        it is important to consider our property-related expenses, which include
        depreciation and amortization, facility lease expense, and interest expense
        that
        are directly related to our communities, and which include capital lease
        accounting treatment, finance accounting treatment, or straight-line accounting
        treatment of rent escalators for many of our leases. These accounting treatments
        all result in greater property-related expense than actual lease payments
        made
        in the early years of the affected leases and less property-related expense
        than
        actual lease payments made in later years, as detailed in the tables
        below.
  **Detail
                    of property-related expenses from lease accounting
                    treatment:****Six
                    Months ended June 30,****2006**
                
                **2005**
                
                **$****D**
                
                **%****D****(in
                    thousands, except percentages)****Total
                    property-related expense:**Depreciation
                    and amortization
                
                **$**
                **24,401**
                
                $
                22,800
                
                $
                1,601
                
                
                7.0
                %Facility
                    lease expense
                
                
                **22,010**
                
                
                20,124
                
                
                1,886
                
                
                9.4
                %Interest
                    expense
                
                
                **24,206**
                
                
                24,368
                
                
                (162
                )
                
                (0.7
                %)Total
                    property-related expense
                
                **$**
                **70,617**
                
                $
                67,292
                
                $
                3,325
                
                
                4.9
                %**Property-related
                    expenses from lease accounting treatment:**Depreciation
                    and amortization
                
                **$**
                **19,426**
                
                $
                19,404
                
                $
                22
                
                
                0.1
                %Interest
                    expense
                
                
                **20,759**
                
                
                21,093
                
                
                (334
                )
                
                (1.6
                %)Straight-line
                    lease expense
                
                
                **512**
                
                
                394
                
                
                118
                
                
                29.9
                %Operating
                    lease expense
                
                
                **21,498**
                
                
                19,730
                
                
                1,768
                
                
                9.0
                %Total
                    property-related lease expense
                
                
                **62,195**
                
                
                60,621
                
                
                1,574
                
                
                2.6
                %Actual
                    lease payments
                
                
                **(51,334**
                **)**
                
                (48,058
                )
                
                (3,276
                )
                
                6.8
                %Expense
                    in excess of lease payments
                
                **$**
                **10,861**
                
                $
                12,563
                
                $
                (1,702
                )
                
                (13.5
                %)
  
  **32**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  Our
        property-related expense associated with our leases exceeded our actual lease
        payments by $10.9 million and $12.6 million for the six months ended June
        30,
        2006 and 2005, respectively. While the impact of lease accounting declined
        by
        $1.7 million in the first two quarters of the current year from the comparable
        quarters last year due to the normal reversal of the timing differences,
        the
        total impact in both periods is significant to our overall operating results.
        It
        should be noted that, notwithstanding the effects of lease accounting treatment,
        the actual lease payments required under most of our leases will continue
        to
        increase annually and, as a result, we will need to improve our results from
        community operations to cover these increases.
 
 **Income
        (Loss) from Discontinued Operations:**
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Income
                  (loss) from discontinued operations,net
                  of tax benefit
              
              **$**
              (44
              )
              $
              (2,920
              )
              $
              2,876
              
              
              (98.5
              %)As
                  a percent of revenue
              
              
              **-**
              
              
              1.5
              %
              
              
              
              
              (1.5
              )
              ppt
 
 The
        loss
        from discontinued operations for the six months ended June 30, 2005, reflects
        an
        impairment loss of approximately $4.0 million from the sale of a facility
        in
        Nevada, partially offset by a gain of approximately $1.3 million from the
        sale
        of a facility in Washington.
 
 **Preferred
        dividends:**
 
 
 **Six
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D****(in
                  thousands, except percentages)**Preferred
                  dividends
              
              **$**
              **-**
              
              $
              599
              
              $
              (599
              )
              
              (100.0
              %)As
                  a percent of revenue
              
              
              **-**
              
              
              0.3
              %
              
              
              
              
              (0.3
              )
              ppt
 
 *Preferred
        dividends:* For the
        six months ended June 30, 2005, preferred dividends totaled $599,000. The
        Series
        B Stock was converted to common stock on June 30, 2005. The preferred dividends
        of $957,000 in the first quarter of 2005 were offset by the reversal of $358,000
        in excess accrued dividends from the straight-line accounting treatment of
        scheduled dividend rate increases.
 
