================================================================================

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                    FORM 10-K

  X           ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
-----                    SECURITIES EXCHANGE ACT OF 1934

                     FOR FISCAL YEAR ENDED: AUGUST 31, 1998
                                       OR
            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
-----           SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

                 For the transition period from _____ to _____.

                         Commission File Number: 0-25878
                                                 -------

                             ILM I LEASE CORPORATION
             (Exact name of registrant as specified in its charter)

       Virginia                                                  04-3248637
-----------------------                                       ----------------
(State of organization)                                       (I.R.S. Employer
                                                             Identification No.)

28 State Street, Suite 1100, Boston, MA                             02109
--------------------------------------------------------------------------------
(Address of principal executive office)                          (Zip Code)

Registrant's telephone number, including area code:             888-257-3550
                                                                ------------

           Securities registered pursuant to Section 12(b) of the Act:

                                                           Name of each exchange
Title of each class                                         on which registered
-------------------                                        ---------------------
        None                                                       None

           Securities registered pursuant to Section 12(g) of the Act:
                      Shares of Common Stock $.01 Par Value
                      -------------------------------------
                                (Title of class)

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
          ---

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

Shares of common stock outstanding as of August 31, 1998: 7,519,430. The
aggregate sales price of the shares sold was $700,000. This does not reflect
market value. There is no current market for these shares.

                       DOCUMENTS INCORPORATED BY REFERENCE

        Documents                                            Form 10-K Reference
-------------------------                                    -------------------
Registration Statement on Form 10 of registrant              Part III, Part IV
dated July 20, 1995, as supplemented [33 Act filing
#33-27653]

Current Report on Form 8-K                                   Part IV
of registrant dated August 21, 1998

================================================================================
<PAGE>


                             ILM I LEASE CORPORATION

                                 1998 FORM 10-K

                                TABLE OF CONTENTS
<TABLE>
<CAPTION>
Part I                                                                                       Page
------                                                                                       ----
<S>              <C>                                                                      <C>
Item  1          Business....................................................................I-1

Item  2          Properties..................................................................I-4

Item  3          Legal Proceedings...........................................................I-5

Item  4          Submission of Matters to a Vote of Security Holders.........................I-6

<CAPTION>
Part II
-------
<S>              <C>                                                                      <C>
Item  5          Market for the Registrant's Shares and Related
                 Stockholder Matters........................................................II-1

Item  6          Selected Financial Data....................................................II-1

Item  7          Management's Discussion and Analysis of Financial Condition
                   and Results of Operations................................................II-2

Item  8          Financial Statements and Supplementary Data................................II-6

Item  9          Changes in and Disagreements with Accountants on Accounting
                   and Financial Disclosure.................................................II-6

<CAPTION>
Part III
--------
<S>              <C>                                                                      <C>
Item  10         Directors and Executive Officers of the Registrant........................III-1

Item  11         Executive Compensation....................................................III-2

Item  12         Security Ownership of Certain Beneficial Owners and Management............III-3

Item  13         Certain Relationships and Related Transactions............................III-3

<CAPTION>
Part IV
-------
<S>              <C>                                                                      <C>
Item  14         Exhibits, Financial Statement Schedules and Reports on Form 8-K............IV-1

Signatures..................................................................................IV-2

Index to Exhibits...........................................................................IV-3

Financial Statements and Supplementary Data...............................................F1-F16
</TABLE>
<PAGE>



                            ILM I LEASE CORPORATION

                                     PART I
                                     ------

Item 1. Business
----------------

     ILM I Lease Corporation (the "Company") was formed in 1994 by ILM Senior
Living, Inc. ("ILM I"), formerly PaineWebber Independent Living Mortgage Fund,
Inc., a publicly-held, non-traded Real Estate Investment Trust ("REIT"), for the
purpose of operating eight rental housing projects that provide independent
living and assisted living services for senior citizens (the "Senior Housing
Facilities") under the terms of a master lease agreement. ILM I contributed
$700,000 to the Company in return for all of the issued and outstanding shares
of the Company's common stock. ILM I had originally made mortgage loans secured
by the Senior Housing Facilities to Angeles Housing Concepts, Inc. ("AHC")
between June 1989 and July 1992. In March 1993, AHC defaulted under the terms of
such mortgage loans and in connection with the settlement of such default, title
to the Senior Housing Facilities was transferred, effective April 1, 1994, to
certain majority-owned, indirect subsidiaries of ILM I, subject to the mortgage
loans. Subsequently, the indirect subsidiaries of ILM I were merged into ILM
Holding, Inc. ("ILM Holding"). As part of the fiscal 1994 settlement agreement
with AHC, AHC was retained as the property manager for all of the Senior Housing
Facilities pursuant to the terms of a management agreement which was assigned to
the Company as of September 1, 1995. As discussed further in Item 7, the
agreement with AHC was terminated in July 1996.

     ILM I has elected to be taxed as a REIT under the Internal Revenue Code of
1986, as amended ("the Code"), for each taxable year of operations. In order to
maintain its status as a REIT, 75% of ILM I's annual gross income must be
Qualified Rental Income as defined by the Code. The rent paid by the residents
of the Senior Housing Facilities likely would not be deemed to be Qualified
Rental Income because of the extent of services provided to residents.
Consequently, the operation of the Senior Housing Facilities by ILM I or its
subsidiaries over an extended period of time could adversely affect ILM I's
status as a REIT. Therefore, ILM I formed the Company to operate the Senior
Housing Facilities, and by means of a distribution, transferred the ownership of
the common stock of the Company to the holders of ILM I common stock on
September 1, 1995. Because the Company, which is taxed as a regular C
corporation, is no longer a subsidiary of ILM I, it can receive service-related
income without endangering the REIT status of ILM I.

     On September 1, 1995, after ILM I received the required regulatory
approval, it distributed all of the outstanding shares of capital stock of the
Company to the holders of record of ILM I's common stock. One share of common
stock of the Company was issued for each full share of ILM I's common stock
held. No fractional shares were issued. Holders of ILM I's common stock were not
required to pay any cash or other consideration or to exchange their common
stock of ILM I for the common stock of the Company. Prior to the distribution of
the Company's stock, ILM I's shareholders received an information statement
fully describing the Company and the distribution of its capital stock.

     The Company's sole business is the operation of the Senior Housing
Facilities. The Company leases the Senior Housing Facilities from ILM Holding, a
majority-owned and consolidated affiliate of ILM I, which currently holds title
to the Senior Housing Facilities, pursuant to a master lease which commenced on
September 1, 1995 and expires on December 31, 1999; provided, however, that such
master lease may be terminated earlier by ILM Holding, in connection with a sale
of the Senior Housing Facilities to a non-affiliated third party, upon 30 days
notice to the Company.

     In July 1996, the Company terminated the property management agreement with
AHC and entered into a property management agreement (the "Management
Agreement") with Capital Senior Management 2, Inc. ("Capital") to handle the
day-to-day operations of the Senior Housing Facilities. Since November 1996,
Lawrence A. Cohen, who, until July 28, 1998, served as a Director of the Company
and President, Chief Executive Officer and Director of ILM I, has also served as
Vice Chairman and Chief Financial Officer of Capital Senior Living Corporation,
an affiliate of Capital. As a result, through July 28, 1998, the management
agreement with Capital was considered a related party transaction.

                                      I-1

<PAGE>

                            ILM I LEASE CORPORATION

Item 1. Business (continued)
----------------------------

     The master lease agreement, which commenced on September 1, 1995, is
between ILM Holding, as owner of the properties and lessor, and the Company, as
lessee. The master lease is a "triple-net" lease whereby the lessee pays all
operating expenses, governmental taxes and assessments, utility charges and
insurance premiums, as well as the costs of all required maintenance, personal
property and non-structural repairs in connection with the operation of the
Senior Housing Facilities. ILM Holding, as the lessor, is responsible for all
major capital improvements and structural repairs to the Senior Housing
Facilities. During the initial term of the master lease, which expires on
December 31, 1999, the Company is obligated to pay annual base rent for the use
of all of the Facilities in the aggregate amount of $6,364,800 per year.
Beginning in January 1997 and for the remainder of the lease term, the Company
is also obligated to pay variable rent for each Senior Housing Facility. Such
variable rent is payable quarterly and equals 40% of the excess, if any, of the
aggregate total revenues for the Senior Housing Facilities, on an annualized
basis, over $16,996,000. Variable rent expense related to fiscal years 1998 and
1997 was $894,000 and $315,000, respectively.

