**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 March 31, 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
      April 30, 2006, there were  17,900,034 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 March 31, 2006, and
                December 31, 2005
            2Condensed
                Consolidated Statements of Operations for the Three
                months ended March 31, 2006 and 2005
            3Condensed
                Consolidated Statements of Cash Flows for the Three
                months ended March 31, 2006 and 2005
            4Notes
                to Condensed Consolidated Financial
                Statements
            5**Item
                2.**
            **Management's
                Discussion and Analysis of Financial Condition
                and Results of Operations**
            15**Item
                3.**
            **Quantitative
                and Qualitative Disclosures About Market
                Risk**
            31**Item
                4.**
            **Controls
                and Procedures**
            31**Part
                II. Other Information**Note:
            Items
                2, 3, 4, and 5 of Part II are omitted because they are not
                applicable.**Item
                1.**
            **Legal
                Proceedings**
            32**Item
                1A.**
            **Risk
                Factors**
            32**Item
                6.**
            **Exhibits**
            33**Signature**
            34














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****March
                31,**
            
            **December
                31,****2006**
            
            **2005**Current
                Assets:Cash
                and cash equivalents
            
            $
            37,172
            
            $
            56,413Short-term
                investments
            
            
            2,054
            
            
            1,885Trade
                accounts receivable, net of allowance of $757 and $744
            
            
            4,351
            
            
            4,604Other
                receivables
            
            
            5,697
            
            
            2,297Tax
                and maintenance escrows
            
            
            4,854
            
            
            6,579Prepaid
                workers' compensation
            
            
            8,793
            
            
            7,542Other
                prepaid expenses
            
            
            7,570
            
            
            6,791Total
                current assets
            
            
            70,491
            
            
            86,111Property
                and equipment, net
            
            
            612,891
            
            
            619,146Property
                held for development
            
            
            402
            
            
            402Notes
                receivable from and investments in affiliates
            
            
            3,686
            
            
            3,709Restricted
                deposits
            
            
            9,967
            
            
            9,660Lease
                and contract acquisition costs, net of amortization of $11,303 and
                $10,487
            
            
            26,181
            
            
            27,167Other
                assets, net
            
            
            1,504
            
            
            1,575Total
                assets
            
            $
            725,122
            
            $
            747,770**LIABILITIES
                AND SHAREHOLDERS' DEFICIT**Current
                Liabilities:Current
                portion of long-term debt
            
            $
            2,871
            
            $
            2,825Current
                portion of capital lease and financing obligations
            
            
            19,822
            
            
            19,028Current
                portion of convertible debentures
            
            
            -
            
            
            5,375Trade
                accounts payable
            
            
            6,699
            
            
            7,070Accrued
                employee compensation and benefits
            
            
            17,221
            
            
            17,372Accrued
                interest
            
            
            955
            
            
            2,355Accrued
                real estate taxes
            
            
            3,825
            
            
            6,478Accrued
                professional and general liability
            
            
            12,615
            
            
            27,994Accrued
                income taxes
            
            
            325
            
            
            4,649Other
                accrued expenses
            
            
            7,872
            
            
            7,280Deferred
                revenue
            
            
            8,609
            
            
            8,143Unearned
                rental income
            
            
            8,492
            
            
            6,350Total
                current liabilities
            
            
            89,306
            
            
            114,919Long-term
                debt, less current portion
            
            
            77,534
            
            
            77,650Capital
                lease and financing obligations, less current portion
            
            
            602,821
            
            
            607,677Convertible
                debentures, less current portion
            
            
            26,575
            
            
            26,625Deferred
                gain on sale of communities
            
            
            25,456
            
            
            26,009Deferred
                rent
            
            
            5,762
            
            
            5,496Other
                long-term liabilities
            
            
            2,386
            
            
            2,467Total
                liabilities
            
            
            829,840
            
            
            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
                outstanding17,883,834
                and 16,486,944 shares at March 31, 2006, and December 31, 2005,
                respectively
            
            
            2
            
            
            2Additional
                paid-in capital
            
            
            82,949
            
            
            79,321Accumulated
                deficit
            
            
            (187,669
            )
            
            (192,396
            )Total
                shareholders' deficit
            
            
            (104,718
            )
            
            (113,073
            )Total
                liabilities and shareholders' deficit
            
            $
            725,122
            
            $
            747,770








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


Discussion
      and Analysis of Financial Condition and Results of Operations.








**2**


Table of Contents








**EMERITUS
                CORPORATION****CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS****(unaudited)****(In
                thousands, except per share data)****Three
                Months ended March 31,****2006**
            
            **2005**Revenues:Community
                revenue
            
            $
            98,895
            
            $
            92,488Other
                service fees
            
            
            1,714
            
            
            1,708Management
                fees
            
            
            457
            
            
            598Total
                operating revenues
            
            
            101,066
            
            
            94,794Expenses:Community
                operations (exclusive of depreciation and amortizationand
                facility lease expense shown separately below)
            
            
            66,367
            
            
            60,405Texas
                lawsuit settlement
            
            
            (12,207
            )
            
            -General
                and administrative
            
            
            8,731
            
            
            7,333Depreciation
                and amortization
            
            
            12,150
            
            
            11,287Facility
                lease expense
            
            
            10,918
            
            
            9,737Total
                operating expenses
            
            
            85,959
            
            
            88,762Operating
                income from continuing operations
            
            
            15,107
            
            
            6,032Other
                income (expense):Interest
                income
            
            
            871
            
            
            231Interest
                expense
            
            
            (11,731
            )
            
            (12,118
            )Equity
                losses in unconsolidated joint ventures
            
            
            (96
            )
            
            -Other,
                net
            
            
            596
            
            
            740Net
                other expense
            
            
            (10,360
            )
            
            (11,147
            )Income
                (loss) from continuing operations before income taxes
            
            
            4,747
            
            
            (5,115
            )Provision
                for income taxes
            
            
            (10
            )
            
            (115
            )Income
                (loss) from continuing operations
            
            
            4,737
            
            
            (5,230
            )Income
                (loss) from discontinued operations
            
            
            (10
            )
            
            1,191Net
                income (loss)
            
            
            4,727
            
            
            (4,039
            )Preferred
                stock dividends
            
            
            -
            
            
            (957
            )Net
                income (loss) to common shareholders
            
            $
            4,727
            
            $
            (4,996
            )Basic
                income (loss) per common share:Continuing
                operations
            
            $
            0.28
            
            $
            (0.57
            )Discontinued
                operations
            
            
            -
            
            
            0.11$
            0.28
            
            $
            (0.46
            )Diluted
                income (loss) per common share:Continuing
                operations
            
            $
            0.25
            
            $
            (0.57
            )Discontinued
                operations
            
            
            -
            
            
            0.11$
            0.25
            
            $
            (0.46
            )Weighted
                average common shares outstanding :Basic
            
            
            17,030
            
            
            10,821Diluted
            
            
            18,819
            
            
            10,821








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


Discussion
      and Analysis of Financial Condition and Results of Operations.