 
 [The
        rest
        of this page is intentionally left blank]
  **33**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  
 **Same
        Community Comparison**
 
 Of
        our
        170 communities, we have operated 162 communities continuously since January
        1,
        2005, and define these as "Same Communities." Since our Biloxi community
        suffered significant damage from Katrina and was out of operation for
        approximately nine months, we have excluded it from this comparison. In
        addition, the analysis below excludes any effect of the $1.7 million adjustment
        to our professional and general liability insurance accrual and general and
        administrative expenses. The following table sets forth a comparison of same
        community results of operations for the three months ended June 30, 2006
        and
        2005.
 
 **Three
                  Months ended June 30,****(In
                  thousands)****$****D**
              
              **%****D****2006**
              
              **2005**
              
              **Fav
                  / (Unfav)**
              
              **Fav
                  / (Unfav)**Revenue
              
              $
              98,516
              
              $
              93,085
              
              $
              5,431
              
              
              5.8
              %Community
                  operations *
              
              
              (65,347
              )
              
              (60,073
              )
              
              (5,274
              )
              
              (8.8
              )Community
                  operating income
              
              
              33,169
              
              
              33,012
              
              
              157
              
              
              0.5Depreciation
                  & amortization
              
              
              (11,484
              )
              
              (11,101
              )
              
              (383
              )
              
              (3.5
              )Facility
                  lease expense
              
              
              (9,903
              )
              
              (9,437
              )
              
              (466
              )
              
              (4.9
              )Operating
                  income
              
              
              11,782
              
              
              12,474
              
              
              (692
              )
              
              (5.5
              )Interest
                  expense, net
              
              
              (11,094
              )
              
              (11,369
              )
              
              275
              
              
              2.4Operating
                  income after interest expense
              
              $
              688
              
              $
              1,105
              
              $
              (417
              )
              
              (37.7
              %)*
                  exclusive of depreciation and amortization and facility lease expense
                  shown separately below
 
 These
        162
        communities represented $98.5 million or 95.0% of our total revenue of $103.7
        million for the second quarter of 2006. The increase in same community revenues
        of $5.4 million was primarily due to improvements in average revenue per
        occupied unit, which accounted for the majority of the increase in revenue.
        The
        minor increase in occupancy had a negligible effect.
 
 The
        table
        below shows the amounts and changes in average monthly revenue per occupied
        unit
        and occupancy rates:
 **Three
                  Months ended June 30,****2006**
              
              **2005**
              
              **$****D**
              
              **%****D**Average
                  monthly revenue per occupied unit
              
              **$**
              **3,094**
              
              $
              2,924
              
              $
              170
              
              
              5.8
              %Average
                  occupancy rate
              
              
              **84.5**
              **%**
              
              84.3
              %
              
              
              
              
              .2
              
              ppt
 
 While
        the
        average occupancy increased slightly, we experienced a recent increase in
        our
        occupancy rate from 84.9% on March 31, 2006, to 85.8% on June 30, 2006, the
        last
        day of each fiscal quarter.
 
 Community
        operating expenses increased approximately $5.3 million primarily from increased
        costs for direct care labor and related employee taxes and benefits of $3.1
        million. The increase also reflects increased utilities of $481,000 and facility
        maintenance cost increases of $460,000. The remaining increase of approximately
        $1.3 million is primarily comprised of other general operating expenses of
        the
        communities, including insurance, marketing, supplies, legal fees, property
        taxes, food costs, telephone, and similar community operating
        expenses.
 
 Property-related
        expenses (depreciation and amortization, facility lease expense, and interest
        expense, net of interest income) increased by approximately $574,000, which
        primarily reflects the effect of annual lease
  **34**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  inflators
        and
        increases in the LIBOR rate from existing operating leases (see
        Item
        3 - Market Risk)resulting in increases in rent and an increase in
        depreciation from increased capital expenditures to improve our properties,
        offset by an increase in interest income on restricted deposits, and a decrease
        in interest expenses due to the pay down of principal balances.
 