     The Senior Housing Facilities which the Company has leased from ILM Holding
as of August 31, 1998 are described below:

<TABLE>
<CAPTION>
                                                                        Rentable      Resident
Property Name and Location (1)             Type of Property               Units      Capacities
------------------------------             ----------------               -----      ----------

<S>                                        <C>                             <C>          <C>
Independence Village of Winston-Salem      Senior Housing Facility         159          161
Winston-Salem, NC

Independence Village of East Lansing       Senior Housing Facility         161          162
East Lansing, MI

Independence Village of Raleigh            Senior Housing Facility         164          205
Raleigh, NC

Independence Village of Peoria             Senior Housing Facility         165          181
Peoria, IL

Crowne Point Apartments                    Senior Housing Facility         135          163
Omaha, NE

Sedgwick Plaza Apartments                  Senior Housing Facility         150          170
Wichita, KS

West Shores                                Senior Housing Facility         136          166
Hot Springs, AR

Villa Santa Barbara (2)                    Senior Housing Facility         125          125
Santa Barbara, CA
</TABLE>

(1)  See Notes to the Financial Statements filed with this Annual Report for a
     description of the agreements through which the Company has leased these
     facilities.

(2)  The Company operates the Villa Santa Barbara facility under a co-tenancy
     arrangement with an affiliated company, ILM II Lease Corporation ("Lease
     II"). The Company and Lease II have entered into a joint tenancy agreement
     which governs the operation of the property and the apportionment of
     revenues and expenses between the parties. Any amounts generated by the
     operations of the Santa Barbara property are equitably apportioned between
     the Company and Lease II (25% and 75%, respectively).

     The Senior Housing Facilities are subject to competition from similar
properties in the vicinities in which they are located. The properties are
located in areas with significant senior citizen populations and, as a result
there are, and will likely continue to be, a variety of competing projects aimed
at attracting senior residents. Such

                                      I-2

<PAGE>

                            ILM I LEASE CORPORATION

Item 1. Business (continued)
----------------------------

projects will generally compete on the basis of rental rates, services,
amenities and location. The Company has no real estate investments located
outside the United States. The Company's sole business is the operation of the
Senior Housing Facilities. Therefore, presentation of information about industry
segments is not applicable.

     Through June 18, 1997, and subject to the supervision of and pursuant to
the general policies set by the Company's Board of Directors, assistance in
managing the business of the Company was provided by PaineWebber Lease Advisor,
L.P. ("PaineWebber"). For discussion purposes, PaineWebber will refer to
PaineWebber Lease Advisor, L.P. and all affiliates of PaineWebber that provided
services to the Company in the past. PaineWebber resigned from this position
effective as of June 18, 1997. PaineWebber agreed to perform certain
administrative services for the Company and its affiliates through August 31,
1997. Through the date of its resignation, PaineWebber performed the day-to-day
operations of the Company and acted as the investment advisor and consultant for
the Company. PaineWebber provided cash management, accounting, tax preparation,
financial reporting, investor communications and relations as well as asset
management services to the Company. These services are now being provided to the
Company, subject to the supervision of the Company's Board of Directors, by
various companies and consultants including Fleet Bank, Ernst & Young LLP,
MAVRICC Management Systems, Inc. and Smith and Company. In addition, C. David
Carlson, who was a Vice President of ILM I until the date of PaineWebber's
resignation and a Vice President of PaineWebber through October 1997, where he
served as Portfolio Manager to the Company, now serves as a consultant to the
Company. The resignation of PaineWebber is discussed further below.

     There are currently three Directors of the Company, none of whom are
affiliates of PaineWebber or the property management company. The Directors are
subject to removal by the vote of the holders of a majority of the outstanding
shares of the Company's common stock.

     The terms of transactions between the Company and PaineWebber and similar
disclosures with respect to relationships of other related parties which provide
services to the Company are set forth in Items 11 and 13 below to which
reference is hereby made for a description of such terms and transactions.

     As discussed further in Item 7, on July 29, 1996, the Company terminated
the property management agreement with AHC and retained Capital to be the
property manager of the Senior Housing Facilities, and ILM I has guaranteed the
payment of all fees due to Capital under the terms of the Management Agreement.
Since November 1996, Lawrence A. Cohen, who, through July 28, 1998, served as a
Director of the Company and President, Chief Executive Officer and Director of
ILM I, has also served as Vice Chairman and Chief Financial Officer of Capital
Senior Living Corporation, an affiliate of Capital. As a result, through July
28, 1998, Capital was considered a related party (see Item 13). Capital earned
property management fees from the Company of $919,000 and $841,000 for the years
ended August 31, 1998 and 1997, respectively.

     At a meeting of the Boards of Directors of ILM I and an affiliated entity,
ILM II Senior Living, Inc., ("ILM II"), formerly PaineWebber Independent Living
Mortgage, Inc., on January 10, 1997, PaineWebber recommended the immediate sale
of the Senior Housing Facilities operated by the Company and held by ILM I as
well as the Senior Housing Facilities held by ILM II, by means of a controlled
auction to be conducted by PaineWebber, at no additional compensation, with
PaineWebber offering to purchase the Senior Housing Facilities held by ILM I and
ILM II for $127 million, thereby guaranteeing the shareholders a "floor" price.
The Senior Housing Facilities operated by the Company under its master lease
with ILM Holding would represent approximately $75 million of this amount. After
taxes and closing costs, net proceeds to ILM I would equal approximately $71
million or approximately $9.41 per share of ILM I common stock. PaineWebber also
stated that if it purchased the properties at the specified price and were then
able to resell the properties at a higher price, PaineWebber would pay any
"excess profits" to the shareholders. To assist the Company and ILM I in
evaluating PaineWebber's proposal, a disinterested, independent investment
banking firm with expertise in healthcare REITs and independent/assisted living
financings was engaged by the Company, ILM I and ILM II and their affiliates.
Following a comprehensive analysis, the investment banking firm recommended that
PaineWebber's proposal should be declined and that

                                      I-3

<PAGE>

                            ILM I LEASE CORPORATION

Item 1. Business (continued)
----------------------------

instead investigation of expansion and restructuring alternatives should be
pursued. After analyzing PaineWebber's proposal and the recommendations and
other information provided by the independent investment banking firm, the
Boards of ILM I and ILM II voted unanimously to decline PaineWebber's proposal
and to explore the alternatives recommended by the independent investment
banking firm. The Boards declined to seek an immediate sale of the properties
because, in the Board's view, the liquidation price would not reflect the "going
concern" values of ILM I and ILM II and, therefore, would not maximize
shareholder value. In addition, the Boards did not consider it advisable to
liquidate ILM I and ILM II on the suggested terms three years prior to their
scheduled termination date.

     PaineWebber indicated to the ILM I and ILM II Boards in its January 10,
1997 proposal that it would not wish to continue to serve as advisor to ILM I,
ILM II and their affiliates if they declined to accept PaineWebber's proposal.
The Company, Lease II, ILM I, and ILM II accepted the resignation of
PaineWebber, effective June 18, 1997. PaineWebber continued to provide certain
administrative services to the Company, Lease II, ILM I, and ILM II through
August 31, 1997, pursuant to the terms of a transition services agreement. The
Company and its affiliates also accepted, effective as of June 18, 1997, the
resignations of those Officers and Directors who were employees of or otherwise
affiliated with PaineWebber.

     The Company and ILM I are continuing to review various strategic
alternatives to maximize shareholder value and liquidity and have engaged
professional financial and legal advisors to formulate and present plans and
proposals for consideration by the Board. Although no definitive plans,
arrangements or understandings have been agreed to at this time, ILM I is
actively reviewing the feasibility of a variety of financial transactions and
proposals, including the reorganization of the ownership of the Senior Housing
Facilities, business combinations with third parties and the sale of ILM I by
means of cash and or stock-for-stock merger. There can be no assurance that any
definitive transaction will be formulated, agreed to or consummated. In
addition, because the master lease is due to terminate on December 31, 1999, but
could be terminated earlier by ILM Holding if the Senior Housing Facilities are
sold by ILM Holding, the Company's operations would not be expected to continue
beyond the date of any such transaction.