**3**


Table of Contents





**EMERITUS
                CORPORATION****CONDENSED
                CONSOLIDATED STATEMENTS OF CASH FLOWS****(unaudited)****(In
                thousands)****Three
                Months Ended March 31,****2006**
            
            **2005**Cash
                flows from operating activities:Net
                income (loss)
            
            $
            4,727
            
            $
            (4,039
            )Adjustments
                to reconcile net income (loss) to net cash provided by (used in)
                operating
                activities:Depreciation
                and amortization
            
            
            12,150
            
            
            11,287Amortization
                of deferred gain
            
            
            (554
            )
            
            (554
            )Gain
                on sale of properties, net
            
            
            -
            
            
            (1,321
            )Amortization
                of loan fees
            
            
            51
            
            
            179Equity
                investment losses
            
            
            96
            
            
            -Stock
                option compensation
            
            
            135
            
            
            -Other
            
            
            230
            
            
            138Changes
                in operating assets and liabilities, net of acquisitions
            
            
            (24,870
            )
            
            (761
            )Net
                cash provided by (used in) operating activities
            
            
            (8,035
            )
            
            4,929Cash
                flows from investing activities:Acquisition
                of property and equipment
            
            
            (3,279
            )
            
            (2,098
            )Acquisition
                of assets in lease transactions
            
            
            -
            
            
            (406
            )Construction
                expenditures - leased properties
            
            
            (1,139
            )
            
            -Management
                and lease acquisition costs
            
            
            (8
            )
            
            (1,458
            )Payments
                from (advances to) affiliates and other managed
                communities
            
            
            313
            
            
            (152
            )Investment
                in affiliates
            
            
            (94
            )
            
            (33
            )Net
                cash used in investing activities
            
            
            (4,207
            )
            
            (4,147
            )Cash
                flows from financing activities:Proceeds
                from sale of stock
            
            
            3,444
            
            
            139Increase
                in restricted deposits
            
            
            (307
            )
            
            (621
            )Debt
                issue and other financing costs
            
            
            -
            
            
            (205
            )Proceeds
                from long-term borrowings and financings
            
            
            -
            
            
            21,426Repayment
                of long-term borrowings
            
            
            (5,733
            )
            
            (21,736
            )Repayment
                of capital lease and financing obligations
            
            
            (4,435
            )
            
            (3,776
            )Other
            
            
            32
            
            
            4Net
                cash used in financing activities
            
            
            (6,999
            )
            
            (4,769
            )Net
                decrease in cash and cash equivalents
            
            
            (19,241
            )
            
            (3,987
            )Cash
                and cash equivalents at the beginning of the period
            
            
            56,413
            
            
            10,748Cash
                and cash equivalents at the end of the period
            
            $
            37,172
            
            $
            6,761Supplemental
                disclosure of cash flow information -Cash
                paid during the period for interest
            
            $
            13,130
            
            $
            12,836Non-cash
                financing and investing activities:Accrued
                and in-kind preferred stock dividends
            
            $
            -
            
            $
            957Debt
                issued for acquisition of property and equipment
            
            $
            289
            
            $
            92Capital
                lease and financing obligations
            
            $
            373
            
            $
            14,600Assets
                held for sale
            
            $
            -
            
            $
            7,891Conversion
                of convertible debentures
            
            $
            50
            
            $
            -Deferred
                lease acquisition cost
            
            $
            178
            
            $
            -











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


Discussion
      and Analysis of Financial Condition and Results of Operations





**4**


Table of Contents





**EMERITUS
      CORPORATION**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**(unaudited)**





**Definitions**





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





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


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


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


4.
            "REIT"
                refers to real estate investment
                trust.


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


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


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


8.
            "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





**5**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


SFAS
      No.
      123R on January 1, 2006. The Company has adopted the “modified prospective”
method in 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 March 31, 2006, and for the three months ended March 31, 2006
      and
      2005. The results of operations for the period ended March 31, 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 $135,000 for
      the
      three months ended March 31, 2006. For the three months ended March 31, 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.





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





**6**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


over
      its
      vesting period. No options were granted in the first quarter of 2006 and there
      have been no modifications to the Company's share-based compensation plans
      during the quarter.





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 4,929 shares
      of
      Common Stock during the quarter ended March 31, 2006, under the ESP Plan. The
      purchase price of the shares was $18.36, which is 85% of $21.60, the market
      price on the last trading day of the current quarter.





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


**Three
                Months Ended March 31,****2006**
            
            **2005**Expected
                life from grant date (in months)
            
            
            3
            
            
            3Weighted
                average risk-free interest rate
            
            
            3.91
            %
            
            2.73
            %Weighted
                average volatility
            
            
            13.50
            %
            
            19.20
            %Dividend
                yield
            
            
            -
            
            
            -








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 quarter.





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
      month
      periods ended March 31, 2006 and 2005, under SFAS No. 123R. The pro forma net
      income and earnings per share for the three months ended March 31, 2006, are
      the
      same since stock-based compensation is calculated under the provisions of SFAS
      No. 123R.





**Three
                Months ended****March
                31,****2006**
            
            **2005****(In
                thousands, except per share data )**Net
                income (loss) to common shareholders:As
                reported
            
            $
            4,727
            
            $
            (4,996
            )Add:
                Stock-based employee compensation expenseincluded
                in reported net income (loss)
            
            
            135
            
            
            -Deduct:
                Stock-based employee compensationdetermined
                under fair value based method for all awards
            
            
            (135
            )
            
            (145
            )Pro
                forma
            
            $
            4,727
            
            $
            (5,141
            )Net
                income (loss) per common share:As
                reported - Basic
            
            $
            0.28
            
            $
            (0.46
            )Pro
                forma - Basic
            
            $
            0.28
            
            $
            (0.48
            )As
                reported - Diluted
            
            $
            0.25
            
            $
            (0.46
            )Pro
                forma - Diluted
            
            $
            0.25
            
            $
            (0.48
            )





**7**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


In
      the
      first quarter of 2006, the adoption of SFAS No. 123R caused net income to
      decrease by $135,000 and basic and diluted earnings per share to each decrease
      by $.01 per share.