 Operating
        income after interest expense decreased $417,000 from the comparable period
        of
        2005 as a result of the changes discussed above. We will continue our efforts
        to
        build our occupancy through increased marketing initiatives, programs that
        address resident mix and a focus on property improvements and other
        community-level enhancements to attract additional long-term residents and
        increase occupancy while maintaining growth in average monthly revenue per
        unit.
        We believe that these initiatives will continue to have a positive impact
        on
        operating performance over time.
 
 **Liquidity
        and Capital Resources**
 
 For
        the
        six months ended June 30, 2006, net cash used in operating activities was
        $4.0
        million. The primary components of cash used in operating activities for
        this
        period were a net change in operating assets and liabilities of $25.6 million,
        amortization of deferred gain of $1.1 million, and $2.9 million of net loss
        from
        operations, partially offset by $24.4 million of depreciation and amortization.
        The $25.6 million use of cash related to operating assets and liabilities
        is
        primarily comprised of those items detailed in the following table. For the
        six
        months ended June 30, 2005, net cash provided by operating activities was
        $8.6
        million. The primary components of operating cash provided by operating
        activities for this period were depreciation and amortization of $22.8 million,
        $4.0 million from the impairment of long-lived asset, and $5.3
        million  of
        net
        income from operations, partially offset by the gain on sale of our investment
        in Alterra of $21.3 million, the net gain on sale of properties of $1.3 million,
        the amortization of deferred gain of $1.1 million, and the net change in
        operating assets and liabilities of $740,000.
 
 **Significant
                  components of changes in operating assets and
                  liabilities:****Six
                  Months Ended June 30,****2006**
              
              **2005**Reduction
                  of Texas settlement liability accruals, including interest
              
              $
              (12,973
              )
              $
              -Payment
                  of Texas Settlement
              
              
              (5,600
              )
              
              -Federal
                  tax deposits, principally related to the Alterra transaction
                  gain
              
              
              (4,200
              )
              
              -Payment
                  of semi-annual debenture interest
              
              
              (1,000
              )
              
              (1,000
              )Initial
                  payment of annual insurance premiums
              
              
              (6,785
              )
              
              (5,371
              )Tax
                  benefit of stock compensation
              
              
              (1,074
              )
              
              -Texas
                  Medicaid accrual
              
              
              500
              
              
              -All
                  other activity, net
              
              
              5,548
              
              
              5,631Net
                  change in operating assets and liabilities
              
              $
              (25,584
              )
              $
              (740
              )
 
 The
        Texas
        settlement impact of $18.6 million and the federal tax deposits of $4.2 million
        related to the Alterra transaction gain, partially offset by the Texas Medicaid
        accrual, a total of $22.3 million, are non-recurring items. The insurance
        payment difference between years is due to a change in payment arrangements
        and
        the variance will even out over the course of the year.
 
 For
        the
        six months ended June 30, 2006, cash used in investing activities was $18.8
        million. The activities that used cash include $10.8 million held in escrow
        for
        the Arbor Place acquisition, $6.4 million for the acquisition of property
        and
        equipment and $2.0 million in construction expenditures for leased property,
        partially offset by a net decrease in investment in affiliates. Net cash
        provided by investing activities amounted to $18.4 million for the six months
        ended June 30, 2005, and was comprised primarily of proceeds from the sale
        of
        the Alterra investment of $25.0 million, partially offset by management and
        lease acquisition costs of approximately $1.5 million, and acquisitions of
        various property and equipment of approximately $5.1 million.
  **35**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  For
        the
        six months ended June 30, 2006, cash used in financing activities was $3.6
        million. Activities resulting in a net cash decrease include $9.1 million
        for
        repayment of capital lease and financing obligations, $6.4 million for repayment
        of borrowings, and $1.2 million for the increase in restricted deposits,
        partially offset by proceeds from the Arbor Place debt of $8.0 million, proceeds
        from the issuance of common stock of approximately $3.8 million, and
        approximately $1.1 million from the tax benefit of stock compensation. For
        the
        six months ended June 30, 2005, net cash used in financing activities was
        $10.3
        million, consisting primarily of $545,000 net repayment of long-term borrowings,
        repayment of capital lease and financing obligations of $7.7 million and
        restricted deposits of $1.7 million. We borrowed $32.2 million to refinance
        debt
        of $21.4 million and pay accumulated preferred dividends of $10.8 million
        during
        the six months ended June 30, 2005.
 
