** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC 20549**

** **

**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

** **

**For thefiscal year ended December 31, 2006**

**OR**

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

** **

**CommissionFile Number 001-16817**

**FIVE STAR QUALITY CARE, INC.**

(Exact Name of Registrant as Specified in its Charter)

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

** **

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

(Address of PrincipalExecutive Offices)

 

**617-796-8387**

(Registrant’s TelephoneNumber)

 

Securities to be registeredpursuant to Section 12(b) of the Act:

 

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

 

Securities to be registered pursuant to Section 12(g)of the Act: None

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

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

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

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

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

Large accelerated filer  o  Accelerated filer  x  Non-accelerated filer  o

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

The aggregate market value of the voting shares of theregistrant held by non-affiliates was $343.4 million based on the $11.07closing price per common share on the American Stock Exchange on June 30,2006.   For purposes of this calculation,an aggregate of 557,582.6 shares of common stock are held by the directors andofficers of the registrant and have been included in the number of shares ofcommon stock held by affiliates, which includes 35,000 shares of common stockheld by Senior Housing Properties Trust.

Number of the registrant’sshares of common stock outstanding as of March 5, 2007: 31,684,134.

 

 

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

**DOCUMENTS INCORPORATED BY REFERENCE**

Certain information required in Items 10, 11, 12, 13and 14 of Part III of this Annual Report on Form 10-K is incorporated byreference from our definitive Proxy Statement for the Annual Meeting ofShareholders scheduled to be held on May 15, 2007, or our definitive ProxyStatement.

**WARNINGCONCERNING FORWARD LOOKING STATEMENTS**

THIS ANNUAL REPORT CONTAINS STATEMENTS WHICHCONSTITUTE FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATESECURITIES LITIGATION REFORM ACT OF 1995 AND OTHER FEDERAL SECURITIES LAWS.ALSO, WHENEVER WE USE WORDS SUCH AS “BELIEVE”, “EXPECT”, “ANTICIPATE”, “INTEND”,“PLAN”, “ESTIMATE” OR SIMILAR EXPRESSIONS, WE ARE MAKING FORWARD LOOKINGSTATEMENTS. THESE FORWARD LOOKING STATEMENTS ARE BASED UPON OUR PRESENT INTENT,BELIEFS OR EXPECTATIONS, BUT FORWARD LOOKING STATEMENTS ARE NOT GUARANTEED TOOCCUR AND MAY NOT OCCUR.  ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSECONTAINED IN OR IMPLIED BY OUR FORWARD LOOKING STATEMENTS AS A RESULT OFVARIOUS FACTORS.

IMPORTANT FACTORS THAT COULD CAUSE ACTUAL RESULTS TODIFFER MATERIALLY FROM THOSE IN OUR FORWARD LOOKING STATEMENTS ARE:

·                  THETERMINATION OF OUR MANAGEMENT AGREEMENTS WITH SUNRISE SENIOR LIVING SERVICES,INC., OR SLS, MAY NOT IMPROVE OUR FINANCIAL RESULTS OR MAY CAUSE US TOEXPERIENCE OPERATING LOSSES.  ALTHOUGH OUR EXPECTATION IS OTHERWISE, WEMAY BE UNABLE TO OPERATE THE COMMUNITIES SLS MANAGED FOR US AS PROFITABLY ASTHEY WERE OPERATED BY SLS; AND

·                  OPERATINGMARGINS FOR OUR TWO REHABILITATION HOSPITALS MAY BE LOWER THAN WE CURRENTLYANTICIPATE OR MAY DECLINE.  WE MAY BE UNABLE TO OPERATE THESE HOSPITALSPROFITABLY AND WE MAY EXPERIENCE LOSSES FROM OUR OPERATION OF THESEHOSPITALS.  ALSO, THE PERCENTAGE OF PATIENTS AT THESE HOSPITALS WHICH MEETCERTAIN MEDICARE REQUIREMENTS MAY NOT BE AS HIGH AS WE CURRENTLY ANTICIPATE ORMAY DECLINE AND, AS A RESULT, THESE HOSPITALS MAY RECEIVE LOWER MEDICARE RATESTHAN WE CURRENTLY ANTICIPATE.

OTHER RISKS MAY ADVERSELY IMPACT US, AS DESCRIBED MOREFULLY IN THIS ANNUAL REPORT UNDER “ITEM 1A. RISK FACTORS.”

YOU SHOULD NOT PLACE UNDUE RELIANCE UPON FORWARDLOOKING STATEMENTS.

EXCEPT AS REQUIRED BY LAW, WE UNDERTAKE NO OBLIGATIONTO UPDATE OR REVISE ANY FORWARD LOOKING STATEMENTS AS A RESULT OF NEWINFORMATION, FUTURE EVENTS OR OTHERWISE.

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**FIVE STARQUALITY CARE, INC.2006 ANNUAL REPORT ON FORM 10-K**

**Table ofContents**
|            | ** ** | **PART I**                                                                                                          | ** ** | ** ** |
|------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|------------|
|       | ** ** | ** **                                                                                                          | ** ** | ** ** |
| Item 1.    |       | Business                                                                                                            | 1          |       |
| Item 1A.   |       | Risk  Factors                                                                                                       | 11         |       |
| Item 1B.   |       | Unresolved Staff  Comments                                                                                          | 18         |       |
| Item 2.    |       | Properties                                                                                                          | 19         |       |
| Item 3.    |       | Legal  Proceedings                                                                                                  | 22         |       |
| Item 4.    |       | Submission of  Matters to a Vote of Security Holders                                                                | 23         |       |
|       |       |                                                                                                                |       |       |
| ** ** | ** ** | **PART II**                                                                                                         | ** ** | ** ** |
| ** ** | ** ** | ** **                                                                                                          | ** ** | ** ** |
| Item 5.    |       | Market For  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 24         |       |
| Item 6.    |       | Selected Financial  Data                                                                                            | 25         |       |
| Item 7.    |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 25         |       |
| Item 7A.   |       | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 38         |       |
| Item 8.    |       | Financial  Statements and Supplementary Data                                                                        | 39         |       |
| Item 9.    |       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                               | 39         |       |
| Item 9A.   |       | Controls and  Procedures                                                                                            | 39         |       |
| Item 9B.   |       | Other Information                                                                                                   | 39         |       |
|       |       |                                                                                                                |       |       |
|       | ** ** | **PART III**                                                                                                        |       |       |
|       |       |                                                                                                                |       |       |
| Item 10.   |       | Directors,  Executive Officers and Corporate Governance                                                             | 40         |       |
| Item 11.   |       | Executive  Compensation*                                                                                            | 40         |       |
| Item 12.   |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 40         |       |
| Item 13.   |       | Certain  Relationships and Related Transactions, and Director Independence*                                         | 40         |       |
| Item 14.   |       | Principal  Accountant Fees and Services*                                                                            | 40         |       |
|       |       |                                                                                                                |       |       |
|       |       | **PART IV**                                                                                                         |       |       |
|       |       |                                                                                                                |       |       |
| Item 15.   |       | Exhibits and  Financial Statement Schedules                                                                         | 41         |       |

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* Incorporated byreference from our Proxy Statement for the Annual Meeting of Shareholdersscheduled to be held on May 15, 2007, to be filed pursuant to Regulation 14A.

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**PART I**

**Item1.    Business**

**GENERAL**

We operate senior livingcommunities, including independent living and congregate care communities,assisted living communities and nursing homes. As of December 31, 2006, we operated 162 communities containing 18,117living units, including 113 primarily independent and assisted livingcommunities containing 13,701 living units and 49 nursing homes containing4,416 living units. Of our 113 primarily independent and assisted livingcommunities, we leased 97 communities containing 12,498 living units fromSenior Housing Properties Trust, or Senior Housing, our former parent, andwe own or lease from parties other thanSenior Housing 16 communities containing 1,203 living units. We lease all buttwo of our nursing homes from Senior Housing. Our 162 communities include 5,601independent living apartments, 6,541 assisted living suites and 5,975 skillednursing beds. We also operate six institutional pharmacies, one of whichprovides mail order pharmaceuticals to the general public, and we operate tworehabilitation hospitals that we lease from Senior Housing. Our tworehabilitation hospitals contain 342 beds available for inpatient services and21 affiliated outpatient clinics. Our principal executive offices are locatedat 400 Centre Street, Newton, Massachusetts 02458, and our telephone number is(617) 796-8387.

**OUR HISTORY**

Spin off from Senior Housing

We were created by Senior Housingin April 2000 to operate nursing homes repossessed or acquired from twoformer Senior Housing tenants. We were incorporated in Delaware in April 2000and reincorporated in Maryland on September 17, 2001. On December 31,2001, Senior Housing distributed substantially all of our outstanding shares toits shareholders and we became a separate publicly owned company listed on theAmerican Stock Exchange, or AMEX. Pursuant to the transaction agreementgoverning this spin off:

·                  SeniorHousing capitalized us with approximately $50.0 million of equity,consisting of cash and working capital, primarily operating receivables, net ofoperating payables;

·                  weagreed to lease 31 primarily independent and assisted living communities thenoperated by Marriott Senior Living Services, Inc., or MSLS, a wholly ownedsubsidiary of Marriott International Inc., or Marriott, upon their acquisitionby Senior Housing which occurred in 2002, as described below;

·                  weleased 53 nursing homes and two assisted living communities from SeniorHousing;

·                  weassumed one lease from the town of Campbell, Nebraska; and

·                  weagreed to acquire FSQ, Inc., or FSQ, the former operating company of thehealthcare business we owned in order to acquire the personnel, systems andassets necessary for our business.

In 2002, we commenced operationsat 51 senior living communities, including the 31 communities then operated byMSLS, and subsequently operated by SLS, a wholly owned subsidiary of SunriseSenior Living, Inc., or Sunrise, and 20 additional communities. In 2003, wecommenced operations at three senior living communities which we lease from SeniorHousing.

Acquisitions

In November 2004, weacquired 100% of the capital stock of LTA Holdings, Inc., or LTA, forapproximately $211.0 million, excluding closing costs. LTA owned, leasedand operated 47 senior living communities with 2,636 living units, whichprimarily offer assisted living services, located in seven states. In addition,LTA had two management contracts with third parties for 12 assisted livingcommunities. We terminated one contract for 11 of these communities on March 1,2005.

 

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In March 2005, we acquired a 62 unit assisted livingcommunity located in Georgia for approximately $6.9 million. In June 2005, weacquired six assisted living communities for approximately $59.0 million. Inorder to finance this acquisition, we sold four senior living communities toSenior Housing in June 2005 for $24.0 million and Senior Housing leased thesecommunities back to us for initial rent of $2.2 million per year. In August 2005, we sold the six communitiesto Senior Housing for net proceeds of $56.7 million and Senior Housing leasedthese communities back to us for initial rent of $5.2 million per year.

Between September and December 2006, we agreed tolease from Senior Housing 11 senior living communities with 1,284****units that Senior Housing acquired from third parties. Sixof these communities are assisted living communities (three of which offer someskilled nursing services), three are independent living communities and two arecontinuing care retirement communities which offer independent living, assistedliving and skilled nursing services. Our rent payable to Senior Housing forthese 11 communities is $9.0 million per year, plus future increases calculatedas a percentage of the revenue increases at these communities after 2007. We addedthese communities to our existing lease with Senior Housing which has a currentterm ending in 2020, plus renewal options thereafter. Residents paysubstantially all of our charges at these communities from their privateresources.

Pharmacies

Between September2003 and November 2006, we acquired a total of six institutional pharmacieslocated in Wisconsin, Nebraska, California, South Carolina and Virginia.

Rehabilitation Hospitals

In February 2006, we agreed to lease tworehabilitation hospitals from Senior Housing. We commenced operations at thesetwo hospitals on October 1, 2006. Our lease with Senior Housing for these twohospitals expires on June 30, 2026, subject to our right to extend the term ofthe lease for an additional 20 years. These two hospitals provide healthrehabilitation services and are located in Braintree and Woburn, Massachusetts.Our rent payable to Senior Housing for these hospitals is $10.3 million peryear. These hospitals offer extensive inpatient and outpatient services that webelieve are similar to services we currently provide in many of our seniorliving communities.

Termination of SLS Management Agreements

During 2005 and 2006, we terminated managementagreements for the 30 senior living communities that SLS managed for us andbegan to directly operate these communities for our own account. In connectionwith these terminations, we paid SLS termination fees totaling $216.1 million. Weno longer pay management fees to SLS.

Discontinued Operations

During 2003 and 2004, we ceased operations at oneskilled nursing facility which we previously leased from Senior Housing andseven assisted living facilities, one of which we previously leased from SeniorHousing.

During 2005, we ceased operations at one assisted living community in LosAngeles, California, and one skilled nursing facility in Milwaukee, Wisconsin. Weleased this community and this facility from Senior Housing.  SeniorHousing sold the assisted living community in California in December 2005 fornet proceeds of approximately $2.6 million, which caused a $260,000 reductionin the annual minimum rent we pay to Senior Housing in accordance with ourlease terms. Senior Housing sold the skilled nursing facility located inWisconsin in December 2006 for net proceeds of approximately $1.3 million,which caused a $130,000 reduction in the annual minimum rent we pay to SeniorHousing in accordance with our lease terms.

During 2006, we ceased operations at two skilled nursing facilitieslocated in Connecticut that we leased from Senior Housing. Senior Housing soldthese facilities in November 2006 for net proceeds of approximately $5.6million, which caused a $559,000 reduction in the annual minimum rent we pay toSenior Housing in accordance with our lease terms.

 

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Equity and Debt Financings

In 2002, we issued 3,823,000shares of our common stock, or common shares, in an underwritten publicoffering raising net proceeds of $26.1 million. In December 2004 andJanuary 2005, we issued 3,620,000 common shares in an underwritten publicoffering raising net proceeds of $28.8 million. In 2005, we issued 7,750,000 common shares in an underwritten publicoffering raising net proceeds of $55.6 million. In 2006, we issued11,500,000 common shares in an underwritten public offering raising netproceeds of $114.1 million and we issued in a private placement $126.5 million principal amount of our 3.75%Convertible Senior Notes due 2026. The notes bear interest at 3.75% per annum,payable semi-annually, and will mature on October 15, 2026, but areredeemable by us beginning on October 20, 2011. In addition, we may be requiredby the note holders to redeem the notes on each of October 15, 2013, October15, 2016 and October 15, 2021.

**OUR GROWTH STRATEGY**

We believe that the aging of theU.S. population will increase demand for independent living properties,assisted living communities, nursing homes and pharmacy and rehabilitationservices. Our principal growth strategy is to profit from this increasingdemand by operating properties that provide high quality services to seniorresidents who pay with private resources and by acquiring and operatingpharmacy and rehabilitation health service providers.

We seek to improve theprofitability of our existing operations by increasing revenues and improvingmargins. We attempt to increase revenues by increasing rates and utilization ofour facilities and services. We attempt to improve margins by limitingincreases in expenses and improving operating efficiencies.

In addition to managing ourexisting operations, we intend to continue to grow our business throughacquisitions of independent and assisted living communities where residents’private resources account for a large majority of revenues. Since we became apublic company in late 2001, we have acquired 112 primarily independent andassisted living communities which in 2006 generated approximately****89% of their revenue from residents’ private resources,rather than from Medicare or Medicaid. We prefer to acquire communities whichhave achieved or are close to stabilized operations. We also seek to makeacquisitions where we can realize cost savings by combining acquired operationswith our existing operations.

We also intend to expand ourinstitutional pharmacy business. We acquired our first pharmacy in Wisconsin in2003. Between 2004 and 2006, we acquired five additional pharmacies: twolocated in Nebraska, one located in California, one located in South Carolinaand one located in Virginia. One of our pharmacies provides mail orderpharmaceuticals to the general public. Whenever we buy an institutionalpharmacy business, we seek to grow its business by providing pharmacy servicesat our senior living communities within the same service area. We are currentlyinterested in acquiring pharmacies in other areas where we own senior livingcommunities.

In October 2006, we began to operate tworehabilitation hospitals located in Braintree and Woburn, Massachusetts. Thesehospitals offer extensive inpatient and outpatient services that are similar toservices we currently provide in many of our senior living communities. We may seek to acquire additional rehabilitationhospitals, as well as expand our rehabilitation business at our existing seniorliving communities.

Although expansion of our nursinghome business is not our primary growth strategy, we have in the pastconsidered acquiring additional nursing homes. Most nursing homes arefinancially dependent upon the Medicare and Medicaid programs. Accordingly, webelieve the potential for profitable operations of nursing homes is limited bygovernment rate settings. In these circumstances, we are only interested inexpanding our nursing home operations at prices which we believe take intoaccount the risks inherent in government funding. In the past few years, wehave been unable to buy nursing homes at prices we consider appropriate, but wemay continue to investigate such opportunities in the future.

**TYPES OF PROPERTIES**

Our present business plancontemplates the ownership, leasing and management of independent livingapartments or congregate care communities, assisted living communities, nursinghomes and rehabilitation hospitals. 

 

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Some of ourproperties combine more than one type of service in a single building orcampus. We operate most of our pharmacies and several of our outpatientrehabilitation clinics from leased commercial spaces.

*Independent Living Apartments or Congregate CareCommunities.*Independentliving apartments, or congregate care communities, provide high levels ofprivacy to residents and require residents to be capable of relatively highdegrees of independence. An independent living apartment usually bundlesseveral services as part of a regular monthly charge. For example, one or twomeals per day in a central dining room, weekly maid service or services of asocial director may be included in the base charge. Additional services aregenerally available from staff employees on a fee for service basis. In someindependent living properties, separate parts of the community are dedicated toassisted living or nursing services. As of March 5, 2007, our businessincludes 5,601 independent living apartments in 43 communities.

*Assisted Living Communities.*Assisted living communities are typicallycomprised of one bedroom units which include private bathrooms and efficiencykitchens. Services bundled within one charge usually include three meals perday in a central dining room, daily housekeeping, laundry, medical remindersand 24 hour availability of assistance with the activities of daily livingsuch as dressing and bathing. Professional nursing and healthcare services areusually available at the community on call or at regularly scheduled times. Asof March 5, 2007, our business includes 6,541 assisted living suites in103 communities.

*Nursing Homes*. Nursing homes generally provide extensive nursingand healthcare services similar to those available in hospitals, without thehigh costs associated with operating theaters, emergency rooms or intensivecare units. A typical purpose built nursing home includes mostly two bed roomswith a separate bathroom in each room and shared dining and bathing facilities.Some private rooms are available for those residents who pay higher rates or forresidents whose medical conditions require segregation. Nursing homes arestaffed by licensed nursing professionals 24 hours per day. As of March 5,2007, our business includes 5,975****skillednursing beds in 76 communities.

*RehabilitationHospitals.*Rehabilitation hospitals, also known as inpatientrehabilitation facilities, or IRFs, provide intensive physical therapy,occupational therapy and speech language pathology services. Patients in IRFsgenerally receive a minimum of three hours of rehabilitation services daily. IRFsalso provide onsite pharmacy, radiology, laboratory, telemetry, hemodialysisand orthotics/prosthetics services. Outpatient satellite clinics are often includedas part of the services offered by IRFs. The two rehabilitation hospitals thatwe began operating in 2006 have 341 bedsavailable for inpatient services and provide extensive outpatient services fromthe hospitals premises. In addition, these two hospitals operate 21 affiliatedoutpatient clinics where patients discharged from the hospitals can continuetheir therapy programs, and receive amputee, brain injury, cardio-pulmonary,orthopedic, spinal cord injury, stroke and neurorehabilitation rehabilitationservices.

*Pharmacies.*Our institutional pharmacies are located in six leasedcommercial spaces and one owned commercial space containing approximately41,114 square feet plus parking areas for our delivery vehicles.

**OPERATING STRUCTURE**

We have four divisional officeswhich are located throughout the country. Each divisional office is responsiblefor multiple regions and is headed by a divisional vice president withextensive experience in the senior living and health rehabilitative industries.We have several regional offices within each division. Each regional office isresponsible for multiple communities and is headed by a regional director ofoperations with extensive experience in the senior living industry. Eachregional office is typically supported by a clinical or wellness director, arehabilitation services director, a regional accounts manager, a humanresources specialist and a sales and marketing specialist. Regional staffs areresponsible for all our community operations within the region, including:

·                  residentservices;

·                  marketingand sales;

·                  hiringof community personnel;

·                  compliancewith applicable legal and regulatory requirements; and

·                  supportingour development and acquisition plans within their region.

 

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Our home office staff performsthe following tasks:

·                  generaloversight of our regional staff, pharmacy and rehabilitation hospitaloperations;

·                  theestablishment of company wide policies and procedures relating to residentcare;

·                  humanresources policies and procedures;

·                  informationtechnology;

·                  Medicareand Medicaid billing;

·                  licensingand certification maintenance;

·                  legalservices;

·                  centralpurchasing;

·                  budgetingand supervision of maintenance and capital expenditures;

·                  implementationof our growth strategy; and

·                  accountingand finance functions, including operations budgeting, portions of accountsreceivable and collections, accounts payable, portions of payroll, financialreporting, and tax planning and compliance.

 

**STAFFING**

***Independent and assisted livingcommunity staffing.***Eachof the independent and assisted living communities we operate for our ownaccount has an executive director responsible for the day to day operations ofthe community, including quality of care, resident services, sales andmarketing, financial performance and staff supervision. The executive directoris supported by department heads, who oversee the care and service of theresidents, a wellness director, who is responsible for coordinating theservices necessary to meet the health care needs of our residents and amarketing director, who is responsible for selling our services. Otherimportant staff include the dining services coordinator, the activitiescoordinator and the property maintenance coordinator.

*****Nursinghome staffing.*****Eachof our nursing homes is managed by a state licensed administrator who issupported by other professional personnel, including a director of nursing, anactivities director, a marketing director, a social services director, abusiness office manager, and physical, occupational and speech therapists. Ourdirectors of nursing are state licensed nurses who supervise our registerednurses, licensed practical nurses and nursing assistants. Staff size andcomposition vary depending on the size and occupancy of each nursing home andon the type of care provided by the nursing home. Our nursing homes alsocontract with physicians who provide certain medical services.

***Pharmacy operations and staffing.***Our institutionalpharmacy operation provides prescriptions, medical supplies, equipment andservices to operators and residents of senior living communities. We do notsell “over the counter” to the public, but our mail order business providesprescriptions and medical supplies to the general public. Each of ourpharmacies is managed by an executive director, who is responsible for the dayto day operations of each pharmacy and our mail order business, includingbillings, sales and marketing, financial performance, compliance withregulatory codes regarding the dispensing of controlled substances and staffsupervision. Other pharmacy personnel include licensed dispensing pharmacists,a director of pharmacy consultation, a medical records director, a nurseconsultant, pharmacy technicians and billing personnel.

***Rehabilitation hospital staffing.***Each IRF is operated under the leadership of ahospital based chief executive officer with the support of senior staff,including a medical director, chief financial officer, director of patient careservices, director of rehabilitation and director of case management. Thehospitals are also staffed with board certified physicians who primarilyspecialize in internal medicine, neurology or physiatry, as well as otherlicensed professionals, including rehabilitation nurses, physical therapists,occupational therapists, speech and language pathologists, nutritioncounselors, neuropsychologists and pharmacists. Each outpatient clinicassociated with our IRFs is managed by an outpatient director who is aregistered occupational or physical therapist.

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** **

**EMPLOYEES**

As of March 5, 2007, wehad approximately 17,108****employees,including 11,960 full timeequivalents. Approximately 93employees, including approximately 78full time equivalents, are represented under two****collectivebargaining agreements, which have remaining terms of approximately 3 years.Except for seven contracts entered into with former owner operators of certainpharmacies which we acquired, we have no employment agreements with our employees.We believe our relations with our union and non-union employees are good.

**GOVERNMENT REGULATION AND REIMBURSEMENT**

Our operations must comply withnumerous federal, state and local statutes and regulations. Also, thehealthcare industry depends significantly upon federal and state programs forrevenues and, as a result, is vulnerable to the budgetary policies of both thefederal and state governments.

*Independent Living Communities.*Government benefits generally are not availablefor services at independent living communities and the resident charges inthese communities are paid from private resources. However, a number of FederalSupplemental Security Income program benefits pay housing costs for elderly ordisabled residents to live in these types of residential communities. TheSocial Security Act requires states to certify that they will establish andenforce standards for any category of group living arrangement in which asignificant number of Supplemental Security Income residents reside or arelikely to reside. Categories of living arrangements which may be subject tothese state standards include independent living apartments and assisted livingcommunities. Because independent living communities usually offer common diningfacilities, in many locations they are required to obtain licenses applicableto food service establishments in addition to complying with land use and lifesafety requirements. In many states, independent living communities arelicensed by state or county health departments, social service agencies oroffices on aging with jurisdiction over group residential communities forseniors. To the extent that independent living communities include units inwhich assisted living or nursing services are provided, these units are subjectto applicable state licensing regulations, and if the communities receiveMedicaid or Medicare funds, to certification standards. In some states,insurance or consumer protection agencies regulate independent livingcommunities in which residents pay entrance fees or prepay for services.

*Assisted Living Communities.*According to the National Academy for State HealthPolicy, or the National Academy, a majority of states provide or are approvedto provide Medicaid payments for services to residents, but not room and board,in some assisted living communities under waivers granted by the FederalCenters for Medicare and Medicaid Services, or CMS, or under Medicaid stateplans. Certain other states are planning some Medicaid funding by preparingstate plan amendments or requesting waivers to fund assisted livingdemonstration projects. Because rates paid to assisted living communityoperators are generally lower than rates paid to nursing home operators, somestates use Medicaid funding of assisted living as a means of lowering the costof services for residents who may not need the higher intensity of healthrelated services provided in nursing homes. States that administer Medicaidprograms for services in assisted living communities are responsible for monitoringthe services at, and physical conditions of, the participating communities.Different states apply different standards in these matters, but generally webelieve these monitoring processes are similar to the concerned states’inspection processes for nursing homes.

As a result of the large numberof states using Medicaid to purchase services at assisted living communitiesand the growth of assisted living in recent years, a majority of states haveadopted licensing standards applicable to assisted living communities. Amajority of states have licensing statutes or standards specifically using theterm “assisted living” and have requirements for communities servicing peoplewith Alzheimer’s disease or dementia. The majority of states have revised theirlicensing regulations recently or are reviewing their policies or drafting orrevising their regulations. State regulatory models vary; there is no nationalconsensus on a definition of assisted living, and no uniform approach by thestates to regulating assisted living communities. Most state licensingstandards apply to assisted living communities whether or not they acceptMedicaid funding. Also, according to the National Academy, a few states requirecertificates of need from state health planning authorities before new assistedliving communities may be developed. Based on our analysis of current economicand regulatory trends, we believe that assisted living communities that becomedependent upon Medicaid or other public payments for a majority of theirrevenues may decline in value because Medicaid rates may fail to keep up withincreasing costs. We also believe that assisted living communities located instates that adopt certificate of need requirements or otherwise restrict thedevelopment of new assisted living communities 

 

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may increase in value because these limitations upondevelopment may help ensure higher occupancy and higher non-governmental rates.

The US. Departmentof Health and Human Services, the Government Accountability Office, or GAO, andthe Senate Special Committee on Aging have recently studied and reported on thedevelopment of assisted living and its role in the continuum of long term careand as an alternative to nursing homes. In 2003, the GAO recommended that CMSstrengthen its oversight of state quality assurance in Medicaid home andcommunity-based services waiver programs. Since then, CMS has commenced aseries of actions to increase its oversight of state quality assurance programsfor assisted living facilities and has provided guidance and technicalassistance to the states to improve their ability to monitor and improve thequality of services paid for through Medicaid waiver programs. Also in 2003, aworking group of assisted living providers, consumers and regulatory organizationsmade recommendations to the Senate Special Committee on Aging on a range ofsubjects, including staffing, funding and regulation of assisted living. We cannot predict whether these studies andreports will result in governmental policy changes or new legislation, or whatimpact any changes may have. Based upon our analysis of current economic andregulatory trends, we do not believe that the federal government is likely tohave a material impact upon the current regulatory environment in which theassisted living industry operates unless it also undertakes expanded fundingobligations. Although CMS is implementing provisions of the Deficit ReductionAct of 2005, or the DRA, enacted in February 2006, that encourage stateMedicaid programs to expand their use of home and community based services asalternatives to institutional services, we do not believe a materiallyincreased financial commitment from the federal government to fund assistedliving is presently likely. However, we do anticipate that assisted livingcommunities will increasingly be licensed and regulated by the various states,and that, in the absence of federal standards, the states’ policies willcontinue to vary widely.

*Nursing Homes-Reimbursement.*About 62% of all nursing home revenues in the U.S.in 2005 (the most recent date for which information is publicly available) camefrom publicly funded programs, including about 44% from Medicaid programs and16% from the Medicare program. Nursing homes are among the most highly regulatedbusinesses in the Country. The federal and state governments regularly monitorthe quality of care provided at nursing homes. State health departments conductsurveys of resident care and inspect the physical condition of nursing homeproperties. These periodic inspections and occasional changes in life safetyand physical plant requirements sometimes require nursing home operators tomake significant capital improvements. These mandated capital improvements havein the past usually resulted in Medicare and Medicaid rate adjustments, albeiton the basis of amortization of expenditures over expected useful lives of theimprovements. A Medicare prospective payment system, or the PPS, was phased inover three years beginning with cost reporting years starting on or afterJuly 1, 1998. Under the PPS, capital costs are part of the prospectiverate and are not community specific. The PPS and other recent legislative andregulatory actions with respect to state Medicaid rates are limiting thereimbursement levels for some nursing home services. At the same time, federaland state enforcement and oversight of nursing homes have been increasing,making licensing and certification of these communities more rigorous.

The PPS was established by theBalanced Budget Act of 1997, and was intended to reduce the rate of growth inMedicare payments for skilled nursing communities. Before the current Medicarepayment system, Medicare rates were community specific and cost based. Underthe current Medicare payment system, skilled nursing facilities receive a fixedpayment for each day of care provided to residents who are Medicarebeneficiaries. Each resident is assigned to a care group depending on thatresident’s medical characteristics and service needs. These care groups areknown as Resource Utilization Groups, or RUGs. Per diem payment rates areestablished for each of these care groups. Medicare payments coversubstantially all services provided to Medicare residents in skilled nursingcommunities, including ancillary services such as rehabilitation therapies. ThePPS is intended to provide incentives to providers to furnish only necessaryservices and to deliver those services efficiently. During the three year phasein period, Medicare rates for skilled nursing communities were based on a blendof community specific costs and rates established by the new Medicare paymentsystem. According to the GAO, between fiscal year 1998 and fiscal year 1999,the first full year of the changed Medicare payment system phase in, the averageMedicare payment per day declined by about 9%.

From November 1999 to January2006, Congress and CMS have provided some periodic relief from the impact ofthe Balanced Budget Act of 1997 through temporary increases in skilled nursingfacility payment rates and temporary moratoria on some therapy limitations forskilled nursing residents covered under Medicare Part B. Effective January 1,2006, CMS implemented changes to the payment categories it uses to set dailypayment rates for Medicare beneficiaries in skilled nursing facilities. CMSintroduced nine new payment categories for medically complex patients,increasing the 

 

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number of categories from 44 to 53, and made revisions toits payment rates for current RUGS. Also effective January 1, 2006, these RUGchanges caused the elimination of certain temporary additional payments forcertain skilled nursing care and rehabilitation groups. The financial impact ofthese changes to the Medicare rates on our operations was to effectivelyeliminate an October 2005 Medicare 3% rate increase; but then in October 2006,the Medicare rates were increased by 3%.

Under the DRA, the federal government is slowing thegrowth of Medicare and Medicaid payments for nursing home services by severalmethods. Medicare bad debt reimbursement has been reduced from 100% to 70% foruncollected cost sharing payments from Medicare beneficiaries who are noteligible for Medicaid. Limits on Medicare payments were also implemented foroutpatient therapies in 2006, with an exception process under whichbeneficiaries could request an exemption from the cap and be granted the amountof services deemed medically necessary by Medicare. Under the Tax Relief andHealth Care Act of 2006, enacted in December 2006, the exemption process hasbeen extended an additional year through 2007. In addition, the DRA increasedthe “look-back” period for prohibited asset transfers that disqualifyindividuals from Medicaid nursing home benefits from three to five years. Theperiod of Medicaid ineligibility begins on the date of the prohibited transferor the date an individual has entered the nursing home and would otherwise beeligible for Medicaid coverage, whichever occurs later, rather than on the dateof the prohibited transfer, effectively extending the Medicaid penalty periodand placing added burdens on nursing homes to collect charges from residentsand their transferees. The DRA includes a demonstration project that will awardcompetitive grants to states to provide home and community based long term careservices to qualified individuals relocated from nursing homes, providing anincreased federal medical assistance percentage for 12 months for eachqualifying beneficiary, during a grant period of at least two years. The DRAalso includes a post acute payment reform demonstration program that willcompare and assess costs and outcomes of services at different long term caresites over three years. Effective January 1,2007, states may include home and community based services as optional servicesunder their Medicaid state plans, rather than only pursuant to waivers ordemonstration projects, and permits such states to cap enrollment, maintainwaiting lists and offer the services in only some regions of a state, as theymay with waivers. These initiatives will likely decrease the demand for nursinghome services and nursing home occupancy and services may decline.