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 average of the three
      and five year U.S. Treasury yield in effect at the time of grant. The expected
      life of the stock options granted (four 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
      following table summarizes the Company’s stock option activity for the first
      quarter ended March 31, 2006:








**2006****Shares**
            
            **Weighted-Average
                Exercise Price**
            
            **Aggregate
                Intrinsic Value ($000)**Outstanding
                at beginning of year
            
            
            1,349,381
            
            $
            3.81Granted
            
            
            -
            
            
            N/AExercised
            
            
            (90,923
            )
            $
            3.45Canceled
            
            
            (667
            )
            $
            3.95Outstanding
                at March 31, 2006
            
            
            1,257,791
            
            $
            3.84
            
            $
            22,343Options
                exercisable at March 31, 2006
            
            
            1,220,291
            
            $
            3.56
            
            $
            22,020Weighted-average
                fair value of options granted during first quarter 2006
            
            
            -
            
            
            N/A








The
      weighted average remaining contractual life was 6.4 years at March 31, 2006,
      for
      stock options outstanding and exercisable. The total intrinsic value for stock
      options outstanding and exercisable was $22.0 million and $13.7 million at
      March
      31, 2006 and 2005, respectively. The total intrinsic value for stock options
      exercised was $1.8 million and $335,000 in the first quarter of 2006 and 2005,
      respectively. As of March 31, 2006, there was $58,000 of total unrecognized
      compensation expense related to nonvested share-based compensation arrangements
      granted under the Plan. That expense is expected to be recognized over a
      weighted average period of three months.





The
      amount of cash received from the exercise of stock options was $313,000 and
      $70,000 in the first quarter of 2006 and 2005, respectively.





**8**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents





**Emeritrust
      Transactions**





*Emeritrust Managed
      Communities* .
      For the
      quarter ended March 31, 2005, the Company managed five communities, which are
      owned by Mr. Baty, for a management fee equal to 5% of gross revenues. The
      agreement currently expires June 30, 2006. 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
      $113,000 and $127,000 for the three months ended March 31, 2006 and
      2005.





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





The
      initial cash lease payment for these two communities is approximately $2.5
      million per year based on 8.6% of the REIT’s investment basis of $29.0 million,
      with annual 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 is required
      to
      pay the Company $168,000 for the three months ended March 31, 2006, and earned
      $244,000 from the Company for the three months ended March 31,
      2005.





*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





**9**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


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.





**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 been previously 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.





**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 three months ended March 31,
      2005.
      In December 2005, the Company sold a community in Las Vegas, Nevada and
      reclassified all prior period operating results to discontinued operations
      in
      the condensed consolidated statements of operations.





**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 unpaid cash dividends of the Series B Stock. Upon
      the
      payment of the dividends on June 30, 2005, Saratoga converted all of the
      outstanding Series B Stock into
      5,365,746 shares of common stock. Preferred stock dividends of $957,000 were
      recorded for the three months ended March 31, 2005, consisting of cash dividends
      of $591,000 and in-kind dividends of $366,000.





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 has been 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.





**10**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents





**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 were substantially the same, except
      that the maturity of the new debentures was July 1, 2008, instead of
      January 1, 2006, and the new debentures could not 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. On February 9, 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. Shares issuable
      upon the exercise of stock options and warrants and conversion of convertible
      debentures and preferred stock have been excluded from the computation for
      2005
      because the effect of their inclusion would be anti-dilutive, whereas only
      the
      convertible debentures are anti-dilutive in 2006 and the warrants and preferred
      stock no longer exist.





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


**Three
                Months ended****March
                31,****2006**
            
            **2005**Convertible
                Debentures(1)
            
            
            1,208
            
            
            1,455Options
            
            
            -
            
            
            1,528Warrants
                - Senior Housing Partners I, L.P.(2)
            
            
            -
            
            
            500Warrants
                - Saratoga Partners(3)
            
            
            -
            
            
            1,000Series
                B Preferred(4)
            
            
            -
            
            
            5,3131,208
            
            
            9,796(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 June 30, 2005.








**11**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


The
      following table summarizes the computation of basic and diluted net income
      (loss) per common share amounts presented in the accompanying condensed
      consolidated statements of operations (in thousands, except per share data):


**Three
                Months ended****March
                31,****2006**
            
            **2005**Basic:Numerator
                for basic net income (loss) per share:Net
                income (loss) to common shareholders
            
            $
            4,727
            
            $
            (4,996
            )Denominator
                for basic net income (loss) per share:Weighted
                average number of common shares outstanding
            
            
            17,030
            
            
            10,821Basic
                net income (loss) per share
            
            $
            0.28
            
            $
            (0.46
            )Diluted:Numerator
                for diluted net income (loss) per share:Net
                income (loss) to common shareholders
            
            $
            4,727
            
            $
            (4,996
            )Denominator
                for diluted net income (loss) per share:Weighted
                average number of common shares outstanding
            
            
            17,030
            
            
            10,821Assumed
                exercise of options and warrants
            
            
            1,789
            
            
            -18,819
            
            
            10,821Diluted
                net income (loss) per share
            
            $
            0.25
            
            $
            (0.46
            )





**Comprehensive
      Income (Loss** **)**





Comprehensive
      income (loss) is the same as net income (loss) to common shareholders for the
      three-month periods ended March 31, 2006 and 2005.


**Liquidity** ****





As
      of
      March 31, 2006, the Company has a working capital deficit of $18.8 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 $17.1 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
      $81.0 million scheduled to be due in 2008.





The
      Company has incurred significant losses since its inception and has an
      accumulated deficit of $187.7 million as of March 31, 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 $8.0 million for the three months ended March 31,
      2006. The primary components of cash used in operating activities for this
      period were net increases in operating assets and





**12**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


liabilities
      of $24.9 million and amortization of deferred gain of $554,000, partially offset
      by $4.7 million of net income from operations and $12.2 million of depreciation
      and amortization. The $24.9 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:****Three
                Months Ended March 31,****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
            
            
            (3,450
            )
            
            (2,552
            )All
                other activity, net
            
            
            2,353
            
            
            2,791Net
                change in operating assets and liabilities
            
            $
            (24,870
            )
            $
            (761
            )





The
      Texas
      settlement impact of $18.6 million and the federal tax deposits of $4.2 million
      related to the Alterra transaction gain, a total of $22.8 million, are
      non-recurring items. The insurance payment difference between years is due
      to a
      change in payment arrangements and will even out over the course of the
      year.