 As
        of
        June 30, 2006, we had a working capital deficit of $28.5 million. We are
        able to
        operate in the position of a working capital deficit because revenues are
        collected more quickly, often in advance, than obligations are required to
        be
        paid. This can result in a low level of current assets to the extent cash
        has
        been deployed in business development opportunities or to pay down long-term
        liabilities. Along those lines, the working capital deficit includes $16.8
        million of deferred revenue and unearned rental income and the level of current
        liabilities is not expected to change year to year in such a way as to require
        the use of significant cash, except for debt maturities of $81.2 million
        scheduled to be due in 2008.
 
 We
        have
        incurred significant losses since our inception and have an accumulated deficit
        of $195.3 million as of June 30, 2006. We believe these losses have resulted
        from our early emphasis on expansion, financing costs arising from multiple
        financing and refinancing transactions related to this expansion, occupancy
        rates remaining lower for longer periods than anticipated, and depreciation
        expense, a non-cash charge, primarily from multiple capital and financing
        leases.
 
 In
        February 2005, a San Antonio, Texas, jury found one of our assisted living
        communities negligent in the care of a resident. The jury awarded a verdict
        against us in the amount of $1.5 million in compensatory damages and $18.0
        million in punitive damages. We appealed the verdict and posted a deposit
        of
        $1.7 million in order to stay the proceedings. In March 2006, we settled
        the
        case for $5.6 million and the deposit was refunded to us, with interest,
        in
        April 2006. In the fourth quarter of 2004, we recorded an additional liability
        accrual of $18.7 million and accrued $766,000 of interest on the judgment
        in 2005. In the first two quarters of 2006, we reduced the accrued interest
        by
        $766,000 and the liability accrual recorded in 2004 by $12.2
        million.
 
 We
        refinanced substantially all of our debt obligations, extending the maturities
        of such financings to dates beyond July 2007, at which time we will need
        to
        refinance or otherwise repay the obligations. Many of our debt instruments
        and
        leases contain “cross-default” provisions pursuant to which a default under one
        obligation can cause a default under one or more other obligations to the
        same
        or other lenders or lessors. Such cross-default provisions affect the majority
        of our properties. Accordingly, any event of default could cause a material
        adverse effect on our financial condition if such debt or leases are
        cross-defaulted. At June 30, 2006, we were in violation of one or more covenants
        in certain of the leases, but obtained waivers from the owners that expire
        on
        July 1, 2007.
 
 Based
        on
        our current operating initiatives and our current cash position, management
        believes that we will be able to generate positive operating cash flow, or
        will
        have adequate cash reserves, or the ability to obtain adequate financing
        to
        cover any potential operating shortfalls and necessary investing and financing
        activities, including required debt service and capital expenditures for
        at
        lease the next twelve months.
 
  **36**
 **MANAGEMENT'S
            DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
            RESULTS OF OPERATIONS - CONTINUED**
 Table of Contents  The
        following table summarizes our contractual obligations at June 30, 2006,
        (in
        thousands):
 
 **Principal
                  and Lease Payments Due by Period****After
                  5****Contractual
                  Obligations**
              
              **Total**
              
              **1
                  year**
              
              **2-3
                  years**
              
              **4-5
                  years**
              
              **years**Long-term
                  debt, including current portion
              
              $
              88,194
              
              $
              3,742
              
              $
              56,024
              
              $
              3,010
              
              $
              25,418Capital
                  lease and financing obligations, including current portion
              