*Nursing Homes-Survey and Enforcement.*In July 1998, GAO issued a report whichfound inadequate care in a significant proportion of California nursing homes. Since1999, the U.S. Department of Health and Human Services, Office of InspectorGeneral has issued several reports concerning quality of care in nursing homes,and the GAO has issued several reports recommending that CMS and the states strengthentheir compliance and enforcement practices, including federal oversight ofstate actions, to better ensure that nursing homes provide adequate care andstates act more consistently. The Senate Special Committee on Aging also heldhearings on these issues. As a result, CMS has undertaken an initiative toincrease the effectiveness of Medicare and Medicaid nursing home survey andenforcement activities. CMS is taking steps to focus more survey andenforcement efforts on nursing homes with findings of substandard care orrepeat violations of Medicare and Medicaid standards and to identify chainoperated communities with patterns of noncompliance. CMS is increasing itsoversight of state survey agencies and requiring state agencies to useenforcement sanctions and remedies more promptly when substandard care orrepeat violations are identified, to investigate complaints more promptly, andto survey communities more consistently. In addition, CMS adopted regulationsexpanding federal and state authority to impose civil money penalties ininstances of noncompliance. Medicare survey results, including fire safetyreports, and average nursing staff hours per resident for each nursing home areposted on the Medicare website at www.medicare.gov. CMS issued a proposedrule in 2006 that would require older nursing homes to install sprinklers andto install battery powered smoke detectors in the interim. When deficiencies under state licensing andMedicare and Medicaid standards are identified, sanctions and remedies such asdenials of payment for new Medicare and Medicaid admissions, civil monetarypenalties, state oversight and loss of Medicare and Medicaid participation orlicensure may be imposed on nursing home operators. Our communities incursanctions and penalties from time to time. If we are unable to curedeficiencies which have been identified or that are identified in the future,additional sanctions may be imposed, and if imposed, may adversely affect ourability to meet our financial obligations and negatively affect our financialcondition and results of operations.

In 2000 and 2002, the Departmentof Health and Human Services and CMS issued reports linking nursing staffinglevels with quality of care. The Bush administration has indicated that it doesnot intend to impose minimum staffing levels or to increase Medicare orMedicaid rates to cover the costs of increased staffing at this time; however,CMS is publishing the nurse staffing level at each nursing home on the internet(www.medicare.gov) to create market pressure to improve nursing homeoperations.

 

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*Rehabilitation Hospital Regulations and RateSetting.* The two rehabilitation hospitals that we beganoperating in 2006 are subject to federal, state and local regulation thataffect their business activities and determine the rates they receive forservices. These facilities are subject to periodic inspection by governmentaland non-governmental agencies to ensure continued compliance with variouslicensure and accreditation standards. In addition, these facilities arecertified by CMS to participate in the Medicare program and receive asignificant portion of their revenues from that program.

On May 7, 2004, CMS issued a rule establishingrevised Medicare standards that rehabilitation hospitals are required to meetin order to participate as IRFs in the Medicare program, known as the “75%Rule.” The 75% Rule generally provides that, to be considered an IRF andreceive reimbursement for services under the IRF-prospective payment system, atleast 75% of a facility’s total inpatient population must require intensiverehabilitation services associated with treatment of at least one of 13designated medical conditions. This means that to maintain their current levelsof revenues many rehabilitation hospitals may need to reduce the number ofnon-qualifying patients treated and replace them with qualifying patients,establish other sources of revenues or both. The 75% Rule is being phased inover a four year period that began on July 1, 2004. For cost reportingperiods starting on and after July 1, 2006, 60% of a facility’s inpatientpopulation must require intensive rehabilitation services for one of CMS’designated medical conditions. For cost reporting periods starting on and afterJuly 1, 2007, the requirement is 65%, and for cost reporting periods startingon and after July 1, 2008, the requirement is 75%. An IRF that fails to meetthe requirements of the 75% Rule is subject to reclassification as a differenttype of healthcare provider; and the effect of such reclassification would beto lower Medicare payment rates. We believe our hospitals are operating incompliance with the current requirements of the 75% Rule and we are takingactions to assure continued compliance with this rule during its full phase in;however, we can provide no assurance that we will be able to continue to complywith these intensifying rules.

*Certificates of Need.*Most states limit the number of nursing homes andhospitals by requiring developers to obtain certificates of need before newcommunities may be built and a few states also limit the number of assistedliving facilities by requiring certificates of need. Also, states such asCalifornia and Texas that have eliminated certificate of need laws often haveretained other means of limiting new development, such as the use of moratoria,licensing laws or limitations upon participation in the state Medicaid program.We believe that these governmental limitations may make existing nursing homesand hospitals more valuable by limiting competition.

*Other Matters*. Federal efforts to target fraud and abuse andviolations of anti-kickback laws and physician referral laws by Medicare andMedicaid providers have also increased. In March 2000, the U.S. Departmentof Health and Human Services Office of Inspector General issued complianceguidelines for nursing communities to assist them in developing voluntarycompliance programs to prevent fraud and abuse. The Office of Inspector Generalissued compliance program guidance for hospitals in 1998 and supplementalguidance in 2005. Rules governing the privacy, use and disclosure ofindividually identified health information took effect in 2003, with civil andcriminal sanctions for noncompliance. An adverse determination concerning anyof our licenses or eligibility for Medicare or Medicaid reimbursement or thecosts of required compliance with applicable federal or state regulations couldadversely affect our ability to meet our financial obligations and negativelyaffect our financial condition and results of operations.

Under the Medicare PrescriptionDrug, Improvement and Modernization Act of 2003, or the MPDIMA, Medicarebeneficiaries may receive prescription drug benefits effective January 1, 2006by enrolling in private health plans or managed care organizations, or if theyremain in traditional Medicare, by enrolling in stand alone prescription drugplans. We believe that this new Medicare drug benefit may increase the demandfor pharmacy products and services, but may also reduce the profitability ofproviding those services as the Government implements various cost controlprocedures. We cannot predict the net impact of this program at this time.

A number of legislative proposalsthat would affect major reforms of the healthcare system have been introducedin the U.S. Congress and many are being considered by some state governments,such as programs for national health insurance, the option of block grants forstates rather than federal matching money for certain state Medicaid services,policies encouraging state Medicaid programs to use home and community basedlong term care services rather than nursing homes, laws authorizing ordirecting Medicare to negotiate rate reductions for prescription drugs,additional Medicare and Medicaid reforms and federal and state cost containmentmeasures, such as freezing Medicare or Medicaid nursing home paymentrates at their current levels and reducing or eliminating annual Medicare 

 

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orMedicaid inflation allowances or gradually reducing rates for nursing homes andrehabilitation hospitals. In connection withrecent fiscal pressures on state governments and increasing costs of Medicaidfunding, legislation and regulation to reduce Medicaid nursing home paymentrates in some states are possible in the future. We cannot predict whether anyof these legislative or regulatory proposals will be adopted or, if adopted,what effect, if any, these proposals would have on our business.

**INSURANCE**

Litigation against senior livingoperators has been increasing during the past few years. As a result, liabilityinsurance costs are rising. In recent years, our insurance costs for workerscompensation and employee healthcare have also increased significantly. Topartially offset these insurance cost increases, we have taken a number ofactions including the following:

·                  we have increased the deductible or retentionamounts for which we are liable under our liability insurance;

·                  wehave established an offshore captive insurance company which participates inour liability insurance program. Some of our premiums for liability insuranceare paid to this company which may retain some of these amounts and theearnings on these amounts based upon our actual claims experiences;

·                  we have acquired another offshore insurance companyand established a captive insurance program for our workers compensationinsurance obligations in those states which permit such arrangements. Thisprogram may allow us to reduce our net workers compensation insurance costs byallowing us to retain the earnings on our reserves, provided our claimsexperience is as projected by various statutory and actuarial formulas;

·                  we have increased the amounts which some of ouremployees are required to pay for health insurance coverage and as co-paymentsfor health services and pharmaceutical prescriptions and decreased the amountof certain healthcare benefits;

·                  we are fully self insured for all employees healthrelated claims;

·                  we have hired professional advisors to help usestablish programs to reduce our insured workers compensation and professionaland general liabilities, including a program to monitor and pro-actively settleliability claims and to reduce workplace injuries; and

·                  we have hired professionals to help us establishappropriate reserves for our retained liabilities and captive insuranceprograms.

 

We self insure up to certain limits for workerscompensation and professional liability. Claims in excess of these limits areretained by third party insurance providers up to contractual limits, over whichwe are self insured. Our current insurancearrangements generally are renewable in June 2007. We do not know if ourinsurance charges and self-insurance reserve requirements will continue toincrease, and we cannot now predict the amount of any such increase, or to whatextent, if at all, we may be able to offset any increase through use of higherdeductibles, retention amounts, self insurance or other means in the future.

**COMPETITION**

The senior living services, pharmacy and the healthrehabilitation businesses are highly competitive. We compete with serviceproviders offering alternate types of services, such as home healthcareservices, as well as other companies providing community based services andrehabilitation services. We may expand our business with Senior Housing;however, Senior Housing is not obligated to provide us with opportunities tolease additional properties. We have large lease obligations and limitedfinanceable assets. Many of our competitors have greater financial resourcesthan we do. For all of these reasons and others, we cannot provide anyassurance that we will be able to compete successfully for business in thesenior living industry.

**ENVIRONMENTAL MATTERS**

Under various federal, state and local laws, owners aswell as tenants and operators of real estate may be required to investigate andclean up hazardous substances released or otherwise present at a property, andmay be held liable to a governmental entity or to third parties for propertydamage or personal injuries and for investigation and clean up costs incurredin connection with any such hazardous substances. Under our leases with SeniorHousing, we 

 

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havealso agreed to indemnify Senior Housing for any such liabilities related to theproperties we lease from Senior Housing. In addition, some environmental lawscreate a lien on a contaminated site in favor of the government for damages andcosts it incurs in connection with the contamination, which lien may be seniorin priority to our leases. We have reviewed environmental surveys of all of ourleased and owned communities. Based upon that review we do not believe that anyof these properties are subject to any material environmental contamination.However, no assurances can be given that a prior owner, operator or occupant ofour communities did not create a material environmental condition not known tous which might have been revealed by a more in depth study of the properties orthat future uses or conditions (including, without limitation, changes inapplicable environmental laws and regulations) will not result in theimposition of environmental liability upon us. The presence or discovery of anymaterial environmental contaminants at our communities could have a materialadverse impact on us.

**INTERNETWEBSITES**

Our internet website address is www.5sqc.com. Copiesof our governance guidelines, code of business conduct and ethics and thecharters of our audit, quality of care, compensation and nominating andgovernance committees may be obtained free of charge by writing to ourSecretary, Five Star Quality Care, Inc., 400 Centre Street, Newton, MA02458 or at our website. We make available, free of charge, on our website, ourAnnual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, ourCurrent Reports on Form 8-K and amendments to these reports filed orfurnished pursuant to Section 13(a) or 15(d) of the Securities ExchangeAct of 1934, as amended, or the Exchange Act, as soon as reasonably practicableafter these forms are filed with, or furnished to, the Securities and ExchangeCommission, or the SEC. Any shareholder or other interested party who desiresto communicate with our independent directors, individually or as a group, maydo so by filling out a report on our website. Our board also provides a processfor security holders to send communications to the entire board. Informationabout the process for sending communications to our board can be found on ourwebsite. Our website address and website addresses of one or more unrelated thirdparties are included several times in this Annual Report on Form 10-K astextual references only and the information in the websites are notincorporated by reference into this Annual Report on Form 10-K.

**Item1A.     Risk Factors**

Our business facesmany risks. The risks described below may not be the only risks we face.Additional risks that we do not yet know of, or that we currently think areimmaterial, may also impair our business operations or financial results. Ifany of the events or circumstances described in the following risks occurs, ourbusiness, financial condition or results of operations could suffer and thetrading price of our debt or equity securities could decline. Investors andprospective investors should consider the following risks and the informationcontained under the heading “Warning Concerning Forward Looking Statements”before deciding whether to invest in our securities.

**RISKS RELATED TO OUR BUSINESS**

**A small percentage decline in our revenues or increase in ourexpenses could have a material negative impact upon our operating results.**

For the year ended December 31, 2006, our revenues were $827.3 million and our operatingexpenses were $941.8 million(including our SLS termination expense of approximately $129.9 million related to 17 managementagreements). A small percentage decline in our revenues or increase in ourexpenses could have a material negative impact upon our operating results.

**We may not achieve the anticipated benefits of ourtermination of management agreements for the 30 communities thatSLS previously managed for us.**

BetweenNovember 2005 and December 2006, we terminated management agreements forthe 30 communities that SLS managed for us. The financial benefits we expect torealize from the termination of these management agreements are largelydependent upon our ability to maintain or increase the occupancy of thesecommunities and to lower certain operating costs. Changing management at seniorliving communities sometimes results in decreased occupancy, declining revenuesand increased costs. The transition of operations at senior living 

 

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communities is oftencomplicated and we can provide no assurance that the benefits we hope toachieve by terminating these SLS management agreements will be realized.

**We may not achieve the anticipated benefits from our lease ofthe two rehabilitation hospitals.**

The historical operating and financial information wehave concerning the two rehabilitation hospitals’ operations that we receivedfrom their prior operator, HealthSouth Corporation, or HealthSouth, may not beaccurate. Also, recent changes in Medicare rate formulas applicable torehabilitation hospitals make it difficult to project these hospitals’ futurefinancial results.  In these circumstances, any projection or implicationthat our future operation of these hospitals will be profitable may prove to beinaccurate.  In addition, the two rehabilitation hospitals may be subjectto retroactive rate adjustments. In fact, we may be unable to operate thesehospitals profitably and we may experience losses from our operation of thesehospitals.

If we are unable to operate these hospitals successfully,our reputation as a provider of health and rehabilitation services may bedamaged. Even if we successfully operate these hospitals, these operations mayhave little or no benefit to our other operations.

**The rehabilitation hospitals may be subject to Medicarereclassification, resulting in lower Medicare rates.**

A significant amount of the revenues at ourrehabilitation hospitals is paid by Medicare and we became more dependent uponthe Medicare program when we began to operate these hospitals than we werebefore we assumed these operations. Under the “75% Rule,” in order to qualifyunder Medicare as an IRF, at least 75% of a facility’s total inpatientpopulation must require intensive rehabilitation services associated withtreatment of at least one of 13 designated medical conditions. The rule isbeing phased in over four years. For cost reporting periods starting on andafter July 1, 2006, the requirement is 60%; for cost reporting periodsstarting on and after July 1, 2007 and July 1, 2008, the requirementwill be 65% and 75%, respectively. We believe that 60% of the patients at therehabilitation hospitals we began to operate on October 1, 2006 meet theserequirements. If these rehabilitation hospitals are unable to meet therequirements of the 75% Rule, they will be subject to Medicare reclassificationas a different type of provider and receive lower Medicare reimbursement rates.

**The failure of Medicare and Medicaid rates to match our costswill reduce our income.**

Some of our current operations, especially our nursing homesand rehabilitation hospitals, receive significant revenues from the Medicareand Medicaid programs. During the year ended December 31, 2006,approximately 33% of our net revenues from residents and 72% of our hospitalrevenues were received from these programs. The federal governmentand some states are now experiencing or have recently experienced fiscaldeficits. Historically, when governmental deficits have increased, cut backs inMedicare and Medicaid funding have often followed. These cut backs sometimesinclude rate reductions, but more often result in a failure of Medicare andMedicaid rates to increase by sufficient amounts to offset increasing costs. Forexample, since the beginning of 2006, there have been cut backs to Medicarefunding which have affected profitability of our current and continuing nursinghome operations. We cannot now predict whether future Medicare and Medicaidrates will be sufficient to cover our future cost increases. Future Medicareand Medicaid rate declines or a failure of these rates to cover increasingcosts could result in our experiencing lower earnings or losses. Therehabilitation hospitals we began to operate on October 1, 2006 receive asignificant part of their revenues from the Medicare program, and theseoperations will increase our exposure to Medicare rate risks.

**Our growth strategy may not succeed.**

Since our spin off from Senior Housing onDecember 31, 2001, we have grown rapidly through acquisitions. Ourbusiness plan includes acquiring additional senior living communities,pharmacies and, possibly, additional rehabilitation hospitals. Our growthstrategy involves risks, including the following:

·                  we may beunable to locate senior living communities, pharmacies or rehabilitationhospitals available for purchase at acceptable prices;

·                  we may beunable to access capital to make acquisitions or operate acquired businesses;

 

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·                  acquiredoperations may not perform in accord with our expectations;

·                  we may berequired to make significant capital expenditures to improve acquiredfacilities, including capital expenditures that may not have been anticipatedby us at the time of the acquisition;

·                  we mayhave difficulty retaining key employees and other personnel at acquiredfacilities;

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

·                  to theextent we incur acquisition debt or leases, our operating leverage may increaseand, to the extent we issue additional equity, our shareholders’ percentage ofownership will be diluted; and

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

Forthese reasons and others:

·                  ourbusiness plan to grow may not succeed;

·                  thebenefits which we hope to achieve by growing may not be achieved;

·                  we maysuffer declines in profitability or suffer recurring losses; and

·                  ourexisting operations may suffer from a lack of management attention or financialresources if such attention and resources are devoted to a failed growthstrategy.

When we acquire new communities, we sometimes see adecline in community occupancy and it may take a period of time for us tostabilize acquired community operations. Our efforts to restore occupancy orstabilize acquired communities’ operations may not be successful. In addition,we cannot provide any assurance that we will not experience a decline inoccupancy at the rehabilitation hospitals we recently began to operate. We haverecently expanded into the institutional and mail order pharmacy businesses. Rehabilitationhospitals and pharmacies are businesses with which we have limited experience,and our initiatives in these areas may not be successful.

**The nature of our business exposes us to litigation risks. Asa result, our insurance costs have increased and may continue to increase, andwe self insure a large portion of our litigation risks.**

The nature of our business exposes us to litigation, andwe are subject to lawsuits in the ordinary course of our business. In severalwell publicized instances, private litigation by residents of senior livingcommunities for alleged abuses has resulted in large damage awards againstother operating companies. Today, some lawyers and law firms specialize inbringing litigation against senior living companies. As a result of thislitigation and potential litigation, our cost of liability insurance hasincreased dramatically during the past few years. Medical liability insurancereform has become a topic of political debate and some states have enactedlegislation to limit future liability awards. However, if such reforms are notgenerally adopted, we expect our insurance costs may continue to increase. Toreduce costs, we self insure a significant amount of our litigation liabilityrisks. Although our reserves for liability self insurance have been determinedwith guidance from third party professionals, our reserves may prove inadequate.Increasing liability insurance costs and increasing self insurance reserves maymaterially negatively affect our results of operations.

**Our business is subject to extensive regulation whichincreases our costs and may result in losses.**

Licensing and Medicare and Medicaid laws requireoperators of senior living communities and rehabilitation hospitals to complywith extensive standards governing operations. There are also various lawsprohibiting fraud by senior living and rehabilitation hospital operators,including criminal laws that prohibit false claims for Medicare and Medicaidcoverage and that regulate patient referrals. In recent years, the federal andstate governments have devoted increased resources to monitoring the quality ofcare at senior living communities and to anti-fraud investigations. Whenquality of care deficiencies are identified or improper billing is uncovered,various sanctions may be imposed, including 

 

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denialof new admissions, exclusion from Medicare or Medicaid program participation,monetary penalties, governmental oversight or loss of licensure. Ourcommunities incur sanctions and penalties from time to time. As a result ofthis extensive regulatory system and increasing enforcement initiatives, wehave experienced increased costs for monitoring quality of care compliance andbilling procedures, and we expect these costs may continue to increase. Also,if we become subject to regulatory sanctions, our business may be adverselyaffected and we might experience financial losses.

**A significant increase in our labor costs may have a materialadverse effect on us.**

Wages and employee benefits represent approximately 47%of our 2006 total operating costs, exclusive of the termination fees we paid toSLS. We compete with other operators of senior living communities andrehabilitation hospitals with respect to attracting and retaining qualifiedpersonnel responsible for the day to day operations of each of our communities.A shortage of nurses or other trained personnel may require us to increase thewages and benefits offered to our employees in order to attract and retainthese personnel or to hire more expensive temporary personnel. Also, we have tocompete for lesser skilled workers with numerous other employers. Further, whenwe acquire new facilities, we may be required to pay increased compensation oroffer other incentives to retain key personnel and other employees. Employmentstatistics published by the government indicate a tightening job market.Historically, these statistics have often foretold increased wage pressures andwe may experience such wage pressures in the near future. For example, recentwage increases in Connecticut made our previous operations in that stateunprofitable. Employee benefits costs, including employee health insurance andworkers compensation insurance costs, have materially increased in recentyears. To help control these costs, we partially self insure our workerscompensation insurance and fully self insure our employee health insurance. Althoughour self insurance reserves have been determined with guidance from third partyprofessionals, our reserves may be inadequate. Increasing employee health andworkers compensation insurance costs and increasing self insurance reserves forthis type of insurance may materially negatively affect our earnings. Noassurance can be given that our labor costs will not increase or that anyincrease will be matched by corresponding increases in rates charged toresidents. Any significant failure by us to control our labor costs or to passon any increased labor costs to residents through rate increases could have amaterial adverse effect on our business, financial condition and results ofoperations.

**Our business requires us to make significant capital expendituresto maintain and improve our facilities.**

Physical characteristics of senior living communities andrehabilitation hospitals are mandated by various governmental authorities. Changesin these regulations may require us to make significant expenditures. Ourcommunities sometimes require significant expenditures to address ongoingrequired maintenance and to make them attractive to residents. In addition, weoften are required to make significant capital expenditures when we acquire newfacilities. Our available financial resources may be insufficient to fund theseexpenditures. In addition to capital expenditures we are making at some of oursenior living communities, we expect that we will need to make certain capitalexpenditures at the rehabilitation hospitals we recently began to operate,which could be significant. Senior Housing has historically provided most ofthe capital we need to improve the properties we lease from it. However,whenever Senior Housing provides such capital, our rent increases and we may beunable to pay the increased rent without experiencing losses.

**Our business is highly competitive and we may be unable tooperate profitably.**

We compete with numerous other companies that providesenior living and rehabilitation hospital services, including home healthcarecompanies and other real estate based service providers. Historically, nursinghomes and rehabilitation hospitals have been somewhat protected fromcompetition by state laws requiring certificates of need to develop new communities;however, these barriers have been eliminated in many states. Also, there arefew barriers to competition for home healthcare or for independent and assistedliving services. Growth in the availability of nursing home alternatives,including assisted living communities, has had and may in the future have theeffect of reducing the occupancy or profitability at nursing homes, includingthose we operate. Many of our existing competitors are larger and have greaterfinancial resources than us. Accordingly, we cannot provide any assurances thatwe will be able to attract a sufficient number of residents to our communities orthat we will be able to attract employees and keep wages and other employeebenefits, insurance costs and other operating expenses at levels which willallow us to compete successfully or to operate profitably.

 

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**We are subject to possible conflicts of interest; we haveengaged in, and expect to continue to engage in, transactions with relatedparties.**

Our business is subject to possible conflicts of interestas follows:

·                  our ChiefExecutive Officer, Evrett W. Benton, and our Chief Financial Officer,Bruce J. Mackey Jr., are also part-time employees of ReitManagement & Research LLC, or RMR.  RMR is the manager for SeniorHousing and we purchase various services from RMR pursuant to a shared servicesagreement;

·                  ourmanaging directors, Barry M. Portnoy and Gerard M. Martin, aremanaging trustees of Senior Housing. Mr. Portnoy also is the majoritybeneficial owner and the chairman of RMR; a subsidiary of RMR leases officespace to us; and Messrs Portnoy and Martin are directors of RMR;

·                  under ourshared services agreement with RMR, in the event of a conflict between SeniorHousing and us, RMR may act on behalf of Senior Housing rather than on ourbehalf; and

·                  as ofDecember 31, 2006, we leased from Senior Housing 144 of the 162 senior livingcommunities that we operated for total annual minimum rent of approximately 114.1 million.  In addition, we also lease our tworehabilitation hospitals from Senior Housing for total annual minimum rent ofapproximately $10.3 million.

On December 31, 2001, Senior Housing distributedsubstantially all of its ownership of our shares to its shareholders.Simultaneously with the spin off, we entered into agreements with SeniorHousing which, among other things, limit ownership of more than 9.8% of ourvoting shares, restrict our ability to take any action that could jeopardizethe tax status of Senior Housing as a real estate investment trust and limitour ability to acquire real estate of types which are owned by Senior Housingor other real estate investment trusts managed by RMR. As a result of theseagreements, our leases with Senior Housing and our shared services agreementwith RMR, Senior Housing, RMR and their respective affiliates have significantroles in our business and we do not anticipate any changes to those roles inthe future. Future business dealings between us, Senior Housing, RMR and theirrespective affiliates may be on terms less favorable to us than we couldachieve on an arm’s length basis. Although we do not believe these conflictshave adversely affected, or will adversely affect, our business, not everyonemay agree with our position.

**The limitations on the ownership of our shares and otheranti-takeover provisions in our governing documents and in our materialagreements may prevent our shareholders from receiving a takeover premium fortheir shares.**

Our charter places restrictions on the ability of anyperson or group to acquire beneficial ownership of more than 9.8% (in number ofshares or value, whichever is more restrictive) of any class of our equitysecurities. The terms of our leases with Senior Housing and our shared servicesagreement with RMR provide that our rights under these agreements may becancelled by Senior Housing and RMR, respectively, upon the acquisition by anyperson or group of more than 9.8% of our voting stock, and upon other change incontrol events, as defined in those documents. If the breach of these ownershiplimitations causes a lease default, shareholders causing the default may becomeliable to us or to other shareholders for damages. Additionally, onMarch 10, 2004, we entered into a rights agreement whereby in the event aperson or group of persons acquires or attempts to acquire 10% or more of ouroutstanding common shares, our shareholders, other than such person or group,will be entitled to purchase additional shares or other securities or propertyat a discount. These agreements and other provisions in our charter and bylawsmay increase the difficulty of acquiring control of us by means of a tenderoffer, open market purchases, a proxy fight or otherwise, if the acquisition isnot approved by our board of directors. Other provisions in our governingdocuments which may deter takeover proposals include the following:

·                  staggeredterms for members of our board of directors;

·                  the powerof our board of directors, without a shareholders’ vote, to authorize and issueadditional shares and create classes of shares on terms that it determines;

·                  a 75%shareholder vote and cause requirements for removal of directors; and

 

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·                  advancenotice procedures with respect to nominations of directors and shareholderproposals.

Forall of these reasons, shareholders may be unable to cause a change of controlof us or to realize a change of control premium for their shares.

**Circumstances that adversely affect the ability of seniors topay for our services could have a material adverse effect on us.**

Approximately 67%of our net revenues from residents from our senior living communities for theyear ended December 31, 2006 were paid by residents from their privateresources. We expect to continue to rely on the ability of our residents to payfor our services from their own financial resources. Inflation or othercircumstances that adversely affect the ability of the elderly to pay for ourservices could have a material adverse effect on our business, financialcondition and results of operations.

**The price of our common shareshas fluctuated, and a number of factors may cause our common share price todecline.**

The market price of our commonshares has fluctuated and could fluctuate significantly in the future inresponse to various factors and events, including, but not limited to, therisks set out in this Annual Report on form 10-K, as well as:

·                  the liquidity of the market for our common shares;

·                  variations in our operating results;

·                  variations from analysts’ expectations; and

·                  general economic and industry trends andconditions.

In addition, the stock market in recent years hasexperienced broad price and volume fluctuations that often have been unrelatedto the operating performance of particular companies.  These market fluctuations may also cause themarket price of our common shares to decline. Our shareholders may be unable to resell their common shares at or aboveprice at which they purchased our shares.

**RISKS RELATED TO OUR NOTES**

**Thenotes we issued in October 2006, and any notes we may issue in the future willbe, effectively subordinated to the debts of our subsidiaries and to our secureddebt.**

We area holding company and conduct substantially all of our operations through oursubsidiaries. Consequently, our ability to pay debt service on our parentcompany notes will be dependent upon the cash flow of our subsidiaries andpayments by those subsidiaries to us as dividends or otherwise. Oursubsidiaries are separate legal entities and have their own liabilities.Payments due on our parent company notes are effectively subordinated toliabilities of our subsidiaries.  Certainof our subsidiaries guarantee our obligations under the notes issued in October2006 and those subsidiaries and additional subsidiaries guarantee ourobligations under our revolving credit facility.  In addition, as of December 31, 2006, oursubsidiaries had approximately $44.8 million of secured indebtednessoutstanding, all of which are obligations of our subsidiaries that are notguarantors of the notes issued in October 2006, and may add additional securedindebtedness under our secured revolving credit facility available forborrowing by us that would effectively rank senior to the outstanding notes,and any new notes we may issue.  Theoutstanding notes, and any new notes we may issue will be, effectivelysubordinated to our secured debt.  Inaddition, non-guarantor subsidiaries have substantial additionalobligations, including trade payables and lease obligations, to which our notesare and will be effectively subordinated.

Our right to receive assets of any of our subsidiariesupon its liquidation or reorganization will be structurally subordinated to theclaims of our subsidiaries, creditors, except to the extent that we arerecognized as a creditor of such 

 

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subsidiary, in which case our claims would still be subordinated to anysecurity interests in the assets of such subsidiaries and any indebtedness ofour subsidiaries that is senior to that held by us. In the event of ourinsolvency, bankruptcy, liquidation, reorganization, dissolution or winding up,we and the subsidiaries that guarantee our outstanding notes, or any new noteswe may issue, may not have sufficient assets to pay amounts due on any or allthe notes.

**We maybe required to prepay our debts at the option of note holders or upon a changeof control.**

Incertain change of control circumstances or if our common shares are no longertraded on a national securities exchange or on an established over the countermarket in the United States, holders of our outstanding notes may have theright to require us to purchase their notes at their principal amount plusaccrued interest.  Holdersof our notes also have the right to require us to purchase for cash all or aportion of their notes on each of October 15, 2013, October 15, 2016 andOctober 15, 2021; however, we may not have sufficient financial resources atthose times to pay the repurchase price and our then existing indebtednesscould restrict or prohibit the repurchase. Any notes we may issue in the future may have similar or even moreonerous terms.

**If weredeem the notes before maturity, and our noteholders may be unable to reinvestproceeds at the same or a higher rate.**

We mayredeem all or a portion of our outstanding notes after a certain amount oftime.  Generally, the redemption pricewill equal the principal amount being redeemed, plus any accrued and unpaidinterest to, but excluding the redemption date. If a redemption occurs, holders of these notes may be unable to reinvestthe money they receive in the redemption at a rate that is equal to or higherthan the rate of return on the redeemed notes. Notes we may issue in the future may also permit redemption beforematurity and create similar risks.

**Theremay be no public market for our notes.**

Althoughresales of our notes have been registered with the SEC and our outstandingnotes are traded in the Private Offerings, Resale and Trading through AutomatedLinkages Market of the National Association of Securities Dealers, Inc., thesenotes are not listed on any securities exchange.  We can provide no assurance that an active tradingmarket for these notes will exist in the future.  Also the limited liquidity of the tradingmarket for our existing notes, or any notes we may issue in the future, and themarket price quoted for our notes may be adversely affected by changes in the overallmarket for fixed income securities, by changes in our financial performance orprospects, or by changes in the prospects for the senior living industrygenerally.