Item 2. Properties
------------------

     As of August 31, 1998, the Company has leased the eight operating
properties referred to under Item 1 to which reference is made for the
description, name and location of such properties.

     Average occupancy levels for each fiscal quarter during 1998, along with an
average for the year, are presented below for each property:

<TABLE>
<CAPTION>
                                                                Average Quarterly Occupancy
                                         ---------------------------------------------------------------------------
                                                                                                         Fiscal 1998
                                            11/30/97        2/28/98        5/31/98         8/31/98         Average
                                            --------        -------        -------         -------       -----------
<S>                                           <C>             <C>            <C>             <C>             <C>
Independence Village
   of Winston-Salem                           96%             95%            94%             92%             94%

Independence Village
   of East Lansing                            93%             95%            94%             94%             94%

Independence Village of Raleigh               96%             97%            98%             96%             97%

Independence Village of Peoria                99%             99%            98%             99%             99%

Crown Pointe Apartments                       98%             99%            98%             96%             98%

Sedgwick Plaza Apartments                     91%             90%            89%             91%             90%

West Shores                                   95%             93%            98%             97%             96%

Villa Santa Barbara                           96%             97%            95%             96%             96%
</TABLE>

                                      I-4

<PAGE>

                            ILM I LEASE CORPORATION

Item 3. Legal Proceedings
-------------------------

     On July 29, 1996, Lease I and ILM Holding (collectively for this Item 3,
the "Companies") terminated a property management agreement with AHC, which
covered the eight Senior Housing Facilities leased by Lease I from ILM Holding
and engaged Capital as property manager. The management agreement with AHC was
terminated for cause pursuant to Sections 1.05(a)(i), (iii) and (iv) of the
agreement. Simultaneously with the termination of the management agreement, the
Companies, together with certain affiliated entities, filed suit against AHC in
the United States District Court for the Eastern District of Virginia for breach
of contract, breach of fiduciary duty and fraud. The Companies alleged, among
other things, that AHC willfully performed actions specifically in violation of
the management agreement and that such actions caused damages to the Companies.

     Due to the termination of the agreement for cause, no termination fee was
paid to AHC. Subsequent to the termination of the management agreement, AHC
filed for protection under Chapter 11 of the U.S. Bankruptcy Code in its
domestic state of California. The filing was challenged by the Companies, and
the Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
November 1996, AHC filed with the Virginia District Court an Answer in response
to the litigation initiated by the Companies and a counterclaim against ILM
Holding. The counterclaim alleged that the management agreement was wrongfully
terminated for cause and requested damages which included the payment of the
termination fee in the amount of $1,250,000, payment of management fees pursuant
to the contract from August 1, 1996 through October 15, 1996, which is the
earliest date that the agreement could have been terminated without cause, and
recovery of attorney's fees and expenses.

     The aggregate amount of damages against all parties as requested in AHC's
counterclaim exceeded $2,000,000. ILM I had guaranteed the payment of a
termination fee at issue in these proceedings to the extent that any termination
fee was deemed payable by the court and in the event that the Company failed to
perform pursuant to its obligations under the management agreement. On June 13,
1997 and July 8, 1997, the court issued orders to enter judgment against ILM I
and ILM II in the amount of $1,000,000 (the "Orders"). The Orders do not contain
any findings of fact or conclusions of law. On July 10, 1997, the Company, ILM
I, ILM II and Lease II filed a notice of appeal to the United States Court of
Appeals for the Fourth Circuit from the Orders.

     On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, the new property manager; Lawrence A.
Cohen, who, through July 28, 1998 was a Director of the Company and President,
Chief Executive Officer and Director of ILM I, and others alleging that the
defendants intentionally interfered with AHC's property management agreement
(the "California litigation"). The complaint sought damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to Federal
District Court in the Central District of California. At a Board meeting on
February 26, 1997, the Company's Board of Directors concluded that since all of
Mr. Cohen's actions relating to the California litigation were taken either on
behalf of the Company under the direction of the Board or as a PaineWebber
employee, the Company or its affiliates should indemnify Mr. Cohen with respect
to any expenses arising from the California litigation, subject to any insurance
recoveries for those expenses. Legal fees paid by the Company and Lease II on
behalf of Mr. Cohen totaled $227,000 as of August 31, 1998. The Company's Board
also concluded that, subject to certain conditions, the Company or its
affiliates should advance up to $20,000 to pay reasonable legal fees and
expenses incurred by Capital in the California litigation. Subsequently, the
Boards of Directors of the Company and Lease II voted to increase the maximum
amount of the advance to Capital to $100,000. By the end of November 1997,
Capital had incurred $100,000 of legal expenses in the California litigation. On
February 2, 1998, the amount to be advanced to Capital was increased to include
75% of the California litigation legal fees and costs incurred by Capital for
December 1997 and January 1998, plus 75% of such legal fees and costs incurred
by Capital thereafter, not to exceed $500,000. By August 31, 1998 Capital had
incurred $683,000 of legal expenses in the California litigation. At August 31,
1998, the amount of legal fees either advanced to Capital or accrued on the
financial statements of Lease I and Lease II for Capital's California litigation
costs totaled approximately $519,000, although the final amount to be reimbursed
to Capital has not yet been determined.

                                      I-5

<PAGE>

                            ILM I LEASE CORPORATION

Item 3. Legal Proceedings (continued)
-------------------------------------

     On August 18, 1998, the Company and its affiliates along with Capital and
its affiliates entered into a settlement agreement with AHC. The Company and
Lease II agreed to pay $1,625,000 and Capital and its affiliates agreed to pay
$625,000 to AHC in settlement of all claims including those related to the
Virginia litigation and the California litigation. The Company and its
affiliates also entered into an agreement with Capital and its affiliates to
mutually release each other from all claims that any such parties may have
against each other, other than any claims under the property management
agreements. The Company's Board of Directors believes that settling the AHC
litigation is a prudent course of action because the settlement amount
represents a small percentage of the increases in cash flow and value achieved
for the Company and its affiliates over the past two years.

     Due to the Order, $1,000,000 had been recorded as a liability by the
Company and Lease II at the end of fiscal year 1997. At August 31, 1997, a
provision of $600,000 for the liability which might have resulted to the Company
had been recorded as "termination for payable" in the financial statements of
the Company, with the remaining $400,000 provision recorded by Lease II. Due to
the final settlement agreement, the 1997 provisions were increased by $625,000
at August 31, 1998. An additional provision of $375,000 was recorded in the
financial statements of the Company with the remaining $250,000 recorded in the
financial statements of Lease II. On September 4, 1998, subsequent to the end of
the fiscal year, the full settlement amounts were paid to AHC and its
affiliates.

Item 4. Submission of Matters to a Vote of Security Holders
-----------------------------------------------------------

     At the Annual Meeting of Shareholders held on July 28, 1998, Julien G.
Redele, Jeffry R. Dwyer, and J. William Sharman, Jr., were elected to serve as
Directors of the Company until the 1999 Annual Meeting, and the designation of
Ernst & Young LLP as auditors for the fiscal year ending August 31, 1998, was
ratified. Jeffry R. Dwyer has served as a Director since September 13, 1994, the
date of incorporation of the Company. J. William Sharman, Jr., has served as a
Director of the Company since September 18, 1997.