              
              618,106
              
              
              20,620
              
              
              51,352
              
              
              66,191
              
              
              479,943Operating
                  leases
              
              
              319,141
              
              
              41,023
              
              
              83,341
              
              
              82,744
              
              
              112,033Convertible
                  debentures
              
              
              26,575
              
              
              -
              
              
              26,575
              
              
              -
              
              
              -$
              1,052,016
              
              $
              65,385
              
              $
              217,292
              
              $
              151,945
              
              $
              617,394
 
 The
        following table summarizes interest on our contractual obligations at June
        30,
        2006, (in thousands):
 
 
 **Interest
                  Due by Period****After
                  5****Contractual
                  Obligations**
              
              **Total**
              
              **1
                  year**
              
              **2-3
                  years**
              
              **4-5
                  years**
              
              **years**Long-term
                  debt
              
              $
              21,657
              
              $
              6,977
              
              $
              8,338
              
              $
              3,801
              
              $
              2,541Capital
                  lease and financing obligations
              
              
              344,943
              
              
              40,672
              
              
              76,959
              
              
              69,538
              
              
              157,774Convertible
                  debentures
              
              
              4,152
              
              
              1,661
              
              
              2,491
              
              
              -
              
              
              -$
              370,752
              
              $
              49,310
              
              $
              87,788
              
              $
              73,339
              
              $
              160,315
 
  
 **Impact
        of Inflation**
 
 To
        date,
        inflation has not had a significant impact on us except for recent increases
        in
        utility costs, which increased approximately 12.6% per occupied unit for
        the six
        months ended June 30, 2006, as compared to the comparable period of the prior
        year. However, inflation could affect our future revenues and operating income
        due to our dependence on the senior resident population, most of whom rely
        on
        relatively fixed incomes to pay for our services. The monthly charges for
        a
        resident's unit and assisted living services are influenced by the location
        of
        the community and local competition. Our ability to increase revenues in
        proportion to increased operating expenses may be limited. To the extent
        we rely
        upon governmental reimbursement programs, we have a limited ability to increase
        rates. In pricing our services, we attempt to anticipate inflation levels,
        but
        there can be no assurance that we will be able to respond to inflationary
        pressures in the future.
 
 **Forward-Looking
        Statements**
 
 “Safe
        Harbor” Statement under the Private Securities Litigation Reform Act of 1995: A
        number of the matters and subject areas discussed in this report that are
        not
        historical or current facts deal with potential future circumstances,
        operations, and prospects. The discussion of such matters and subject areas
        is
        qualified by the inherent risks and uncertainties surrounding future
        expectations generally, and also may materially differ from our actual future
        experience as a result of such factors as: the effects of competition and
        economic conditions on the occupancy levels in our communities; our ability
        under current market conditions to maintain and increase our resident charges
        in
        accordance with our rate enhancement programs without adversely affecting
        occupancy levels; increases in interest costs as a result of re-financings;
        our
        ability to control community operation expenses, including insurance and
        utility
        costs, without adversely affecting the level of occupancy and the level of
        resident charges; our ability to generate cash flow sufficient to service
        our
        debt and other fixed payment requirements; our ability to find sources of
        financing and capital on satisfactory terms to meet our cash requirements
        to the
        extent that they are not met by operations, and other uncertainties related
        to
        professional liability claims. We have attempted to identify, in context,
        certain of the factors that we currently believe may cause actual future
        experience and results to differ from our current expectations regarding
        the
        relevant matter or subject area. These and other risks and uncertainties
        are
        detailed in our reports filed with the SEC, including our Annual Reports
        on Form
        10-K and Quarterly Reports Form 10-Q.
 
 
  **37**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**
 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, 2006, we had no variable rate borrowings.
        However, we do have certain operating lease obligations based on LIBOR, with
        a
        LIBOR cap of approximately 5.3%. As of June 30, 2006, the LIBOR rate was
        5.3%
        and we currently have no variable rate exposure for additional lease expense.
        This analysis does not consider changes in the actual level of borrowings
        or
        operating lease obligations that may occur subsequent to June 30, 2006. This
        analysis also does not consider the effects of the reduced level of overall
        economic activity that could exist in such an environment, nor does it consider
        actions that management might be able to take with respect to our financial
        structure to mitigate the exposure to such a change.
 