**Increased leverage may harm our financial condition andresults of operations.**

Our total consolidated long term debt as of December 31,2006 was approximately $138.0** **millionand represented approximately 67% of our total book capitalization as of thatdate.  In addition to our indebtedness,we have substantial lease and other obligations.  The indenture governing our outstanding notesdoes not limit the amount of additional indebtedness, including senior orsecured indebtedness, which we can create, incur, assume or guarantee, nor doesthe indenture limit the amount of indebtedness or other liabilities that oursubsidiaries can create, incur, assume or guarantee.

Ourlevel of indebtedness could have important consequences to our investors,because:

·                  it could affectour ability to satisfy our debt obligations;

·                  the portion ofour cash flows from operations required to make interest and principal paymentswill not be available for operations, working capital, capital expenditures,expansion, acquisitions or general corporate or other purposes;

·                  it may impairour ability to obtain additional financing in the future;

·                  it may limit ourflexibility in planning for, or reacting to, changes in our business andindustry; and

 

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·                  it may make usmore vulnerable to downturns in our business, our industry or the economy ingeneral than a company with less debt leverage.

**Conversion rights of our outstandingnotes may be detrimental to holders of our common shares.**

Outstanding notes are convertible into our common shares in variouscircumstances.  The initial conversionrate (equivalent to an initial conversion price of $13.00 per common share) issubject to adjustment upon the occurrence of various events, including if wemake dividends or distributions on our common shares.  If a holder elects to convert these notes inconnection with a “make whole fundamental change”, as defined in the indenturegoverning these notes, that occurs on or prior to October 20, 2011, theconversion rate may be increased by a premium based on the market price of ourcommon shares at the time.  Make wholefundamental changes include certain transactions constituting a change ofcontrol, our liquidation or dissolution and certain related events.

The conversion of some or all of our outstanding notes will dilute theownership interests of our shareholders. Any sales in the public market of the common shares issuable upon suchconversion could adversely affect prevailing market prices of our commonshares.  In addition, the existence ofthe outstanding convertible notes may encourage short selling by marketparticipants because the conversion of these notes could depress the price ofour common shares.  These conversionrights also may make more difficult or discourage a party from taking over ourcompany and removing incumbent management and may discourage or impedetransactions that might otherwise be in the interests of our commonshareholders.  Any future issuance ofconvertible securities by us may create similar risks.

**Future issuances of common shares and hedgingactivities may depress the trading price of our common shares.**

Any issuance of equity securities, including the issuanceof shares upon conversion of our outstanding notes, could dilute the interestsof our existing shareholders, including holders who have received shares uponconversion of their notes, and could substantially decrease the trading priceof our common shares and of the notes. We may issue equity securities in the future for a number of reasons,including to finance our operations and growth strategy, to adjust our ratio ofdebt to equity, to satisfy our obligations upon the exercise of outstandingwarrants or options or for other reasons.

In addition, the price of our common shares could also beaffected by possible sales of our common shares by investors who view ouroutstanding notes as a more attractive means of equity participation in us andby hedging or arbitrage trading activity involving both our outstanding notesand common shares.  This hedging orarbitrage could, in turn, affect the trading price of our outstanding notes andof our common shares.

**We do not intend to pay cash dividends on our commonshares in the foreseeable future.**

We have never declared or paid any cash dividends on ourcommon shares, and we currently do not anticipate paying any cash dividends inthe foreseeable future. Because we do not anticipate paying cash dividends forthe foreseeable future, holders who convert our outstanding notes into ourcommon shares will not realize a return on their investment unless the tradingprice of our common shares appreciates.

**Item 1B.  UnresolvedStaff Comments**

None.

 

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**Item 2. Properties**

**OUR SENIOR LIVINGCOMMUNITIES**

As of December 31, 2006, we operated 162 senior living communities which we havecategorized into two groups as follows:
| ** **                                   | ** ** | ** **                   | ** ** | **Type of units** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **               | ** ** | ** **                                                            | ** ** |
|----------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|-----------------------------------------------------------------------|------------|
| **Type of community**              | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.**   | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home beds** | ** ** | **Total  living  units** | ** ** | **Occupancy  for the year  ended  Dec. 31, 2006** | ** ** | **Revenues  for the year  ended  Dec. 31, 2006  (in thousands)** | ** ** | **Percent of  revenues  from  private  resources** | ** ** |
| Independent and  assisted living communities |       | 113                          |       | 5,506                       |       | 6,541                       |       | 1,654                       |       | 13,701                   |       | 92                                                                    | %          | $ | 503,246 |   | 90 | % |
| Skilled nursing  facilities                  |       | 49                           |       | 95                          |       | —                      |       | 4,321                       |       | 4,416                    |       | 89                                                                    | %          | 242,843 |   | 22 | % |
| Totals:                                      |       | 162                          |       | 5,601                       |       | 6,541                       |       | 5,975                       |       | 18,117                   |       | 91                                                                    | %          | $ | 746,089 |   | 67 | % |

 

**Independent and Assisted Living Communities **

As of December 31, 2006, we operated 113 independent and assisted livingcommunities.  We lease 97 of thesecommunities from Senior Housing and four of these communities from Health CareProperty Investors, or HCPI, and we own the remaining 12 communities.  These communities have 13,701 living unitsand are located in 24 states.  Thefollowing table provides additional information about these communities and theiroperations as of December 31, 2006:
| ** **          | ** ** | ** **                   | ** ** | **Type of units** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **               | ** ** | ** **                                                            | ** ** |
|---------------------|------------|------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|-----------------------------------------------------------------------|------------|
| **Location**        | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.**   | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home beds** | ** ** | **Total  living  units** | ** ** | **Occupancy  for the year  ended  Dec. 31, 2006** | ** ** | **Revenues  for the year  ended  Dec. 31, 2006  (in thousands)** | ** ** | **Percent of  revenues  from  private  resources** | ** ** |
| 1. Alabama          |       | 6                            |       | —                      |       | 258                         |       | —                      |       | 258                      |       | 93                                                                    | %          | $ | 7,822 |   | 100 | % |
| 2. Arizona          |       | 4                            |       | 520                         |       | 221                         |       | 188                         |       | 929                      |       | 90                                                                    | %          | 35,417 |   | 89 | % |
| 3. California       |       | 4                            |       | 461                         |       | 180                         |       | 59                          |       | 700                      |       | 93                                                                    | %          | 27,075 |   | 94 | % |
| 4. Delaware         |       | 5                            |       | 335                         |       | 199                         |       | 341                         |       | 875                      |       | 92                                                                    | %          | 48,518 |   | 76 | % |
| 5. Florida          |       | 8                            |       | 1,205                       |       | 595                         |       | 153                         |       | 1,953                    |       | 94                                                                    | %          | 55,682 |   | 83 | % |
| 6. Georgia          |       | 10                           |       | 111                         |       | 481                         |       | 40                          |       | 632                      |       | 94                                                                    | %          | 14,157 |   | 99 | % |
| 7. Illinois         |       | 1                            |       | 110                         |       | —                      |       | —                      |       | 110                      |       | 85                                                                    | %          | 595 |   | 100 | % |
| 8. Indiana          |       | 1                            |       | 117                         |       | 30                          |       | 74                          |       | 221                      |       | 95                                                                    | %          | 13,124 |   | 82 | % |
| 9. Kansas           |       | 2                            |       | 253                         |       | 30                          |       | 60                          |       | 343                      |       | 92                                                                    | %          | 12,871 |   | 86 | % |
| 10. Kentucky        |       | 9                            |       | 483                         |       | 291                         |       | 183                         |       | 957                      |       | 95                                                                    | %          | 33,974 |   | 86 | % |
| 11.  Massachusetts  |       | 1                            |       | —                      |       | 125                         |       | —                      |       | 125                      |       | 91                                                                    | %          | 6,674 |   | 100 | % |
| 12. Maryland        |       | 6                            |       | 275                         |       | 324                         |       | —                      |       | 599                      |       | 95                                                                    | %          | 24,618 |   | 100 | % |
| 13. Mississippi     |       | 2                            |       | —                      |       | 130                         |       | —                      |       | 130                      |       | 77                                                                    | %          | 870 |   | 100 | % |
| 14. Missouri        |       | 1                            |       | 114                         |       | —                      |       | —                      |       | 114                      |       | 68                                                                    | %          | 1,793 |   | 100 | % |
| 15. Nebraska        |       | 1                            |       | —                      |       | 73                          |       | —                      |       | 73                       |       | 84                                                                    | %          | 2,206 |   | 100 | % |
| 16. North  Carolina |       | 5                            |       | —                      |       | 461                         |       | —                      |       | 461                      |       | 87                                                                    | %          | 16,491 |   | 99 | % |
| 17. New Jersey      |       | 1                            |       | 217                         |       | 139                         |       | 60                          |       | 416                      |       | 87                                                                    | %          | 15,634 |   | 75 | % |
| 18. New Mexic       |       | 1                            |       | 114                         |       | 35                          |       | 60                          |       | 209                      |       | 94                                                                    | %          | 11,219 |   | 94 | % |
| 19. Ohio            |       | 1                            |       | 144                         |       | 112                         |       | 60                          |       | 316                      |       | 92                                                                    | %          | 16,479 |   | 78 | % |
| 20. Pennsylvania    |       | 6                            |       | —                      |       | 609                         |       | —                      |       | 609                      |       | 84                                                                    | %          | 16,818 |   | 100 | % |
| 21. South  Carolina |       | 13                           |       | —                      |       | 652                         |       | 68                          |       | 720                      |       | 94                                                                    | %          | 25,258 |   | 99 | % |
| 22. Tennessee       |       | 10                           |       | —                      |       | 586                         |       | 14                          |       | 600                      |       | 93                                                                    | %          | 16,410 |   | 100 | % |
| 23. Texas           |       | 5                            |       | 900                         |       | 346                         |       | 294                         |       | 1,540                    |       | 93                                                                    | %          | 70,949 |   | 85 | % |
| 24. Virginia        |       | 10                           |       | 147                         |       | 664                         |       | —                      |       | 811                      |       | 89                                                                    | %          | 28,592 |   | 100 | % |
| Totals:             |       | 113                          |       | 5,506                       |       | 6,541                       |       | 1,654                       |       | 13,701                   |       | 92                                                                    | %          | $ | 503,246 |   | 90 | % |

 

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**Skilled Nursing Facilities**

As of December 31, 2006, we operated 49 skillednursing facilities.  We lease 47 of thesefacilities from Senior Housing and we own the other two facilities.  Thesefacilities have 4,416 living units and are located in 11 states.  The following table provides additionalinformation about these facilities and their operations as of December 31,2006:
| ** **    | ** ** | ** **                   | ** ** | **Type of units** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **               | ** ** | ** **                                                            | ** ** |
|---------------|------------|------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|-----------------------------------------------------------------------|------------|
| **Location**  | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.**   | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home beds** | ** ** | **Total  living  units** | ** ** | **Occupancy  for the year  ended  Dec. 31, 2006** | ** ** | **Revenues  for the year  ended  Dec. 31, 2006  (in thousands)** | ** ** | **Percent of  revenues  from  private  resources** | ** ** |
| 1. Arizona    |       | 1                            |       | —                      |       | —                      |       | 125                         |       | 125                      |       | 81                                                                    | %          | $ | 6,287 |   | 24 | % |
| 2. California |       | 4                            |       | —                      |       | —                      |       | 396                         |       | 396                      |       | 95                                                                    | %          | 27,321 |   | 19 | % |
| 3. Colorado   |       | 7                            |       | 64                          |       | —                      |       | 759                         |       | 823                      |       | 88                                                                    | %          | 47,908 |   | 26 | % |
| 4. Georgia    |       | 3                            |       | —                      |       | —                      |       | 334                         |       | 334                      |       | 94                                                                    | %          | 16,122 |   | 8 | % |
| 5. Iowa       |       | 7                            |       | 19                          |       | —                      |       | 476                         |       | 495                      |       | 89                                                                    | %          | 26,453 |   | 16 | % |
| 6. Kansas     |       | 1                            |       | 4                           |       | —                      |       | 55                          |       | 59                       |       | 97                                                                    | %          | 2,788 |   | 31 | % |
| 7. Michigan   |       | 2                            |       | —                      |       | —                      |       | 273                         |       | 273                      |       | 88                                                                    | %          | 22,866 |   | 13 | % |
| 8. Missouri   |       | 2                            |       | —                      |       | —                      |       | 180                         |       | 180                      |       | 89                                                                    | %          | 7,001 |   | 23 | % |
| 9. Nebraska   |       | 14                           |       | —                      |       | —                      |       | 817                         |       | 817                      |       | 86                                                                    | %          | 36,744 |   | 29 | % |
| 10. Wisconsin |       | 6                            |       | —                      |       | —                      |       | 723                         |       | 723                      |       | 89                                                                    | %          | 41,287 |   | 23 | % |
| 11. Wyoming   |       | 2                            |       | 8                           |       | —                      |       | 183                         |       | 191                      |       | 80                                                                    | %          | 8,066 |   | 28 | % |
| Totals:       |       | 49                           |       | 95                          |       | —                      |       | 4,321                       |       | 4,416                    |       | 89                                                                    | %          | $ | 242,843 |   | 22 | % |

 

**OUR INPATIENTREHABILITATION HOSPITALS**

As of December 31, 2006,we operated two inpatient rehabilitation hospitals that we lease from SeniorHousing that are located in Massachusetts. We commenced operations at these two hospitals on October 1, 2006.  These two hospitals have 342 beds availablefor inpatient services and 21 affiliated outpatient clinics.  The hospitals had $26.1 million in revenuesfor the three months ended December 31, 2006 and occupancy was 60% for thethree months ended December 31, 2006. During the three months ended December 31, 2006 approximately 72% of therevenues related to these hospitals came from the Medicare and Medicaidprograms, and 59% came from the Medicare program.

**OUR SENIOR HOUSING LEASES**

We have six leases with SeniorHousing.  Four of these leases are for114 skilled nursing facilities and independent and assisted living communitiesthat we operate, one of these leases is for the 30 communities previouslymanaged by SLS that we now operate for our own account and one of these leasesis for the two rehabilitation hospitals that we operate.  The following is a summary of thematerial terms of our leases.  Because itis a summary, it does not contain all of the information that may be importantto you.  If you would like moreinformation, you should read the leases which we have listed in Item 15 of thisAnnual Report on Form 10-K and incorporated herein by reference.

The following table is a summaryof our leases:
| ** **                                                                                          | ** ** | **Number of  properties** | ** ** | **Annual  minimum rent as of  December 31, 2006** | ** ** | **Initial expiration  date** | ** **        | **Renewal terms**                                                |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|----------------------------------------------------------------------------|------------|-----------------------------------|-------------------|-----------------------------------------------------------------------|
| 1. Four leases  for skilled nursing facilities and independent and assisted living  communities (1) |       | 114                            |       | $                                                                          | 49.1       |                              | December 31, 2020 |                                                                  | One 15-year renewal option. |
|                                                                                                |       |                           |       |                                                                       |       |                              |              |                                                                  |
| 2. One lease for  communities previously managed by SLS                                             |       | 30                             |       | 65.0                                                                       |       | December 31, 2017                 |              | Two consecutive renewal options for 10 and 5 years  (15 years total). |
|                                                                                                |       |                           |       |                                                                       |       |                              |              |                                                                  |
| 3. One lease for  rehabilitation hospitals                                                          |       | 2                              |       | 10.3                                                                       |       | June 30, 2026                     |              | One 20-year renewal option.                                           |
| Totals                                                                                              |       | 146                            |       | $                                                                          | 124.4      |                              |              |                                                                  |   |

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(1)                                  Three of these four leases exist to accommodatemortgage financings in affect at the time Senior Housing acquired the leasedproperties; we have agreed to combine all four of these leases into one leasewhen these mortgages are paid.

 

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*Percentagerent.* All of our leaseswith Senior Housing, other than our lease for the two rehabilitation hospitals,require us to pay additional rent equal to 4% of the amount by which grossrevenues of the communities we operate exceed gross revenues in a base year.

*Operatingcosts.*  Each lease is a so-called “triple-net” leasewhich requires us to pay all costs incurred in the operation of the properties,including the costs of personnel, services to residents, insurance and realestate and personal property taxes.

*Rent duringrenewal term.*  Rent during each renewal term is the same asthe minimum rent and percentage rent payable during the initial term.

*Non economiccircumstances.*  If we determine that continued operations ofone or more properties is not economically practical, we may negotiate withSenior Housing to close or sell that community, including Senior Housing’sownership in the property. In the event of such a sale, Senior Housing receivesthe net proceeds and our rent for the remaining properties in the affectedlease is reduced according to formulas in the leases.

*Licenses.* Our leases require usto obtain, maintain and comply with all applicable permits and licensesnecessary to operate our properties.

*Maintenance andalterations.*  We are required to operate continuously andmaintain, at our expense, the leased properties in good order and repair,including structural and nonstructural components. We may request SeniorHousing to fund amounts needed for repairs and renovations in return for rentadjustments to provide Senior Housing a return on its investment according toformulas set forth in the leases. At the end of each lease term, we arerequired to surrender the leased properties in substantially the same conditionas existed on the commencement date of the lease, subject to any permittedalterations and ordinary wear and tear.

*Assignment andsubletting.*  Senior Housing’s consent is generallyrequired for any direct or indirect assignment or sublease of any of theproperties. In the event of any assignment or subletting, we will remain liableunder the applicable lease.

*Indemnificationand insurance.*  With limited exceptions, we are required toindemnify Senior Housing from all liabilities which may arise from theownership or operation of the leased properties. We generally are required tomaintain commercially reasonable insurance, including captive self insurance,for:

·                  “all-risk” property insurance, in an amount equalto 100% of the full replacement cost of the properties;

·                  business interruption insurance;

·                  comprehensive general liability insurance,including bodily injury and property damage, in amounts as are generallymaintained by companies providing senior living services;

·                  flood insurance if any property is located inwhole or in part in a flood plain;

·                  workers compensation insurance if required by law;and

·                  such additional insurance as may be generallymaintained by companies providing senior living services, includingprofessional and general liability insurance.

 

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Each lease requires that SeniorHousing be named as an additional insured under these policies.

*Damage,destruction, condemnation and environmental matters.*  If any ofthe leased properties is damaged by fire or other casualty or taken for apublic use, we are generally obligated to rebuild unless the community cannotbe restored. If the property cannot be restored, Senior Housing will generallyreceive all insurance or taking proceeds and we are liable to Senior Housingfor the amount of any deductible or deficiency between the replacement cost andthe insurance proceeds, and our rent will be adjusted pro rata.  We are also required to remove and dispose ofany hazardous substance at the leased properties in compliance with allapplicable environmental laws and regulations.

*Events ofdefault.*  Events of default under each lease includethe following:

·                  our failure to pay rent or any other sum when due;

·                  our failure to maintain the insurance requiredunder such lease;

·                  any person or group acquiring ownership of 9.8% ormore of our outstanding voting stock or any change in our control or sale of amaterial portion of our assets without Senior Housing’s consent;

·                  the occurrence of certain events with respect toour insolvency or dissolution;

·                  our default under indebtedness which gives theholder the right to accelerate;

·                  our being declared ineligible to receivereimbursement under Medicare or Medicaid programs for any of the leasedproperties which participate in such programs or the revocation of any materiallicense required for our operations; and

·                  our failure to perform any terms, covenants oragreements of the leases and the continuance thereof for a specified period oftime after written notice.

 

*Remedies.*  Upon theoccurrence of any event of default, each lease provides that, among otherthings, Senior Housing may, to the extent legally permitted:

·                  accelerate the rents;

·                  terminate the leases in whole or in part;

·                  enter the property and take possession of any andall our personal property and retain or sell the same at a public or privatesale;

·                  make any payment or perform any act required to beperformed by us under the leases; and

·                  rent the property and recover from us thedifference between the amount of rent which would have been due under the leaseand the rent received from the re-letting.

We are obligated to reimburseSenior Housing for all costs and expenses incurred in connection with anyexercise of the foregoing remedies.

*Management.*  We may notenter into any new management agreement affecting any leased property withoutthe prior written consent of Senior Housing.

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

*Financinglimitations; security.*  Without Senior Housing’s consent we may notincur debt secured by our investments in our tenant subsidiaries. Further, ourtenant subsidiaries are prohibited from incurring liabilities other thanoperating liabilities incurred in the ordinary course of business, liabilitiessecured by our accounts receivable or purchase money debt. We have pledged 100%of the equity interests of certain of our tenant subsidiaries to Senior Housingand to certain of its lenders, and we may pledge interests in our leases onlyif the pledge is consented to by Senior Housing.

**Item 3.    LegalProceedings**

In the ordinary course of business we are involved in litigationincidental to our business; however, we are not aware of any material pendinglegal proceeding affecting us for which we might become liable or the outcomeof which we expect to have a material impact on us.

 

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**Item4.  Submission of Matters to a Vote ofSecurity Holders**

**None.**

 

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**PART II**

**Item5.  Market for Registrant’s CommonEquity, Related Stockholder Matters and Issuer Purchases of Equity Securities**

Our common shares are traded on the AMEX (symbol: FVE). The followingtable sets forth for the periods indicated the high and low sale prices for ourcommon shares as reported by the AMEX: 
| **2005**       | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $        | 9.19       |    | $          | 6.80 |   |
| Second Quarter |       | 8.65     |       | 5.60    |       |
| Third Quarter  |       | 9.09     |       | 6.75    |       |
| Fourth Quarter |       | 7.98     |       | 6.02    |       |
|                |            |          |            |         |            |  |  |

 
| **2006**       | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------|------------|------------|------------|------------|------------|
| First Quarter  |       | $          | 12.10      |       | $          | 7.70 |   |
| Second Quarter |       | 11.64      |       | 9.20       |       |
| Third Quarter  |       | 11.95      |       | 8.75       |       |
| Fourth Quarter |       | 11.25      |       | 9.43       |       |
|                |            |            |            |            |            |  |  |

 

The closing price of ourcommon shares on the AMEX on March 5, 2007, was $10.51** **pershare.

As of March 5, 2007, there were 3,177 shareholders of record, andwe estimate that as of such date there were in excess of 35,200 beneficialowners of our common shares.

We have not paid any dividends in the past and do not expect to paydividends in the foreseeable future.

Issuances of unregistered shares during the fourthquarter were as follows: on November 15, 2006, pursuant to our stock option andstock incentive plan, certain of our employees and others who provide servicesto us received grants totaling 97,200 shares of common stock, par value $0.01per share, valued at $10.51 per share, the closing price of our common shareson the AMEX on that day.  All of thesegrants were made pursuant to an exemption from registration contained insection 4(2) of the Securities Act of 1933, as amended.

 

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**Item 6.    Selected Financial Data**

The following table setsforth selected financial data for the periods and dates indicated.** **Comparative resultsare impacted by community acquisitions and dispositions during the periodsshown.  This data should be read inconjunction with, and is qualified in its entirety by reference to, management’sdiscussion and analysis of financial condition and results of operations andthe consolidated financial statements and accompanying notes included in thisAnnual Report on Form 10-K. 
| ** **                                    | ** ** | **Year ended December 31,**                         | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| Operating data:                               | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                                |       | $                                                                  | 827,337    |   | $ | 734,023 |   | $ | 597,824 |   | $ | 545,380 |   | $ | 487,902 |   |
| Net (loss)  income from continuing operations |       | (112,040                                                           | )          | (81,159 | ) | 5,181 |   | (5,079 | ) | (9,796 | ) |
| Net loss from  discontinued operations        |       | (4,625                                                             | )          | (3,000 | ) | (1,890 | ) | (2,860 | ) | (3,378 | ) |
| Net (loss)  income                            |       | $                                                                  | (116,665   | ) | $ | (84,159 | ) | $ | 3,291 |   | $ | (7,939 | ) | $ | (13,174 | ) |
| Net (loss) income per  share:                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| (Loss) income  from continuing operations     |       | $                                                                  | (3.92      | ) | $ | (5.45 | ) | $ | 0.59 |   | $ | (0.60 | ) | $ | (1.30 | ) |
| Loss from  discontinued operations            |       | (0.16                                                              | )          | (0.20 | ) | (0.22 | ) | (0.34 | ) | (0.45 | ) |
| Net (loss)  income                            |       | $                                                                  | (4.08      | ) | $ | (5.65 | ) | $ | 0.37 |   | $ | (0.94 | ) | $ | (1.74 | ) |
| Balance sheet data (as  of December 31):      |       |                                                               |       |   |   |   |   |   |   |   |   |
| Total assets                                  |       | $                                                                  | 366,411    |   | $ | 228,940 |   | $ | 222,985 |   | $ | 147,370 |   | $ | 133,197 |   |
| Total  indebtedness                           |       | 171,271                                                            |       | 45,329 |   | 42,581 |   | 10,436 |   | 16,123 |   |
| Other long term  obligations                  |       | 28,098                                                             |       | 25,465 |   | 18,065 |   | 16,196 |   | 17,723 |   |
| Total shareholders’  equity              |       | $                                                                  | 67,430     |   | $ | 68,804 |   | $ | 95,904 |   | $ | 64,427 |   | $ | 65,047 |   |

 

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

**GENERAL INDUSTRY TRENDS**

The senior livingindustry is experiencing growth as a result of demographic factors.  According to census data, the population inthe United States over age 75 is growing much faster than the generalpopulation.  A large number ofindependent and assisted living communities were built in the 1990s.  This development activity caused an excesssupply of new, high priced communities. Longer than projected fill up periods resulted in low occupancy, pricediscounting and financial distress for many independent and assisted livingoperators.  Development activity wassignificantly reduced in the early part of this decade.  We believe that the supply and demand forthese types of facilities is today nationwide about balanced.  We believe that the aging of the U.S.population and the almost complete reliance of independent and assisted livingservices upon revenues from residents’ private pay resources should mean thatthese types of facilities can be profitably operated for the foreseeablefuture.  However, it appears to us thattoday some investors may be assuming that the improvements in financial resultsrealized at these types of communities during the past few years may continueindefinitely.  The reported sales pricesbeing paid today for some independent and assisted living communities seem toexceed replacement cost, including fill up losses.  We are concerned that new developmentactivity may occur in the near future, and it is currently unclear whether thisactivity will result in excess or moderate new supply which can be absorbedwithout adversely affecting existing market conditions.

The increasing availabilityof assisted living facilities in the 1990s caused occupancy at many nursinghomes to decline.  This fact, togetherwith restrictions on development of new nursing homes by most states, hascaused nursing care to be delivered in many older facilities.  We believe that many nursing homes currentlyin operation are becoming physically obsolete and that eventually politicalpressures from an aging population will cause governmental authorities topermit increased new construction.

Rehabilitation hospitalsprovide intensive medical services, intensive physical therapy, occupationaltherapy and speech language services beyond the capability customarilyavailable in skilled nursing facilities. We believe that if 

 

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we are successful in ouroperation of our rehabilitation hospitals, our reputation in the rehabilitationbusiness (including providing outpatient rehabilitation services) will beenhanced.  This may provide otherpossible opportunities for us to acquire additional IRFs or to provide increasingamounts of rehabilitation services at our senior living communities.

Institutionalpharmacies provide large quantities of drugs at locations where patients withrecurring pharmacy requirements are concentrated.  The business rationale for an institutionalpharmacy is to deliver drugs and pharmacy services more efficiently and atlower costs than from expensive retail locations which cater to short termrequirements.  The aging of thepopulation and recent pharmacological innovations have created rapidly growingdemand for pharmacy drugs and services. We believe that the Medicare D benefits program which became effectiveJanuary 1, 2006 will increase the demand for pharmacy drugs and services andthat cost containment pressures, which inevitably will be part of thisgovernment funded program, will increase business for efficient institutionalpharmacy businesses such as those we have recently begun to operate, but thatthese same cost containment pressures may limit the long term profitability ofthis business.

We earn ourrevenues from residents primarily by providing housing and services to ourresidents.  During 2006, approximately33% of our net revenues from residents at our senior living communities camefrom the Medicare and Medicaid programs and 67% of our net revenues fromresidents came from private pay and other resources.  We bill all private pay residents in advancefor the housing and services to be provided in the following month.

Our materialexpenses were:

·                  Wages andbenefits — includes wages for our employees working at our senior livingcommunities and wage related expenses such as health insurance, workerscompensation insurance and other benefits.

·                  Other operatingexpenses — includes utilities, housekeeping, dietary, maintenance, marketing,insurance and community level administrative costs at our senior livingcommunities.

·                  Hospitalexpenses — includes wages and benefits for our hospital based staff and otheroperating expenses related to our hospital business.

·                  Pharmacyexpenses — includes the cost of drugs dispensed to our patients as well aswages and benefits for our pharmacies and staff and other operating expensesrelated to our pharmacy business.

·                  Rent expense —we lease 144 of our 162 senior living communities and two rehabilitationhospitals from Senior Housing and four senior living communities from HCPI.

·                  Management feeto SLS — fees for the senior living communities SLS historically managed forus.

·                  General andadministrative expenses — principally wage related costs for headquarters andregional staff supporting our communities.

·                  Depreciation andamortization expense — we incur depreciation expense on buildings and furnitureand equipment.

·                  Interest expense— includes interest on outstanding debt balances and amortization of deferredfinancing costs.

The followinginformation should be read in conjunction with the consolidated financialstatements included in this Annual Report on Form 10-K.

 

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**Yearended December 31, 2006 versus year ended December 31, 2005**

The following tablespresent an overview of our portfolio for the years ended December 31, 2006 and2005:
| ** **                                                            | ** ** | **For the years ended December 31,**                    | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                                                         | ** ** | **2005** | ** ** | **$ Variance** | ** ** | **Change** | ** ** |
| ** **                                                            | ** ** | **(dollars in thousands, except per day amounts)** | ** ** |
| Net revenues from  residents                                          |       | $                                                                                | 748,003    |   | $ | 700,891 |   | $ | 47,112 |   | 7 | % |
| Hospital revenue                                                      |       | 26,130                                                                           |       | — |   | 26,130 |   | — |   |
| Pharmacy revenue                                                      |       | 53,204                                                                           |       | 33,132 |   | 20,072 |   | 61 | % |
| Wages and benefits                                                    |       | 384,005                                                                          |       | 356,367 |   | 27,638 |   | 8 | % |
| Other operating  expenses                                             |       | 187,335                                                                          |       | 180,694 |   | 6,641 |   | 4 | % |
| Hospital expenses                                                     |       | 23,589                                                                           |       | — |   | 23,589 |   | — |   |
| Pharmacy expenses                                                     |       | 52,972                                                                           |       | 31,823 |   | 21,149 |   | 66 | % |
| Management fee to SLS                                                 |       | 8,744                                                                            |       | 21,256 |   | (12,512 | ) | -59 | % |
| Termination expense for  SLS management agreements                    |       | 129,913                                                                          |       | 86,286 |   | 43,627 |   | 51 | % |
| Rent expense                                                          |       | 111,481                                                                          |       | 98,890 |   | 12,591 |   | 13 | % |
| General and administrative                                            |       | 33,829                                                                           |       | 28,221 |   | 5,608 |   | 20 | % |
| Depreciation and  amortization                                        |       | 9,950                                                                            |       | 7,114 |   | 2,836 |   | 40 | % |
| Impairment of assets                                                  |       | —                                                                           |       | 2,333 |   | (2,333 | ) | — |   |
| Interest and other  income                                            |       | 6,806                                                                            |       | 1,543 |   | 5,263 |   | 341 | % |
| Interest expense                                                      |       | 4,365                                                                            |       | 3,741 |   | 624 |   | 17 | % |
| Provision for income  taxes                                           |       | —                                                                           |       | — |   | — |   | — |   |
| Loss from discontinued  operations                                    |       | (4,625                                                                           | )          | (3,000 | ) | (1,625 | ) | -54 | % |
| Net loss                                                              |       | (116,665                                                                         | )          | (84,159 | ) | (32,506 | ) | -39 | % |
|                                                                  |       |                                                                             |       |   |   |   |   |   |   |
| No. of senior living  communities (end of period)                     |       | 162                                                                              |       | 151 |   | — |   | 11 |   |
| No. of living units  (end of period)                                  |       | 18,117                                                                           |       | 16,810 |   | — |   | 1,307 |   |
| Occupancy                                                             |       | 91                                                                               | %          | 90 | % | — |   | 1 | % |
| Average daily rate                                                    |       | $                                                                                | 124        | ** ** | $ | 127 |   | $ | (3 | ) | -2 | % |
| Percent of net revenues  from residents from Medicare                 |       | 14                                                                               | %          | 15 | % | — |   | -1 | % |
| Percent of net revenues  from residents from Medicaid                 |       | 19                                                                               | %          | 20 | % | — |   | -1 | % |
| Percent of net revenues from residents from private and other sources |       | 67                                                                               | %          | 65 | % | — |   | 2 | % |

 

Comparable Communities(communities that we operated continuously since January 1, 2005):
| ** **                                                            | ** ** | **For the years ended December 31,**                    | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                                                         | ** ** | **2005** | ** ** | **$ Variance** | ** ** | **Change** | ** ** |
| ** **                                                            | ** ** | **(dollars in thousands, except per day amounts)** | ** ** |
| Net revenues from  residents                                          |       | $                                                                                | 716,170    |   | $ | 688,782 |   | $ | 27,388 |   | 4 | % |
| Community expenses                                                    |       | 544,333                                                                          |       | 527,524 |   | 16,809 |   | 3 | % |
| No. of communities (end  of period)                                   |       | 144                                                                              |       | 144 |   | — |   | — |   |
| No. of living units  (end of period)                                  |       | 16,160                                                                           |       | 16,160 |   | — |   | — |   |
| Occupancy                                                             |       | 90                                                                               | %          | 90 | % | — |   | — |   |
| Average daily rate                                                    |       | $                                                                                | 135        |   | $ | 130 |   | 5 |   | 4 | % |
| Percent of net revenues  from residents from Medicare                 |       | 14                                                                               | %          | 15 | % | — |   | -1 | % |
| Percent of net revenues  from residents from Medicaid                 |       | 20                                                                               | %          | 20 | % | — |   | — |   |
| Percent of net revenues from residents from private and other sources |       | 66                                                                               | %          | 65 | % | — |   | 1 | % |
|                                                                       |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |

 

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The 7% increase in net revenues from residents is due primarily torevenues from the six communities we acquired in June 2005, the 11 communitieswe acquired in the fourth quarter of 2006, higher per diem charges to residentsand a 1% increase in occupancy.  The 4%increase in net revenues from residents at the communities that we haveoperated continuously since January 1, 2005 is due primarily to higher per diemcharges to residents.  The increase inrevenues from our hospitals is a result of our beginning operations at our hospitalsin October 2006.  The 61% increase inrevenues from our pharmacies is a result of our acquiring one pharmacy in eachof June 2005, December 2005, May 2006 and November 2006.