While
      the
      revenue per unit grew from the comparable period in the prior year, it grew
      more
      slowly than the Company’s targeted growth and the weighted average occupancy
      rate decreased by 1.1 percentage points to 83.9% for the first quarter of 2006
      from 85.0% for the first quarter of 2005. The Company is responding to this
      occupancy decline through increased marketing initiatives, programs that address
      resident mix and increasing maintenance and other community level expenses
      to
      attract additional long-term residents. Management believes that these
      initiatives will 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
      to the Company, with interest of $45,000, 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 quarter of 2006, the Company reduced the accrued interest by $766,000
      and the liability accrual recorded in 2004 by $12.2 million.





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.





In
      2002
      and continuing through 2005, the Company refinanced substantially all of its
      debt obligations, extending the maturities of such financings to dates in March
      2007 or thereafter, at which time the Company will need to refinance or
      otherwise repay the obligations. Many of the Company's debt instruments and





**13**
 **EMERITUS
            CORPORATION**
 **NOTES
            TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
 **Continued**
 **(unaudited)**


Table of Contents


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 March 31, 2006, the Company was in violation of one or
      more
      covenants in certain of the leases, but obtained waivers from the owners that
      expire on April 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
      September 2004, the Company committed to sell a community in Issaquah,
      Washington, that under SFAS No. 144 *“Accounting
      for the Impairment or Disposal of Long-Lived Assets,* ”
      qualified as an asset held for sale. 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. Both 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****March
                31,****2006**
            
            **2005****Total
                revenue:**Issaquah
            
            $
            -
            
            $
            -Las
                Vegas
            
            
            -
            
            
            342Total
            
            $
            -
            
            $
            342**Net
                income (loss):**Issaquah
            
            $
            -
            
            $
            1,319Las
                Vegas
            
            
            (10
            )
            
            (128
            )Total
            
            $
            (10
            )
            $
            1,191








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      rest
      of this page is intentionally left blank]











**14**


Table of Contents


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





**Definitions**





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





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


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


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


4.
            "REIT"
                refers to real estate investment
                trust.


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


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


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


8.
            "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 first quarter of 2006,





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managed
      communities had decreased to 13 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 March 31,**
            
            **As
                of December 31,**
            
            **As
                of March 31,****2006**
            
            **2005**
            
            **2005****Buildings**
            
            **Units**
            
            **Buildings**
            
            **Units**
            
            **Buildings**
            
            **Units**Owned
                (1)
            9
            
            707
            
            9
            
            707
            
            6
            
            454Leased
                (2 )
            161
            
            12,805
            
            161
            
            12,805
            
            161
            
            12,820Consolidated
                Portfolio
            170
            
            13,512
            
            170
            
            13,512
            
            167
            
            13,274Managed/Admin
                Services (3)
            12
            
            1,355
            
            13
            
            1,443
            
            14
            
            1,467Joint
                Venture/Partnership
            1
            
            140
            
            1
            
            140
            
            1
            
            140Operated
                Portfolio
            183
            
            15,007
            
            184
            
            15,095
            
            182
            
            14,881Percentage
                increase (4)
            (0.5%)
            
            (0.6%)
            
            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 March 31, 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,
      and
      another in March 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
      March 31, 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 three
      months ended March 31, 2006, increased to $3,046 from $2,902 for the same period
      in 2005. This change represents an increase of $144 or 5.0%. For the fourth
      quarter of 2005, our average monthly revenue per unit was $3,026. 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.





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In
      our
      consolidated portfolio, our average occupancy rate decreased to 83.9% for the
      three months ended March 31, 2006, from 85.0% for the three months ended March
      31, 2005. For the fourth quarter of 2005, our average occupancy rate was 83.6%.
      We believe the decline in occupancy over the past year is largely related to
      our
      recent detailed review of all aspects of our operations in response to the
      Texas
      verdict, which resulted in more conservative admission and discharge policies
      to
      insure our services were more than adequate to care for our residents, and
      not a
      signal of any underlying operating performance issues or industry trends. We
      also believe this occupancy decline has bottomed out as evidenced by an increase
      in our average occupancy from December 31, 2005, to March 31, 2006. 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 March 31,
      2006,
      we had an accumulated deficit of approximately $187.7 million. We believe that
      these losses have resulted from our early emphasis on expansion, financing
      costs
      arising from multiple financing and refinancing transactions related to this
      expansion, occupancy rates remaining lower for longer periods than we
      anticipated, and depreciation expense, 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
      currently expires June 30, 2006. 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 $113,000 and $127,000 for the three months
      ended March 31, 2006 and 2005.





*Emeritrust
      Lease.* 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 $791,000 in the current year quarter.





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. We have the right of
      first refusal to purchase the entire 20-community portfolio and Mr. Baty is
      personally guaranteeing our 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 is required
      to
      pay us $168,000 for the three months ended March 31, 2006 and earned $244,000
      from us for the three months ended March 31, 2005.





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





*Debt
      Restructuring*





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.





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. We 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.





*CPM/JEA
      Transactions*





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. 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, and resulting in an increase in interest and depreciation expense
      of approximately $136,000 and $179,000, respectively, in the current year
      quarter.





*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 and
      depreciation of $290,000 and $343,000, respectively, in the current year
      quarter.





*Sale
      of Communities*





On
      November 1, 2004, we sold a single community located in Issaquah, Washington,
      for cash and assumption of liabilities for a total of $9.6 million. Since we
      had
      a continuing involvement in the community until such time as the buyer was
      granted a license to operate the community, which occurred on January 7, 2005,
      we deferred recognition of the sale and associated gain until the first quarter
      of 2005. We recorded a gain of $1.3 million related to this sale in discontinued
      operations in our condensed consolidated statements





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of
      operations for the three months ended March 31, 2005.  In December 2005, we
      sold a community in Las Vegas, Nevada and reclassified all prior period
      operating results to discontinued operations in the condensed consolidated
      statements of operations.





*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 by
      us of accrued and unpaid cash dividends on the Series B Stock, 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 unpaid cash dividends of the Series B Stock, resulting in an increase
      in
      interest expense of approximately $266,000 in the current year quarter. 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.





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, we 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 has been 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.





*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 were substantially the same, except
      that the maturity of the new debentures was July 1, 2008, instead of
      January 1, 2006, and the new debentures could not 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. On February 9, 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, our chief executive officer and a director, and Stanley L.
      Baty,
      a director, own $15.8 million of the debentures.