                                      I-6

<PAGE>

                            ILM I LEASE CORPORATION

                                     PART II
                                     -------

Item 5. Market for the Registrant's Shares and Related Stockholder Matters
--------------------------------------------------------------------------

     Prior to September 1, 1995, the Company was a wholly-owned subsidiary of
ILM I. Pursuant to a reorganization and distribution agreement, ILM I
capitalized the Company with $700,000, an amount estimated to provide the
Company with necessary working capital. On September 1, 1995, MAVRICC Management
Systems, Inc., as the distribution agent, caused to be issued on the stock
records of the Company the distributed common stock of the Company, in
uncertificated form, to the holders of record of ILM I common stock at the close
of business on July 14, 1995. One share of the Company's common stock was
distributed for each outstanding share of ILM I common stock. No certificates or
scrip representing fractional shares of the Company's common stock were issued
to holders of ILM I common stock as part of the distribution. In lieu of
receiving fractional shares, each holder of ILM I common stock who would
otherwise have been entitled to receive a fractional share of the Company's
common stock received a cash payment equivalent to $0.15 per share for such
fractional interest. At August 31, 1998, there were 5,103 record holders of the
Company's shares. The shares do not trade on an established exchange and the
only market that has developed is a secondary market. Although PaineWebber and
others may endeavor to assist Shareholders desiring to sell their shares by
attempting to match requests to sell shares with requests to purchase shares,
such transfers are not expected to be frequent.

     The Company did not pay cash dividends in fiscal years 1998, 1997 and 1996.
The Company intends to review this policy during fiscal 1999, and may or may not
determine to pay cash dividends in the future. Payment of dividends, if any,
will be at the discretion of the Company's Board of Directors and will depend
upon such factors as the Company's financial condition, earnings, anticipated
investments and other relevant factors.

Item 6. Selected Financial Data
-------------------------------

                                              ILM I Lease Corporation
                                   (Dollars in thousands, except per share data)

<TABLE>
<CAPTION>
                                             For the year ended       For the year ended     For the year ended
                                               August 31, 1998          August 31, 1997        August 31, 1996
                                            --------------------     -------------------    -------------------

<S>                                                 <C>                     <C>                   <C>    
Revenues                                            $19,294                 $18,121               $ 17,285

Income (loss) before income taxes                   $  (435)                $  (479)              $    603

Income tax expense (benefit)                        $   (54)                $  (192)              $    241

Net income (loss)                                   $  (381)                $  (287)              $    362
                                                  =========               =========             ==========
Net income (loss) per share of
   common stock                                     $ (0.05)                $ (0.04)              $   0.05
                                                  =========               =========             ==========

Total assets                                        $ 3,198                 $ 2,633               $  2,797

Shares outstanding                                7,519,430               7,519,430             7,519,430
</TABLE>

     The above selected financial data should be read in conjunction with the
financial statements and related notes appearing in item 14 in this annual
report.

                                      II-1

<PAGE>

                            ILM I LEASE CORPORATION

Item 7. Management's Discussion and Analysis of Financial Condition and Results
-------------------------------------------------------------------------------
of Operations
-------------

Liquidity and Capital Resources

       The Company was formed in 1995 by ILM I, a publicly-held, non-traded
REIT, for the purpose of operating eight Senior Housing Facilities under the
terms of a master lease agreement. ILM I contributed $700,000 in return for all
of the issued and outstanding shares of the Company's common stock. ILM I had
originally made mortgage loans secured by the Senior Housing Facilities to AHC
between June 1989 and July 1992. In March 1993, AHC defaulted under the terms of
such mortgage loans and in connection with the settlement of such default, title
to the Senior Housing Facilities was transferred, effective April 1, 1994, to
certain majority-owned, indirect subsidiaries of ILM I, subject to the mortgage
loans. Subsequently, these indirect subsidiaries were merged into ILM Holding,
which is also a majority-owned subsidiary of ILM I. As part of the fiscal 1994
settlement agreement with AHC, AHC was retained as the property manager for the
Senior Housing Facilities pursuant to the terms of an agreement which was
assigned to the Company as of September 1, 1995. As discussed further below, the
agreement with AHC was terminated in July 1996.

       ILM I has elected to be taxed as a REIT under the Internal Revenue Code
of 1986, as amended ("the Code"), for each taxable year of operations. In order
to maintain its status as a REIT, 75% of ILM I's annual gross income must be
Qualified Rental Income as defined by the Code. The rent paid by the residents
of the Senior Housing Facilities likely would not be deemed to be Qualified
Rental Income because of the extent of services provided to residents.
Consequently, the operation of the Senior Housing Facilities by ILM I or its
subsidiaries over an extended period of time could adversely affect ILM I's
status as a REIT. Therefore, ILM I formed the Company to operate the Senior
Housing Facilities, and by means of a distribution, transferred the ownership of
the common stock of the Company to the holders of ILM I common stock. Because
the Company, which is taxed as a regular C corporation, is no longer a
subsidiary of ILM I, it can receive service-related income without endangering
the REIT status of ILM I. On September 1, 1995, after ILM I received the
required regulatory approval, it distributed all of the outstanding shares of
capital stock of the Company to the holders of record of ILM I's common stock.
One share of common stock of the Company was issued for each full share of ILM
I's common stock held. No fractional shares were issued. Holders of ILM I's
common stock were not required to pay any cash or other consideration or to
exchange their common stock of ILM I for the common stock of the Company. Prior
to the distribution of the Company's stock, ILM I's shareholders received an
information statement fully describing the Company and the distribution of its
capital stock.

       The master lease agreement, which commenced on September 1, 1995, is
between ILM Holding, as owner of the properties and lessor, and the Company, as
lessee. The master lease is a "triple-net" lease whereby the Company, as the
lessee, pays all operating expenses, governmental taxes and assessments, utility
charges and insurance premiums, as well as the costs of all required
maintenance, personal property and non-structural repairs in connection with the
operation of the Senior Housing Facilities. ILM Holding, as the lessor, is
responsible for all major capital improvements and structural repairs to the
Senior Housing Facilities. If the Company and ILM Holding decide that any of the
Senior Housing Facilities should be expanded, the master lease agreement between
the Company and ILM Holding would be amended to include such expansion. During
the initial term of the master lease, which expires on December 31, 1999, the
Company is obligated to pay annual base rent for the use of all of the Senior
Housing Facilities in the aggregate amount of $6,364,800 each year. Beginning in
January 1997 and for the remainder of the lease term, the Company is also
obligated to pay variable rent for each Senior Housing Facility. Such variable
rent is payable quarterly and equals 40% of the excess, if any, of the aggregate
total revenues for the Senior Housing Facilities, on an annualized basis, over
$16,996,000. Variable rent expense related to the years ended August 31, 1998
and 1997, respectively, was $894,000 and $315,000.

                                      II-2

<PAGE>

                            ILM I LEASE CORPORATION

Item 7. Management's Discussion and Analysis of Financial Condition and Results
-------------------------------------------------------------------------------
of Operations (continued)
-------------------------

     As noted above, the Company's master lease is scheduled to expire on
December 31, 1999. Accordingly, since the Company does not have any current
plans to operate or own any other facilities or engage in any other business
outside of its relationship with ILM I, there is no assurance that the Company's
operations will continue beyond December 1999. The master lease may be
terminated earlier, however, by ILM Holding upon 30 days notice to the Company
in connection with a sale to a non-affiliated third party of the Senior Housing
Facilities.

     On July 29, 1996, the Company terminated the agreement with AHC covering
eight Senior Housing Facilities leased by the Company (see "Item 3, Legal
Proceedings") and retained Capital to be the manager of the Senior Housing
Facilities. Lawrence A. Cohen, who, through July 28, 1998 served as a Director
of the Company and President, Chief Executive Officer and Director of ILM I, has
also served as Vice Chairman and Chief Financial Officer of Capital Senior
Living Corporation, an affiliate of Capital, since November 1996. As a result,
until July 28, 1998, Capital was considered a related party. Under the terms of
the management agreement, Capital earns a base management fee equal to 4% of the
gross operating revenues of the Senior Housing Facilities, as defined, as well
as an incentive management fee equal to 25% of the amount by which net cash flow
of the Senior Housing Facilities, as defined, exceeds a specified base amount.
Each August 31, beginning on August 31, 1997, the base amount is increased based
on the percentage increase in the consumer price index as well as 15% of
facility expansion costs. ILM I has guaranteed the payment of all fees due to
Capital under the terms of the management agreement.