Our 8% increase in wages and benefits costs is primarily due to wagesand benefits at the six communities we acquired in June 2005, the 11communities we acquired in the fourth quarter of 2006 and wage increases.  The 4% increase in other operating expenses,which include utilities, housekeeping, dietary, maintenance, insurance andcommunity level administrative costs, primarily results from the otheroperating expenses at the six communities we acquired in June 2005, the 11communities we acquired in the fourth quarter of 2006 and increased chargesfrom third parties.  The communityexpenses for the communities that we have operated continuously since January1, 2005 have increased by 3%, principally due to wage and benefitincreases.  The increase in hospitalexpenses is a result of our beginning operations at our hospitals in October2006.  The 66% increase in pharmacyexpenses is a result of our acquiring one pharmacy in each of June 2005,December 2005, May 2006 and November 2006. Management fees to SLS decreased by 59% due to our termination of 12management agreements in November 2005, one agreement in February 2006, 10agreements in June 2006 and seven agreements in December 2006.  The 13% rent expense increase is primarilydue to the communities that we began to lease in 2005 and 2006, the hospitalswe began to lease in October 2006 and our payment of additional rent forcapital improvements purchased by Senior Housing since January 1, 2005.

In April 2006, we sent notices to SLS to terminate managementagreements for 10 of the 17 senior living communities that SLS then managed forus.  In June 2006, we paid SLStermination fees totaling $89.8 million and terminated the SLS managementagreements for these 10 communities.  InDecember 2006, we terminated the last seven agreements under which SLS managedsenior living communities for us and paid SLS termination fees totaling $40.1million.  We no longer pay managementfees to SLS.

The 20%****increase in general andadministrative expenses for the year ended December 31, 2006 results from thesix communities we acquired in June 2005, the 11 communities we acquired in thefourth quarter of 2006, the 30 communities we began to operate that werepreviously managed for us by SLS and the rehabilitation hospitals we began tooperate in October 2006.

The 40% increase in depreciation and amortization for the year endedDecember 31, 2006 is primarily attributable to our purchase of furniture andfixtures for our communities and in connection with our pharmacy acquisitions.

Our interest and other income increased by $5.3million, or 341%, for the year ended December 31, 2006, compared to the yearended December 31, 2005, primarily as a result of a payment from HealthSouth tosettle numerous transition matters and claims related to our assumption of theoperations of the two rehabilitation hospitals. The amount of this settlement was approximately $2.4 million.  Interest and other income also increased as aresult of higher levels of investable cash and increased yields on our cash andinvestments.

Our interest expense increased by 17%,****primarilydue to the issuance of our convertible notes in October 2006.

Because of our operating loss carryforwards, we do not anticipate owingfederal tax in 2006.

Loss from discontinued operations for the year ended December 31, 2006 was$4.6 million, compared to a loss of $3.0 million for the year ended December31, 2005.  The losses in both years areprimarily due to operating expenses we incurred as a result of our shuttingdown operations at two communities in 2005 and 2006.

 

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

The following tables present an overview of our portfolio for the yearsended December 31, 2005 and 2004:
| ** **                                                            | ** ** | **For the years ended December 31,**                    | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                                                         | ** ** | **2004** | ** ** | **$ Variance** | ** ** | **Change** | ** ** |
| ** **                                                            | ** ** | **(dollars in thousands, except per day amounts)** | ** ** |
| Net revenues from  residents                                          |       | $                                                                                | 700,891    |   | $ | 584,615 |   | $ | 116,276 |   | 20 | % |
| Pharmacy revenue                                                      |       | 33,132                                                                           |       | 13,209 |   | 19,923 |   | 151 | % |
| Wages and benefits                                                    |       | 356,367                                                                          |       | 302,282 |   | 54,085 |   | 18 | % |
| Other operating  expenses                                             |       | 180,694                                                                          |       | 153,472 |   | 27,222 |   | 18 | % |
| Pharmacy expenses                                                     |       | 31,823                                                                           |       | 12,093 |   | 19,730 |   | 163 | % |
| Management fee to SLS                                                 |       | 21,256                                                                           |       | 19,293 |   | 1,963 |   | 10 | % |
| Termination expense for  SLS management agreements                    |       | 86,286                                                                           |       | — |   | 86,286 |   | — |   |
| Rent expense                                                          |       | 98,890                                                                           |       | 82,453 |   | 16,437 |   | 20 | % |
| General and  administrative                                           |       | 28,221                                                                           |       | 20,052 |   | 8,169 |   | 41 | % |
| Depreciation and  amortization                                        |       | 7,114                                                                            |       | 3,372 |   | 3,742 |   | 111 | % |
| Impairment of assets                                                  |       | 2,333                                                                            |       | — |   | 2,333 |   | — |   |
| Interest and other  income                                            |       | 1,543                                                                            |       | 1,666 |   | (123 | ) | -7 | % |
| Interest expense                                                      |       | 3,741                                                                            |       | 1,172 |   | 2,569 |   | 219 | % |
| Provision for income taxes                                            |       | —                                                                           |       | 120 |   | (120 | ) | — |   |
| Loss from discontinued  operations                                    |       | (3,000                                                                           | )          | (1,890 | ) | (1,110 | ) | -59 | % |
| Net (loss) income                                                     |       | (84,159                                                                          | )          | 3,291 |   | (87,450 | ) | -2,657 | % |
|                                                                  |       |                                                                             |       |   |   |   |   |   |   |
| No. of senior living  communities (end of period)                     |       | 151                                                                              |       | 144 |   | — |   | 7 |   |
| No. of living units  (end of period)                                  |       | 16,810                                                                           |       | 16,054 |   | — |   | 756 |   |
| Occupancy                                                             |       | 90                                                                               | %          | 89 | % | — |   | 1 | % |
| Average daily rate                                                    |       | $                                                                                | 127        |   | $ | 112 |   | $ | 15 | ** ** | 13 | % |
| Percent of net revenues  from residents from Medicare                 |       | 15                                                                               | %          | 16 | % | — |   | -1 | % |
| Percent of net revenues  from residents from Medicaid                 |       | 20                                                                               | %          | 20 | % | — |   | — |   |
| Percent of net revenues from residents from private and other sources |       | 65                                                                               | %          | 64 | % | — |   | 1 | % |

 

Comparable Communities(communities that we operated continuously since January 1, 2004):
| ** **                                                            | ** ** | **For the years ended December 31,**                    | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                                                         | ** ** | **2004** | ** ** | **$ Variance** | ** ** | **Change** | ** ** |
| ** **                                                            | ** ** | **(dollars in thousands, except per day amounts)** | ** ** |
| Net revenues from  residents                                          |       | $                                                                                | 604,967    |   | $ | 574,952 |   | $ | 30,015 |   | 5 | % |
| Community expenses                                                    |       | 469,062                                                                          |       | 448,161 |   | 20,901 |   | 5 | % |
| No. of communities (end  of period)                                   |       | 97                                                                               |       | 97 |   | — |   | — |   |
| No. of living units  (end of period)                                  |       | 13,410                                                                           |       | 13,410 |   | — |   | — |   |
| Occupancy                                                             | ** ** | 90                                                                               | %          | 90 | % | — |   | — |   |
| Average daily rate                                                    |       | $                                                                                | 137        |   | $ | 131 |   | 6 |   | 5 | % |
| Percent of net revenues  from residents from Medicare                 |       | 17                                                                               | %          | 18 | % | — |   | -1 | % |
| Percent of net revenues  from residents from Medicaid                 |       | 23                                                                               | %          | 23 | % | — |   | — |   |
| Percent of net revenues from residents from private and other sources |       | 60                                                                               | %          | 57 | % | — |   | 3 | % |
|                                                                       |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |

 

The 20% increase in netrevenues from residents is due primarily to revenues from the 47 communities weacquired in November 2004, the six communities we acquired in June 2005, higherper diem charges to residents and a 1% increase in occupancy.  The 5% increase in net revenues fromresidents at the communities that we operated 

 

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continuously since January 1, 2004 is due primarily tohigher per diem charges to residents. The increase in revenues from our pharmacies is a result of ouracquiring one pharmacy in September 2004 and another pharmacy in June 2005.

Our 18% increase in wages and benefits costs is primarily due to wagesand benefits at the 47 communities we acquired in November 2004, the sixcommunities we acquired in June 2005 and wage increases.  The 18% increase in other operating expenses,which include utilities, housekeeping, dietary, maintenance, insurance andcommunity level administrative costs, primarily results from the otheroperating expenses at the 47 communities we acquired in November 2004, the six communitieswe acquired in June 2005 and increased charges from third parties.  The community expenses for the communitiesthat we have operated continuously since January 1, 2004 increased by 5%principally due to wage and benefit increases. The 163% increase in pharmacy expenses is a result of our acquiring onepharmacy in September 2004 and another pharmacy in June 2005.  Management fees related to the 30 communitiesthat SLS managed for us increased by 10% because of increased revenues at thesecommunities and a contractual increase in the formula for calculating themanagement fee.  The 20% rent expenseincrease is due to additional communities that we began to lease in 2004 and2005, and our payment of additional rent for capital improvements purchased bySenior Housing since January 1, 2004.

The termination expense for SLS management agreements arose from ourtermination of management agreements for 13 of the 30 senior living communitiesthat SLS then managed for us.  In August2005, we notified SLS of the termination of management agreements for 12 seniorliving communities, and, in November 2005, we terminated these SLS managementagreements for a payment of $81.5 million. In February 2006, we terminated the management agreement for one additionalcommunity for a payment of $4.8 million, but because we sent a bindingtermination notice to SLS for this community in December 2005, we accrued thistermination fee in 2005.

The 41% increase in general and administrative expenses for the year endedDecember 31, 2005 primarily results from our increased operations at the 47communities we acquired in November 2004, the six communities we acquired inJune 2005, integration costs associated with our acquisition of thosecommunities and increased audit and professional services fees for compliancewith the requirements of the Sarbanes-Oxley Act of 2002.

The 111% increase in depreciation and amortization for the year endedDecember 31, 2005 is primarily attributable to the 47 communities we acquiredin November 2004, the six communities we acquired in June 2005 and our purchaseof furniture and fixtures for our communities then managed by SLS.

To partially fund our termination fees for the 12 management agreementswith SLS on November 1, 2005, we sold the six communities that we acquired inJune 2005 to Senior Housing for net proceeds of $56.7 million, and SeniorHousing leased these communities back to us. In connection with the sale of these communities to Senior Housing, werecognized a $2.3 million impairment charge to reduce the carrying value ofthese communities to the amount realized upon their sale to SeniorHousing.  The purchase price paid to usby Senior Housing is the same amount as the purchase price we paid to theseller of the communities.  Theimpairment loss which we recognized in 2005 relates principally to transactioncosts which we previously capitalized.

Our interest and other income decreased by 7% primarily because oflower levels of investable cash.

Our interest expense increased by $2.6 million, or 219%, primarily dueto the mortgages we assumed in connection with certain acquisitions.

The provision for income taxes decreased because we do not anticipateowing tax under the alternative minimum tax regime in 2005.  We accrued $120,000 of federal alternativeminimum income tax expense during the year ended December 31, 2004.

Loss from discontinued operations for the year ended December 31, 2005was $3.0 million, compared to a loss of $1.9 million for the year endedDecember 31, 2004.  The losses in bothyears are primarily the result of our ceasing operations at two communities in2005 and three communities in 2004.

 

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**LIQUIDITY AND CAPITALRESOURCES**

We believe that a combination ofour cash on hand, our efforts to increase revenues and contain costs, ourability to borrow on our revolving credit facility, our ability to sell toSenior Housing certain capital improvements made to communities that we leasefrom Senior Housing and the possibility of sales or financings of our ownedcommunities will be sufficient to meet our working capital needs, operatingexpenses, rent payments to Senior Housing, debt service and capitalexpenditures for the next 12 months and the foreseeable future.

**Assets and Liabilities**

Our current assets at December31, 2006 were $205.8 million, compared to $94.1****millionat December 31, 2005.  At December31, 2006 and 2005, we had cash and cash equivalents of $46.2 million and $16.4****million, respectively. This increase in cash and cash equivalents is primarily the result ofthe issuance of our convertible notes in October 2006.  Our current liabilities were $132.9****million at December 31, 2006, compared to $90.0****million at December 31, 2005.  The increase in current liabilities isprimarily the result of our electing to prepay seven mortgages in accordancewith the terms of the related indebtedness.   We expect to complete these prepayments totaling approximately $28.7million by March 31, 2007.

**OurLeases with Senior Housing**

As of March 5, 2007, welease 144 senior living communities and two rehabilitation hospitals fromSenior Housing under six leases.  Ourleases with Senior Housing require us to pay minimum rent of $124.4****million annually and percentage rent for most communities.

The terms of our leases withSenior Housing contain provisions whereby Senior Housing may cancel our rightsunder these agreements upon the acquisition by any person or group of more than9.8% of our voting stock and upon other “change of control” events.  These leases also limit our ability tocreate, incur, assume or guarantee indebtedness.  As of March 5, 2007, we believe we arein compliance with the terms of our leases with Senior Housing.

Upon our request, Senior Housing reimburses ourcapital expenditures made at the communities we lease from Senior Housing andincreases our rent pursuant to contractual formulas.  Senior Housing reimbursed us $23.7 million during the year ended December31, 2006 for capital expenditures made at these leased communities andincreased our annual rent by approximately $2.3million.

                In February 2006,we assumed the operations of a community from SLS which is located in Coral Springs,Florida. We began a significant capital improvement project at this communityin 2006 that will continue into 2007 and the cost of this project may totalapproximately $5.0 million.  Pursuant to the terms of our lease withSenior Housing, Senior Housing will fund the cost of this capital improvementproject and our annual rent payable to Senior Housing will increase pursuant tothe formula set forth in the lease.

 

**Our Revenues**

Our revenues from services toresidents at our communities are our primary source of cash to fund ouroperating expenses, including rent, principal and interest payments on our debtand our capital expenditures.  At some ofour communities, operating revenues for nursing home services are received fromthe Medicare and Medicaid programs.  Medicareand Medicaid revenues from residents were earned primarily at our 49 nursinghomes.  We derived 33% and 35% of our netrevenues from residents from these programs for the years ended December 31,2006 and 2005, respectively.

Our Medicare net revenues fromsenior living community residents totaled $103.7****millionand $105.0 million for theyears ended December 31, 2006 and 2005,respectively.  In each of October 2006and 2005, our Medicare rates increased by approximately 3% over the priorperiod.  Our change in Medicare revenuesfrom 2005 to 2006 resulted from a slight decrease in the number of residents atour facilities who were eligible for Medicare. Effective January 1,2006, CMS implemented changes to the payment categories it uses to set dailypayment rates for Medicare beneficiaries in skilled nursing facilities.  These categories are known as ResourceUtilization Groups, or RUGs.  CMS hasintroduced nine new payment categories for medically complex patients,increasing the number of categories from 44 to 53, and 

 

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hasmade revisions to its payment rates for current RUGs.  Also effective January 1, 2006, these RUGchanges eliminated certain temporary additional payments for certain skillednursing care and rehabilitation groups. These changes to Medicare reimbursement rates effectively eliminated thebenefit of the October 2005 Medicare rate increases.

Our Medicaid net revenues fromsenior living community residents totaled $141.7 million and $137.0 million for the years ended December 31, 2006 and 2005, respectively.  The Bush administration and certain membersof the Senate and the House of Representatives have recently proposed Medicareand Medicaid policy changes and rate reductions to be phased in during the nextseveral years.  In addition, some of thestates in which we operate either have not raised Medicaid rates by amountssufficient to offset increasing costs or are expected to reduce Medicaidfunding.  The magnitude of the potentialMedicare and Medicaid rate reductions and the impact of the failure of theseprograms to increase rates to match increasing expenses, as well as themagnitude of the potential Medicare and Medicaid policy changes, cannotcurrently be estimated, but they may be material to our operations, may affectour future results of operations and may produce losses.

We began to operate two rehabilitationhospitals in October 2006.  Approximately72% of our revenues from these hospitals came from the Medicare and Medicaidprograms.  In May 2004, CMSissued a rule establishing revised Medicare standards that rehabilitationhospitals are required to meet in order to participate as IRFs in the Medicareprogram, known as the “75% Rule”.  The75% Rule is being phased in over a four year period that began on July 1,2004.  For cost reporting periodsstarting on and after July 1, 2006, 60% of a facility’s inpatient populationmust require intensive rehabilitation services for one of CMS’ designatedmedical conditions.  For cost reportingperiods starting on and after July 1, 2007, the requirement is 65% and for costreporting periods starting on and after July 1, 2008, the requirement is75%.  An IRF that fails to meet therequirements of the 75% Rule is subject to reclassification as a different typeof healthcare provider; and the effect of such reclassification would be tolower Medicare payment rates.

Under the MPDIMA, Medicarebeneficiaries may receive prescription drug benefits effective January 1, 2006by enrolling in private health plans or managed care organizations, or if theyremain in a traditional Medicare program, by enrolling in stand alone prescriptiondrug plans.  As a result, our pharmacy operations became more dependent uponthe Medicare program.

**Insurance**

Recent increases in the costs ofinsurance, especially tort liability insurance, workers compensation andemployee health insurance, may continue to have an adverse impact upon ourfuture results of operations.  Althoughwe self insure a large portion of these costs, our costs have increased as aresult of the higher costs that we incur to settle claims.

**Acquisitions and Related Financings**

In March 2005, we acquired a 62 unit assisted livingcommunity located in Georgia for approximately $6.9 million.  We financed the acquisition with cash onhand.

In June 2005, we acquired six assisted livingcommunities for approximately $59.0 million; these communities had a combinedlicensed resident capacity of 654 and are located in western Pennsylvania.  We funded this purchase using $10.0 milliondrawn under our revolving credit facility, the proceeds of a sale leasebacktransaction and a mortgage transaction with Senior Housing.  In connection with these transactions, wesold four assisted living communities to Senior Housing for $24.0 million andSenior Housing leased these communities back to us for initial rent of $2.2million per year.  Senior Housing alsoprovided us with a $43.5 million first mortgage line of credit secured by thesix purchased communities.  We borrowed$24.0 million under the first mortgage line of credit when we closed thispurchase and repaid it in August 2005 with proceeds raised from our sale ofcommon shares.

In October 2005, we sold six communities to SeniorHousing for net proceeds of $56.7 million and Senior Housing leased thesecommunities back to us.  Our initial rentto Senior Housing for these communities was $5.2 million per annum.  The purchase price paid to us by SeniorHousing is the same amount as the purchase price we paid 

 

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toacquire the communities.  In connectionwith the sale and leaseback of the six communities, we terminated the firstmortgage line of credit with Senior Housing which had been secured by thesefacilities.

Between September and December 2006, we agreed tolease 11 senior living communities with 1,284 units which Senior Housingacquired from third parties.  Six ofthese communities are assisted living communities (three of which offer someskilled nursing services), three are independent living communities and two arecontinuing care retirement communities which offer independent living, assistedliving and skilled nursing services.  Ourrent payable to Senior Housing for these 11 communities is $9.0 million peryear, plus future increases calculated as a percentage of the revenue increasesat these communities after 2007.  Weadded these communities to our existing lease with Senior Housing which has acurrent term ending in 2020, plus renewal options thereafter.  Residents pay substantially all of ourcharges at these communities from their private resources.

Between June 2005 and November 2006, we acquired fourinstitutional pharmacy businesses located in Omaha, Nebraska, West Hills, California, Myrtle Beach, SouthCarolina and Vienna, Virginia for approximately $4.6 million, $450,000, $3.6 million and $2.3 million,respectively.

**Rehabilitation Hospitals**

In October 2006, we began to lease two rehabilitationhospitals from Senior Housing.  The termof the lease for these two hospitals expires on June 30, 2026, subject to ourright to extend the term of the lease for an additional 20 years. These twohospitals provide health rehabilitation services and are located in Braintreeand Woburn, Massachusetts.  Our rentpayable to Senior Housing for these hospitals is $10.3 million per year.  These hospitals offer extensive inpatient andoutpatient services that we believe are similar to services we provide, or mayprovide, in many of our senior living communities.

**Discontinued Operations**

                During 2005, weceased operations at one assisted living community in Los Angeles, Californiaand one skilled nursing facility in Milwaukee, Wisconsin.  We leased this community and this facilityfrom Senior Housing.  Senior Housing soldthe assisted living community located in California in December 2005 for netproceeds of approximately $2.6 million, which caused a $260,000 reduction inthe annual minimum rent we pay to Senior Housing in accordance with our leaseterms.  Senior Housing sold the skillednursing facility located in Wisconsin in December 2006 for net proceeds ofapproximately $1.3 million, which caused a $130,000 reduction in the annualminimum rent we pay to Senior Housing in accordance with our lease terms.

 

                In June 2006, weceased operations at two skilled nursing facilities located in Connecticut thatwe leased from Senior Housing.  SeniorHousing sold those facilities in November 2006 for net proceeds ofapproximately $5.6 million, which caused a $559,000 reduction in the annualminimum rent we pay to Senior Housing in accordance with our lease terms.

 

**Termination of SLS Management Agreements**

In November 2005, we terminated management agreementsfor 12 of the 30 senior living communities that SLS then managed for us, paidSLS termination fees totaling $81.5 million and began to directly operate thesecommunities.  We funded this terminationpayment with cash on hand, including the proceeds from our August and September2005 common share offering, and with the proceeds of a sale leasebacktransaction with Senior Housing for the six communities we acquired in June2005.  In February 2006, we terminated amanagement agreement for one senior living community that SLS then managed forus, paid SLS a termination fee of $4.8 million and began to directly operatethis community.  In June 2006, weterminated management agreements for 10 of the 17 senior living communitiesthat SLS then managed for us, paid SLS termination fees totaling $89.8 millionand began to directly operate these communities.  We funded this termination payment with cashon hand, including the proceeds from our April 2006 common share offering.  In December 2006, we terminated managementagreements for all of the remaining senior living communities that SLS thenmanaged for us, paid SLS termination fees totaling $40.1 million and began todirectly operate these communities.  Wefunded this termination payment with cash on hand, including the proceeds fromour issuance of the convertible notes in October 2006.  We no longer pay management fees to SLS.

 

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**Equity and Debt Financings**

In December 2004and January 2005, we issued 3,620,000 common shares in an underwritten publicoffering raising net proceeds of $28.8 million. We used a portion of the proceedsraised in this offering to pay off a $16.8 million mortgage loan with SeniorHousing, and we added the remainder to our cash balances.  In August and September 2005, we issued7,750,000 common shares in an underwritten public offering raising net proceedsof $55.6 million.  We used a portion ofthe proceeds raised in this offering to pay off the $24.0 million firstmortgage line of credit with Senior Housing described above and to reduceamounts outstanding under our revolving credit facility, and we added theremainder to available cash balances.  InApril 2006, we issued 11,500,000 common shares in an underwritten publicoffering raising net proceeds of $114.0 million.  We used a portion of the proceeds raised inthis offering to pay the $89.8 million in termination fees for the 10 SLSmanagement agreements we terminated in June 2006, and we added the remainder toavailable cash balances.  In October2006, we issued in a private placement $126.5million principal amount of our convertible notes.  Weused the proceeds raised in this private placement to pay the termination feesfor the remaining management agreements with SLS, and we added the remainder toavailable cash balances.

**Contractual Obligations Table**

              As of December 31, 2006, ourcontractual obligations were as follows (dollars in thousands):
| ** **                                                      | ** ** | **Payment due by period** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------------|------------|
| **Contractual Obligations**                                | ** ** | **Total**                                | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Debt Obligations (1)                                            |       | $                                        | 171,271    |   | $ | 33,317 |   | $ | 406 |   | $ | 353 |   | $ | 137,195 |   |
| Operating Lease  Obligations (2)                                |       | 1,611,820                                |       | 125,584 |   | 251,167 |   | 251,167 |   | 983,902 |   |
| Other Long Term  Liabilities Reflected on our Balance Sheet (3) |       | 18,464                                   |       | — |   | 14,433 |   | 4,031 |   | — |   |
| Total                                                           |       | $                                        | 1,801,555  |   | $ | 158,901 |   | $ | 266,006 |   | $ | 255,551 |   | $ | 1,121,097 |   |

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(1)                                  DebtObligations are the amounts due under several HUD insured mortgages as well asour outstanding convertible notes.  DebtObligations due in less than one year include the entire balances for the sevenmortgages that we expect to prepay by March 31, 2007.

(2)                                  OperatingLease Obligations are the minimum lease payments to Senior Housing and HCPIthrough the current lease terms ending between 2014 and 2026.  These amounts do not include percentage rentthat may become payable under these leases.

(3)                                  OtherLong Term Liabilities Reflected on our Balance Sheet are primarily insurance reserves related to workerscompensation and professional liability insurance.

**Debt Instruments andCovenants**

The interest rate on borrowings under our revolving credit facility isLIBOR plus a premium.  The maximum amountavailable under this facility is $25.0 million, and is subject to limitationsbased upon qualifying collateral.  We arethe borrower under the revolving credit facility and certain of oursubsidiaries guarantee our obligations under the facility.  The facility is secured by our and ourguarantor subsidiaries’ accounts receivable, deposit accounts and relatedassets.  The facility is available foracquisitions, working capital and general business purposes.  The facility contains covenants requiring usto maintain collateral, minimum net worth and certain other financial ratios,places limits on our ability to incur or assume debt or create liens withrespect to certain of our properties and has other customary provisions.  In certain circumstances and subject toavailable collateral and lender approvals, the maximum amount which we may drawunder this credit facility may be increased to $50.0 million.  In July 2006, we entered into an amendment tothe facility to lower the interest paid on drawings under the facility and toextend the termination date to May 8, 2008. The termination date may be further extended twice, in each case bytwelve months, subject to lender approval, our payment of extension fees andother conditions.  As of December 31,2006 and March 5, 2007, no amounts were outstanding under this creditfacility.  As of December 31, 2006 andMarch 5, 2007, we believe we are in compliance with all applicable covenantsunder this revolving credit facility.

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At December 31, 2006, we had 11 HUD insured mortgage loans totaling$44.8 million that were secured by nine of our communities.  By March 31, 2007, we expect to have prepaidseven mortgages that were secured by six of our communities.  We expect topay approximately $28.7 millionto payoff these seven mortgages, which will consist of approximately $27.8million in principal and approximately $881,000 in prepayment penalties. Because we had carried these mortgages at a premium to their fair value, wewill recognize a gain of approximately $4.5 million in connection with theearly extinguishment of debt.  The weighted average interest rate on thesemortgages was 7.3%.  The weightedaverage interest rate on the remaining four mortgages is 6.1%.** **Payments of principal and interest are due monthlyon our remaining four mortgages until maturities at varying dates ranging fromFebruary 2032 to June 2039.  Thesemortgages contain standard HUD mortgage covenants.  As of December 31, 2006 and March 5, 2007, webelieve we are in compliance with all covenants of these four mortgages.

In October 2006,we issued in a private placement $126.5 millionprincipal amount of convertible notes, which included $16.5 million principalamount of the notes issued pursuant to the underwriters exercise of an overallotment option. Our net proceeds from this private placement wereapproximately $122.6 million.  Thesenotes are convertible into our common shares at any time.  The initial conversion rate, which is subjectto possible adjustment, is 76.9231 common shares per $1,000 principal amount ofnotes, which represents an initial conversion price of $13.00 per share.  A holder that surrenders notes for conversionin connection with a “make whole fundamental change,” as defined in theindenture governing the notes, that occurs before October 20, 2011 may in somecircumstances be entitled to an increased conversion rate (i.e., a lower pershare conversion price).

The convertiblenotes bear interest at a rate of 3.75% per annum, payable semi-annually inarrears on April 15 and October 15 of each year, starting on April 15,2007.  The notes mature on October 15,2026.  On or after October 20, 2011, wemay redeem the notes, in whole or in part, at a redemption price in cash equalto 100% of the principal amount of the notes we redeem, plus any accrued andunpaid interest.  On each of October 15,2013, October 15, 2016 and October 15, 2021, holders of the notes may requireus to purchase all or a portion of their notes at a purchase price in cashequal to 100% of the principal amount of the notes to be purchased, plus anyaccrued and unpaid interest.  If a “fundamentalchange,” as defined in the indenture governing the notes, occurs, holders ofthe notes may require us to repurchase all or a portion of their notes for cashat a repurchase price equal to 100% of the principal amount of the notes to berepurchased, plus any accrued and unpaid interest and, in certaincircumstances, plus a make whole premium as defined in the indenture governingthe notes.  The notes are guaranteed bycertain of our wholly owned subsidiaries. Our subsidiary guarantors may be released from their obligations undercertain circumstances.  As of  December 31, 2006 and March 5, 2007, webelieve we are in compliance with all covenants of the indenture pursuant towhich these notes were issued.

**Off Balance SheetArrangements**

**As of December 31, 2006, we had nooff balance sheet arrangements, commercial paper, derivatives, swaps, hedges,third party guarantees, or material joint ventures or partnerships.**

**Related Person Transactions**

We were a 100% owned subsidiaryof Senior Housing before December 31, 2001. On December 31, 2001, Senior Housing distributed substantially allof our then outstanding shares to its shareholders.  In order to effect this spin off and togovern relations after the spin off, we entered into agreements with SeniorHousing and others pursuant to which it was agreed, among other things, that:

·                  so long as Senior Housing remains a real estateinvestment trust, or a REIT, we may not waive the share ownership restrictionsin our charter on the ability of any person or group to acquire more than 9.8%of any class of our equity shares without the consent of Senior Housing;

·                  so long as we are a tenant of Senior Housing, wewill not permit nor take any action that, in the reasonable judgment of SeniorHousing or HRPT Properties Trust (another REIT), or HRPT, might jeopardize thetax status of Senior Housing or HRPT as REITs;

 

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·                  Senior Housing has the option, upon theacquisition by a person or group of more than 9.8% of our voting stock and uponother change in control events, as defined, to cancel all of our rights underthe leases we have with Senior Housing; and

·                  so long as we maintain our shared servicesagreement with RMR we will not acquire or finance any real estate without firstgiving Senior Housing, HRPT or any other publicly owned REIT or other entitymanaged by RMR, the opportunity to acquire or finance real estate investmentsof the type in which Senior Housing, HRPT or any other publicly owned REIT orother entity managed by RMR, respectively, invest.

At the time of our spin off fromSenior Housing, all of the persons serving as our directors were trustees ofSenior Housing.  Our two managingdirectors, Messrs. Martin and Portnoy, are currently the managing trusteesof Senior Housing.