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The
      following table shows the changes in buildings from December 31, 2004, through
      March 31, 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****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.











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**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****Three
                Months ended**
            
            **ended****March
                31,**
            
            **March
                31,****2006**
            
            **2005**
            
            **2006-2005**Revenues:
            
            
            100.0
            %
            
            100.0
            %
            
            6.6
            %Expenses:Community
                operations*
            
            
            65.7
            
            
            63.7
            
            
            (9.9
            )Texas
                lawsuit settlement
            
            
            (12.1
            )
            
            -
            
            
            N/AGeneral
                and administrative
            
            
            8.6
            
            
            7.7
            
            
            (19.1
            )Depreciation
                and amortization
            
            
            12.0
            
            
            11.9
            
            
            (7.6
            )Facility
                lease expense
            
            
            10.8
            
            
            10.3
            
            
            (12.1
            )Total
                operating expenses
            
            
            85.0
            
            
            93.6
            
            
            3.2Operating
                income from continuing operations
            
            
            15.0
            
            
            6.4
            
            
            150.4Other
                income (expense)Interest
                income
            
            
            0.9
            
            
            0.2
            
            
            277.1Interest
                expense
            
            
            (11.6
            )
            
            (12.8
            )
            
            3.2Equity
                losses in unconsolidated joint ventures
            
            
            (0.1
            )
            
            -
            
            
            N/AOther,
                net
            
            
            0.5
            
            
            0.8
            
            
            19.5Net
                other expense
            
            
            (10.3
            )
            
            (11.8
            )
            
            7.1Income
                (loss) from continuing operationsbefore
                income taxes
            
            
            4.7
            
            
            (5.4
            )
            
            N/AProvision
                for income taxes
            
            
            -
            
            
            (0.2
            )
            
            N/AIncome
                (loss) from continuing operations
            
            
            4.7
            
            
            (5.6
            )
            
            N/AIncome
                from discontinued operations, net of tax benefit
            
            
            -
            
            
            1.3
            
            
            N/ANet
                income (loss)
            
            
            4.7
            %
            
            (4.3
            %)
            
            N/A*
                exclusive of depreciation and amortization and facility lease expense
                shown separately below











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Comparison
      of the three months ended March 31, 2006 and 2005





**Total
      Operating Revenues:**








**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Community
                revenue
            
            $
            98,895
            
            $
            92,488
            
            $
            6,407
            
            
            6.9
            %Other
                service fees
            
            
            1,714
            
            
            1,708
            
            
            6
            
            
            0.4
            %Total
                community revenues
            
            
            100,609
            
            
            94,196
            
            
            6,413
            
            
            6.8
            %Management
                fees
            
            
            457
            
            
            598
            
            
            (141
            )
            
            (23.6
            %)Total
                operating revenues
            
            $
            101,066
            
            $
            94,794
            
            $
            6,272
            
            
            6.6
            %








The
      increase in community revenue and other service fees of $6.4 million in the
      three months ended March 31, 2006, compared to the three months ended March
      31,
      2005, was primarily due to increases in the average monthly revenue per unit,
      which accounted for approximately $4.7 million of the increase. Average monthly
      revenue per unit was $3,046 for the first quarter of 2006 compared to $2,902
      for
      the comparable quarter of 2005, an increase of approximately $144 per occupied
      unit, or 5.0%. The average occupancy rate for the three months ended March
      31,
      2006, decreased 1.1 percentage points to 83.9% from 85.0% and resulted in a
      reduction of revenues from the comparable quarter of approximately $1.4 million.
      The remainder of the increase is due to the 491 overall increase in the number
      of occupied units due primarily to the acquisition or lease of seven communities
      since December 31, 2004.





Our
      revenue per unit grew more slowly than our targeted growth and our occupancy
      declined primarily due to our recent detailed review of all aspects of our
      operations in response to the Texas verdict. This review resulted in a decline
      in occupancy from implementation of more conservative admission and discharge
      policies, which were intended to insure our services were adequate to attend
      to
      our residents requiring a higher level of care. We do not believe this is a
      signal of any underlying operating performance issues or industry trends. We
      experienced an increase in our occupancy rate from 84.2% on December 31, 2005,
      to 85.0% on March 31, 2006, the last day of each fiscal quarter. We have
      responded and will continue to respond to this decline through increased
      marketing initiatives, programs that address resident mix and increasing
      maintenance and other community-level expenses to attract additional long-term
      residents and increase occupancy while maintaining growth in average monthly
      revenue per unit. We believe that these initiatives will have a positive impact
      on operating performance over time.





The
      decrease in management fee income of approximately $141,000 for the first
      quarter of 2006 as compared to 2005 was primarily due to two communities now
      leased in the first quarter of 2006 that were managed in the same quarter of
      the
      prior year and the cessation of management contracts on three additional
      communities in July 2005, January 2006, and March 2006.





**Community
      Operations:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Community
                operations
            
            $
            66,367
            
            $
            60,405
            
            $
            5,962
            
            
            9.9
            %








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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 $6.0 million, or 9.9%. Of
      that amount, approximately $2.3 million was due to the seven communities
      acquired since January 1, 2005. Of the remainder of $3.7 million, approximately
      $2.2 million was increased staffing costs and approximately $1.5 million was
      due
      to increases in utilities, repairs and maintenance, bad debts, marketing,
      property taxes, and telephone expenses, partially offset by decreases in
      insurance and business licenses and taxes. Excluding the liability insurance
      adjustment, community operating expenses were 65.7% of total operating revenues
      for the first quarter of 2006 compared to 63.7% for the first quarter of 2005.





**General
      and Administrative:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**General
                and administrative
            
            $
            8,731
            
            $
            7,333
            
            $
            1,398
            
            
            19.1
            %





The
      increase in G&A expenses of $1.4 million was primarily related to staffing
      costs for regional and corporate overhead positions of approximately $315,000,
      non-cash stock option compensation expense of $135,000, and $230,000 in other
      employee benefit expenses. In addition, approximately $754,000 of the increase
      related to increased accounting, legal, and consulting fees, including direct
      project costs to comply with internal control requirements under the
      Sarbanes-Oxley Act of 2002, and increases in our audit fees. As a percentage
      of
      total operating revenues, G&A expenses increased to 8.6% for the three
      months ended March 31, 2006, compared to 7.7% for the three months ended March
      31, 2005.