     On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, the new property manager; Lawrence A.
Cohen, who, through July 28, 1998 was a Director of the Company and President,
Chief Executive Officer and Director of ILM I, and others alleging that the
defendants intentionally interfered with AHC's property management agreement
(the "California litigation"). The complaint sought damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to Federal
District Court in the Central District of California. At a Board meeting on
February 26, 1997, the Company's Board of Directors concluded that since all of
Mr. Cohen's actions relating to the California litigation were taken either on
behalf of the Company under the direction of the Board or as a PaineWebber
employee, the Company or its affiliates should indemnify Mr. Cohen with respect
to any expenses arising from the California litigation, subject to any insurance
recoveries for those expenses. Legal fees paid by the Company and Lease II on
behalf of Mr. Cohen totaled $227,000 as of August 31, 1998. The Company's Board
also concluded that, subject to certain conditions, the Company or its
affiliates should advance up to $20,000 to pay reasonable legal fees and
expenses incurred by Capital in the California litigation. Subsequently, the
Boards of Directors of the Company and Lease II voted to increase the maximum
amount of the advance to Capital to $100,000. By the end of November 1997,
Capital had incurred $100,000 of legal expenses in the California litigation. On
February 2, 1998, the amount to be advanced to Capital was increased to include
75% of the California litigation legal fees and costs incurred by Capital for
December 1997 and January 1998, plus 75% of such legal fees and costs incurred
by Capital thereafter, not to exceed $500,000.

     By August 31, 1998 Capital had incurred $683,000 of legal expenses in the
California litigation. At August 31, 1998, the amount of legal fees either
advanced to Capital or accrued on the financial statements of Lease I and Lease
II for Capital's California litigation costs totaled approximately $519,000,
although the final amount to be reimbursed to Capital has not yet been
determined.

     Occupancy levels for the eight properties which the Company leases from ILM
Holding averaged 96% for the year ended August 31, 1998. The Senior Housing
Facilities have generated sufficient net cash flow to cover the base master
lease payments at their current level of $6,364,800 per year since the inception
of the Company's operations. As noted above, the master lease also provides for
the payment of variable rent beginning in January 1997. The Senior Housing
Facilities are currently generating gross revenues which are in excess of the
specified threshold in the variable rent calculation, as discussed further
above. Accordingly, the Company had variable rental expense in fiscal years 1998
and 1997 in the amount of $894,000 and $315,000, respectively.

                                      II-3

<PAGE>

                            ILM I LEASE CORPORATION

Item 7. Management's Discussion and Analysis of Financial Condition and Results
-------------------------------------------------------------------------------
of Operations (continued)
-------------------------

     At August 31, 1998, the Company had cash and cash equivalents of
$1,897,000. Such amounts will be used for the Company's working capital
requirements. As noted above, under the terms of the master lease, the Lessor is
responsible for any major capital improvements or structural repairs to the
Senior Housing Facilities. Consequently, the Company does not have any material
commitments for capital expenditures. Furthermore, the Company does not
currently anticipate the need to engage in any borrowing activities. As a
result, substantially all of the Company's cash flow will be generated from
operating activities. The Company did not pay cash dividends in fiscal years
1998, 1997 and 1996. The Company intends to review this policy during fiscal
1999, and may or may not determine to pay cash dividends in the future. Payment
of dividends, if any, will be at the discretion of the Company's Board of
Directors and will depend upon such factors as the Company's financial
condition, earnings, anticipated investments and other relevant factors. The
source of future liquidity is expected to be from operating cash flow from the
Senior Housing Facilities, net of the master lease payments to ILM Holding, and
interest income earned on invested cash reserves. Such sources of liquidity are
expected to be adequate to meet the Company's operating requirements on both a
short-term and long-term basis.

     The Company relies upon PC-based systems and does not expect to incur
material costs to transition to Year 2000 compliant systems in its internal
operations. The Company does not expect this project to have a significant
effect on operations. The Company will continue to implement systems and all new
investments are expected to be with Year 2000 compliant software.

Results of Operations

1998 Compared to 1997
---------------------

     Revenues. Total revenues were $19,294,000 for the year ended August 31,
1998 compared to $18,121,000 for the year ended August 31, 1997, representing an
increase of $1,173,000 or 6.5%. Rental and other income from the Company's
senior housing operations increased $1,183,000 primarily as a result of improved
occupancies and increases in rental rates at certain of the facilities located
in strong markets.

     Expenses. Total expenses were $19,729,000 in fiscal 1998 compared to
$18,600,000 in fiscal 1997, representing an increase of $1,129,000 or 6.1%. This
increase was principally comprised of increases in master lease expense of
$579,000, dietary and food service salaries, wages and expenses of $135,000,
general and administrative expenses of $593,000, property management fees of
$78,000, and additional termination fee expense incurred in fiscal 1998 of
$375,000 (see "Item 3, Legal Proceedings"). In addition, total charges to
depreciation expense in 1998 include additional depreciation expense of $136,000
in recognition of changes in remaining useful life for certain assets purchased
in 1997 and prior to conform to the lease termination date, as such assets are
not subject to repurchase by ILM Holding. These increases were offset, in part,
by a decrease in administrative salaries, wages and expenses of $59,000,
marketing salaries, wages and expenses of $27,000, other property operating
expenses of $88,000 and advisory fees of $70,000. The increase in master lease
expense is the result of variable rents due under the Master Lease Agreement in
1998. General and administrative expense increased as a result of higher AHC
litigation expenses in 1998 coupled with the analysis of restructuring
alternatives performed by an independent investment banking firm. The increases
in other operating costs cited above were the result of higher operating levels
associated with improved occupancies.

     Income tax expense. Income tax benefit decreased from $192,000 in fiscal
1997 to a benefit of $54,000 in fiscal 1998, after giving effect to the $120,000
valuation allowance in 1998 on the Company's deferred tax asset. The effective
income tax rate was 7% in fiscal 1998 and 40% in fiscal 1997. The 1997 deferred
tax provision reflects a reclassification of $240,000 of current tax expense in
1997, which was ultimately determined to be deductible in 1998.

     Net income (loss). Primarily as a result of the factors discussed above,
net loss increased from a net loss of $287,000 in fiscal 1997 to a net loss of
$381,000 in fiscal 1998.

                                      II-4

<PAGE>

                            ILM I LEASE CORPORATION


Item 7. Management's Discussion and Analysis of Financial Condition and Results
-------------------------------------------------------------------------------
of Operations (continued)
-------------------------

1997 Compared to 1996
---------------------

     Revenues. Total revenues were $18,121,000 for the year ended August 31,
1997, compared to $17,285,000 for the year ended August 31, 1996, representing
an increase of $836,000, or 4.8%. Rental and other income from the Company's
senior housing operations increased $822,000, primarily as a result of improved
occupancies and increases in rental rates at certain of the facilities located
in strong markets.

     Expenses. Total expenses were $18,600,000 in 1997 compared to $16,682,000
in 1996, representing an increase of $1,918,000 or ll.5%. This increase was
principally comprised of increases in master lease expense of $315,000, dietary
and food service salaries, wages and expenses of $262,000, administrative
salaries, wages and expenses of $171,000, general and administrative expenses of
$545,000 and other property operating expenses of $136,000, as well as the
$600,000 termination fee expense which was accrued in 1997 (see "Item 3, Legal
Proceedings"). These increases were offset, in part, by a decrease in property
management fees as a result of the July Master Lease Agreement for the first
time in 1997. General and administrative expense increased as a result of higher
AHC litigation expenses in 1997 coupled with the analysis of restructuring
alternatives performed by an independent investment banking firm. The increases
in other operating costs cited above were the result of higher operating levels
associated with improved occupancies and the implementation of a health
insurance program for property-level staff.

     Income tax expense. Income tax expense decreased from $241,000 in 1996 to a
benefit of $192,000 in 1997 as a result of a net loss before taxes of $479,000
as the effective income tax rate was 40% in both years.

     Net income. Primarily as a result of the factors discussed above, net
income decreased from $362,000 in 1996 to a net loss of $287,000 in 1997.

Inflation
---------

     The Company completed its third full year of operations in fiscal 1998. The
effects of inflation and changes in prices on the Company's operating results to
date have not been significant.