Of the 162 senior livingcommunities we operate, 144 are leased from Senior Housing for total annualminimum rent of $114.1 million.

Since January 1, 2006, we haveentered into several transactions with Senior Housing, including:

·                  In October 2006, we began to lease tworehabilitation hospitals from Senior Housing. The term of the lease for these two hospitals expires on June 30, 2026,subject to our right to extend the term of the lease for an additional 20years.   These two hospitals providehealth rehabilitation services and are located in Braintree and Woburn,Massachusetts.  Our rent payable toSenior Housing for these hospitals is $10.3 million per year.  These hospitals offer extensive inpatient andoutpatient services that we believe are similar to services we provide, or mayprovide, in many of our senior living communities.

·                  In June 2006, weceased operations at two communities located in Connecticut that were leasedfrom Senior Housing.  In November 2006,Senior Housing sold these two communities for net proceeds of approximately$5.6 million, which will reduce the annual minimum rent we pay to SeniorHousing under our lease by $559,000.

·                  BetweenSeptember and December 2006, we agreed to lease 11 senior living communitieswith 1,284 units which Senior Housing acquired from third parties.  Six of these communities are assisted livingcommunities (three of which offer some skilled nursing services), three areindependent living communities and two are continuing care retirement communitieswhich offer independent living, assisted living and skilled nursingservices.  Our rent payable to SeniorHousing for these 11 communities is $9.0 million per year, plus futureincreases calculated as a percentage of the revenue increases at thesecommunities after 2007.  We added thesecommunities to our existing lease with Senior Housing which has a current termending in 2020, plus renewal options thereafter.  Residents pay substantially all of ourcharges at these communities from their private resources.

·                  During 2006, aspermitted by our leases with Senior Housing, we sold to Senior Housing, atcost, approximately $23.7 million of improvements made to properties leasedfrom Senior Housing, and, as a result, our annual rent payable to Senior Housingincreased by approximately $2.3 million.

RMR provides certain management and administrative services to us undera shared services agreement. RMR is compensated at an annual rate equal to 0.6%of our total revenues. Aggregate fees earned by RMR for services during 2006,2005 and 2004, were $4.9 million, $4.7 million and $3.7 million,respectively.  RMR also provides theinternal audit function for us and for other publicly owned companies to whichit provides management or other services. Our pro rata share of RMR’s costs in providing that function for theyears ended 2006, 2005 and 2004 was $173,000, $106,938 and $80,489,respectively.  Our audit committeeappoints our director of internal audit, and our compensation committeeapproves his salary.  Our compensationcommittee also approves the costs we pay with respect to our internal auditfunction.  The fact that RMR hasresponsibilities to other entities, including our most significant landlord,Senior Housing, could create conflicts; and in the event of such conflictsbetween Senior Housing and us, the shared services agreement allows RMR to acton behalf of Senior Housing rather than on our behalf.  RMR is beneficially owned by Messrs.Barry M. Portnoy, one of our managing directors, and his son, Adam D. Portnoy,President and Chief Executive Officer and a director of RMR, a managing trusteeof HRPT and Hospitality Properties Trust (another 

 

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REIT) and a nominee forelection as a managing trustee of Senior Housing.  Alltransactions between us and RMR are approved by our compensation committee.

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

A subsidiary of RMR is the ownerof the building in which our headquarters is located.  This lease expires in 2011. We paid rent,which includes our proportional share of utilities and real estate taxes, underthis lease during 2006, 2005 and 2004 of $938,000, $711,000 and $561,000,respectively.  This lease has beenamended at various times to take into account our needs for increasing space.

In December 2006, we commencedleasing space for a regional office in Atlanta, Georgia from HRPT.  This lease expires in 2011.  We paid rent, which includes our proportionalshare of utilities and real estate taxes, under this lease during 2006 of$4,709.

We believe that all ourtransactions with related parties are on reasonable commercial terms; and allsuch transactions between us and related parties are approved by ourindependent directors.

**CriticalAccounting Policies**

Our critical accounting policies concern revenue recognition, our assessmentof the net realizable value of our accounts receivable, the realizable value oflong term assets, accounting for long term care contracts, accounting forbusiness combinations and our assessment of reserves related to our selfinsurance programs.

Our revenue recognition policies involve judgments about Medicare andMedicaid rate calculations.  Thesejudgments are based principally upon our experience with these programs and ourknowledge and familiarity with the current rules and regulations of theseprograms.  We recognize revenues whenservices are provided and these amounts are reported at their estimated netrealizable amounts.  Some Medicare andMedicaid revenues are subject to audit and retroactive adjustment, andsometimes retroactive legislative changes.

Our policies for valuing accounts receivable involve significantjudgments based upon our experience, including consideration of the age of thereceivables, the terms of the agreements with our residents, their third partypayors or other obligors, the residents or payors stated intent to pay, theresidents or payors financial capacity and other factors which may includelitigation or appeal proceedings.

We regularly evaluate whether events or changes in circumstances haveoccurred that could indicate impairment in the value of long lived assets.  If there is an indication that the carryingvalue of an asset is not recoverable, we estimate the projected undiscountedcash flows from the asset to determine if an impairment loss should be recognized.  We determine the amount of impairment loss bycomparing the historical carrying value of the asset to its estimated fairvalue.  We determine estimated fair valuethrough an evaluation of recent financial performance, recent sales of similarassets, market conditions and projected discounted cash flows of propertiesusing standard industry valuation techniques. This process requires that estimates be made and errors in our judgmentsor estimates could have a material effect on our financial statements.

At one of our communities, we offer continuing care contracts underwhich residents may pay admission fees in exchange for reduced charges duringtheir occupancy.  These fees may berefundable or non-refundable, or partially refundable and partially non-refundable.  We record these fees as obligations andamortize the non-refundable amounts into revenue over the actuarially determined remaining lives of the individual residentswhich are the expected periods of occupancy.  Actuarially determined remaining lives areestimates based upon general demographic samplings and averages.  Our decision to amortize the non-refundablefees over actuarially determined lives is based upon our estimates that theseresidents will remain at our facilities for that period.  The actual remaining lives and the actualperiod of occupancy of the individual residents who pay the non-refundable feesmay differ materially from these estimates. In the future, if we find that such differences are material, we maychange the actuarial tables which 

 

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we use and we may change our estimates that theseresidents will remain at our facilities for these periods; and these changescould have a material impact upon our financial statements.

Each of our acquisitions has been accounted for as a purchase businesscombination in accordance with Statement of Financial Accounting Standards No.141.  Purchase accounting requires thatwe make certain judgments and estimates based on our experience, including determiningthe fair value and useful lives of assets acquired and the fair value ofliabilities assumed.  Some of ourjudgments and estimates are also based upon published industry statistics andin some cases third party appraisals.

Determining reserves for the self insurance portions of our insuranceprograms involves significant judgments based upon our experience, includingprojected settlements for pending claims, known incidents which we expect mayresult in claims, estimates of incurred but not yet reported claims, claimsexperience, estimated litigation costs and other factors.  We also periodically receive and rely uponrecommendations from professional consultants in establishing these reserves;however, these reserves may prove to be materially inaccurate.

In the future we may need to revise the judgments, estimates andassessments we use to formulate our critical accounting policies to incorporateinformation which is not now known.  Wecannot predict the effect changes to these premises underlying our criticalaccounting policies may have on our future results of operations, although suchchanges could be material and adverse.

**Inflation and Deflation**

Inflation in the past several years in the U.S. has been modest.  Future inflation might have either positiveor negative impacts on our business. Rising price levels may allow us to increase occupancy charges toresidents, but may also cause our operating costs, including our percentagerent, to increase.  Also, our ability toaffect rate increases paid by the Medicare and Medicaid programs will belimited despite inflation.

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

**Seasonality**

Our senior living business is subject to modest effects ofseasonality.  During the calendar fourthquarter holiday periods, nursing home and assisted living residents aresometimes discharged to join family celebrations and admission decisions areoften deferred. The first quarter of each calendar year usually coincides withincreased illness among nursing home and assisted living residents which canresult in increased costs or discharges to hospitals. As a result of thesefactors, nursing home and assisted living operations sometimes produce greaterearnings in the second and third quarters of a calendar year and lesser earningsin the first and fourth quarters. We do not believe that this seasonality willcause fluctuations in our revenues or operating cash flow to such an extentthat we will have difficulty paying our expenses, including rent, which do notfluctuate seasonally.

**Item7A.  Quantitative and QualitativeDisclosures About Market Risk**

We are exposed to risks associated with market changes in interestrates.  We manage our exposure to thismarket risk by monitoring available financing alternatives.  Our strategy to manage exposure to changes ininterest rates is unchanged from December 31, 2005.  Other than as described below, we do notforesee any significant changes in our exposure to fluctuations in interestrates or in how we manage this exposure in the near future.

 Changes in market interest ratesalso affect the fair value of our debt obligations; increases in marketinterest rates decrease the fair value of our fixed rate debt, while decreasesin market interest rates increase the fair value of our fixed rate debt.   For example: based upon discounted cash flowanalysis, if prevailing interest rates were to increase by 10%, the marketvalue of our $171.3 million mortgage debt and convertible notes outstanding onDecember 31, 2006 would decline by about $6.8 million; and, similarly, ifprevailing interest rates were to decline by 10% and other 

 

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credit market considerations remained unchanged, themarket value of our $171.3 million mortgage debt and convertible notesoutstanding on December 31, 2006, would increase by about $7.4****million.

Our revolving creditfacility bears interest at floating rates and matures in May 2008.  As of December 31, 2006 and March 5, 2007, noamounts were outstanding under this credit facility.  We borrow in U.S. dollars and borrowingsunder our revolving credit facility bear interest at LIBOR plus 150 basispoints.  Accordingly, we are vulnerableto changes in U.S. dollar based short term rates, specifically LIBOR.  A change in interest rates would not affectthe value of any outstanding floating rate debt but could affect our operatingresults.  For example, if the maximumamount of $25.0 million were drawn under our credit facility and interest ratesdecreased or increased by 1% per annum, our interest expense would decrease orincrease by $250,000 per year, or $0.01 per share, based on currentlyoutstanding common shares.  If interestrates were to change gradually over time, the impact would occur over time.

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

**Item8. Financial Statements and Supplementary Data**

The information required by this Item is included inItem 15 of this Annual Report on Form 10-K.

**Item9. Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure**

None.

**Item9A.  Controls and Procedures**

As of the end of theperiod covered by this report, our management carried out an evaluation, underthe supervision and with the participation of our President and Chief ExecutiveOfficer and our Treasurer and Chief Financial Officer, of the effectiveness ofour disclosure controls and procedures pursuant to Exchange Act Rules 13a-15and 15d-15.  Based upon that evaluation,our President and Chief Executive Officer and our Treasurer and Chief FinancialOfficer concluded that our disclosure controls and procedures are effective.

There have been nochanges in our internal control over financial reporting during the quarterended December 31, 2006 that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

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

We areresponsible for establishing and maintaining adequate internal control over financialreporting. Our internal control system is designed to provide reasonableassurance to our management and board of directors regarding the preparationand fair presentation of published financial statements. All internal controlsystems, no matter how well designed, have inherent limitations. Therefore,even those systems determined to be effective can provide only reasonableassurance with respect to financial statement preparation and presentation.

Ourmanagement assessed the effectiveness of our internal control over financialreporting as of December 31, 2006. In making this assessment, it used thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission in *Internal Control IntegratedFramework*. Based on our assessment, we believe that, as of December31, 2006, our internal control over financial reporting is effective.

Ernst & Young LLP,the independent registered public accounting firm that audited our 2006consolidated financial statements included in this Annual Report on Form 10-K,has issued an attestation report on our assessment of our internal control overfinancial reporting. Its report appears elsewhere herein.

**Item9B.  Other Information**

**None.**

** **

39

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** **

**PART III**

**Item10.  Directors and Executive Officers andCorporate Governance**

We have a code ofbusiness conduct and ethics that applies to all our representatives, includingour officers and directors.  Our code ofbusiness conduct and ethics is posted on our website, www.5sqc.com.  A printed copy of our code of businessconduct and ethics is also available free of charge to any person who requestsa copy.  We intend to disclose anyamendments or waivers to our code of business conduct and ethics applicable toour principal executive officer, principal financial officer, principalaccounting officer or controller (or any person performing similar functions)on our website.

The remainder of the information required by Item 10 is incorporated byreference to our definitive Proxy Statement, which will be filed not later than120 days after the end of our fiscal year.

**Item11.  Executive Compensation**

The information required by Item 11 is incorporated byreference to our definitive Proxy Statement, which will be filed not later than120 days after the end of our fiscal year.

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

Equity Compensation Plan Information.  We may grant options and common shares to ourofficers, directors, employees and other individuals who render services to us,subject to vesting requirements under our 2001 Stock Option and Stock IncentivePlan, as amended, or the Plan.  Inaddition, each of our directors receives 4,000 shares per year as part of hisor her annual compensation for serving as a director and such shares may beawarded under the Plan.  The terms ofgrants made under the Plan are determined by our board of directors or acommittee thereof at the time of the grant. The following table is as of December 31, 2006.

 
| ** **                                                  | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities  reflected in  column (a))** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                                                          | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                  | ** ** |
| Equity  compensation plans approved by security holders     |       | None                                                                                                                                             |       | None                                                                                                        |       | 2,645,500                                                                                                                                                                                                | (1)        |
| Equity  compensation plans not approved by security holders |       | None                                                                                                                                             |       | None                                                                                                        |       | None                                                                                                                                                                                                     |       |
| Total                                                       |       | None                                                                                                                                             |       | None                                                                                                        |       | 2,645,500                                                                                                                                                                                                |       |

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(1) Pursuant to the termsof the Plan, in no event shall the number of shares issued exceed 3,000,000.

The remainder of the information required by Item 12is incorporated by reference to our definitive Proxy Statement, which will befiled not later than 120 days after the end of our fiscal year.

**Item13.  Certain Relationships and RelatedTransactions and Directors Independence**

The information required by Item 13 is incorporated byreference to our definitive Proxy Statement, which will be filed not later than120 days after the end of our fiscal year.

**Item14.  Principal Accountant Fees andSchedules**

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

 

40

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**Item15.  Exhibits and Financial StatementSchedules**

(a)  Index toFinancial Statements 
| Consolidated Financial  Statements of Five Star Quality Care, Inc.                                              | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                            |       |
| Reports of  Independent Registered Public Accounting Firm                                                       | F-1        |
| Consolidated Balance  Sheet at December 31, 2006 and 2005                                                  | F-3        |
| Consolidated  Statement of Operations for the years ended December 31, 2006, 2005 and  2004                | F-4        |
| Consolidated  Statement of Shareholders’ Equity for the years ended December 31, 2006,  2005 and 2004 | F-5        |
| Consolidated  Statement of Cash Flows for the years ended December 31, 2006, 2005 and  2004                | F-6        |
| Notes to  Consolidated Financial Statements                                                                     | F-7        |

 

All other schedules for which provision is made in theapplicable accounting regulations of the Securities and Exchange Commission arenot required under the related instructions, or are inapplicable, and thereforehave been omitted.

 (b)      Exhibits
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 2.1         |       | Transaction Agreement, dated as of December 7, 2001,  by and among Senior Housing Properties Trust, certain subsidiaries of Senior  Housing Properties Trust party thereto, the Company, certain subsidiaries of  the Company party thereto, FSQ, Inc., Hospitality Properties Trust, HRPT  Properties Trust and Reit Management & Research LLC.*(Incorporated by  reference to Senior Housing Properties Trust’s Current Report on  Form 8-K dated December 13, 2001.)* |
| 2.2         |       | Purchase and Sale Agreement, dated as of March 1,  2004, by and among Ellicott City Land I, LLC and Ellicott City Land II, LLC,  collectively as Sellers and SNH CHS Properties Trust, as Purchaser.*(Incorporated by  reference to the Company’s Current Report on Form 8-K dated March 1, 2004.)*                                                                                                                                                                                         |
| 2.3         |       | Purchase and Sale Agreement, dated as of January 21,  2005, by and among the Company, as Purchaser, and Franciscan Manor  Associates, LLC, Muirfield Associates, LLC, Prestwicke Associates, LLC, Royal  Aberdeen, LLC, Troon Associates, LLC and Turnberry Associates, LLC, as  Seller.*(Incorporated  by reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2004).*                                                                                   |
| 2.4         |       | First Amendment to Purchase and Sale Agreement,  dated as of February 3, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke  Associates, LLC, Royal Aberdeen, LLC, Troon Associates, LLC and Turnberry  Associates, LLC, as Seller.*(Incorporated by reference to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2004).*                                                                 |
| 2.5         |       | Second Amendment to Purchase and Sale Agreement,  dated as of May 13, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke  Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates, LLC and  Turnberry Associates, LLC,*as Sellers. (Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)*                                                                          |
| 2.6         |       | Third Amendment to Purchase and Sale Agreement,  dated as of May 16, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke Associates,  LLC, Royal Aberdeen Associates, LLC, Troon Associates, LLC and Turnberry  Associates, LLC, as Sellers.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)*                                                                           |
| 2.7         |       | Fourth Amendment to Purchase and Sale Agreement,  dated as of May 25, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke  Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates, LLC and  Turnberry Associates, LLC, as Sellers.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)*                                                                          |

 

41

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| 2.8         |   | Fifth Amendment to Purchase and Sale Agreement,  dated as of May 27, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke  Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates, LLC and  Turnberry Associates, LLC, as Sellers. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated June 3, 2005.)*     |
|-------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.9         |   | Sixth Amendment to Purchase and Sale Agreement,  dated as of June 3, 2005, by and among the Company, as Purchaser, and  Franciscan Manor Associates, LLC, Muirfield Associates, LLC, Prestwicke  Associates, LLC, Royal Aberdeen Associates, LLC, Troon Associates, LLC and  Turnberry Associates, LLC, as Sellers.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)*      |
| 2.10        |   | Purchase and Sale Agreement, dated as of June 3,  2005, by and among FSQ Crown Villa Business Trust, Morningside of Belmont,  LLC, Morningside of Greenwood, L.P. and Five Star Quality Care-GA, LLC, as  Sellers, and SNH CHS Properties Trust, SNH/LTA Properties Trust and SNH/LTA  Properties GA LLC, as*Purchasers. (Incorporated by reference to the Company’s  Current Report on Form 8-K dated June 3, 2005.)* |
| 2.11        |   | Purchase and Sale Agreement, dated as of October 31,  2005, by and among SNH/LTA Properties Trust, as Purchaser, and Five Star  Quality Care-GHV, LLC and Five Star Quality Care-MVSP, LLC, as Sellers.*(Incorporated by  reference to the Company’s Current Report on Form 8-K dated November 4,  2005.)*                                                                                                             |
| 3.1         |   | Composite copy of Articles of Amendment and  Restatement of the Company*. (Incorporated by  reference to the Company’s Current Report on Form 8-K dated March 31, 2006.)*                                                                                                                                                                                                                                              |
| 3.2         |   | Composite copy of Amended and Restated Bylaws of the  Company*. (Incorporated by reference to the Company’s  Current Report on Form 8-K dated March 10, 2004.)*                                                                                                                                                                                                                                                        |
| 3.3         |   | Articles Supplementary, as corrected by Certificate  of Correction dated as of March 19, 2004.*(Incorporated by  reference to the Company’s Form 8-A dated March 19, 2004 and the Company’s  Quarterly Report on Form 10-Q for the quarter ended March 31, 2004,  respectively.)*                                                                                                                                 |
| 4.1         |   | Specimen Certificate for shares of common stock of the  Company.*(Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-69846, as amended  on November 8, 2001.)*                                                                                                                                                                                                     |
| 4.2         |   | Description of Capital Stock of the Company.*(Contained in  Exhibits 3.1 and 3.2.)*                                                                                                                                                                                                                                                                                                                                         |
| 4.3         |   | Rights Agreement, dated as of March 10, 2004, by and  between the Company and Equiserve Trust Company, N.A.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated March 10, 2004.)*                                                                                                                                                                                                            |
| 4.4         |   | Appointment of Successor Rights Agent, dated as of  December 13, 2004, by and between the Company and Wells Fargo Bank, National  Association, a national banking association.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated December 13, 2004.)*                                                                                                                                      |
| 4.5         |   | Indenture related to 3.75% Convertible Senior Notes  due 2026, dated as of October 18, 2006, by and among the Company, each of the  guarantors named therein and U.S. Bank National Association, as Trustee.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 24, 2006.)*                                                                                                         |
| 4.6         |   | Registration Rights Agreement, dated as of October  18, 2006, by and among the Company, each of the guarantors named therein and  the Initial Purchasers named therein.*(Incorporated by reference to the Company’s Current Report on Form 8-K dated  October 24, 2006.)*                                                                                                                                              |
| 10.1†  |   | 2001 Stock Option and Stock Incentive Plan of the  Company, as amended.*(Incorporated by  reference to the Company’s Current Report on Form 8-K dated May 25, 2006.)*                                                                                                                                                                                                                                                  |
| 10.2†# |   | Form of Restricted Share Agreement.*(Incorporated by reference to the Company’s Quarterly Report on Form  10-Q for the quarter ended June 30, 2003.)*                                                                                                                                                                                                                                                                  |
| 10.3†# |   | Representative Indemnification Agreement*. (Incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the quarter ended June 30, 2004.)*                                                                                                                                                                                                                                                           |
| 10.4†  |   | *Summary of Director Compensation. (Incorporated  by reference to the Company’s Current Report on Form 8-K dated May 25, 2006.)*                                                                                                                                                                                                                                                                                       |
| 10.5        |   | Shared Services Agreement, dated as of  January 2, 2002, by and between the Company and Reit  Management & Research LLC.*(Incorporated by  reference to the Company’s Registration Statement on Form S-1, File No.  333-83648, as amended on December 5, 2001.)*                                                                                                                                    |
| 10.6        |   | Amendment No. 1 to Shared Services Agreement,  dated as of January 14, 2002, by and between the Company and Reit  Management & Research LLC.*(Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-83648.)*                                                                                                                                            |

 

42

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| 10.7  |   | Amendment No. 2 to Shared Services Agreement, dated  as of March 10, 2004, by and between the Company and Reit Management &  Research LLC.*(Incorporated by reference to the Company’s Current Report on Form  8-K dated March 10, 2004.)*                                                                                                                                                                                                                                                                                                                        |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8  |   | Mortgage, dated as of April 19, 2004, between Five  Star Quality Care-Howell, LLC and Love Funding Corporation.*(Incorporated by reference to the Company’s Quarterly Report on Form  10-Q for the quarter ended March 31,  2004.)*                                                                                                                                                                                                                                                                                                                         |
| 10.9  |   | Second Amended and Restated Lease Agreement, dated  as of November 19, 2004, by and among, Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and  Five Star Quality Care Trust, as Tenant.*(Incorporated by reference to the  Company’s Registration Statement on Form S-1, File No. 333-119955,  as amended on November 29, 2004.)* |
| 10.10 |   | First Amendment to Second Amended and Restated Lease  Agreement, dated as of May 17, 2005, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated June 3, 2005.)*                                                        |
| 10.11 |   | Second Amendment to Second Amended and Restated  Lease Agreement, dated as of June 3, 2005, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)*                                                             |
| 10.12 |   | Third Amendment to Second Amended and Restated Lease  Agreement, dated as of October 31, 2005, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated November 4, 2005.)*                                                      |
| 10.13 |   | Third [Fourth] Amendment to Second Amended and  Restated Lease Agreement, dated as of December 30, 2005, by and among  Ellicott City Land I LLC, Ellicott City Land II LLC, HRES2 Properties Trust,  SNH CHS Properties Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR  Properties Trust, SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as  Landlord, and Five Star Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Current  Report on Form 8-K dated October 5, 2006.)*                                             |
| 10.14 |   | Letter Agreement, dated as of March 13, 2006, by and  between Senior Housing Properties Trust and Five Star Quality Care Trust.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 5, 2006.)*                                                                                                                                                                                                                                                                                                                                      |
| 10.15 |   | Fifth Amendment to Second Amended and Restated Lease  Agreement, dated as of September 1, 2006, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Current Report on Form 8-K dated  October 5, 2006.)*                                                      |
| 10.16 |   | Sixth Amendment to Second Amended and Restated Lease  Agreement, dated as of October 1, 2006, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated October 5, 2006.)*                                                        |
| 10.17 |   | Seventh Amendment to Second Amended and Restated  Lease Agreement, dated as of October 1, 2006, by and among Ellicott City  Land I LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS  Properties Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR  Properties Trust, SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as  Landlord, and Five Star Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 11, 2006.)*                                                |

 

43

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| 10.18 |   | Eighth Amendment to Second Amended and Restated  Lease Agreement, dated as of November 1, 2006, by and among Ellicott City  Land I LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS  Properties Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR  Properties Trust, SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as  Landlord, and Five Star Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 30, 2006.)* |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19 |   | Ninth Amendment to Second Amended and Restated Lease  Agreement, dated as of November 1, 2006, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Filed  herewith.)*                                                                                                          |
| 10.20 |   | Tenth Amendment to Second Amended and Restated Lease  Agreement, dated as of November 6, 2006, by and among Ellicott City Land I  LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Filed  herewith.)*                                                                                                          |
| 10.21 |   | Eleventh Amendment to Second Amended and Restated  Lease Agreement, dated as of December 22, 2006, by and among Ellicott City  Land I LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS  Properties Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR  Properties Trust, SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as  Landlord, and Five Star Quality Care Trust, as Tenant.*(Filed herewith.)*                                                                                                       |
| 10.22 |   | Twelfth Amendment to Second Amended and Restated  Lease Agreement, dated as of January 1, 2007, by and among Ellicott City Land  I LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties  Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust,  SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant.*(Filed  herewith.)*                                                                                                         |
| 10.23 |   | Guaranty Agreement, dated as of December 31,  2001, made by the Company, as Guarantor, for the benefit of the Landlord  under the Second Amended and Restated Master Lease Agreement, dated as of  November 19, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and Five Star Quality Care Trust, as Tenant,  as amended.*(Incorporated by reference to Senior Housing Properties Trust’s  Current Report on Form 8-K dated December 31, 2001.)*                                     |
| 10.24 |   | Security Agreement, dated as of December 31,  2001, by and among Five Star Quality Care Trust and the Landlord under the  Second Amended and Restated Master Lease Agreement, dated as of November 19,  2004, by and among certain affiliates of Senior Housing Properties Trust, as  Landlord, and Five Star Quality Care Trust, as Tenant, as amended.*(Incorporated by  reference to the Company’s Registration Statement on Form S-1, File No.  333-83648, as amended on December 5, 2001.)*                                  |
| 10.25 |   | First Amendment to Security Agreement, dated as of  April 19, 2004, by and among Five Star Quality Care Trust and the Landlord  under the Second Amended and Restated Master Lease Agreement, dated as of  November 19, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and Five Star Quality Care Trust, as Tenant,  as amended.*(Filed herewith.)*                                                                                                                                                |
| 10.26 |   | Second Amendment to Security Agreement, dated as of  May 17, 2005, by and among Five Star Quality Care Trust and the Landlord  under the Second Amended and Restated Master Lease Agreement, dated as of  November 19, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and Five Star Quality Care Trust, as Tenant,  as amended.*(Incorporated by reference to the Company’s Current Report on Form  8-K dated June 3, 2005.)*                                                                 |
| 10.27 |   | Guaranty Agreement, dated as of October 25, 2002,  made by the Company, as Guarantor, for the benefit of SNH CHS Properties  Trust and Senior Housing Properties Trust.*(Incorporated by reference to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2002.)*                                                                                                                                                                                                                                                |
| 10.28 |   | Guaranty Agreement, dated as of October 25, 2002,  made by Five Star Quality Care-MD, LLC, Five Star Quality Care-NC, LLC and  Five Star Quality Care-VA, LLC, as Guarantors, for the benefit of SNH CHS  Properties Trust.*(Incorporated by reference to the Company’s  Report on Form 10-K for the year ended December 31, 2002.)*                                                                                                                                                                                                   |
| 10.29 |   | Security Agreement, dated as of October 25, 2002, by  and between FVE-CHS LLC and SNH CHS Properties Trust.*(Incorporated by reference to the Company’s  Report on Form 10-K for the year ended December 31, 2002.)*                                                                                                                                                                                                                                                                                                                   |

 

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| 10.30 |   | Security Agreement, dated as of October 25, 2002, by  and among Five Star Quality Care-MD, LLC, Five Star Quality Care-NC, LLC,  Five Star Quality Care-VA, LLC and SNH CHS Properties Trust.*(Incorporated by  reference to the Company’s Report on Form 10-K for the year ended December  31, 2002.)*                                                                                                                                                                               |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.31 |   | Amended and Restated Pledge of Shares of Beneficial  Interest Agreement, dated as of May 6, 2005, made by FSQ, Inc. for the  benefit of the Landlord under the Second Amended and Restated Lease  Agreement, dated as of November 19, 2004, by and among certain affiliates of  Senior Housing Properties Trust, as Landlord, and Five Star Quality Care  Trust, as Tenant, as amended.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)* |
| 10.32 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of June 3, 2005, by and  among the Company, certain affiliates of the Company and certain affiliates  of Senior Housing Properties Trust.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated June 3, 2005.)*                                                                                                                                            |
| 10.33 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of October 31, 2005, by and  among the Company, certain affiliates of the Company and certain affiliates  of Senior Housing Properties Trust.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated November 4, 2005.)*                                                                                                                                    |
| 10.34 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of September 1, 2006, by  and among the Company, certain affiliates of the Company and certain  affiliates of Senior Housing Properties Trust.*(Incorporated by reference to the Company’s Current Report on Form  8-K dated October 5, 2006.)*                                                                                                                                    |
| 10.35 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of October 1, 2006, by  and among the Company, certain affiliates of the Company and certain  affiliates of Senior Housing Properties Trust.*(Incorporated by reference to the Company’s Current Report on Form  8-K dated October 5, 2006.)*                                                                                                                                 |
| 10.36 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of November 1, 2006, by and  among the Company, certain affiliates of the Company and certain affiliates  of Senior Housing Properties Trust.*(Incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the quarter ended September 30,  2006.)*                                                                                                              |
| 10.37 |   | Partial Termination and Confirmation of Guarantees  and Other Incidental Documents, dated as of November 1, 2006, by and among  the Company, certain affiliates of the Company and certain affiliates of  Senior Housing Properties Trust.*(Filed herewith.)*                                                                                                                                                                                                                              |
| 10.38 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of November 6, 2006, by and  among the Company, certain affiliates of the Company and certain affiliates  of Senior Housing Properties Trust.*(Filed herewith.)*                                                                                                                                                                                                                        |
| 10.39 |   | Confirmation of Guarantees and Confirmation and Amendment  of Other Incidental Documents, dated as of December 22, 2006, by and among  the Company, certain affiliates of the Company and certain affiliates of  Senior Housing Properties Trust.*(Filed herewith.)*                                                                                                                                                                                                                       |
| 10.40 |   | Confirmation of Guarantees and Confirmation and  Amendment of Other Incidental Documents, dated as of January 1, 2007, by and  among the Company, certain affiliates of the Company and certain affiliates  of Senior Housing Properties Trust.*(Filed herewith.)*                                                                                                                                                                                                                         |
| 10.41 |   | Amended Master Lease Agreement, dated as of  January 11, 2002, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and FS Tenant Holding Company Trust and FS  Tenant Pool III Trust, as Tenant.*(Incorporated by reference to Senior  Housing Properties Trust’s Current Report on Form 8-K dated December 31,  2001.)*                                                                                                                 |
| 10.42 |   | First Amendment to Amended Master Lease Agreement,  dated as of October 1, 2002, by and among certain affiliates of Senior  Housing Properties Trust, as Landlord, and FS Tenant Holding Company Trust  and FS Tenant Pool III Trust, as Tenant.*(Incorporated by reference to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2002.)*                                                                                                                      |
| 10.43 |   | Second Amendment to Amended Master Lease Agreement,  dated as of March 1, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and FS Tenant Holding Company Trust and FS  Tenant Pool III Trust, collectively as Tenant.*(Incorporated by reference to the  Company’s Annual Report on Form 10-K for the year ended December 31, 2004 .)*                                                                                                         |
| 10.44 |   | Letter Agreement, dated as of March 13, 2006, by and  among Senior Housing Properties Trust, as Landlord, and FS Tenant Holding  Company Trust and FS Tenant Pool III Trust, collectively as Tenant.*(Filed herewith.)*                                                                                                                                                                                                                                                                    |