**Depreciation
      and Amortization:**








**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Depreciation
                and amortization
            
            $
            12,150
            
            $
            11,287
            
            $
            863
            
            
            7.6
            %





The
      increase is primarily the result of the depreciation and amortization related
      to
      the December 2005 Arkansas acquisition, leasehold improvement depreciation
      from
      capital expenditures to improve our properties, and depreciation from capital
      leases acquired in March 2005. In 2006, depreciation and amortization
      represented 12.0% of total operating revenues, compared to 11.9% for the same
      period in 2005.





**Facility
      Lease Expense:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Facility
                lease expense
            
            $
            10,918
            
            $
            9,737
            
            $
            1,181
            
            
            12.1
            %








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The
      increase in facility lease expense of $1.2 million was primarily due to the
      operating lease of two new communities discussed under Emeritrust Lease, which
      accounted for approximately $791,000 of the increase. The remaining increase
      of
      $390,000 was primarily attributable to performance-based lease inflators of
      existing operating leases. We leased 77 and 76 communities under operating
      leases as of March 31, 2006 and 2005, respectively. One of these communities
      was
      leased as of March 31, 2005, and thus, was leased for only one day in the first
      quarter of 2005. Facility lease expense as a percentage of revenues was 10.8%
      for the three months ended March 31, 2006, and 10.3% for the three months ended
      March 31, 2005.





**Interest
      Income:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Interest
                income
            
            $
            871
            
            $
            231
            
            $
            640
            
            
            277.1
            %





The
      increase in interest income of $640,000 was primarily attributable to interest
      earned on investments of cash that was received in the sale of our ownership
      interest in Alterra, interest income earned on restricted deposits, and interest
      earned on the court bond paid as result of the initial judgment in the Texas
      lawsuit, as further discussed under “Legal Proceedings.”





**Interest
      Expense:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Interest
                expense
            
            $
            11,731
            
            $
            12,118
            
            $
            (387
            )
            
            (3.2
            %)





The
      decrease in interest expense of $387,000 for the first quarter 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
      $379,000 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 normal
      pay down of principal balances over the past year. As a percentage of total
      operating revenues, interest expense decreased to 11.6% in the first quarter
      of
      2006 from 12.8% for the first quarter of 2005. Excluding the reduction in the
      interest accrual related to the lawsuit settlement, interest expense was 12.4%
      of total operating revenues for the three months ended March 31,
      2006.





**Other,
      net:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Other,
                net
            
            $
            596
            
            $
            740
            
            $
            (144
            )
            
            (19.5
            %)





The
      decrease in Other, net income of $144,000 for the first quarter of 2006 as
      compared to the first quarter of 2005 is primarily due to the payment of
      $125,000 in 2006 to resolve an acquisition-related dispute.





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**Income
      taxes:**








**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Provision
                for income taxes
            
            $
            10
            
            $
            115
            
            $
            (105
            )
            
            (91.3
            %)





The
      provision for income taxes for the quarter ended March 31, 2006, is for state
      income and franchise tax liabilities.  There is no Federal tax for the
      current quarter due to net operating losses for federal tax purposes after
      adjusting for lease accounting treatments and other differences between
      financial accounting and tax.  The provision for income taxes for the
      quarter ended March 31, 2005, is principally due to Federal alternative minimum
      tax and state income and franchise tax liabilities on taxable income after
      adjusting for differences between financial accounting and tax.





**Net
      Income (Loss) and Property-Related Expense:** **





In
      comparing the net income (loss) for the three months ended March 31, 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 March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)****Total
                property-related expense:**Depreciation
                and amortization
            
            $
            12,150
            
            $
            11,287
            
            $
            863
            
            
            7.6
            %Facility
                lease expense
            
            
            10,918
            
            
            9,737
            
            
            1,181
            
            
            12.1
            %Interest
                expense
            
            
            11,731
            
            
            12,118
            
            
            (387
            )
            
            (3.2
            %)Total
                property-related expense
            
            $
            34,799
            
            $
            33,142
            
            $
            1,657
            
            
            5.0
            %**Property-related
                expenses from lease accounting treatment:**Depreciation
                and amortization
            
            $
            9,699
            
            $
            9,618
            
            $
            81
            
            
            0.8
            %Interest
                expense
            
            
            10,400
            
            
            10,443
            
            
            (43
            )
            
            (0.4
            %)Straight-line
                lease expense
            
            
            285
            
            
            155
            
            
            130
            
            
            83.9
            %Operating
                lease expense
            
            
            10,633
            
            
            9,583
            
            
            1,050
            
            
            11.0
            %Total
                property-related lease expense
            
            
            31,017
            
            
            29,799
            
            
            1,218
            
            
            4.1
            %Actual
                lease payments
            
            
            (25,487
            )
            
            (23,665
            )
            
            (1,822
            )
            
            7.7
            %Expense
                in excess of lease payments
            
            $
            5,530
            
            $
            6,134
            
            $
            (604
            )
            
            (9.8
            %)








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Our
      property-related expense associated with our leases exceeded our actual lease
      payments by $5.5 million and $6.1 million for the three months ended March
      31,
      2006 and 2005, respectively. While the impact of lease accounting declined
      by
      $604,000 in the current year quarter from the comparable quarter last year,
      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 increase our revenues and
      our results from community operations to cover these increases.


**Income
      (Loss) from Discontinued Operations:**





**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Income
                (loss) from discontinued operations,net
                of tax benefit
            
            $
            (10
            )
            $
            1,191
            
            $
            (1,201
            )
            
            (100.8
            %)





Loss
      from
      discontinued operations for the three months ended March 31, 2006, was $10,000
      compared to $1.2 million income for the comparable period in 2005, most of
      which
      related to the gain on the sale of a facility in Washington.





**Preferred
      dividends:**








**Three
                Months ended March 31,****2006**
            
            **2005**
            
            **$****D**
            
            **%****D****(in
                thousands)**Preferred
                dividends
            
            $
            -
            
            $
            957
            
            $
            (957
            )
            
            (100.0
            %)





*Preferred
      dividends:* For the
      three months ended March 31, 2006 and 2005, preferred dividends totaled zero
      and
      $957,000, respectively. The preferred dividends for the three months ended
      March
      31, 2006, were zero because the Series B Stock was converted to common stock
      on
      June 30, 2005.








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      rest
      of this page is intentionally left blank]





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*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 adjustment to our
      professional and general liability insurance accrual related to the settlement
      of a lawsuit as further described under “Legal Proceedings,” and general and
      administrative expenses. The following table sets forth a comparison of same
      community results of operations for the three months ended March 31, 2006 and
      2005.