     Inflation in future periods is likely to cause increases in the Company's
expenses, which may be partially offset by increases in revenues from the tenant
leases at the Senior Housing Facilities. Rental revenues may tend to rise with
inflation since the rental rates on the tenant leases, which are short-term in
nature, can be adjusted to keep pace with inflation as market conditions allow.
As noted above, under the terms of the master lease agreement between the
Company and ILM Holding, the Company is obligated to pay variable rent, in
addition to the base rent owed, in an amount equal to 40% of the excess of total
revenues from the Senior Housing Facilities over a specified base amount.
Accordingly, to the extent that the total revenues are in excess of this
threshold, a portion of the increase in revenues would be payable to the Lessor.

Item 8. Financial Statements and Supplementary Data
---------------------------------------------------

     The financial statements and supplementary data are included under Item 14
of this annual report.

Item 9. Changes in and Disagreements with Accountants on Accounting and
-----------------------------------------------------------------------
Financial Disclosure
--------------------

     None.

                                      II-5

<PAGE>

                            ILM I LEASE CORPORATION

Item 7. Management's Discussion and Analysis of Financial Condition and Results
-------------------------------------------------------------------------------
of Operations (continued)
-------------------------

Forward-Looking Information

     CERTAIN STATEMENTS INCLUDED IN THIS ANNUAL REPORT ON FORM 10-K ("ANNUAL
REPORT") CONSTITUTE "FORWARD-LOOKING STATEMENTS" INTENDED TO QUALIFY FOR THE
SAFE HARBORS FROM LIABILITY ESTABLISHED BY SECTION 27A OF THE SECURITIES ACT OF
1933, AS AMENDED (THE "SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES ACT
OF 1934, AS AMENDED (THE "EXCHANGE ACT"). THESE FORWARD-LOOKING STATEMENTS
GENERALLY CAN BE IDENTIFIED AS SUCH BECAUSE THE CONTEXT OF THE STATEMENT WILL
INCLUDE WORDS SUCH AS "BELIEVES," "COULD," "MAY," "SHOULD," "ENABLE," "LIKELY,"
"PROSPECTS," "SEEK," "PREDICTS," "POSSIBLE," "FORECASTS," "PROJECTS,"
"ANTICIPATES," "EXPECTS" AND WORDS OF ANALOGOUS IMPORT AND CORRELATIVE
EXPRESSIONS THEREOF, AS WELL AS STATEMENTS PRECEDED OR OTHERWISE QUALIFIED BY:
"THERE CAN BE NO ASSURANCE" OR "NO ASSURANCE CAN BE GIVEN." SIMILARLY,
STATEMENTS THAT DESCRIBE THE COMPANY'S FUTURE PLANS, OBJECTIVES, STRATEGIES OR
GOALS ALSO ARE FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS MAY ADDRESS FUTURE
EVENTS AND CONDITIONS CONCERNING, AMONG OTHER THINGS, THE COMPANY'S CASH FLOWS,
RESULTS OF OPERATIONS AND FINANCIAL CONDITION; THE CONSUMMATION OF ACQUISITION
AND FINANCING TRANSACTIONS AND THE EFFECT THEREOF ON THE COMPANY'S BUSINESS,
ANTICIPATED CAPITAL EXPENDITURES, PROPOSED OPERATING BUDGETS AND ACCOUNTING
RESERVES; LITIGATION; PROPERTY EXPANSION AND DEVELOPMENT PROGRAMS OR PLANS;
REGULATORY MATTERS; AND THE COMPANY'S PLANS, GOALS, STRATEGIES AND OBJECTIVES
FOR FUTURE OPERATIONS AND PERFORMANCE. ANY SUCH FORWARD-LOOKING STATEMENTS ARE
SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN SUCH FORWARD-LOOKING
STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO A NUMBER OF
ASSUMPTIONS REGARDING, AMONG OTHER THINGS, GENERAL ECONOMIC, COMPETITIVE AND
MARKET CONDITIONS. SUCH ASSUMPTIONS NECESSARILY ARE BASED ON FACTS AND
CONDITIONS AS THEY EXIST AT THE TIME SUCH STATEMENTS ARE MADE, THE PREDICTION OR
ASSESSMENT OF WHICH MAY BE DIFFICULT OR IMPOSSIBLE AND, IN ANY CASE, BEYOND THE
COMPANY'S CONTROL. FURTHER, THE COMPANY'S BUSINESS IS SUBJECT TO A NUMBER OF
RISKS THAT MAY AFFECT ANY SUCH FORWARD-LOOKING STATEMENTS AND ALSO COULD CAUSE
ACTUAL RESULTS OF THE COMPANY TO DIFFER MATERIALLY FROM THOSE PROJECTED OR
IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. ALL FORWARD-LOOKING STATEMENTS
CONTAINED IN THIS ANNUAL REPORT ARE EXPRESSLY QUALIFIED IN THEIR ENTIRETY BY THE
CAUTIONARY STATEMENTS IN THIS PARAGRAPH. MOREOVER, THE COMPANY DOES NOT INTEND
TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS TO REFLECT ANY CHANGES IN
GENERAL ECONOMIC, COMPETITIVE OR MARKET CONDITIONS AND DEVELOPMENTS BEYOND ITS
CONTROL.

     READERS OF THIS ANNUAL REPORT ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON
ANY OF THE FORWARD-LOOKING STATEMENTS SET FORTH HEREIN AND THE COMPANY MAKES
ABSOLUTELY NO PROMISES, GUARANTEES, REPRESENTATIONS OR WARRANTIES AS TO THE
ACCURACY THEREOF.

                                      II-6

<PAGE>


                             ILM I LEASE CORPORATION


                                    PART III
                                    --------

Item 10. Directors and Executive Officers of the Registrant
-----------------------------------------------------------

     There currently are three Directors of the Company. The Directors are
subject to removal by the vote of the holders of a majority of the outstanding
shares of the Company's common stock. The Directors are responsible for the
general policies of the Company, but they are not required to personally conduct
the business of the Company in their capacities as Directors.

     (a) and (b) The names and ages of the Directors and Executive Officers of
     the Company during fiscal 1998 are as follows:

<TABLE>
<CAPTION>
                                                                                     Dates
     Name                        Office                                     Age      of Office
     ----                        ------                                     ---      ---------

     <S>                         <C>                                        <C>      <C>
     Julien G. Redele            President and Director                     63       7/28/98-present
     Jeffry R. Dwyer             Secretary and Director                     52       9/13/94*-present
     J. William Sharman, Jr.     Director                                   58       9/18/97-present

     Lawrence A. Cohen           Director                                   45       9/13/94*-9/28/98
     John B. Watts III           Director                                   45       9/13/94*-9/28/98
</TABLE>

     * The date of incorporation of the Company.

     (c) There is no family relationship among any of the current Directors or
     Officers. All of the current Directors and Officers of the Company have
     been elected to serve until the Company's next annual meeting.

     (d) The business experience of each of the Directors and Executive Officers
     of the Company is as follows:

     Julien G. Redele is one of the original founders of SFRE, Inc., a Dutch
owned real estate investment and development firm which has served since 1963 as
advisor to Dutch institutional, corporate and individual investors active in the
United States. Mr. Redele serves as a Director of the Island Preservation
Partnership. Mr. Redele attended Westersingel Business School, Rotterdam, where
he studied economics, law and finance. Mr. Redele also presently serves as
President and Director of Lease II.

     Jeffry R. Dwyer is Secretary and Director of the Company. Mr. Dwyer has
been a shareholder of Greenberg Traurig, which has provided legal services to
the Company and its affiliates since June 1997. From 1993 to 1997 Mr. Dwyer was
a partner with the law firm of Akin, Gump, Strauss, Hauer & Feld in the District
of Columbia. Prior to joining Akin, Gump, Strauss, Hauer & Feld, Mr. Dwyer was a
partner with the law firm of Morrison & Foerster from 1989 to 1993. Mr. Dwyer
also presently serves as Secretary and a Director of ILM I, ILM II and Lease II.
Mr. Dwyer has written several law review articles and a major treatise on real
estate financing and taught Real Estate Planning as an Adjunct Professor at the
Georgetown University law Center. Mr. Dwyer graduated from Georgetown University
and received his law degree from the Georgetown University Law Center.