 

45

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| 10.45 |   | Guaranty Agreement, dated as of January 11,  2002, made by the Company, as Guarantor, for the benefit of the Landlord  under the Amended Master Lease Agreement, dated January 11, 2002, by and  among certain affiliates of Senior Housing Properties Trust, as Landlord, and  FS Tenant Holding Company Trust and FS Tenant Pool III Trust, as Tenant.*(Incorporated by  reference to Senior Housing Properties Trust’s Current Report on Form 8-K  dated December 31, 2001.)*                           |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.46 |   | Pledge of Shares of Beneficial Interest Agreement,  dated as of January 11, 2002, made by FSQ, Inc. for the benefit of  the Landlord under the Amended Master Lease Agreement, dated January 11,  2002, by and among certain affiliates of Senior Housing Properties Trust, as  Landlord, and FS Tenant Holding Company Trust and FS Tenant Pool III Trust,  as Tenant.*(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File No.  333-83648, as amended on December 5, 2001.)* |
| 10.47 |   | Security Agreement, dated as of January 11,  2002, by and among FS Tenant Holding Company Trust and the Landlord under the  Amended Master Lease Agreement, dated January 11, 2002, by and among certain  affiliates of Senior Housing Properties Trust, as Landlord, and FS Tenant  Holding Company Trust and FS Tenant Pool III Trust, as Tenant.*(Incorporated by  reference to the Company’s Registration Statement on Form S-1, File No.  333-83648, as amended on December 5, 2001.)*                          |
| 10.48 |   | Lease Agreement, dated as of November 19, 2004,  by and among certain affiliates of Senior Housing Properties Trust, as  Landlord, and certain affiliates of the Company as Tenant.*(Incorporated by  reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                         |
| 10.49 |   | Lease Agreement, dated as of November 19, 2004,  by and among certain affiliates of Senior Housing Properties Trust, as  Landlord, and certain affiliates of the Company as Tenant.*(Incorporated by  reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                         |
| 10.50 |   | Guaranty Agreement, dated as of November 19,  2004, made by the Company in favor of the Beneficiaries named therein.*(Incorporated by reference to the Company’s Registration Statement  on Form S-1, File No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                                              |
| 10.51 |   | Guaranty Agreement, dated as of November 19,  2004, made by the Company in favor of the Beneficiaries named therein.*(Incorporated by reference to the Company’s Registration Statement  on Form S-1, File No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                                                                              |
| 10.52 |   | Amended and Restated Master Lease Agreement, dated  as of October 1, 2006, by and among HRES1 Properties Trust, as landlord, and  FS Patriot LLC and FS Commonwealth LLC, jointly and severally as tenant.*(Filed herewith.)*                                                                                                                                                                                                                                                                                                  |
| 10.53 |   | Amended and Restated Guaranty Agreement, dated as of  October 1, 2006, by the Company for the benefit of Senior Housing Properties  Trust and HRES1 Properties Trust.*(Filed herewith.)*                                                                                                                                                                                                                                                                                                                                       |
| 10.54 |   | Amended and Restated Security Agreement, dated as of  October 1, 2006, between FS Patriot LLC and FS Commonwealth LLC, as tenant,  and HRES1 Properties Trust, as secured party.*(Filed herewith.)*                                                                                                                                                                                                                                                                                                                            |
| 10.55 |   | Amended and Restated Pledge Agreement, dated as of  October 1, 2006, by FSQ, Inc. for the benefit of HRES1 Properties Trust.*(Filed herewith.)*                                                                                                                                                                                                                                                                                                                                                                                |
| 10.56 |   | Credit and Security Agreement, dated as of May 9,  2005, by and among the Company, each of the Guarantors party thereto and  Wachovia Bank, National Association.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated May 13, 2005.)*                                                                                                                                                                                                                                                           |
| 10.57 |   | First Amendment to Credit and Security Agreement,  dated as of July 22, 2005, by and among the Company, each of the Guarantors  party thereto and Wachovia Bank, National Association.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated August 23, 2005.)*                                                                                                                                                                                                                                   |
| 10.58 |   | Second Amendment to Credit and Security Agreement,  dated as of August 15, 2005, by and among the Company, each of the Guarantors  party thereto and Wachovia Bank, National Association.*(Incorporated by reference to the  Company’s Current Report on Form 8-K dated August 23, 2005.)*                                                                                                                                                                                                                                |
| 10.59 |   | Third Amendment to Credit and Security Agreement,  dated as of July 11, 2006, by and among the Company, each of the Guarantors  party thereto and Wachovia Bank, National Association. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated July 17, 2006.)*                                                                                                                                                                                                                                    |
| 10.60 |   | Fourth Amendment to Credit and Security Agreement,  dated as of October 11, 2006, by and among the Company, each of the  Guarantors party thereto and Wachovia Bank, National Association.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 11, 2006.)*                                                                                                                                                                                                                         |

 

46

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| 12.1 |   | Computation of Ratio of Earnings to Fixed Charges.*(Filed herewith.)*                                        |
|------|--------|--------------------------------------------------------------------------------------------------------------|
| 21.1 |   | Subsidiaries of the Company.*(Filed herewith.)*                                                              |
| 23.1 |   | Consent of Ernst & Young LLP.*(Filed herewith.)*                                                         |
| 31.1 |   | Rule 13a-14(a) Certification of Chief Executive  Officer.*(Filed  herewith.)*                                |
| 31.2 |   | Rule 13a-14(a) Certification of Chief Financial  Officer.*(Filed  herewith.)*                                |
| 32.1 |   | Section 1350 Certification of Chief Executive  Officer and Chief Financial Officer. *(Furnished  herewith.)* |

----

†                   Indicates a management contract or a compensatoryplan, contract or arrangement.

#                   Agreement filed is illustrative of numerous otheragreements to which the Company is a party.

 

47

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**Report of Independent Registered Public AccountingFirm**

To the Board of Directorsand Shareholders of Five Star Quality Care, Inc.

We have audited the accompanying consolidated balancesheets of Five Star Quality Care, Inc., as of December 31, 2006 and 2005, andthe related consolidated statements of operations, shareholders’ equity andcash flows for each of the three years in the period ended December 31,2006.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.   An audit also includesassessing the accounting principles used and significant estimates made by management,as well as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Five Star Quality Care, Inc. at December 31, 2006 and 2005, and theconsolidated results of their operations and their cash flows for each of thethree years in the period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Five Star Quality Care, Inc.’s internal control over financialreporting as of December 31, 2006, based on criteria established in InternalControl — Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 28, 2007expressed an unqualified opinion thereon.

/s/ Ernst &Young LLP

Boston, Massachusetts

February 28, 2007

 

F-1

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**Report of Independent Registered PublicAccounting Firm**

To the Board ofDirectors and Shareholders of Five Star Quality Care, Inc.

We have auditedmanagement’s assessment, included in Item 9A of Five Star Quality Care, Inc.’sAnnual Report on Form 10-K under the heading Management Report on Assessment ofInternal Control Over Financial Reporting, that Five Star Quality Care, Inc.maintained effective internal control over financial reporting as of December31, 2006, based on criteria established in the Internal Control-IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (the “COSO criteria”).  Five Star Quality Care, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting.  Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of thecompany’s internal control over financial reporting based on our audit.

We conducted our auditin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standards require that we plan and performthe audit to obtain reasonable assurance about whether effective internalcontrol over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control overfinancial reporting, evaluating management’s assessment, testing and evaluatingthe design and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances.  Webelieve that our audit provides a reasonable basis for our opinion.

A company’s internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles.  A company’s internal control overfinancial reporting includes those policies and procedures that (1) pertain tothe maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2)provide reasonable assurance that transactions are recorded as necessary topermit preparation of financial statements in accordance with generallyaccepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion,management’s assessment that Five Star Quality Care, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2006, is fairlystated, in all material respects, based on the COSO criteria.  Also, inour opinion, Five Star Quality Care, Inc., maintained, in all materialrespects, effective internal control over financial reporting as of December31, 2006, based on the COSO criteria.

We also haveaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheets of Five StarQuality Care, Inc. as of December 31, 2006 and 2005, and the relatedconsolidated statements of operations, shareholders’ equity and cash flows foreach of the three years in the period ended December 31, 2006 and our reportdated February 28, 2007 expressed an unqualified opinion thereon.

 

/s/ Ernst &Young LLP

Boston, Massachusetts 

February28, 2007

 

F-2

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**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATED BALANCE SHEET**

*(dollarsin thousands, except share data)*
| ** **                                                                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                         |       |                  |       |   |   |
| Current assets:                                                                                                                                                    |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                          |       | $                     | 46,241     |   | $ | 16,376 |   |
| Accounts receivable, net of allowance of $5,005 and  $6,124 at December 31, 2006 and 2005, respectively                                                            |       | 67,791                |       | 46,124 |   |
| Prepaid expenses                                                                                                                                                   |       | 16,112                |       | 7,560 |   |
| Investments                                                                                                                                                        |       | 50,434                |       | 632 |   |
| Restricted cash — insurance arrangements                                                                                                                      |       | 3,043                 |       | 2,639 |   |
| Restricted investments — insurance arrangements                                                                                                               |       | 2,448                 |       | 2,442 |   |
| Restricted cash — other                                                                                                                                       |       | 4,925                 |       | 10,281 |   |
| Other current assets                                                                                                                                               |       | 14,766                |       | 8,060 |   |
| Total current  assets                                                                                                                                              |       | 205,760               |       | 94,114 |   |
|                                                                                                                                                               |       |                  |       |   |   |
| Property and  equipment, net                                                                                                                                       |       | 114,898               |       | 96,743 |   |
| Restricted cash  — insurance arrangements                                                                                                                     |       | 7,786                 |       | 6,528 |   |
| Restricted  investments — insurance arrangements                                                                                                              |       | 6,262                 |       | 6,039 |   |
| Restricted cash  — other                                                                                                                                      |       | 774                   |       | 914 |   |
| Mortgage notes  receivable                                                                                                                                         |       | 2,484                 |       | 5,337 |   |
| Goodwill and  other intangible assets                                                                                                                              |       | 22,611                |       | 18,048 |   |
| Other long term  assets                                                                                                                                            |       | 5,836                 |       | 1,217 |   |
|                                                                                                                                                               |       | $                     | 366,411    |   | $ | 228,940 |   |
|                                                                                                                                                               |       |                  |       |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                     |       |                  |       |   |   |
|                                                                                                                                                               |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                              |       |                  |       |   |   |
| Accounts payable                                                                                                                                                   |       | $                     | 22,805     |   | $ | 14,639 |   |
| Accrued expenses                                                                                                                                                   |       | 18,825                |       | 14,470 |   |
| Accrued compensation and benefits                                                                                                                                  |       | 19,218                |       | 18,341 |   |
| Due to Senior Housing Properties Trust (“SNH”)                                                                                                           |       | 9,988                 |       | 8,659 |   |
| Due to Sunrise Senior Living Services, Inc. (“SLS”)                                                                                                      |       | —                |       | 7,185 |   |
| Mortgage notes payable                                                                                                                                             |       | 33,317                |       | 626 |   |
| Accrued real estate taxes                                                                                                                                          |       | 6,035                 |       | 7,872 |   |
| Security deposit liability                                                                                                                                         |       | 12,309                |       | 11,854 |   |
| Other current liabilities                                                                                                                                          |       | 10,432                |       | 6,322 |   |
| Total current  liabilities                                                                                                                                         |       | 132,929               |       | 89,968 |   |
|                                                                                                                                                               |       |                  |       |   |   |
| Long term  liabilities:                                                                                                                                            |       |                  |       |   |   |
| Mortgage notes payable                                                                                                                                             |       | 11,454                |       | 44,703 |   |
| Convertible senior notes                                                                                                                                           |       | 126,500               |       | — |   |
| Continuing care contracts                                                                                                                                          |       | 3,649                 |       | 3,638 |   |
| Other long term liabilities                                                                                                                                        |       | 24,449                |       | 21,827 |   |
| Total long term  liabilities                                                                                                                                       |       | 166,052               |       | 70,168 |   |
| Commitments and  contingencies                                                                                                                                     |       |                  |       |   |   |
| Shareholders’  equity:                                                                                                                                        |       |                  |       |   |   |
| Preferred stock,  par value $0.01: 1,000,000 shares authorized, none issued                                                                                        |       | —                |       | — |   |
| Common stock,  par value $0.01: 50,000,000 shares authorized, 31,682,134 and 20,060,934  shares issued and outstanding at December 31, 2006 and 2005, respectively |       | 316                   |       | 201 |   |
| Additional  paid-in capital                                                                                                                                        |       | 286,344               |       | 171,552 |   |
| Accumulated  deficit                                                                                                                                               |       | (219,435              | )          | (102,770 | ) |
| Unrealized gain  (loss) on investments                                                                                                                             |       | 205                   |       | (179 | ) |
| Total shareholders’ equity                                                                                                                                    |       | 67,430                |       | 68,804 |   |
|                                                                                                                                                               |       | $                     | 366,411    |   | $ | 228,940 |   |

 

See accompanyingnotes*.*

* *

F-3

----

 

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

(*in thousands, except per share data)*
| ** **                                                    | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                     |       |                                                         |       |   |   |   |   |
| Net revenues from residents                                   |       | $                                                            | 748,003    |   | $ | 700,891 |   | $ | 584,615 |   |
| Hospital revenue                                              |       | 26,130                                                       |       | — |   | — |   |
| Pharmacy revenue                                              |       | 53,204                                                       |       | 33,132 |   | 13,209 |   |
| Total revenues                                                |       | 827,337                                                      |       | 734,023 |   | 597,824 |   |
|                                                          |       |                                                         |       |   |   |   |   |
| Operating  expenses:                                          |       |                                                         |       |   |   |   |   |
| Wages and benefits                                            |       | 384,005                                                      |       | 356,367 |   | 302,282 |   |
| Other operating expenses                                      |       | 187,335                                                      |       | 180,694 |   | 153,472 |   |
| Hospital expenses                                             |       | 23,589                                                       |       | — |   | — |   |
| Pharmacy expenses                                             |       | 52,972                                                       |       | 31,823 |   | 12,093 |   |
| Management fee to SLS                                         |       | 8,744                                                        |       | 21,256 |   | 19,293 |   |
| Termination expense for SLS management agreements             |       | 129,913                                                      |       | 86,286 |   | — |   |
| Rent expense                                                  |       | 111,481                                                      |       | 98,890 |   | 82,453 |   |
| General and administrative                                    |       | 33,829                                                       |       | 28,221 |   | 20,052 |   |
| Depreciation and amortization                                 |       | 9,950                                                        |       | 7,114 |   | 3,372 |   |
| Impairment of assets                                          |       | —                                                       |       | 2,333 |   | — |   |
| Total operating  expenses                                     |       | 941,818                                                      |       | 812,984 |   | 593,017 |   |
|                                                          |       |                                                         |       |   |   |   |   |
| Operating (loss)  income                                      |       | (114,481                                                     | )          | (78,961 | ) | 4,807 |   |
| Interest and other income                                     |       | 6,806                                                        |       | 1,543 |   | 1,666 |   |
| Interest expense                                              |       | (4,365                                                       | )          | (3,741 | ) | (1,172 | ) |
|                                                          |       |                                                         |       |   |   |   |   |
| (Loss) income  from continuing operations before income taxes |       | (112,040                                                     | )          | (81,159 | ) | 5,301 |   |
| Provision for income taxes                                    |       | —                                                       |       | — |   | (120 | ) |
| (Loss) income  from continuing operations                     |       | (112,040                                                     | )          | (81,159 | ) | 5,181 |   |
|                                                          |       |                                                         |       |   |   |   |   |
|  Loss from discontinued operations                       |       | (4,625                                                       | )          | (3,000 | ) | (1,890 | ) |
|                                                          |       |                                                         |       |   |   |   |   |
| Net (loss)  income                                            |       | $                                                            | (116,665   | ) | $ | (84,159 | ) | $ | 3,291 |   |
|                                                          |       |                                                         |       |   |   |   |   |
| Weighted average  shares outstanding                          |       | 28,605                                                       |       | 14,879 |   | 8,716 |   |
|                                                          |       |                                                         |       |   |   |   |   |
| Basic and  diluted (loss) income per share from:              |       |                                                         |       |   |   |   |   |
| Continuing operations                                         |       | $                                                            | (3.92      | ) | $ | (5.45 | ) | $ | 0.59 |   |
| Discontinued operations                                       |       | (0.16                                                        | )          | (0.20 | ) | (0.22 | ) |
| Net (loss)  income per share                                  |       | $                                                            | (4.08      | ) | $ | (5.65 | ) | $ | 0.37 |   |

 

See accompanyingnotes*.*

* *

F-4

----

 

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ EQUITY**

*(dollarsin thousands, except share data)*
| ** **                                      | ** ** | **Number of  Shares** | ** ** | **Common Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Gain  (Loss) on  Investments** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|----------------------------------|------------|--------------------------|------------|---------------------------------------|------------|-----------|------------|
| Balance at  December 31, 2003                   |       | 8,513,634                  |       | $                     | 85         |                             | $          | 86,244                   |       | $                                     | (21,902    | )         | $          | — |   | $ | 64,427 |   |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Comprehensive  income:                          |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Net income                                      |       | —                     |       | —                |       | —                           |       | 3,291                    |       | —                                |       | 3,291     |       |
| Unrealized loss on investments                  |       | —                     |       | —                |       | —                           |       | —                   |       | (40                                   | )          | (40       | )          |
| Total  comprehensive income                     |       | —                     |       | —                |       | —                           |       | 3,291                    |       | (40                                   | )          | 3,251     |       |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Stock grants                                    |       | 83,000                     |       | 1                     |       | 540                              |       | —                   |       | —                                |       | 541       |       |
| Issuance of  stock, pursuant to equity offering |       | 3,500,000                  |       | 35                    |       | 27,650                           |       | —                   |       | —                                |       | 27,685    |       |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Balance at  December 31, 2004                   |       | 12,096,634                 |       | 121                   |       | 114,434                          |       | (18,611                  | )          | (40                                   | )          | 95,904    |       |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Comprehensive  income:                          |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Net loss                                        |       | —                     |       | —                |       | —                           |       | (84,159                  | )          | —                                |       | (84,159   | )          |
| Unrealized loss on investments                  |       | —                     |       | —                |       | —                           |       | —                   |       | (139                                  | )          | (139      | )          |
| Total  comprehensive income                     |       | —                     |       | —                |       | —                           |       | (84,159                  | )          | (139                                  | )          | (84,298   | )          |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Stock grants                                    |       | 84,300                     |       | 1                     |       | 584                              |       | —                   |       | —                                |       | 585       |       |
| Issuance of  stock, pursuant to equity offering |       | 7,880,000                  |       | 79                    |       | 56,534                           |       | —                   |       | —                                |       | 56,613    |       |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Balance at  December 31, 2005                   |       | 20,060,934                 |       | 201                   |       | 171,552                          |       | (102,770                 | )          | (179                                  | )          | 68,804    |       |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Comprehensive  income:                          |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Net loss                                        |       | —                     |       | —                |       | —                           |       | (116,665                 | )          | —                                |       | (116,665  | )          |
| Unrealized gain on investments                  |       | —                     |       | —                |       | —                           |       | —                   |       | 384                                   |       | 384       |       |
| Total  comprehensive income                     |       | —                     |       | —                |       | —                           |       | (116,665                 | )          | 384                                   |       | (116,281  | )          |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Stock grants                                    |       | 121,200                    |       | 1                     |       | 1,276                            |       | —                   |       | —                                |       | 1,277     |       |
| Issuance of  stock, pursuant to equity offering |       | 11,500,000                 |       | 114                   |       | 113,516                          |       | —                   |       | —                                |       | 113,630   |       |
|                                            |       |                       |       |                  |       |                             |       |                     |       |                                  |       |      |       |
| Balance at  December 31, 2006                   |       | 31,682,134                 |       | $                     | 316        |                             | $          | 286,344                  |       | $                                     | (219,435   | )         | $          | 205 |   | $ | 67,430 |   |

 

See accompanyingnotes*.*

* *

F-5

----

* *

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

(*dollars in thousands)*
| ** **                                                                                      | ** ** | **For the year ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                          |       |                                                         |       |   |   |   |   |
| Net (loss) income                                                                               |       | $                                                            | (116,665   | ) | $ | (84,159 | ) | $ | 3,291 |   |
| Adjustments to reconcile net (loss) income to cash  (used in) provided by operating activities: |       |                                                         | ** ** |   |   |   |   |
| Depreciation and amortization                                                                   |       | 9,950                                                        | ** ** | 7,113 |   | 3,372 |   |
| Impairment of assets                                                                            |       | —                                                       | ** ** | 2,333 |   | — |   |
| Loss from discontinued operations                                                               |       | 4,625                                                        | ** ** | 3,000 |   | 1,890 |   |
| Provision for losses on receivables, net                                                        |       | (1,119                                                       | )          | 845 |   | 973 |   |
| Unrealized gain (loss) on investments                                                           |       | 384                                                          |       | (139 | ) | (40 | ) |
| Changes in assets and liabilities:                                                              |       |                                                         |       |   |   |   |   |
| Accounts receivable                                                                             |       | (20,232                                                      | )          | (8,234 | ) | (6,098 | ) |
| Prepaid expenses and other assets                                                               |       | (16,433                                                      | )          | (430 | ) | 942 |   |
| Investments                                                                                     |       | (49,802                                                      | )          | (632 | ) | — |   |
| Accounts payable and accrued expenses                                                           |       | 12,521                                                       |       | 1,629 |   | (10,093 | ) |
| Accrued compensation and benefits                                                               |       | 877                                                          |       | 3,511 |   | 4,066 |   |
| Due to SNH                                                                                      |       | 1,329                                                        |       | 698 |   | 1,900 |   |
| Due (from) to SLS                                                                               |       | (7,185                                                       | )          | 6,876 |   | (5,825 | ) |
| Other current and long term liabilities                                                         |       | 5,159                                                        |       | 13,955 |   | 7,114 |   |
| Cash (used in) provided by operating activities                                                 |       | (176,591                                                     | )          | (53,634 | ) | 1,492 |   |
|                                                                                            | ** ** | ** **                                                   | ** ** |   | ** ** | ** ** | ** ** |
| Net cash used in  discontinued operations                                                       |       | (4,625                                                       | )          | (3,000 | ) | (1,890 | ) |
|                                                                                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                          | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits into restricted cash and investment  accounts, net                                     |       | (926                                                         | )          | (10,050 | ) | (5,290 | ) |
| Acquisition of property and equipment                                                           |       | (51,134                                                      | )          | (105,473 | ) | (138,936 | ) |
| Acquisition of pharmacy, net of cash acquired                                                   |       | (5,968                                                       | )          | (4,880 | ) | (3,525 | ) |
| Proceeds from sales of property and equipment                                                   |       | —                                                       |       | 80,678 |   | 122,682 |   |
| Proceeds from disposition of property and equipment  held for sale                              |       | 23,729                                                       |       | 15,470 |   | 9,457 |   |
| Withdrawals from restricted cash for purchases of  property and equipment                       |       | 4,531                                                        |       | 8,614 |   | 7,521 |   |
| Cash used in investing activities                                                               |       | (29,768                                                      | )          | (15,641 | ) | (8,091 | ) |
|                                                                                            |       |                                                         |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                          |       |                                                         |       |   |   |   |   |
| Proceeds from issuance of common stock, net                                                     |       | 114,907                                                      |       | 56,752 |   | 27,725 |   |
| Proceeds from borrowings on revolving credit  facility                                          |       | 38,000                                                       |       | 32,000 |   | 22,000 |   |
| Repayments of borrowings on revolving credit  facility                                          |       | (38,000                                                      | )          | (32,000 | ) | (26,000 | ) |
| Proceeds from first mortgage line of credit                                                     |       | —                                                       |       | 24,000 |   | — |   |
| Repayments of first mortgage line of credit                                                     |       | —                                                       |       | (24,000 | ) | — |   |
| Proceeds from convertible senior notes payable                                                  |       | 126,500                                                      |       | — |   | — |   |
| Proceeds from mortgage note payable                                                             |       | —                                                       |       | 3,485 |   | 122,015 |   |
| Repayments of mortgage notes payable                                                            |       | (558                                                         | )          | (737 | ) | (123,467 | ) |
| Cash provided by financing activities                                                           |       | 240,849                                                      |       | 59,500 |   | 22,273 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| Change in cash  and cash equivalents                                                            |       | 29,865                                                       |       | (12,775 | ) | 13,784 |   |
| Cash and cash  equivalents at beginning of year                                                 |       | 16,376                                                       |       | 29,151 |   | 15,367 |   |
| Cash and cash  equivalents at end of year                                                       |       | $                                                            | 46,241     |   | $ | 16,376 |   | $ | 29,151 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                            |       |                                                         |       |   |   |   |   |
| Cash paid for interest                                                                          |       | $                                                            | 2,702      |   | $ | 2,634 |   | $ | 512 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| Non-cash  investing and financing activities:                                                   |       |                                                         |       |   |   |   |   |
| Issuance of common stock                                                                        |       | 1,277                                                        |       | 585 |   | 541 |   |
| Assumption of  mortgage                                                                         |       | —                                                       |       | — |   | 86,764 |   |

 

See accompanying notes*.*

 

F-6

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**FIVE STARQUALITY CARE, INC.**

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(*dollars in thousands, except per share data)*

**1. Organization andBusiness**

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

As of December 31, 2006, we operated162 senior living communities containing 18,117 living units, including 113primarily independent and assisted living communities containing 13,701 livingunits and 49 nursing homes containing 4,416 living units.  Of our 113 primarily independent and assistedliving communities, we leased 97 communities containing 12,498 living unitsfrom Senior Housing, our former parent, and we own or lease from parties other than Senior Housing 16 communitiescontaining 1,203 living units.  We leaseall but two of our nursing homes from Senior Housing.  Our 162 communities include 5,601 independentliving apartments, 6,541 assisted living suites and 5,975 skilled nursingbeds.  We also operate six institutionalpharmacies, one of which provides mail order pharmaceuticals to the generalpublic, and we operate two rehabilitation hospitals that we lease from SeniorHousing.  Our two rehabilitationhospitals contain 342 beds available for inpatient services and 21 affiliatedoutpatient clinics.

We experienced losses in 2005 and 2006. We believe that a combination of ourcash on hand, our efforts to increase revenues and contain costs, our abilityto borrow on our revolving credit facility, our ability to sell to SeniorHousing certain capital improvements made to communities leased from SeniorHousing and the possibility of sales or financings of our owned communitieswill be sufficient to meet our working capital needs, operating expenses, rentpayments to Senior Housing, debt service and capital expenditures for the next12 months and the foreseeable future.

**2.  Summary of Significant Accounting Policies**

*Basis of Presentation.* The accompanying consolidated financial statements include our accountsand those of all of our subsidiaries. All intercompany transactions have beeneliminated.

*Use of Estimates.*  Preparation of these financial statements inconformity with accounting principles generally accepted in the United Statesrequires us to make estimates and assumptions that may affect the amountsreported in these financial statements and related notes.  Some significant estimates include our selfinsurance reserves and the allowance for doubtful accounts and contractualallowances.  The actual results coulddiffer from our estimates.  Estimates andassumptions are reviewed periodically, and the effects of changes, if any, arereflected in the consolidated financial statements in the period that they aredetermined.

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

*Investments. * Investments include securitiesthat are held principally for resale in the near term.  These investments are classified as tradingand are carried at fair value, with changes in fair value recorded inearnings.  Trading investments atDecember 31, 2006 consist entirely of auction rate securities.  We did not have any trading investments atDecember 31, 2005.  Interest anddividends are included in net interest income. In 2006, these investments generated interest income of $330.

Securities not classified as trading are classified as available forsale and carried at fair value, with unrealized gains and losses reported as aseparate component of shareholders’ equity. Available for sale investments at December 31, 2006 and 2005 consistedof corporate bonds, preferred securities and variable rate demandobligations.  At December 31, 2006, ourinvestments had a fair value of $4,334 and an unrealized holding gain of$231.  At December 31, 2005, ourinvestments had a fair value of $632 and an unrealized holding loss of $18.

 

F-7

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

*Restricted investments — insurance arrangements*.  Restricted investments — insurancearrangements are investments held by our captive insurance companies that maybe used to pay claims under our self insurance programs.  These investments are classified as availablefor sale and carried at fair value, with unrealized gains and losses reportedas a separate component of shareholders’ equity.  The unrealized loss on investments shown onthe consolidated balance sheet represents the difference between the marketvalue of these investments calculated by using quoted market prices on the datethey were acquired and on December 31, 2006. At December 31, 2006, our investments had a fair value of $8,710 and an unrealized holding gain of $153.  At December 31, 2005, ourinvestments had a fair value of $8,481 and an unrealized holding loss of $161.

*Restricted cash - other. *Restricted cash - other asof December 31, 2006 and 2005 includes the following amounts for which we arerequired to establish escrows: (i) Florida regulatory requirements; (ii) futurecapital expenditures, as required by our leases with Senior Housing and ourmanagement agreements with SLS; (iii) real estate taxes and capitalexpenditures as required by our mortgages; (iv) resident security deposits and(v) miscellaneous business reasons:   
| ** **  | ** **                                                                                                               | **2006 ** | ** ** | **2005**           | ** ** |
|-------------|--------------------------------------------------------------------------------------------------------------------------|----------------|------------|--------------------|------------|
| ** **  | ** **                                                                                                               | **Current**    | ** ** | **Long term** | ** ** | **Current** | ** ** | **Long term** | ** ** |
| (i)    | Florida regulatory  requirements                                                                                         |           | $          | —             |       | $ | 518 |   | $ | — |   | $ | 518 |   |
| (ii)   | Future capital  expenditures, as required by our leases with  Senior Housing or our management agreements  with SLS |           | —     |               | —     |   | 5,060 |   | — |   |
| (iii)  | Real estate  taxes and capital expenditures as required by our mortgages                                                 |           | 2,870      |               | —     |   | 2,000 |   | — |   |
| (iv)   | Resident  security deposits                                                                                              |           | 2,055      |               | —     |   | 3,221 |   | — |   |
| (v)    | Regulatory                                                                                                               |           | —     |               | 256        |   | — |   | 396 |   |
| **Total**   |                                                                                                                     | $              | 4,925      |               | $          | 774 |   | $ | 10,281 |   | $ | 914 |   |

 

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

During 2006, 2005 and 2004, we increased our allowance for doubtfulaccounts by $4,165, $3,950 and $3,600, respectively, and wrote off accountsreceivable of $5,284, $3,104 and $2,627, respectively.

Included in accounts receivable as of December 31, 2006 and 2005 areamounts due from the Federal Government Medicare program of $32,586****and $14,103, respectively, and amounts due from variousstate Medicaid programs of $15,576 and $16,392, respectively.

*Deferred finance costs*.  We capitalize issuance costs related toborrowings and amortize the deferred costs over the terms of the respectiveloans.  The unamortized balance ofdeferred finance costs was $4,897****and $1,039 atDecember 31, 2006 and 2005, respectively. Accumulated amortization related to deferred finance costs was $526 and$1,013 at December 31, 2006 and 2005, respectively.  At December 31, 2006, the weighted averageamortization period remaining is approximately 21 years.  The amortization expenses to be incurredduring the next five years as of December 31, 2006 are $384 in 2007 and $214 ineach of 2008, 2009, 2010 and 2011.

*Property and equipment.*  Property and equipment is stated atcost.  We record depreciation on propertyand equipment on a straight line basis over estimated useful lives of up to 40years for buildings, up to 15 years for building improvements and up to sevenyears for personal property.  Weregularly evaluate whether events or changes in circumstances have occurredthat could indicate impairment in the value of long lived assets.  If there is an indication that the carryingvalue of an asset is not recoverable, we estimate the projected undiscountedcash flows from the asset to determine if an impairment loss should berecognized.  We determine the amount of 

 

F-8

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impairment loss by comparing the historical carryingvalue of the asset to its estimated fair value. We determine estimated fair value through an evaluation of recentfinancial performance, recent sales of similar assets, market conditions andprojected discounted cash flows of properties using standard industry valuationtechniques.

During 2005, we recognized a $2,333 impairment charge to reduce thecarrying value of six communities to the amount realized upon their sale toSenior Housing (see Note 11).