 **Item
        4. Controls and Procedures******
 
 (a) *Evaluation
        of disclosure controls and procedures.*
 
 Our
        chief
        executive officer and our chief financial officer, after evaluating the
        effectiveness of our “disclosure controls and procedures” (as defined in Rules
        13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period
        covered by this quarterly report, have concluded that, as of that date, our
        disclosure controls and procedures were effective.
 
 *(b)*
            *Changes
                in internal controls* 
 We
        also
        carried out an evaluation of the internal control over financial reporting
        to
        determine whether any changes occurred during the period covered by this
        report.
        Based on such evaluation, there has been no change in our internal control
        over
        financial reporting that occurred during the most recently completed fiscal
        quarter ended June 30, 2006, that materially affected, or is reasonably likely
        to materially affect, our internal control over financial reporting.
 
 
 
 [The
        rest
        of this page is intentionally left blank]
 
  **38**
 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.
        Accruals for these claims have been based upon actuarial and/or estimated
        exposure, taking into account self-insured retention or deductibles, as
        applicable. While we cannot predict the results with certainty, except as
        noted
        below, we do not believe that any liability from any such lawsuits or other
        matters will have a material effect on our financial position, results of
        operations, or liquidity. A discussion of our general and professional liability
        is contained in the same 2005 Form 10-K under "Significant Accounting Policies
        and Use of Estimates."
 
 In
        February 2005, a San Antonio, Texas, jury found one of our assisted living
        communities negligent in the care of a resident. The jury awarded a verdict
        against us in the amount of $1.5 million in compensatory damages and $18.0
        million in punitive damages. The verdict was in connection with an action
        that
        alleged negligence brought by the relatives of a resident at one of our assisted
        living facilities. We appealed the verdict and posted $1.7 million in order
        to
        stay the proceedings while the appellate process ran its course, or until
        the
        case was otherwise resolved. We recorded an additional liability accrual
        of
        $18.7 million in the fourth quarter of 2004 and accrued interest of $766,000
        on
        the unpaid judgment at the rate of 5% per annum during 2005. In March 2006,
        we
        settled the action for $5.6 million. In the first two quarters of 2006, we
        reduced the accrued interest by $766,000 and the liability accrual recorded
        in
        2004 by $12.2 million. The deposit with the court, including interest, was
        refunded in April 2006.
 
 In
        February 2004, the California Public Interest Research Group brought an action
        against owners and operators of assisted living communities and senior housing
        facilities including us. The action 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 the California case since we filed our 2005
        Form
        10-K with the SEC on March 16, 2006.
 
 In
        March
        2006, we received a request for documents from the Office of the Attorney
        General of Texas, in connection with its inquiry into compliance with
        certain Medicaid regulations at six of our communities in Texas that participate
        in the Community Based Alternative program of the Texas Department of Aging
        and
        Disability.  Participation in the program requires eligible rooms to have
        an area equipped with a sink, refrigerator, cooking appliance, adequate space
        for food preparation, and storage space for utensils and supplies.  An
        audit by the department revealed that some of the rooms used for
        residents in the program did not have some or all of those items. We
        addressed the State's concerns raised in the audits and all rooms were equipped
        with the above regulatory requirements as of April 10, 2006, at a cost of
        approximately $618,000.
  We
        began
        settlement discussions with the attorney general's office in late May
        2006 to resolve the matter.  Initially, the attorney general’s office
        sought $6.6 million, which equates to three times the total amount of all
        payments made to us by the State of Texas since the inception of our Medicaid
        contract, plus interest and attorney fees.  We responded in July 2006,
        advising the attorney general’s office that all the services for which Medicaid
        could, and did, lawfully pay were provided to the program residents despite
        the absence of some of the kitchen items.  Accordingly, recovery of
        the total of all payments to us was unjustified.  The letter advised the
        attorney general's office that the absence of the required items during the
        period of non-compliance was valued at $176,000.  In August 2006, we
        offered to settle the matter for $500,000. The discussions are continuing.
 