     J. William Sharman, Jr. was President and Director of the Company until
July 28, 1998, when Julien G. Redele succeeded him as President. Mr. Sharman is
also a Director of Lease II. Mr. Sharman is the Chairman of the Board and CEO of
Lancaster Hotels and Resorts, Inc., a hotel management company. Mr. Sharman
served for ten years as Chairman of the Board and President of the Lancaster
Group, Inc., a real estate development firm based in Houston, Texas, which is
the predecessor of Lancaster Hotel Management, L.C. and Bayou Equities, Inc. Mr.
Sharman serves as a Director of Small Luxury Hotels, Ltd. of the United Kingdom,
an international hotel marketing and reservations firm, and also serves on the
Board of Trustees of St. Edwards University in Austin, Texas. Mr. Sharman also
presently serves as President and Director of ILM I and ILM II. He has a
Bachelor of Science degree from the University of Notre Dame.


                                      III-1
<PAGE>


                             ILM I LEASE CORPORATION


Item 10. Directors and Executive Officers of the Registrant (continued)
-----------------------------------------------------------------------

     Lawrence A. Cohen served as Director of the Company from inception until
July 28, 1998. In November 1996, he also became Vice Chairman and Chief
Financial Officer of Capital Senior Living Corporation, an affiliate of Capital,
which was contracted by the Company in July 1996 to perform property management
services for the Senior Housing Facilities. Mr. Cohen was President and Chief
Executive Officer of PaineWebber Properties Incorporated until August 1996. Mr.
Cohen joined PaineWebber in January 1989 as its Executive Vice President and
Director of Marketing and Sales. Mr. Cohen had also been a Director of Lease II
and President, Chief Executive Officer and Director of ILM I and ILM II until
July 28, 1998. Mr. Cohen received his LL.M. (in Taxation) from New York
University School of Law and his J.D. degree from St. John's University School
of Law. Mr. Cohen received his B.B.A. degree in accounting from George
Washington University. He is a member of the New York Bar and is a Certified
Public Accountant.

     John B. Watts III was a Director of the Company and of Lease II until July
28, 1998. Mr. Watts currently directs institutional real estate acquisitions for
the PNL Companies in New York. Mr. Watts was Senior Vice President and Director
of Real Estate Advisory and Portfolio Management at PaineWebber, where he was
employed from June 1988 to August 1996. Mr. Watts has over 19 years of
experience in acquisitions, dispositions and finance of real estate and has
directed the portfolios of real estate partnerships and REITS. He received
degrees of Bachelor of Architecture, Bachelor of Arts and Master of Business
Administration from the University of Arkansas.

     (e) Except for the Feldman litigation as discussed below, none of the
current Directors and Officers were involved in legal proceedings which are
material to an evaluation of his or her ability or integrity as a Director or
Officer. On May 8, 1998 Andrew A. Feldman and Jeri Feldman, as Trustees for the
Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990 commenced a
purported class action on behalf of that trust and all other shareholders of ILM
I and ILM II (affiliates of the Company, as previously described) in the Supreme
Court of the State of New York, County of New York against ILM I, ILM II and
Lawrence A. Cohen, Jeffry R. Dwyer, Julien G. Redele, Carl J. Schramm and J.
William Sharman, Jr. as the Directors of both corporations. The class action
complaint alleges that the Directors engaged in wasteful and oppressive conduct
and breached fiduciary duties in preventing the sale or liquidation of the
assets of ILM I and ILM II, diverting certain of their assets and changing the
nature of ILM I and ILM II. The complaint seeks damages in an unspecified
amount, punitive damages, the judicial dissolution of ILM I and ILM II, an order
requiring the Directors to take all steps to maximize shareholder value,
including either an auction or liquidation, and rescinding certain agreements,
and attorney's fees. On July 8, 1998, the defendants moved to dismiss the
complaint on all counts.

     Subsequent to the end of the fiscal year, in an oral ruling from the bench
on December 8, 1998, the Court granted the Company's dismissal motion in part
and gave the plaintiffs leave to amend their complaint. In sum, the Court
accepted the defendant's position that all claims relating to so-called
"derivative" actions were filed improperly and were properly dismissed. In
addition, the Court dismissed common law claims for punitive damages, but
allowed plaintiffs 30 days to allege any claims which allegedly injured
shareholders without injuring ILM I as a whole. The defendants doubt that such a
cause of action could be alleged and continue to believe that this lawsuit is
meritless. The defendants have directed outside counsel to continue vigorously
contesting the action.

     (f) Compliance With Exchange Act Filing Requirements: The Securities
Exchange Act of 1934 requires the Officers and Directors of the Company, and
persons who own more than ten percent of the Company's outstanding common stock,
to file certain reports of ownership and changes in ownership with the
Securities and Exchange Commission. Officers, Directors and ten-percent
beneficial holders are required by SEC regulations to furnish the Company with
copies of all Section 16(a) forms they file.

     Based solely on its review of the copies of such forms received by it, the
Company believes that, during the year ended August 31, 1998, there was
compliance with all filing requirements applicable to its Officers and Directors
and ten-percent beneficial holders.


                                      III-2
<PAGE>


                             ILM I LEASE CORPORATION


Item 11. Executive Compensation
-------------------------------

     The Company's Directors each receive annual compensation of $12,000 plus
$500 for attending each Board of Directors meeting and reimbursement for
expenses incurred in attending meetings and as a result of other work performed
for the Company. Officers of the Company are not compensated.

     Lawrence A. Cohen, who was a Director of the Company until July 28, 1998,
received compensation from and was an employee of Capital Senior Living
Corporation, an affiliate of Capital, a related party.

     Jeffry R. Dwyer receives compensation from and is a shareholder of
Greenberg Traurig, which acts as Counsel to the Company and its affiliates.

     The former officers of the Company who were also officers of PaineWebber
received compensation from PaineWebber which indirectly related to services to
the Company because the Company was required to pay certain fees to PaineWebber
as described in Item 13. When PaineWebber resigned as advisor to the Company,
the former officers resigned effective the same date; therefore no services were
provided by such persons subsequent to June 18, 1997.

Item 12. Security Ownership of Certain Beneficial Owners and Management
-----------------------------------------------------------------------

     (a) As of the date hereof, no person of record owns or is known by the
     Registrant to own beneficially more than five percent of the outstanding
     shares of common stock of the Company.

     (b) The Directors and Officers of the Company do not have any direct or
     indirect ownership of shares of the Company's common stock as of the date
     hereof.

     (c) There exists no arrangement, known to the Company, the operation of
     which may at a subsequent date result in a change in control of the
     Company.

Item 13. Certain Relationships and Related Transactions
-------------------------------------------------------

     Subject to the supervision of the Company's Board of Directors, assistance
in managing the business of the Company was provided by PaineWebber. Under the
advisory agreement, PaineWebber had specific management responsibilities; to
perform day-to-day operations of the Company and to act as the investment
advisor and consultant for the Company in connection with general policy and
investment decisions. PaineWebber received a fee in an amount equal to 0.5% of
the gross operating revenue of the facilities. PaineWebber earned management
fees totaling $0, $70,000 and $88,000 for the years ended August 31, 1998, 1997
and 1996, respectively. PaineWebber was reimbursed for direct expenses relating
to the administration of the Company. Paine Webber performed certain accounting,
tax preparation, securities law compliance and investor communication and
relations services for the Company. Included in general and administrative
expenses on the accompanying statements of income for the years ended August 31,
1998, 1997 and 1996 is $0, $80,000 and $73,000, respectively, representing
reimbursements to PaineWebber for providing such services to the Company. As
discussed in Items 1 and 7, the Company, ILM I, ILM II and their affiliates
accepted the resignation of Paine Webber effective as of June 18, 1997. The
Company, ILM I, ILM II and their affiliates and Paine Webber entered into a
transition services agreement pursuant to which PaineWebber would continue to
provide certain administrative services to the Company, ILM I, ILM II and their
affiliates through August 31, 1997.