*Goodwilland other intangible assets.*   Goodwill representsthe costs of business acquisitions in excess of the fair value of identifiablenet assets acquired.  We review goodwilland other intangible assets annually, or more frequently if events or changesin circumstances exist, for impairment. If our review indicates that the carrying amount of goodwill and otherintangible assets exceeds its fair value, we reduce the carrying amount to fairvalue.

*Self insurance.*  We self insure up to certain limits forworkers compensation and professional liability.  Claims in excess of these limits are retainedby third party insurance providers up to contractual limits, over which we areself insured.  We fully self insure allemployee health related claims.  Weaccrue the estimated cost of self insured amounts based on projectedsettlements for pending claims, known incidents which we expect may result inclaims, estimates of incurred but not yet reported claims and incidents andexpected changes in premiums for insurance provided by third party insurerswhose policies provide for retroactive adjustments.  We periodically adjust these estimates basedupon our claims experience, recommendations from our professional consultants,changes in market conditions and other factors; such adjustments may bematerial.

*Continuing care contracts. *Residents at one of our communities may enter into continuing carecontracts.  We offer two forms ofcontinuing care contracts to new residents. One form of contract provides that 10% ofthe resident admission fee becomes non-refundable upon occupancy, and theremaining 90% becomes non-refundable at therate of 1.5% per month of theoriginal amount over the subsequent 60 months. The second form of contractprovides that 30% of the resident admission fee is non-refundable uponoccupancy and 70% is refundable.  Threeother forms of continuing care contracts are in effect for existing residentsbut are not offered to new residents.  One historical form of contract provides thatthe resident admission fee is 10% non-refundable upon occupancy and 90%refundable.  A secondhistorical form of contract provides that the resident admission fee is 100%refundable.  A third historical form of contract provides that the resident admission feeis 1% refundable and 99% non-refundable upon admission.  In each case, we amortize the non-refundable partof these fees into revenue over the actuarially determined remaining life ofthe resident, which is the expected period of occupancy by the resident.  We pay refunds of our admission fees when residentsrelocate from our communities.  Wereport the refundable amount of these admission fees as current liabilities andthe nonrefundable amount as deferred revenue, a portion of which is classifiedas a current liability.  Portions of therefundable payments are included in restricted cash in our consolidated balancesheet.  The refundable admission fees asof December 31, 2006 and 2005 were $10,575 and $6,197, respectively.

*Convertibledebt. *In October 2006, we sold $126,500 inaggregate principal amount of convertible notes (see Note 8).  Holders of these notes may convert theirnotes into shares of our common stock subject to prior maturity, redemption orrepurchase. On or after October 20, 2011, we have the option, or the CallOption, to redeem the notes at a redemption price equal to 100% of theprincipal amount of the notes, plus accrued but unpaid interest. On each ofOctober 15, 2013, 2016 and 2021, holders of the notes have the option, orthe Put Option, to require us to purchase all or a portion of their notes at apurchase price in cash equal to 100% of the principal amount of the notes, plusaccrued but unpaid interest.  A holder thatsurrenders the notes for conversion in connection with a make whole fundamentalchange that occurs before October 20, 2011 may in certain circumstances beentitled to an increased conversion rate, or the Make Whole Payment.

*Leases. *On the inception date of alease and upon any relevant amendments to such lease, we test theclassification of such lease as either a capital lease or an operatinglease.  None of our leases have met anyof the criteria to qualify as a capital lease under SFAS 13, *“Accounting for Leases”,*and, therefore, we have accountedfor all of our leases as operating leases.

*Incometaxes*.  We account forincome taxes under the provisions of Statement of Financial AccountingStandards, or SFAS, No. 109, *“Accounting for IncomeTaxes”*, or SFAS 109.  UnderSFAS No. 109, deferred tax assets and liabilities are determined based on thedifference between the financial statement and tax bases of assets 

 

F-9

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and liabilities usingenacted tax rates in effect for the year in which the differences are expectedto affect taxable income. Valuation allowances are established when necessaryto reduce deferred tax assets to the amounts that are expected to be realized(see Note 5).

We pay franchise taxes in certain states in which we haveoperations.  We have included franchisetaxes in general and administrative and other operating expenses in ourconsolidated statement of operations.

*Fair value of financial instruments. *Our financial instrumentsare limited to cash and cash equivalents, trading securities, securities held for sale, accounts receivable,accounts payable, the refundable portion of continuing care contracts, mortgagenotes receivable and payable and our convertible notes.  The fair value of these financial instrumentswas not materially different from their carrying values at December 31, 2006and 2005.  Our estimates of fair valueswere based on current market prices and discounted cash flow analysis.

*Revenue recognition.*  Our revenues are derived primarily fromservices to residents and patients at our senior living communities andhospitals.  We accrue revenues whenservices are provided.  Some of ourservices are provided with the expectation of payment from governments or otherthird party payors.  We derivedapproximately 33%, 36% and 41% of our net resident revenues in 2006, 2005 and2004, respectively, from payments under federal and state medical assistanceprograms.  For the three months endedDecember 31, 2006, approximately 72% of our hospital revenues were received from these programs.  Revenues under some of these programs aresubject to audit and retroactive adjustment.

Medicare revenues from residents totaled $103,735, $105,033 and$102,287 during 2006, 2005 and 2004, respectively.  Medicaid revenues from residents totaled$141,661, $136,963 and $133,127 during 2006, 2005 and 2004, respectively.  Our Medicare and Medicaid revenues from ourhospitals were $13,744 and $5,020, respectively for the three months endedDecember 31, 2006.  Both the FederalGovernment and some of the states in which we operate are considering plans toreduce Medicare and Medicaid funding, or to stop or reduce the projectedincreases in such funding.  We cannotestimate the magnitude of potential Medicaid and Medicare rate reductions butit may be material.  Medicaid andMedicare rates reductions or a failure of such program to increase rates tomatch our increasing costs, if they occur, may have a negative impact in ourrevenues, may decrease our net income and may cause us to incur losses.

*Per common share amounts.*  We computed earnings (loss) per share for theyears ended December 31, 2006, 2005 and 2004, using the weighted average numberof shares outstanding during each year. We have no common share equivalents other than unvested restrictedstock, or other dilutive instruments other than our convertible notes.

*Reclassifications.*  Reclassifications have been made to the prior years’financial statements to conform to the current year’s presentation.  Material changes are limited to reclassifyingidentifiable intangible assets to goodwill and other intangible assets from otherlong term assets.  Thesereclassifications had no effect on net income (loss) or shareholders’ equity.

*RecentlyIssued Accounting Standards*. On December 16, 2004, theFinancial Accounting Standards Board, or the FASB, issued SFAS Statement No.123 (revised 2004), “Share-Based Payment”, or SFAS 123(R), which is a revisionof SFAS Statement No. 123, “Accounting for Stock-Based Compensation”, or SFAS123.  SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issuedto Employees”, and amends SFAS Statement No. 95, “Statement of Cash Flows”.Generally, the approach in SFAS 123(R) is similar to the approach described inSFAS 123.  However, SFAS 123(R) requires all share based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values. Pro forma disclosure is no longer an alternative.  The Companyadopted SFAS 123(R) on January 1, 2006 using the prospective method asdescribed in SFAS No. 123(R).  The adoption of this standard did not havea material impact in our fiscal year 2006.

*NewAccounting Pronouncement*. In June 2006, the FASB issuedInterpretation No. 48 “Accounting for Uncertainty in Income Taxes”, or FIN48.  FIN 48 is effective for fiscal years beginning after December 15,2006.  FIN 48 prescribes how we shouldrecognize, measure and present in our financial statements uncertain taxpositions that we have taken or we expect to take in a tax return.  Pursuant to FIN 48, we can recognize a taxbenefit only if it is “more likely than not” that a particular tax positionwill be sustained upon examination or audit.  To the extent 

 

F-10

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the “more likely than not”standard has been satisfied, the benefit associated with a tax position is measuredas the largest amount that is more than 50% likely of being realized uponsettlement.  We are currently evaluatingthe effect that adoption of FIN 48 will have on our consolidated financialstatements; however, we do not anticipate the effect, if any, will be material.

**3.  Property and Equipment**

Property and equipment, at cost, as of December 31, 2006 and 2005,consists of:

|                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Land                               |       | $        | 6,685      |     | $          | 6,439 |   |
| Buildings and  improvements        |       | 82,293   |       | 75,540   |       |
| Furniture,  fixtures and equipment |       | 46,685   |       | 26,215   |       |
|                               |       | 135,663  |       | 108,194  |       |
| Accumulated  depreciation          |       | (20,765  | )          | (11,451  | )          |
|                               |       | $        | 114,898    |     | $          | 96,743 |   |

** **

**As of December 31, 2006 and 2005,we had assets classified as held for sale of $15,266 and $5,331, respectively,included in our property and equipment, that we intend to sell to SeniorHousing as permitted by our leases.**

**4.**** **  **Goodwilland Other Intangible Assets**

During 2006 and 2005, we recorded $3,663 and $1,426****of goodwill generated from acquisitions discussed in Note11 to these consolidated financial statements. As of December 31, 2006 and 2005, we had goodwill of $17,722 and$14,059, respectively.

During 2006 and2005, we recorded $1,344 and $2,580 of intangible assets that related tocustomer relationships we acquired in connection with our pharmacyacquisitions. These intangible assets are subject to amortization.  As of December 31, 2006 and 2005, theunamortized balance of intangible assets was $5,986 and $4,305, respectively.  At December 31, 2006, the weighted averageamortization period remaining is approximately 17 years.  We amortize intangible assets using thestraight-line method over the useful lives of the assets commencing on the dateof acquisition.  Amortization expenseassociated with customer agreements totaled $380, $219 and $118 in 2006, 2005and 2004, respectively. Accumulated amortization was $716 and $337 at December31, 2006 and 2005, respectively. Amortization expense is estimated to be approximately $399 in 2007, $394in 2008 and $311in 2009, 2010 and 2011, respectively.

**5.  Income Taxes**

Significant components of our deferred tax assets and liabilities as ofDecember 31, 2006 and 2005, are as follows:

|                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                                        |       |     |       |     |       |
| Continuing care contracts                                    |       | $        | 2,324      |     | $          | 2,473 |   |
| Depreciable assets                                           |       | —   |       | 825      |       |
| Allowance for doubtful accounts                              |       | 2,197    |       | 2,462    |       |
| Deferred gains on sale lease-back transactions               |       | 2,578    |       | 3,494    |       |
| Insurance reserves                                           |       | 4,040    |       | 3,615    |       |
| Tax credits                                                  |       | 1,547    |       | 1,464    |       |
| Tax loss carry forwards (including SLS termination  expense) |       | 81,714   |       | 33,042   |       |
| Other                                                        |       | 799      |       | 240      |       |
| Total deferred tax asset before valuation allowance          |       | 95,199   |       | 47,632   |       |
| Valuation allowance:                                         |       | (91,884  | )          | (44,826  | )          |
|                                                         |       | 3,315    |       | 2,807    |       |
| Deferred tax liabilities:                                    |       |     |       |     |       |
| Depreciable assets                                           |       | (656     | )          | 0        |       |
| Lease expense                                                |       | (2,271   | )          | (2,570   | )          |
| Goodwill                                                     |       | (433     | )          | (224     | )          |
| Other                                                        |       | 45       |       | (13      | )          |
| Total                                                        |       | (3,315   | )          | (2,807   | )          |
|                                                         |       |     |       |     |       |
| Net deferred tax  assets:                                    |       | $        | —     |     | $          | — |   |

 

F-11

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As a result of our short operating historyand reported losses, we have not currently recognized the benefit of ourdeferred tax assets.  We will continue toassess our ability to generate sufficient taxable income during future periodsin which our deferred tax assets may be utilized.  When we believe that we will more likely thannot recover our deferred tax assets, we will record a reduction in thevaluation reserve as an income tax benefit in the consolidated statement ofoperations, which will affect our results of operations.

Our operations in the year ended December 31, 2006 resulted in a taxableloss.  As of December 31, 2006 we havetax loss carry forwards of approximately $202,465 that may be carried forwardto offset future taxable income.  Our netoperating loss carry forwards will expire beginning in 2023, if unused.  The tax loss carry forward is subject toaudit and adjustments by the Internal Revenue Service.

The principal reasons for the difference between our effective tax(benefit) rate and the U.S. Federal statutory income tax (benefit) rate are asfollows:

|                                                           | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Taxes at  statutory U.S. federal income tax rate          |       | (35.0                                                         | )%         | (35.0 | )% | 34.0 | % |
| State and local  income taxes, net of federal tax benefit |       | (5.2                                                          | )%         | (5.2 | )% | 5.3 | % |
| Tax credits                                               |       | (0.1                                                          | )%         | (0.3 | )% | (17.9 | )% |
| Alternative  Minimum Tax                                  |       | 0.0                                                           | %          | 0.0 | % | 3.5 | % |
| Change in  federal statutory rate                         |       | 0.0                                                           | %          | (0.2 | )% | 0.0 | % |
| Change in  valuation allowance                            |       | 40.4                                                          | %          | 41.7 | % | (21.4 | )% |
| Other  differences, net                                   |       | (0.1                                                          | )%         | (1.0 | )% | 0.0 | % |
| Effective tax rate                                        |       | 0.0                                                           | %          | 0.0 | % | 3.5 | % |

 

**6.  Line of Credit**

The maximum amountavailable under this facility is $25,000, and is subject to limitations basedupon qualifying collateral.  We are theborrower under this revolving credit facility and certain of our subsidiaries guaranteeour obligations under the facility.  Thefacility is secured by our and our guarantor subsidiaries’ accounts receivable,deposit accounts and related assets.  Thefacility is available for acquisitions, working capital and general businesspurposes.  The facility containscovenants requiring us to maintain collateral, minimum net worth and certainother financial ratios, places limits on our ability to incur or assume debt orcreate liens with respect to certain of our properties and has other customaryprovisions.  In certain circumstances andsubject to available collateral and lender approvals, the maximum amount whichwe may draw under this credit facility may be increased to $50,000.  In July 2006, we entered into an amendment tothe facility to lower the interest paid on drawings under the facility and toextend the termination date to May 8, 2008. The termination date may be further extended twice, in each case bytwelve months, subject to lender approval, our payment of extension fees andother 

 

F-12

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conditions.  As of December 31, 2006 and March 5, 2007, noamounts were outstanding under this credit facility.  As of December 31, 2006 and March 5, 2007 webelieve we are in compliance with all applicable covenants under this revolvingcredit facility.  Interest expense andother associated costs related to this facility and our prior revolving creditfacility were $205**,**$167 and $85****for the years ended December 31, 2006, 2005 and 2004,respectively.

**7.  Mortgages Payable**

At December 31, 2006, nine of our communities wereencumbered by 11 Department of Housing and Urban Development, or HUD, insuredmortgages.  In order to record themortgages that we assumed in connection with the November 2004 acquisition ofmortgaged properties from LTA Holdings, Inc., or LTA, at their estimated fairvalue, we recorded mortgage premiums totaling $6,534.  We are amortizing the mortgage premiums as areduction to interest expense over the remaining term of the mortgages.  Mortgage interest expense, net of premiumamortization, was $2,768 and $2,427 for the years ended December 31, 2006 and2005, respectively.  The mortgagesrequire monthly payments into escrowfor taxes, insurance and property replacement funds.  Withdrawals from escrow require HUD approval.

By March 31, 2007, we expect to have prepaid sevenmortgages that were secured by six of our communities.  We will payapproximately $28,681 to payoff these seven mortgages, which will consist ofapproximately $27,826 in principal and approximately $881 in prepayment penalties. Because we had carried these mortgages at a premium to their fair value, wewill recognize a gain of approximately $4,464 in connection with the earlyextinguishment of debt in 2007.  Theweighted average cash interest rate for these seven mortgages was 7.3%.

The following table is a summary of the mortgage notespayable that will be outstanding as of March 31, 2007:
| **Principal  Balance  as of  December 31,  2006** | ** ** | **Monthly  Payment** | ** ** | **Cash  Interest  Rate** | ** ** | **Effective  Interest  Rate** | ** ** | **Maturity Date** | ** ** | **Fair Value  Premium  Adjustment  as of  December 31,  2006** | ** ** | **Total  Mortgage  Payable as of  December 31,  2006** | ** ** |
|-------------------------------------------------------------|------------|----------------------|------------|--------------------------|------------|-------------------------------|------------|------------------------|------------|-------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| $                                                           | 4,885      |                 | $          | 27                       |       | 5.55                          | %          | 5.55                   | %          | May 2039                                                                 |       | $                                                                     | —     |   | $ | 4,885 |   |
| 1,338                                                       |       | 10                   |       | 8.00                     | %          | 5.60                          | %          | January 2038      |       | 382                                                                           |       | 1,720                                                                 |       |
| 3,410                                                       |       | 19                   |       | 5.25                     | %          | 5.25                          | %          | June 2035         |       | —                                                                        |       | 3,410                                                                 |       |
| 1,184                                                       |       | 9                    |       | 8.45                     | %          | 5.60                          | %          | November 2037     |       | 400                                                                           |       | 1,584                                                                 |       |
| $                                                           | 10,817     |                 | $          | 65                       |       | 6.08                          | %(1)       |                   |       |                                                                          |       | $                                                                     | 782        |   | $ | 11,599 |   |

----

(1)             Weighted averageinterest rate

 

Principal payments dueunder the terms of these four mortgages are as follows:

| 2007       |   | $      | 127    |   |
|------------|--------|--------|--------|--------|
| 2008       |   | 135    |   |
| 2009       |   | 143    |   |
| 2010       |   | 151    |   |
| 2011       |   | 160    |   |
| Thereafter |   | 10,101 |   |
|       |   | $      | 10,817 |   |

** **

 

F-13

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**8.  Convertible Senior Notes due 2026**

In October 2006,we issued in a private placement $126,500principal amount of convertible notes, which included $16,500 principal amountissued pursuant to the underwriters’ exercise of an option to cover overallotments.  Our net proceeds fromthis offering were approximately $122,600.

These notes areconvertible into our common shares at any time. The initial conversion rate, which is subject to adjustment, is 76.9231common shares per $1 principal amount of notes, which represents an initialconversion price of $13.00 per share.  Aholder that surrenders notes for conversion in connection with a “make-wholefundamental change”, as defined in the indenture governing the notes, thatoccurs before October 20, 2011 may in some circumstances be entitled to anincreased conversion rate.

These notes bearinterest at a rate of 3.75% per annum, payable semi-annually in arrears onApril 15 and October 15 of each year, starting on April 15, 2007.  The notes mature on October 15, 2026.  On or after October 20, 2011, we may redeemthe notes, in whole or in part, at a redemption price in cash equal to 100% ofthe principal amount of the notes we redeem, plus any accrued and unpaidinterest.  On each of October 15, 2013,October 15, 2016 and October 15, 2021, holders of the notes may require us topurchase all or a portion of their notes at a purchase price in cash equal to100% of the principal amount of the notes to be purchased, plus any accrued andunpaid interest.  If a “fundamentalchange”, as defined in the indenture governing the notes, occurs, holders ofthe notes may require us to repurchase all or a portion of their notes for cashat a repurchase price equal to 100% of the principal amount of the notes to berepurchased, plus any accrued and unpaid interest and, in certaincircumstances, plus a make whole premium as defined in the indenture governingthe notes.  Interest expense related tothe notes was $974 for the year ended December 31, 2006.  The notes are guaranteed by certain of ourwholly owned subsidiaries.  Oursubsidiary guarantors may be released from their obligations under certaincircumstances.  As of  December 31, 2006 and March 5, 2007, webelieve we are in compliance with all applicable covenants of the indenturepursuant to which the notes were issued.

**9.  Leases**

As of December 31, 2006, we leased 144 communities and two hospitalsunder six non-cancelable leases with Senior Housing, and leased 4 communitiesunder a lease with Healthcare Property Investors, Inc., or HCPI.  These leases are “triple-net” leases whichrequire that we pay for all costs incurred in the operation of the communities,including the cost of insurance and real estate taxes, maintain the communitiesand indemnify the landlord for any liability which may arise from its ownershipduring the lease term

Our leases with Senior Housing for our 144 seniorliving communities require us to pay additional rent equal to 4% of the amountby which gross revenues of the communities we operate exceed gross revenues ina base year.

Senior Housing has agreed to fund amounts that werequest for renovations and improvements to communities we lease from them inreturn for rent increases according to formulas in the leases.  In 2006, Senior Housing funded $23,729****for renovations andimprovements to some of our communities. As a result and in accordance with our leases, our annual minimum rentto Senior Housing increased by $2,340.

The following table is a summary of our leases: 
| ** **                                                                                                         | ** ** | **Number of   properties** | ** ** | **Annual  minimum rent   as of  December 31, 2006** | ** ** | **Initial expiration   date** | ** **        | **Renewal terms**                                                           | ** **                   |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------|-------------------|----------------------------------------------------------------------------------|------------------------------|
|                                                                                                               |       |                                 |       |                                                                         |       |                                    |              |                                                                             |                         |
| 1. Four Senior Housing  leases for skilled nursing facilities and independent and assisted living  communities (1) |       | 114                                  |       | $                                                                            | 49,139     |                                    | December 31, 2020 |                                                                             | One 15-year renewal  option. |   |
|                                                                                                               | ** ** | ** **                           | ** ** | ** **                                                                   |       |                                    |              |                                                                             |                         |
| 2. One Senior Housing  lease for communities previously operated by SLS                                            |       | 30                                   |       | 65,012                                                                       |       | December 31, 2017                       |              | Two consecutive renewal  options for 10 and 5 years  (15 years total). |                         |
|                                                                                                               |       |                                 |       |                                                                         |       |                                    |              |                                                                             |                         |
| 3. One Senior Housing  lease for rehabilitation hospitals                                                          |       | 2                                    |       | 10,250                                                                       |       | June 30, 2026                           |              | One 20-year renewal  option.                                                     |                         |
|                                                                                                               |       |                                 | ** ** | ** **                                                                   |       |                                    |              |                                                                             |                         |
| 4. One HCPI lease                                                                                                  |       | 4                                    |       | 1,183                                                                        |       | June 30, 2014                           |              | Two 10-year renewal options.                                                     |                         |
|                                                                                                               |       |                                 |       |                                                                         |       |                                    |              |                                                                             |                         |
| Totals                                                                                                             |       | 150                                  | ** ** | $                                                                            | 125,584    |                                    |              |                                                                             |                         |   |

 

(1)                                  Threeof these four leases exist to accommodate mortgage financings in affect at thetime Senior Housing acquired the leased properties; we have agreed to combineall four of these leases into one lease when these mortgages are paid.

F-14

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The future minimum rentsrequired by our leases as of December 31, 2006, are as follows:

| 2007       |   | $       | 125,584   |   |
|------------|--------|---------|-----------|--------|
| 2008       |   | 125,584 |      |
| 2009       |   | 125,584 |      |
| 2010       |   | 125,584 |      |
| 2011       |   | 125,584 |      |
| Thereafter |   | 983,901 |      |
|       |   | $       | 1,611,821 |   |

 

**10.   Shareholders’ Equity**

In January, August and September 2005, weissued a total of 7,880,000 common shares in underwritten public offeringsraising proceeds, net of underwriting commissions and other costs, of $56,613.

In April 2006, we issued 11,500,000 commonshares in an underwritten public offering raising proceeds, net of underwritingcommissions and other costs, of $113,630.

We issued 121,200 and84,300 common shares in 2006 and 2005, respectively, to our directors, officersand others who provide services to us. We valued the shares at the average price of our common shares on theAmerican Stock Exchange on the dates of issue, or $1,277 in total in 2006,based on a $10.53 weighted average share price and $585 in total in 2005 basedon a $6.95 weighted average share price. Shares issued to directors vested immediately; shares issued to ourofficers and other individuals who provide services to us vest in three to fiveyears and are recognized in our statement of operations ratably.  As of December 31, 2006, 2,645,500 of ourcommon shares remain available for issuance under our 2001 Stock Option andStock Incentive Plan.

**11.   Acquisitions**

In March 2005, we acquired a 62 unit assisted living community locatedin Georgia for approximately $6,900.  Wefinanced this acquisition with cash on hand.

In June 2005, we acquired six assisted living communities forapproximately $59,000, including closing costs. These communities have a licensed resident capacity of 654 and arelocated in western Pennsylvania.  Wefunded this purchase using $10,000 drawn under our revolving credit facilityand the proceeds from a sale leaseback and a mortgage transaction with SeniorHousing.  We acquired these communitiesbecause they compliment our business strategy of focusing our operations inhigh quality senior living assets when residents pay for our services withprivate resources.  All of the revenuesof these communities come from residents’ private resources.  In connection with this acquisition, we soldfour different assisted living communities in June 2005 to Senior Housing

F-15

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for $24,000 and Senior Housing leased thesecommunities back to us for initial rent of $2,160 per annum.  Senior Housing also provided a $43,500 firstmortgage line of credit secured by six communities.  We borrowed $24,000 under this first mortgageline of credit when we closed the purchase and repaid it in August 2005 withthe proceeds from our sale of common shares described in Note 10 above.  We allocated the purchase price ofapproximately $59,000 to land, buildings and equipment.

In connection with our termination of management agreements for 12communities managed by SLS in November 2005, we sold the six communities toSenior Housing for $56,680, and Senior Housing leased these communities back tous.  Our initial rent to Senior Housingfor these communities is $5,220 per annum. We recognized a $2,333 impairment charge to reduce the carrying value ofthese communities to the amount realized upon the sale to Senior Housing, or$56,680.  The gross purchase price paidto us by Senior Housing was equal to the same amount as the purchase price wepaid to the seller of the communities. The impairment loss which we recognized relates principally totransaction costs.

In addition to our community acquisitions, we have purchased fourinstitutional pharmacies in 2005 and 2006. In June 2005, we purchased one pharmacy located in Nebraska forapproximately $4,600.  In December 2005,we purchased another pharmacy located in California for approximately$450.  In May 2006, we purchased anotherpharmacy in South Carolina for approximately $3,600.  In November 2006, we purchased anotherpharmacy located in Virginia for approximately $2,300.  We allocated the purchase prices of thesepharmacies to working capital assets, customer relationships and goodwill basedon the fair value of the assets acquired and liabilities assumed.

**We accounted for each of theseacquisitions using the purchase method of accounting, and we have included theresults of operations of these acquisitions in our consolidated statement ofoperations from the date of acquisition. Our purchase accounting allocations for certain 2006 acquisitions ispreliminary, primarily with respect to our valuations of intangibles.  We expect to complete our purchase accountingallocations during 2007.  Pro formaresults for these 2006 acquisitions have not been presented because the effectof the acquisitions is not considered material.**

**12.   Discontinued Operations**

During 2005, we ceased operations at one assisted living community inLos Angeles, California, and one skilled nursing facility in Milwaukee,Wisconsin.  We leased this community andthis facility from Senior Housing.  Senior Housing sold the assistedliving community located in California in December 2005 for net proceeds ofapproximately $2,600, which caused a $260 reduction in the annual minimum rentwe pay to Senior Housing in accordance with our lease terms.  Senior Housing sold the skilled nursing facilitylocated in Wisconsin in December 2006 for net proceeds of approximately $1,300,which caused a $130 reduction in the annual minimum rent we pay to SeniorHousing in accordance with our lease terms.

During 2006, we ceased operations at two skilled nursing facilitieslocated in Connecticut that we leased from Senior Housing.  Senior Housing sold these facilities inNovember 2006 for net proceeds of approximately $5,600, which caused a $559reduction in the annual minimum rent we pay to Senior Housing in accordancewith our lease terms.

As of December 31, 2006, substantially all of our assets and liabilitiesrelated to the communities where we have ceased operations have been disposedof and paid, respectively.  We havereclassified the consolidated statement of operations for all periods presentedto show the results of operations of these communities as discontinued.  Below is a summary of the operating resultsof these discontinued operations included in the financial statements for theyears ended December 31, 2006, 2005 and 2004:

 

|          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------|------------|----------|------------|----------|------------|----------|------------|
|     |       |     |       |     |       |     |       |
| Revenues |       | $        | 19,078     |     | $          | 31,676   |       | $ | 30,462 |   |
| Expenses |       | 23,703   |       | 34,676   |       | 32,352   |       |
| Net loss |       | $        | (4,625     | )        | $          | (3,000   | )          | $ | (1,890 | ) |

** **

F-16

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**13.  Transactions with Affiliates**

We were a 100% owned subsidiaryof Senior Housing before December 31, 2001. On December 31, 2001, Senior Housing distributed substantially allof our then outstanding shares to its shareholders.  In order to effect this spin off and togovern relations after the spin off, we entered into agreements with SeniorHousing and others pursuant to which it was agreed, among other things, that:

·                  so long as Senior Housing remains a real estateinvestment trust, or a REIT, we may not waive the share ownership restrictionsin our charter on the ability of any person or group to acquire more than 9.8%of any class of our equity shares without the consent of Senior Housing;

·                  so long as we are a tenant of Senior Housing, wewill not permit nor take any action that, in the reasonable judgment of SeniorHousing or HRPT Properties Trust (another REIT which owns shares of Senior Housing),or HRPT, might jeopardize the tax status of Senior Housing or HRPT as REITs;

·                  Senior Housing has the option, upon theacquisition by a person or group of more than 9.8% of our voting stock and uponother change in control events, as defined, to cancel all of our rights underthe leases we have with Senior Housing; and

·                  so long as we maintain our shared servicesagreement with RMR we will not acquire or finance any real estate without firstgiving Senior Housing, HRPT or any other publicly owned REIT or other entitymanaged by RMR, the opportunity to acquire or finance real estate investmentsof the type in which Senior Housing, HRPT or any other publicly owned REIT orother entity managed by RMR, respectively, invest.

At the time of our spin off fromSenior Housing, all of the persons serving as our directors were trustees ofSenior Housing.  Our two managingdirectors, Messrs. Martin and Portnoy, are currently the managing trusteesof Senior Housing.

Of the 162 senior livingcommunities we operate, 144 are leased from Senior Housing for total annualminimum rent of $114,151.

Since January 1, 2006, we haveentered into several transactions with Senior Housing, including:

·                  In October 2006, we began to lease tworehabilitation hospitals from Senior Housing. The term of the lease for these two hospitals expires on June 30, 2026,subject to our right to extend the term of the lease for an additional 20years.   These two hospitals providehealth rehabilitation services and are located in Braintree and Woburn,Massachusetts.  Our rent payable toSenior Housing for these hospitals is $10,250 per year.  These hospitals offer extensive inpatient andoutpatient services that we believe are similar to services we provide, or mayprovide,  in many of our senior livingcommunities.

·                  In June 2006, we ceased operations at twocommunities located in Connecticut that were leased from Senior Housing. InNovember 2006, Senior Housing sold these two facilities for net proceeds ofapproximately $5,600, which will reduce the annual minimum rent we pay toSenior Housing under our lease by $559.

·                  BetweenSeptember and December 2006, we agreed to lease 11 senior living communitieswith 1,284 units which Senior Housing acquired from third parties.  Six of these communities are assisted livingcommunities (three of which offer some skilled nursing services), three areindependent living communities and two are continuing care retirementcommunities which offer independent living, assisted living and skilled nursingservices.  Our rent payable to SeniorHousing for these 11 communities is $9,007 per year, plus future increasescalculated as a percentage of the revenue increases at these communities after2007.  We added these communities to ourexisting lease with Senior Housing which has a current term ending in 2020,plus renewal options thereafter. Residents pay substantially all of our charges at these communities fromtheir private resources.

F-17

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·                  During 2006, aspermitted by our leases with Senior Housing, we sold to Senior Housing, atcost, approximately $23,729 of improvements made to properties leased fromSenior Housing, and, as a result, our annual rent payable to Senior Housingincreased by approximately $2,340.

RMR provides certain management and administrative services to us undera shared services agreement. RMR is compensated at an annual rate equal to 0.6%of our total revenues. Aggregate fees earned by RMR for services during 2006,2005 and 2004, were $4,857, $4,663 and $3,700, respectively. RMR also providesthe internal audit function for us and for other publicly owned companies towhich it provides management  or otherservices.  Our pro rata share of RMR’scosts in providing that function for the years ended 2006, 2005 and 2004 was$173, $107 and $80, respectively.  Ouraudit committee appoints our director of internal audit, and our compensationcommittee approves his salary.  The factthat RMR has responsibilities to other entities, including our most significantlandlord, Senior Housing, could create conflicts; and in the event of suchconflicts between Senior Housing and us, the shared services agreement allowsRMR to act on behalf of Senior Housing rather than on our behalf.  RMR is beneficially owned by Messrs.Barry M. Portnoy, one of our managing directors, and his son, Adam D. Portnoy,President and Chief Executive Officer and a director of RMR, a managing trusteeof HRPT and Hospitality Properties Trust (another REIT) and a nominee forelection as managing trustee of Senior Housing. All transactions between us and RMRare approved by our compensation committee.