**Three
                Months ended March 31,****(In
                thousands)****$****D**
            
            **%****D****2006**
            
            **2005**
            
            **Fav
                / (Unfav)**
            
            **Fav
                / (Unfav)**Revenue
            
            $
            96,176
            
            $
            93,524
            
            $
            2,652
            
            
            2.8
            %Community
                operations *
            
            
            (63,902
            )
            
            (59,723
            )
            
            (4,179
            )
            
            (7.0
            )Community
                operating income
            
            
            32,274
            
            
            33,801
            
            
            (1,527
            )
            
            (4.5
            )Depreciation
                & amortization
            
            
            (11,395
            )
            
            (11,069
            )
            
            (326
            )
            
            (2.9
            )Facility
                lease expense
            
            
            (9,735
            )
            
            (9,361
            )
            
            (374
            )
            
            (4.0
            )Operating
                income
            
            
            11,144
            
            
            13,371
            
            
            (2,227
            )
            
            (16.7
            )Interest
                expense, net
            
            
            (11,048
            )
            
            (11,384
            )
            
            336
            
            
            3.0Operating
                income after interest expense
            
            $
            96
            
            $
            1,987
            
            $
            (1,891
            )
            
            (95.2
            %)*
                exclusive of depreciation and amortization and facility lease expense
                shown separately below





These
      162
      communities represented $96.2 million or 95.2% of our total revenue of $101.1
      million for the first quarter of 2006. The increase in same community revenues
      of $2.7 million was primarily due to improvements in average revenue per
      occupied unit, which contributed approximately $4.8 million, partially offset
      by
      a decrease in occupancy, which had a negative effect of approximately $2.1
      million. Average revenue per occupied unit increased by $148 per month or 5.1%
      for the three months ended March 31, 2006, as compared to the three months
      ended
      March 31, 2005. Weighted average occupancy decreased 1.5 percentage points
      to
      83.6% for the three months ended March 31, 2006 from 85.1% for the three months
      ended March 31, 2005. However, we experienced an increase in our occupancy
      rate
      from 84.0% on December 31, 2005, to 84.9% on March 31, 2006, the last day of
      each fiscal quarter.





Community
      operating expenses increased approximately $4.2 million primarily from increased
      costs for direct care labor and related employee taxes and benefits of $2.3
      million. The increase also reflects increased utilities of $511,000 and facility
      maintenance cost increases of $294,000. The remaining increase of approximately
      $1.1 million is primarily comprised of other general operating expenses of
      the
      communities, including bad debts, marketing, property taxes, insurance,
      telephone, food costs, and similar community operating expenses.





Property-related
      expenses (depreciation and amortization, facility lease expense, and interest
      expense, net of interest income) increased by approximately $364,000, which
      primarily reflects the effect of performance-based lease inflators of existing
      operating leases 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, a decrease in facility
      capital lease interest expenses due to the normal pay down of the related
      principal balances.





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Operating
      income after interest expense decreased $1.9 million from the comparable period
      of 2005 as a result of the changes discussed above. We are responding to this
      decline through increased marketing initiatives, programs to address resident
      mix and increasing maintenance and other community-level expenses to attract
      long-term residents and increase occupancy while maintaining growth in our
      average monthly revenue per unit.





**Liquidity
      and Capital Resources**





For
      the
      three months ended March 31, 2006, net cash used in operating activities was
      $8.0 million. The primary components of cash used in operating activities for
      this period were net increases in operating assets and liabilities of $24.9
      million and amortization of deferred gain of $554,000, partially offset by
      $4.7
      million of net income from operations and $12.2 million of depreciation and
      amortization. The $24.9 million use of cash related to operating assets and
      liabilities is primarily comprised of those items detailed in the following
      table. For the three months ended March 31, 2005, net cash provided by operating
      activities was $4.9 million. The primary components of operating cash provided
      by operating activities for this period were depreciation and amortization
      of
      $11.3 million,  partially
      offset by the adjustment for the net gain on sale of properties of $1.3 million,
      the net increase in operating assets and liabilities of $761,000 (which included
      a $1.0 million semi-annual interest payment on the debentures), the amortization
      of deferred gain of $554,000, the amortization of loan fees of $179,000, and
      the
      net loss of $4.0 million.





**Significant
                components of changes in operating assets and
                liabilities:****Three
                Months Ended March 31,****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
            
            
            (3,450
            )
            
            (2,552
            )All
                other activity, net
            
            
            2,353
            
            
            2,791Net
                change in operating assets and liabilities
            
            $
            (24,870
            )
            $
            (761
            )





The
      Texas
      settlement impact of $18.6 million and the federal tax deposits of $4.2 million
      related to the Alterra transaction gain, a total of $22.8 million, are
      non-recurring items. The insurance payment difference between years is due
      to a
      change in payment arrangements and will even out over the course of the
      year.





For
      the
      three months ended March 31, 2006, cash used in investing activities was $4.2
      million. The activities that used cash include $3.3 million for the acquisition
      of property and equipment and $1.1 million in construction expenditures for
      leased property, partially offset by a net decrease in investment in affiliates.
      Net cash used in investing activities amounted to $4.1 million for the three
      months ended March 31, 2005, and was comprised primarily of management and
      lease
      acquisition costs of approximately $1.5 million, and acquisitions of various
      property and equipment of approximately $2.5 million.





For
      the
      three months ended March 31, 2006, cash used in financing activities was $7.0
      million. Activities resulting in a net cash decrease include $5.7 million for
      repayment of long-term borrowings and $4.4 million for repayment of capital
      lease and financing obligations, partially offset by proceeds from the issuance
      of common stock of approximately $3.4 million. For the three months ended March
      31, 2005, net cash used in financing activities was $4.8 million, consisting
      primarily of repayment of capital lease and financing obligations of $3.8
      million and net payment of long-term borrowings of $310,000. We refinanced
      $21.4
      million in borrowings during the three months ended March 31, 2005.





As
      of
      March 31, 2006, we had a working capital deficit of $18.8 million. We are able
      to operate in the position of a working capital deficit because revenues are
      collected more quickly, often in advance, than





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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 $17.1 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
      $81.0 million scheduled to be due in 2008.





We
      have
      incurred significant losses since our inception and have an accumulated deficit
      of $187.7 million as of March 31, 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 of
      $45,000, in April 2006. In the fourth quarter of 2004, we recorded an additional
      liability accrual of $18.7 million and accrued $766,000 of interest on the
      judgment in 2005. In the first quarter of 2006, we reduced the accrued interest
      by $766,000 and the liability accrual recorded in 2004 by $12.2
      million.