 While
        we
        believe we have incurred a liability in this matter, the range of possible
        outcomes is wide and the ultimate resolution is not readily determinable. 
Accordingly, we have recorded a liability in the amount of $500,000 as of
        June
        30, 2006, as our best estimate of the ultimate outcome.  We will assess our
        liability as discussions continue and will make adjustments, if any, to our
        recorded liability as more information becomes available to us.
  **39**
 Table
        of Contents
 **Item
        1A. Risk Factors**
 
 In
        addition to the other information set forth in this report, you should carefully
        consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual
        Report on Form 10-K for the year ended December 31, 2005, which could materially
        affect our business, financial condition or future results. The risks described
        in our Annual Report on Form 10-K are not the only risks facing our Company.
        Additional risks and uncertainties not currently known to us or that we
        currently deem to be immaterial also may materially adversely affect our
        business, financial condition and/or operating results.
 
 **Item
        4.****Submission
        of Matters to a Vote of Security Holders**
 
 (a)
              The
                  Annual Meeting of Shareholders was held on June 14,
                  2006.
 
 (b)
              All
                  director nominees listed in the proxy statement were elected at
                  the
                  meeting.
  **Nominees
        for Election**
 
 **Class
        I Directors (terms to expire in 2009)**
 
 Robert
        E.
        Marks
 David
        W.
        Niemiec
  **Continuing
        Directors**
 
 **Class
        II Directors (terms to expire 2007)**
 
 Stanley
        L. Baty
 Raymond
        R. Brandstrom
 T.
        Michael Young
  **Class
        III Directors (terms to expire in 2008)**
 
 Daniel
        R.
        Baty
 Bruce
        L.
        Busby
 Charles
        P. Durkin, Jr.
 
 (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 ·
            A
                proposal to adopt the Emeritus 2006 Equity Incentive
                Plan. 
 **Election
                  of Directors:****Abstain
                  or****Name**
              
              **For**
              
              **Against**
              
              **Broker
                  Non-vote**Robert
                  E. Marks
              
              17,292,766
              
              -
              
              6,174David
                  W. Niemiec
              
              17,216,403
              
              -
              
              82,537
  **40**
 Table of Contents   
 **Ratification
                  of Independent Public Accountants:****For**
              
              **Against**
              
              **Abstain**
              
              **Broker
                  Non-vote**17,289,624
              
              7,921
              
              1,395
              
              591,594**Approval
                  of the Emeritus 2006 Equity Incentive Plan:****For**
              
              **Against**
              
              **Abstain**
              
              **Other
                  Non-vote**13,867,154
              
              1,255,716
              
              12,696
              
              2,754,968
 
 (d)
        Not
        applicable.
 
 **Item
        6. Exhibits**
  **Footnote****Number**
                
                **Description**
                
                **Number****10.87**
                
                **Arbor
                    Place Acquisition on July 1, 2006 of one 100 unit
                    community**10.87.1
                LOAN
                    AGREEMENT between ESC ARBOR PLACE, LLC, a Washington limited
                    liability
                    company and GENERALELECTRIC
                    CAPITAL CORPORATION and THE OTHER FINANCIAL INSTITUTIONS WHO
                    ARE OR
                    HEREAFTERBECOME
                    PARTIES TO THIS AGREEMENT Dated as of June 30, 2006
                
                (2)**10.9**
                
                **2006
                    Equity Incentive Plan**
                
                (1)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 9, 2006.
                
                (2)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 9, 2006.
                
                (2)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 9, 2006.
                
                (2)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 9, 2006.
                
                (2)
 
 Footnotes:(1)
                Incorporated
                    by reference to the indicated exhibit filed with the Company's
                    Definitive
                    Proxy Statement on FormDEF
                    14A on May 1, 2006.(2)
                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 9, 2006
              EMERITUS
                  CORPORATION(Registrant)/s/
                  Raymond R. BrandstromRaymond
                  R. Brandstrom, Vice President of Finance,Chief
                  Financial Officer, and Secretary
 
  **42**