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

A subsidiary of RMR is the ownerof the building in which our headquarters is located.  This lease expires in 2011. We paid rent,which includes our proportional share of utilities and real estate taxes, underthis lease during 2006, 2005 and 2004 of $938, $711 and $561,respectively.  This lease has beenamended at various times to take into account our needs for increasing spaceand all amendments to this lease have been approved by our independentdirectors.

In December 2006, we commencedleasing space for a regional office in Atlanta, Georgia from HRPT.  This lease expires in 2011.  We paid rent  which includes ourproportional share of utilities and real estate taxes, under this lease during2006 of $5.

We believe that all ourtransactions with related parties are all on reasonable commercial terms; andall such transactions between us and related parties are approved by ourindependent directors.

**14.  Employee Benefit Plans**

We have established and assumed several employee savings plans underthe provisions of Section 401(k) of the Internal Revenue Code.  Allemployees are eligible to participate in at least one of our plans and areentitled, upon termination or retirement, to receive their vested portion ofthe plan assets.  For some of our plans, we match a certain level ofemployee contributions.  We also pay certain expenses related to all ofour plans.  Expenses for all our plans, including our contributions, were$193, $244 and $35 for the years ended December 31, 2006, 2005 and 2004,respectively.

**15.  Segment Information**

**During 2005 and 2006 we operatedsubstantially in one reportable segment, which is the business of operatingsenior living communities, including independent living and congregate carecommunities, assisted living communities and nursing homes.  Our pharmacyand rehabilitation hospital operations are not significant segments of ourbusiness and, accordingly, we combine those segments with our business ofoperating senior living communities.  If and as these businesses grow wemay reconsider whether segment reporting is appropriate.  All of our operations and assets are locatedin the United States**.

F-18

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**16.  Guarantor Financial Information**

Our convertiblenotes are guaranteed by certain of our domestic wholly owned subsidiaries.  Such guarantees are full, unconditional andjoint and several.  Separate financialstatements of the wholly owned subsidiaries are not presented because we havedetermined that they would not be material. Condensed consolidating financial information related to the Company,its guarantor subsidiaries and non-guarantor subsidiaries as of December 31,2006, 2005 and 2004 are reflected below:

 
| **Condensed Consolidating Statement of Operations** | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **For the year ended December 31, 2006**  | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                              | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                               |       |       |       |                        | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net revenues from residents                                             |       | $          | —     |                        | $          | 328,786                           |       | $                | 419,217    |             | $          | — |   | $ | 748,003 |   |
| Hospital revenue                                                        |       | —     |       |                        |       | 26,130                            |       | —           |       | 26,130           |       |
| Pharmacy revenue                                                        |       | —     |       |                        |       | 53,204                            |       | —           |       | 53,204           |       |
| Total revenues                                                          |       |       |       | 328,786                     |       | 498,551                           |       | —           |       | 827,337          |       |
|                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating  expenses:                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Wages and benefits                                                      |       | —     |       | 143,329                     |       | 240,676                           |       | —           |       | 384,005          |       |
| Other operating expenses                                                |       | —     |       | 87,773                      |       | 99,562                            |       | —           |       | 187,335          |       |
| Hospital expenses                                                       |       | —     |       | —                      |       | 23,589                            |       | —           |       | 23,589           |       |
| Pharmacy expenses                                                       |       | —     |       | —                      |       | 52,972                            |       | —           |       | 52,972           |       |
| Management fee to SLS                                                   |       | —     |       | 8,744                       |       | —                            |       | —           |       | 8,744            |       |
| Termination expense for SLS management agreements                       |       | —     |       | 129,913                     |       | —                            |       | —           |       | 129,913          |       |
| Rent expense                                                            |       | —     |       | 65,171                      |       | 46,310                            |       | —           |       | 111,481          |       |
| General and administrative                                              |       | —     |       | —                      |       | 33,829                            |       | —           |       | 33,829           |       |
| Depreciation and amortization                                           |       | —     |       | 4,192                       |       | 5,758                             |       | —           |       | 9,950            |       |
| Total operating  expenses                                               |       | —     |       | 439,122                     |       | 502,696                           |       | —           |       | 941,818          |       |
|                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating (loss)  income                                                |       | —     |       | (110,336                    | )          | (4,145                            | )          | —           |       | (114,481         | )          |
| Interest and other income                                               |       | —     |       | 313                         |       | 6,493                             |       | —           |       | 6,806            |       |
| Interest expense                                                        |       | —     |       | (24                         | )          | (4,341                            | )          | —           |       | (4,365           | )          |
| Equity in earnings of subsidiaries                                      |       | (116,665   | )          | —                      |       | —                            |       | 116,665          |       | —           |       |
|                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| (Loss) income  from continuing operations before income taxes           |       | (116,665   | )          | (110,047                    | )          | (1,993                            | )          | 116,665          |       | (112,040         | )          |
| Provision for income taxes                                              |       | —     |       | —                      |       | —                            |       | —           |       | —           |       |
| (Loss) income  from continuing operations                               |       | (116,665   | )          | (110,047                    | )          | (1,993                            | )          | 116,665          |       | (112,040         | )          |
|                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Loss from  discontinued operations                                      |       | —     |       | (74                         | )          | (4,551                            | )          | —           |       | (4,625           | )          |
|                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Net (loss) income                                                       |       | $          | (116,665   | )                           | $          | (110,121                          | )          | $                | (6,544     | )                | $          | 116,665 |   | $ | (116,665 | ) |

** **

F-19

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** **
| **Condensed Consolidating Statement of Operations** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|-----------------------------------|------------|-----------------------------------------------|------------|------------------|------------|------------------|------------|
| **For the year ended December 31, 2005**  | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                              | ** ** | **Parent** | ** ** | **Guarantor   Subsidiaries** | ** ** | **Non-   Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                               |       |       |       |                              |       |                                          |       |             |       |             |       |
| Net revenues from residents                                             |       | $          | —     |                              | $          | 314,990                                       |       | $                | 385,901    |             | $          | — |   | $ | 700,891 |   |
| Pharmacy revenue                                                        |       | —     |       | —                            |       | 33,132                                        |       | —           |       | 33,132           |       |
| Total revenues                                                          |       | —     |       | 314,990                           |       | 419,033                                       |       | —           |       | 734,023          |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Operating  expenses:                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Wages and benefits                                                      |       | —     |       | 131,779                           |       | 224,588                                       |       | —           |       | 356,367          |       |
| Other operating expenses                                                |       | —     |       | 90,368                            |       | 90,326                                        |       | —           |       | 180,694          |       |
| Pharmacy expenses                                                       |       | —     |       | —                            |       | 31,823                                        |       | —           |       | 31,823           |       |
| Management fee to SLS                                                   |       | —     |       | 21,256                            |       | —                                        |       | —           |       | 21,256           |       |
| Termination expense for SLS management agreements                       |       | —     |       | 86,286                            |       | —                                        |       | —           |       | 86,286           |       |
| Rent expense                                                            |       | —     |       | 64,556                            |       | 34,334                                        |       | —           |       | 98,890           |       |
| General and administrative                                              |       | —     |       | —                            |       | 28,221                                        |       | —           |       | 28,221           |       |
| Depreciation and amortization                                           |       | —     |       | 2,562                             |       | 4,552                                         |       | —           |       | 7,114            |       |
| Impairment of assets                                                    |       | —     |       | —                            |       | 2,333                                         |       | —           |       | 2,333            |       |
| Total operating  expenses                                               |       | —     |       | 396,807                           |       | 416,177                                       |       | —           |       | 812,984          |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Operating (loss)  income                                                |       | —     |       | (81,817                           | )          | 2,856                                         |       | —           |       | (78,961          | )          |
| Interest and other income                                               |       | —     |       | 170                               |       | 1,373                                         |       | —           |       | 1,543            |       |
| Interest expense                                                        |       | —     |       | —                            |       | (3,741                                        | )          | —           |       | (3,741           | )          |
| Equity in earnings of subsidiaries                                      |       | (84,159    | )          | —                            |       | —                                        |       | 84,159           |       | —           |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| (Loss) income  from continuing operations before income taxes           |       | (84,159    | )          | (81,647                           | )          | 488                                           |       | 84,159           |       | (81,159          | )          |
|  Provision for  income taxes                                       |       | —     |       | —                            |       | —                                        |       | —           |       | —           |       |
| (Loss) income  from continuing operations                               |       | (84,159    | )          | (81,647                           | )          | 488                                           |       | 84,159           |       | (81,159          | )          |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Loss from  discontinued operations                                      |       | —     |       | (272                              | )          | (2,728                                        | )          | —           |       | (3,000           | )          |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Net (loss) income                                                       |       | $          | (84,159    | )                                 | $          | (81,919                                       | )          | $                | (2,240     | )                | $          | 84,159 |   | $ | (84,159 | ) |

** **
| **Condensed Consolidating Statement of Operations** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|-----------------------------------|------------|-----------------------------------------------|------------|------------------|------------|------------------|------------|
| **For the year ended December 31, 2004**  | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                              | ** ** | **Parent** | ** ** | **Guarantor   Subsidiaries** | ** ** | **Non-   Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                               |       |       |       |                              |       |                                          |       |             |       |             |       |
| Net revenues from residents                                             |       | $          | —     |                              | $          | 302,760                                       |       | $                | 281,855    |             | $          | — |   | $ | 584,615 |   |
| Pharmacy revenue                                                        |       | —     |       | —                            |       | 13,209                                        |       | —           |       | 13,209           |       |
| Total revenues                                                          |       | —     |       | 302,760                           |       | 295,064                                       |       | —           |       | 597,824          |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Operating  expenses:                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Wages and benefits                                                      |       | —     |       | 126,868                           |       | 175,414                                       |       | —           |       | 302,282          |       |
| Other operating expenses                                                |       | —     |       | 88,287                            |       | 65,185                                        |       | —           |       | 153,472          |       |
| Pharmacy expenses                                                       |       | —     |       | —                            |       | 12,093                                        |       | —           |       | 12,093           |       |
| Management fee to SLS                                                   |       | —     |       | 19,293                            |       | —                                        |       | —           |       | 19,293           |       |
| Rent expense                                                            |       | —     |       | 64,023                            |       | 18,430                                        |       | —           |       | 82,453           |       |
| General and administrative                                              |       | —     |       | —                            |       | 20,052                                        |       | —           |       | 20,052           |       |
| Depreciation and amortization                                           |       | —     |       | 1,339                             |       | 2,033                                         |       | —           |       | 3,372            |       |
| Total operating  expenses                                               |       | —     |       | 299,810                           |       | 293,207                                       |       | —           |       | 593,017          |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Operating income                                                        |       | —     |       | 2,950                             |       | 1,857                                         |       | —           |       | 4,807            |       |
| Interest and other income                                               |       | —     |       | 66                                |       | 1,600                                         |       | —           |       | 1,666            |       |
| Interest expense                                                        |       | —     |       | —                            |       | (1,172                                        | )          | —           |       | (1,172           | )          |
| Equity in earnings of subsidiaries                                      |       | 3,291      |       | —                            |       | —                                        |       | (3,291           | )          | —           |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Income (loss)  from continuing operations before income taxes           |       | 3,291      |       | 3,016                             |       | 2,285                                         |       | (3,291           | )          | 5,301            |       |
| Provision for income taxes                                              |       | —     |       | —                            |       | (120                                          | )          | —           |       | (120             | )          |
| Income (loss)  from continuing operations                               |       | 3,291      |       | 3,016                             |       | 2,165                                         |       | (3,291           | )          | 5,181            |       |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Loss from  discontinued operations                                      |       | —     |       | (692                              | )          | (1,198                                        | )          | —           |       | (1,890           | )          |
|                                                                    |       |       |       |                              |       |                                          |       |             |       |             |       |
| Net income (loss)                                                       |       | $          | 3,291      |                              | $          | 2,324                                         |       | $                | 967        |             | $          | (3,291 | ) | $ | 3,291 |   |

** **

F-20

----

** **
| **Condensed Consolidating Balance Sheet**                  | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **As of December 31, 2006**                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ASSETS                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current assets:                                                           |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash equivalents                                                 |       | $          | —     |                        | $          | 8,065                             |       | $                | 38,176     |             | $          | — |   | $ | 46,241 |   |
| Accounts receivable, net                                                  |       | —     |       | 13,209                      |       | 54,582                            |       | —           |       | 67,791           |       |
| Investments                                                               |       | —     |       | —                      |       | 50,434                            |       | —           |       | 50,434           |       |
| Prepaid expenses and other current assets                                 |       | —     |       | 8,353                       |       | 32,941                            |       | —           |       | 41,294           |       |
| Total current  assets                                                     |       | —     |       | 29,627                      |       | 176,133                           |       | —           |       | 205,760          |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Property and  equipment, net                                              |       | —     |       | 23,061                      |       | 91,837                            |       | —           |       | 114,898          |       |
| Investment in  subsidiary and long term receivable from (to) subsidiaries |       | 200        |       | —                      |       | 200                               |       | (400             | )          | —           |       |
| Restricted cash                                                           |       | —     |       | 3,072                       |       | 11,750                            |       | —           |       | 14,822           |       |
| Intercompany                                                              |       | 228,656    |       | —                      |       | —                            |       | (228,656         | )          | —           |       |
| Mortgage notes  receivable                                                |       | —     |       | —                      |       | 2,484                             |       | —           |       | 2,484            |       |
| Goodwill and  other intangible assets                                     |       | —     |       | —                      |       | 22,611                            |       | —           |       | 22,611           |       |
| Other long term  assets                                                   |       | —     |       | —                      |       | 5,836                             |       | —           |       | 5,836            |       |
|                                                                      |       | $          | 228,856    |                        | $          | 55,760                            |       | $                | 310,851    |             | $          | (229,056 | ) | $ | 366,411 |   |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                  |       |       |       |                        |       |                              |       |             |       |             |       |
| ** **                                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current  liabilities:                                                     |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and other current liabilities                            |       | $          | —     |                        | $          | 41,852                            |       | $                | 57,760     |             | $          | — |   | $ | 99,612 |   |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 33,317                            |       | —           |       | 33,317           |       |
| Total current  liabilities                                                |       | —     |       | 41,852                      |       | 91,077                            |       | —           |       | 132,929          |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Long term  liabilities:                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 11,454                            |       | —           |       | 11,454           |       |
| Convertible senior notes                                                  |       | —     |       | —                      |       | 126,500                           |       | —           |       | 126,500          |       |
| Notes payable to related parties                                          |       | 200        |       | —                      |       | —                            |       | (200             | )          | —           |       |
| Other long term liabilities                                               |       | —     |       | 6,431                       |       | 21,667                            |       | —           |       | 28,098           |       |
| Total long term  liabilities                                              |       | —     |       | 6,431                       |       | 159,621                           |       | (200             | )          | 166,052          |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Total  shareholders’ equity                                          |       | 228,656    |       | 7,477                       |       | 60,153                            |       | (228,856         | )          | 67,430           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       | $          | 228,856    |                        | $          | 55,760                            |       | $                | 310,851    |             | $          | (229,056 | ) | $ | 366,411 |   |

** **

F-21

----

** **
| **Condensed Consolidating Balance Sheet**                  | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **As of December 31, 2005**                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ASSETS                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current assets:                                                           |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash                                                                      |       | $          | —     |                        | $          | 7,076                             |       | $                | 9,300      |             | $          | — |   | $ | 16,376 |   |
| Accounts receivable, net                                                  |       | —     |       | 15,535                      |       | 30,589                            |       | —           |       | 46,124           |       |
| Investments                                                               |       | —     |       | —                      |       | 632                               |       | —           |       | 632              |       |
| Prepaid expenses and other current assets                                 |       | —     |       | 6,143                       |       | 24,839                            |       | —           |       | 30,982           |       |
| Total current  assets                                                     |       | —     |       | 28,754                      |       | 65,360                            |       | —           |       | 94,114           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Property and  equipment, net                                              |       | —     |       | 19,200                      |       | 77,543                            |       | —           |       | 96,743           |       |
| Investment in  subsidiary and long term receivable from (to) subsidiaries |       | 200        |       | —                      |       | 200                               |       | (400             | )          | —           |       |
| Restricted cash                                                           |       | —     |       | 3,798                       |       | 9,683                             |       | —           |       | 13,481           |       |
| Intercompany                                                              |       | 113,749    |       | —                      |       | —                            |       | (113,749         | )          | —           |       |
| Mortgage notes  receivable                                                |       | —     |       | —                      |       | 5,337                             |       | —           |       | 5,337            |       |
| Goodwill and  other intangible assets                                     |       | —     |       | —                      |       | 18,048                            |       | —           |       | 18,048           |       |
| Other long term  assets                                                   |       | —     |       | 402                         |       | 815                               |       | —           |       | 1,217            |       |
|                                                                      |       | $          | 113,949    |                        | $          | 52,154                            |       | $                | 176,986    |             | $          | (114,149 | ) | $ | 228,940 |   |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current liabilities:                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and other current liabilities                            |       | $          | —     |                        | $          | 25,262                            |       | $                | 64,080     |             | $          | — |   | $ | 89,342 |   |
| Current mortgage notes payable                                            |       | —     |       | —                      |       | 626                               |       | —           |       | 626              |       |
| Total current  liabilities                                                |       | —     |       | 25,262                      |       | 64,706                            |       | —           |       | 89,968           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Long term  liabilities:                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 44,703                            |       | —           |       | 44,703           |       |
| Notes payable to related parties                                          |       | 200        |       | —                      |       | —                            |       | (200             | )          | —           |       |
| Other long term liabilities                                               |       | —     |       | 6,179                       |       | 19,286                            |       | —           |       | 25,465           |       |
| Total long term  liabilities                                              |       | 200        |       | 6,179                       |       | 63,989                            |       | (200             | )          | 70,168           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Total  shareholders’ equity                                          |       | 113,749    |       | 20,713                      |       | 48,291                            |       | (113,949         | )          | 68,804           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       | $          | 113,949    |                        | $          | 52,154                            |       | $                | 176,986    |             | $          | (114,149 | ) | $ | 228,940 |   |

** **

F-22

----

** **
| **Condensed Consolidating Balance Sheet**                  | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **As of December 31, 2004**                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ASSETS                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current assets:                                                           |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash                                                                      |       | $          | —     |                        | $          | 7,650                             |       | $                | 21,501     |             | $          | — |   | $ | 29,151 |   |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts receivable, net                                                  |       | —     |       | 11,676                      |       | 25,066                            |       | —           |       | 36,742           |       |
| Prepaid expenses and other current assets                                 |       | —     |       | 12,498                      |       | 15,852                            |       | —           |       | 28,350           |       |
| Total current  assets                                                     |       | —     |       | 31,824                      |       | 62,419                            |       | —           |       | 94,243           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Property and  equipment, net                                              |       | —     |       | 12,671                      |       | 82,518                            |       | —           |       | 95,189           |       |
| Investment in  subsidiary and long term receivable from (to) subsidiaries |       | 200        |       | —                      |       | 200                               |       | (400             | )          | —           |       |
| Restricted cash                                                           |       | —     |       | 8,842                       |       | 3,322                             |       | —           |       | 12,164           |       |
| Intercompany                                                              |       | 56,551     |       | —                      |       | —                            |       | (56,551          | )          | —           |       |
| Mortgage notes  receivable                                                |       | —     |       | —                      |       | 6,099                             |       | —           |       | 6,099            |       |
| Goodwill and  other intangible assets                                     |       | —     |       | —                      |       | 11,548                            |       | —           |       | 11,548           |       |
| Other long term  assets                                                   |       | —     |       | 402                         |       | 3,340                             |       | —           |       | 3,742            |       |
|                                                                      |       | $          | 56,751     |                        | $          | 53,739                            |       | $                | 169,446    |             | $          | (56,951 | ) | $ | 222,985 |   |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current liabilities:                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and other current liabilities                            |       | $          | —     |                        | $          | 24,597                            |       | $                | 41,838     |             | $          | — |   | $ | 66,435 |   |
| Current mortgage notes payable                                            |       | —     |       | —                      |       | 463                               |       | —           |       | 463              |       |
| Total current  liabilities                                                |       | —     |       | 24,597                      |       | 42,301                            |       | —           |       | 66,898           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Long term  liabilities:                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 42,118                            |       | —           |       | 42,118           |       |
| Notes payable to related parties                                          |       | 200        |       | —                      |       | —                            |       | (200             | )          | —           |       |
| Other long term liabilities                                               |       | —     |       | 6,320                       |       | 11,745                            |       | —           |       | 18,065           |       |
| Total long term  liabilities                                              |       | 200        |       | 6,320                       |       | 53,863                            |       | (200             | )          | 60,183           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Total  shareholders’ equity                                          |       | 56,551     |       | 22,822                      |       | 73,282                            |       | (56,751          | )          | 95,904           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       | $          | 56,751     |                        | $          | 53,739                            |       | $                | 169,446    |             | $          | (56,951 | ) | $ | 222,985 |   |

** **

F-23

----

** **
| **Condensed Consolidating Cash Flow Statement**                          | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **For the year ended December 31, 2006**                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash  Flows from operating activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Net (loss)  income                                                                           |       | $          | (116,665   | )                           | $          | (110,120                          | )          | $                | (6,545     | )                | $          | 116,665 |   | $ | (116,665 | ) |
| Undistributed  equity in earnings of subsidiaries                                            |       | 116,665    |       | —                      |       | —                            |       | (116,665         | )          | —           |       |
| Adjustments to  reconcile net income to cash provided by (used in) operating activities, net |       | —     |       | 118,138                     |       | (182,689                          | )          | —           |       | (64,551          | )          |
| Net cash used in operating activities                                                        |       | —     |       | 8,018                       |       | (189,234                          | )          | —           |       | (181,216         | )          |
| **Cash  Flows from investing activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Capital  expenditures                                                                        |       | —     |       | (17,481                     | )          | (39,621                           | )          | —           |       | (57,102          | )          |
| Proceeds from  the sale of property and equipment                                            |       | —     |       | 9,425                       |       | 14,304                            |       | —           |       | 23,729           |       |
| Other, net                                                                                   |       | —     |       | 1,027                       |       | 2,578                             |       | —           |       | 3,605            |       |
| Net cash (used in) provided by investing activities                                          |       | —     |       | (7,029                      | )          | (22,739                           | )          | —           |       | (29,768          | )          |
| **Cash  Flows from financing activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Proceeds from  issuance of common shares, net                                                |       | —     |       | —                      |       | 114,907                           |       | —           |       | 114,907          |       |
| Change in  borrowings, net                                                                   |       | —     |       | —                      |       | 125,942                           |       | —           |       | 125,942          |       |
| Net cash provided by financing activities                                                    |       | —     |       | —                      |       | 240,849                           |       | —           |       | 240,849          |       |
| Change in cash  and cash equivalents                                                         |       | —     |       | 989                         |       | 28,876                            |       | —           |       | 29,865           |       |
| Cash and cash  equivalents at beginning of period                                            |       | —     |       | 7,076                       |       | 9,300                             |       | —           |       | 16,376           |       |
| Cash and cash  equivalents at end of period                                                  |       | $          | —     |                        | $          | 8,065                             |       | $                | 38,176     |             | $          | — |   | $ | 46,241 |   |

** **

F-24

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** **
| **Condensed Consolidating Cash Flow Statement**                          | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **For the year ended December 31, 2005**                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash  Flows from operating activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Net (loss)  income                                                                           |       | $          | (84,159    | )                           | $          | (81,919                           | )          | $                | (2,240     | )                | $          | 84,159 |   | $ | (84,159 | ) |
| Undistributed  equity in earnings of subsidiaries                                            |       | 84,159     |       | —                      |       | —                            |       | (84,159          | )          | —           |       |
| Adjustments to  reconcile net income to cash provided by (used in) operating activities, net |       | —     |       | 80,502                      |       | (52,977                           | )          | —           |       | 27,525           |       |
| Net cash used in operating activities                                                        |       | —     |       | (1,417                      | )          | (55,217                           | )          | —           |       | (56,634          | )          |
| **Cash  Flows from investing activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Capital  expenditures                                                                        |       | —     |       | (19,722                     | )          | (90,631                           | )          | —           |       | (110,353         | )          |
| Proceeds from  the sale of property and equipment                                            |       | —     |       | 7,769                       |       | 88,379                            |       | —           |       | 96,148           |       |
| Other, net                                                                                   |       | —     |       | 12,796                      |       | (14,232                           | )          | —           |       | (1,436           | )          |
| Net cash (used in) provided by investing activities                                          |       | —     |       | 843                         |       | (16,484                           | )          | —           |       | (15,641          | )          |
| **Cash  Flows from financing activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Proceeds from  issuance of common shares, net                                                |       | —     |       | —                      |       | 56,752                            |       | —           |       | 56,752           |       |
| Change in  borrowings, net                                                                   |       | —     |       | —                      |       | 2,748                             |       | —           |       | 2,748            |       |
| Other, net                                                                                   |       | —     |       | —                      |       | —                            |       | —           |       | —           |       |
| Net cash provided by financing activities                                                    |       | —     |       | —                      |       | 59,500                            |       | —           |       | 59,500           |       |
| Change in cash  and cash equivalents                                                         |       | —     |       | (574                        | )          | (12,201                           | )          | —           |       | (12,775          | )          |
| Cash and cash  equivalents at beginning of period                                            |       | —     |       | 7,650                       |       | 21,501                            |       | —           |       | 29,151           |       |
| Cash and cash  equivalents at end of period                                                  |       | $          | —     |                        | $          | 7,076                             |       | $                | 9,300      |             | $          | — |   | $ | 16,376 |   |

** **

F-25

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** **
| **Condensed Consolidating Cash Flow Statement**                          | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **For the year ended December 31, 2004**                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash  Flows from operating activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Net income  (loss)                                                                           |       | $          | 3,291      |                        | $          | 2,324                             |       | $                | 967        |             | $          | (3,291 | ) | $ | 3,291 |   |
| Undistributed  equity in earnings of subsidiaries                                            |       | (3,291     | )          | —                      |       | —                            |       | 3,291            |       | —           |       |
| Adjustments to  reconcile net income to cash provided by (used in) operating activities, net |       | —     |       | 7,721                       |       | (11,410                           | )          | —           |       | (3,689           | )          |
| Net cash (used in) provided by operating activities                                          |       | —     |       | 10,045                      |       | (10,443                           | )          | —           |       | (398             | )          |
| **Cash  Flows from investing activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Capital expenditures                                                                         |       | —     |       | (18,813                     | )          | (123,648                          | )          | —           |       | (142,461         | )          |
| Proceeds from  the sale of property and equipment                                            |       | —     |       | 5,746                       |       | 126,393                           |       | —           |       | 132,139          |       |
| Other, net                                                                                   |       | —     |       | (2,484                      | )          | 4,715                             |       | —           |       | 2,231            |       |
| Net cash (used in) provided by investing activities                                          |       | —     |       | (15,551                     | )          | 7,461                             |       | —           |       | (8,091           | )          |
| **Cash  Flows from financing activities:**                                                   |       |       |       |                        |       |                              |       |             |       |             |       |
| Proceeds from  issuance of common shares, net                                                |       | —     |       | —                      |       | 27,725                            |       | —           |       | 27,725           |       |
| Change in  borrowings, net                                                                   |       | —     |       | —                      |       | (5,452                            | )          | —           |       | (5,452           | )          |
| Other, net                                                                                   |       | —     |       | —                      |       | —                            |       | —           |       | —           |       |
| Net cash provided by financing activities                                                    |       | —     |       | —                      |       | 22,273                            |       | —           |       | 22,273           |       |
| Change in cash  and cash equivalents                                                         |       | —     |       | (5,506                      | )          | 19,290                            |       | —           |       | 13,784           |       |
| Cash and cash  equivalents at beginning of period                                            |       | —     |       | 13,156                      |       | 2,211                             |       | —           |       | 15,367           |       |
| Cash and cash  equivalents at end of period                                                  |       | $          | —     |                        | $          | 7,650                             |       | $                | 21,501     |             | $          | — |   | $ | 29,151 |   |

 

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

The following is a summary of unaudited quarterly results of operationsfor the years ended December 31, 2006 and 2005:
| ** **                                    | ** ** | **2006**           | ** ** |
|-----------------------------------------------|------------|--------------------|------------|
| ** **                                    | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                      |       | $                  | 192,603    |   | $ | 196,056 |   | $ | 201,073 |   | $ | 237,605 |   |
| Net income  (loss) from continuing operations |       | 2,493              |       | (86,335 | ) | 5,517 |   | (33,715 | ) |
| Net income  (loss)                            |       | 1,660              |       | (87,191 | ) | 3,196 |   | (34,330 | ) |
| Net income (loss) per  common share           |       | $                  | 0.08       |   | $ | (2.82 | ) | $ | 0.10 |   | $ | (1.09 | ) |

 
| ** **                             | ** ** | **2005**           | ** ** |
|----------------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                               |       | $                  | 174,510    |   | $ | 178,401 |   | $ | 187,628 |   | $ | 193,484 |   |
| Net income from  continuing operations |       | 1,048              |       | 2,193 |   | (83,444 | ) | (956 | ) |
| Net income                             |       | 1,256              |       | 1,167 |   | (84,374 | ) | (2,208 | ) |
| Net income per common  share           |       | $                  | 0.10       |   | $ | 0.10 |   | $ | (5.64 | ) | $ | (0.11 | ) |

** **

F-26

----

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

Pro forma operating results assuming commencement of operations, as ofJanuary 1, 2005, of the six communities we acquired in June 2005 are asfollows:

|                                    | ** ** | **2005**        | ** ** |
|------------------------------------|------------|-----------------|------------|
| ** **                         | ** ** | ** **      | ** ** |
| ** **                         | ** ** | **(unaudited)** | ** ** |
| Revenues                           |       | $               | 742,269    |   |
| Expenses                           |       | 819,668         |       |
| Operating loss                     |       | (77,399         | )          |
| Interest and  other income         |       | 1,596           |       |
| Interest expense                   |       | (4,892          | )          |
| Loss from  continuing operations   |       | (80,695         | )          |
| Loss from  discontinued operations |       | (3,000          | )          |
| Net loss                           |       | $               | (83,695    | ) |

 

Theseunaudited pro forma operating results do not represent or are not indicative ofour operating results for any future date or period.  Actual future results may be materiallydifferent from pro forma results. Differences could arise from many factors.

F-27

----

 

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|        | FIVE STAR QUALITY CARE, INC.          |
|--------|---------------------------------------|
|   |                                  |
|   |                                  |
|   | By:                                   |   /s/ Evrett  W. Benton |   |
|   | Evrett W. Benton                      |
|   | President and Chief Executive Officer |

 

Dated:  March 7, 2007

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
| Signature                  | ** ** | **Title**                      | ** **                            | **Date** |
|----------------------------|------------|--------------------------------|---------------------------------------|----------|
|                       |       |                           |                                  |     |
| /s/ Evrett W. Benton       |       |                           | President and Chief Executive Officer |     | March 7, 2007 |
| Evrett W. Benton           |       |                           |                                  |     |
|                       |       |                           |                                  |     |
| /s/ Bruce J. Mackey Jr.    |       |                           | Chief Financial Officer and Treasurer |     | March 7, 2007 |
| Bruce J. Mackey Jr         |       | (Principal Accounting Officer) |                                  |     |
|                       |       |                           |                                  |     |
| /s/ Barry M. Portnoy       |       |                           | Managing Director                     |     | March 7, 2007 |
| Barry M. Portnoy           |       |                           |                                  |     |
|                       |       |                           |                                  |     |
| /s/ Gerard M. Martin       |       |                           | Managing Director                     |     | March 7, 2007 |
| Gerard M. Martin           |       |                           |                                  |     |
|                       |       |                           |                                  |     |
| /s/ Bruce M. Gans          |       |                           | Director                              |     | March 7, 2007 |
| Bruce M. Gans              |       |                           |                                  |     |
|                       |       |                           |                                  |     |
| /s/ Barbara D. Gilmore     |       |                           | Director                              |     | March 7, 2007 |
| Barbara D. Gilmore         |       |                           |                                  |     |
|                       |       |                           |                                  |     |
| /s/ Arthur G. Koumantzelis |       |                           | Director                              |     | March 7, 2007 |
| Arthur G. Koumantzelis     |       |                           |                                  |     |

 

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