Throughout
      2004 and continuing through the first quarter of 2005, we refinanced
      substantially all of our debt obligations, extending the maturities of such
      financings to dates beyond March 31, 2007, and thereafter, at which time we
      will
      need to refinance or otherwise repay the obligations. Many of our debt
      instruments and leases contain “cross-default” provisions pursuant to which a
      default under one obligation can cause a default under one or more other
      obligations to the same or other lenders or lessors. Such cross-default
      provisions affect 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
      March
      31, 2006, we were in violation of one or more covenants in certain of the
      leases, but obtained waivers from the owners that expire on April 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 on an
      annual basis, 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.





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      rest
      of this page is intentionally left blank]














**29**
 **MANAGEMENT'S
              DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**
 **AND
              RESULTS OF OPERATIONS - CONTINUED**


Table of Contents


The
      following table summarizes our contractual obligations at March 31, 2006, (in
      thousands):





**Principal
                and Lease Payments Due by Period****Less
                than**
            
            
            
            
            
            **After
                5****Contractual
                Obligations**
            
            **Total**
            
            **1
                year**
            
            **1-3
                years**
            
            **4-5
                years**
            
            **years**Long-term
                debt, including current portion
            
            $
            80,405
            
            $
            2,871
            
            $
            57,182
            
            $
            2,385
            
            $
            17,967Capital
                lease and financing obligations, including current portion
            
            
            622,643
            
            
            19,822
            
            
            49,605
            
            
            64,204
            
            
            489,012Operating
                leases
            
            
            339,957
            
            
            40,993
            
            
            82,728
            
            
            85,140
            
            
            131,096Convertible
                debentures
            
            
            26,575
            
            
            -
            
            
            26,575
            
            
            -
            
            
            -$
            1,069,580
            
            $
            63,686
            
            $
            216,090
            
            $
            151,729
            
            $
            638,075





The
      following table summarizes interest on our contractual obligations at March
      31,
      2006, (in thousands):








**Interest
                Due by Period****Less
                than**
            
            
            
            
            
            **After
                5****Contractual
                Obligations**
            
            **Total**
            
            **1
                year**
            
            **1-3
                years**
            
            **4-5
                years**
            
            **years**Long-term
                debt
            
            $
            12,399
            
            $
            5,331
            
            $
            6,246
            
            $
            702
            
            $
            120Capital
                lease and financing obligations
            
            
            355,241
            
            
            40,980
            
            
            77,740
            
            
            70,569
            
            
            165,952Convertible
                debentures
            
            
            4,152
            
            
            1,661
            
            
            2,491
            
            
            -
            
            
            -$
            371,792
            
            $
            47,972
            
            $
            86,477
            
            $
            71,271
            
            $
            166,072











**Impact
      of Inflation**





To
      date,
      inflation has not had a significant impact on us. However, inflation could
      affect our future revenues and operating income due to our dependence on the
      senior resident population, most of whom rely on relatively fixed incomes to
      pay
      for our services. The monthly charges for a resident's unit and assisted living
      services are influenced by the location of the community and local competition.
      Our ability to increase revenues in proportion to increased operating expenses
      may be limited. To the extent we rely upon governmental reimbursement programs,
      we have a limited ability to increase rates. In pricing our services, we attempt
      to anticipate inflation levels, but there can be no assurance that we will
      be
      able to respond to inflationary pressures in the future.





**Forward-Looking
      Statements**





“Safe
      Harbor” Statement under the Private Securities Litigation Reform Act of 1995: A
      number of the matters and subject areas discussed in this report that are not
      historical or current facts deal with potential future circumstances,
      operations, and prospects. The discussion of such matters and subject areas
      is
      qualified by the inherent risks and uncertainties surrounding future
      expectations generally, and also may materially differ from our actual future
      experience as a result of such factors as: the effects of competition and
      economic conditions on the occupancy levels in our communities; our ability
      under current market conditions to maintain and increase our resident charges
      in
      accordance with our rate enhancement programs without adversely affecting
      occupancy levels; 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.











**30**


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 March 31, 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 LIBOR rates increase above the current
      level, we will be exposed to higher lease expense costs. As of March 31, 2006,
      the LIBOR rate was 4.8%. If LIBOR interest rates were to increase to the cap,
      our annual facility lease expense would increase and our net income would
      decrease by approximately $460,000. This amount is determined by considering
      the
      impact of hypothetical interest rates on these operating lease obligations
      as of
      March 31, 2006, and does not consider changes in the actual level of borrowings
      or operating lease obligations that may occur subsequent to March 31, 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 March 31, 2006, that materially affected, or is reasonably likely
      to materially affect, our internal control over financial reporting.











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      rest
      of this page is intentionally left blank]








**31**


Table of Contents


**PART
      II. OTHER INFORMATION**





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





**Item
      1. Legal Proceedings**





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





In
      February 2005, a San Antonio, Texas, jury found one of our assisted living
      communities negligent in the care of a resident. The jury awarded a verdict
      against us in the amount of $1.5 million in compensatory damages and $18.0
      million in punitive damages. The verdict was in connection with an action that
      alleged negligence brought by the relatives of a resident at one of our assisted
      living facilities. We appealed the verdict and posted $1.7 million in order
      to
      stay the proceedings while the appellate process ran its course, or until the
      case was otherwise resolved. We recorded an additional liability accrual of
      $18.7 million in the fourth quarter of 2004 and accrued interest of $766,000
      on
      the unpaid judgment at the rate of 5% per annum during 2005. In March 2006,
      we
      settled the action for $5.6 million. In the first quarter of 2006, we reduced
      the accrued interest by $766,000 and the liability accrual recorded in 2004
      by
      $12.2 million. The deposit with the court was refunded in April 2006, plus
      interest of approximately $45,000.





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. 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."





**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.








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      rest
      of this page is intentionally left blank]








**32**


Table of Contents





**Item
      6. Exhibits**











**Footnote****Number**
            
            **Description**
            
            **Number**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 May 10, 2006.
            
            (1)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 May 10, 2006.
            
            (1)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 May 10, 2006.
            
            (1)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 May 10, 2006.
            
            (1)








Footnotes:(1)
            Filed
                herewith.











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      rest
      of this page is intentionally left blank]

















**33**


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:
                May 10, 2006
            EMERITUS
                CORPORATION(Registrant)/s/
                Raymond R. BrandstromRaymond
                R. Brandstrom, Vice President of Finance,Chief
                Financial Officer, and Secretary





**34**