     The advisory relationship with PaineWebber ceased on June 18, 1997;
therefore the payment of advisory fees ceased as of that date. Other services,
such as accounting, compliance, investor communications and relations, and cash
management services ceased on August 31, 1997; therefore, the Company was not
obligated to pay service fees past August 31, 1997 to PaineWebber.


                                      III-3
<PAGE>


                             ILM I LEASE CORPORATION


Item 13. Certain Relationships and Related Transactions (continued)
-------------------------------------------------------------------

     The Company retained Capital to be the property manager of the Senior
Housing Facilities pursuant to a Management Agreement which commenced on July
29, 1996. As discussed in Note 1, Lawrence A. Cohen, who served as a Director of
the Company as well as President, Chief Executive Officer and Director of ILM I
through July 28, 1998, has also served as Vice Chairman and Chief Financial
Officer of Capital Senior Living Corporation, an affiliate of Capital, since
November 1996. Under the Management Agreement, Capital generally is required to
perform all operational functions necessary to operate the Senior Housing
Facilities other than certain administrative functions. The functions performed
by Capital include periodic reporting to and coordination with the Company,
leasing the individual units in the Senior Housing Facilities, maintaining bank
accounts, maintaining books and records, advertising and marketing the Senior
Housing Facilities, hiring and supervising on-site personnel, and performing
maintenance. Under the terms of the Management Agreement, Capital earns a base
management fee equal to 4% of the gross operating revenues of the Senior Housing
Facilities, as defined. Capital also earns an incentive management fee equal to
25% of the amount by which the net cash flow of the Senior Housing Facilities,
as defined, exceeds a specified base amount. Each August 31, beginning on August
31, 1997, the base amount is increased based on the percentage increase in the
Consumer Price Index as well as 15% of Facility expansion costs. ILM I has
guaranteed the payment of all fees due to the terms of the Management Agreement.
Capital earned property management fees from the Company of $919,000, $841,000
and $75,000 for the years ended August 31, 1998, 1997, and 1996, respectively.

     On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, the new property manager; Lawrence A.
Cohen, who, through July 28, 1998 was a Director of the Company and President,
Chief Executive Officer and Director of ILM I, and others alleging that the
defendants intentionally interfered with AHC's property management agreement
(the "California litigation"). The complaint sought damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to Federal
District Court in the Central District of California. At a Board meeting on
February 26, 1997, the Company's Board of Directors concluded that since all of
Mr. Cohen's actions relating to the California litigation were taken either on
behalf of the Company under the direction of the Board or as a PaineWebber
employee, the Company or its affiliates should indemnify Mr. Cohen with respect
to any expenses arising from the California litigation, subject to any insurance
recoveries for those expenses. Legal fees paid by the Company and Lease II on
behalf of Mr. Cohen totaled $227,000 as of August 31, 1998. The Company's Board
also concluded that, subject to certain conditions, the Company or its
affiliates should advance up to $20,000 to pay reasonable legal fees and
expenses incurred by Capital in the California litigation. Subsequently, the
Boards of Directors of the Company and Lease II voted to increase the maximum
amount of the advance to Capital to $100,000. By the end of November 1997,
Capital had incurred $100,000 of legal expenses in the California litigation. On
February 2, 1998, the amount to be advanced to Capital was increased to include
75% of the California litigation legal fees and costs incurred by Capital for
December 1997 and January 1998, plus 75% of such legal fees and costs incurred
by Capital thereafter, not to exceed $500,000. By August 31, 1998 Capital had
incurred $683,000 of legal expenses in the California litigation. At August 31,
1998, the amount of legal fees either advanced to Capital or accrued on the
financial statements of Lease I and Lease II for Capital's California litigation
costs totaled approximately $519,000, although the final amount to be reimbursed
to Capital has not yet been determined.

     On September 18, 1997, the Company entered into an agreement with Capital
Senior Development, Inc., an affiliate of Capital, to manage the development
process for the potential expansion of several of the Senior Housing Facilities.
Capital Senior Development, Inc. will receive a fee equal to 7% of the total
development costs of these expansions if they are pursued. ILM Holding will
reimburse the Company for all costs related to these potential expansions
including fees to Capital Senior Development, Inc. For the years ended August
31, 1998 and 1997, Capital Senior Development, Inc. earned fees from the Company
of $212,000 and $0, respectively, for managing pre-construction development
activities for potential expansions of the Senior Housing Facilities.

     Jeffry R. Dwyer, Secretary and Director of the Company, is a shareholder of
Greenberg Traurig, which began acting as Counsel to the Company and its
affiliates in late fiscal year 1997. Greenberg Traurig earned fees from the
Company of $168,000 and $0 for the years ended August 31, 1998 and 1997,
respectively.


                                      III-4
<PAGE>


                             ILM I LEASE CORPORATION


                                     PART IV
                                     -------

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
------------------------------------------------------------------------

         (a) The following documents are filed as part of this report:

             (1) and (2)  Financial Statements and Schedules:
                          -----------------------------------

                          The response to this portion of Item 14 is submitted
                          as a separate section of this report. See Index to
                          Financial Statements and Financial Statement
                          Schedules at page F-1.

              (3)         Exhibits:
                          ---------

                          The exhibits listed on the accompanying index to
                          exhibits at page IV-3 are filed as part of this
                          Report.

         (b) Exhibits:

                          See (a)(3) above.

                          The Company filed a Current Report on Form 8-K dated
                          August 21, 1998, reporting the Company's settlement
                          of the AHC litigation.

         (c) Financial Statement Schedules:

                          The response to this portion of Item 14 is submitted
                          as a separate section of this report. See Index to
                          Financial Statements and Financial Statement
                          Schedules at page F-1.


                                      IV-1
<PAGE>


                             ILM I LEASE CORPORATION


                                   SIGNATURES
                                   ----------

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                             ILM I LEASE CORPORATION



                                             By:  /s/ Jeffry R. Dwyer
                                                 -------------------------------
                                                 Jeffry R. Dwyer
                                                 Chief Operating Officer
                                                 (Principal Accounting Officer)



Dated: February 12, 1999
     ----------------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Company in the
capacity and on the dates indicated.



By:  /s/ Jeffry R. Dwyer                         Date: January 14, 1999
    -----------------------------------               --------------------------
    Jeffry R. Dwyer
    Director



By:                                              Date:
    -----------------------------------               --------------------------
    Julien G. Redele
    Director



By:  /s/ J. William Sharman, Jr.                 Date: January 7, 1999
    -----------------------------------              ---------------------------
    J. William Sharman, Jr.
    Director


                                      IV-2
<PAGE>


                             ILM I LEASE CORPORATION


                           ANNUAL REPORT ON FORM 10-K
                                  Item 14(a)(3)

                             ILM I LEASE CORPORATION


                                INDEX TO EXHIBITS

<TABLE>
<CAPTION>
                                                                                Page Number in the Report
  Exhibit No.                Description of Document                            or Other Reference
-------------------------    -----------------------------------------          ------------------------------------
<S>                          <C>                                                <C>
(3) and (4)                  Registration Statement on Form 10 of               Filed with the Commission pursuant
                             the Registrant dated July 20, 1995, as             to Rule 424(c) and incorporated
                             supplemented.                                      herein by reference.

(13)                         Annual Reports to Shareholders                     No Annual Report for the year ended
                                                                                August 31, 1998 has been sent to
                                                                                the Shareholders. An Annual Report
                                                                                will be sent to the Shareholders
                                                                                subsequent to this filing.

(27)                         Financial Data Schedule                            Filed as last page of EDGAR
                                                                                submission following the Financial
                                                                                Statements and Financial Statement
                                                                                Schedule required by Item 14.
</TABLE>


                                      IV-3
<PAGE>


                             ILM I LEASE CORPORATION


                           ANNUAL REPORT ON FORM 10-K
                         Item 14(a)(1) and (2) and 14(d)

                             ILM I LEASE CORPORATION


         INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES

<TABLE>
<CAPTION>
                                                                                                        Reference
                                                                                                        ---------

ILM I Lease Corporation:

         <S>                                                                                               <C>
         Report of Ernst & Young LLP, Independent Auditors                                                 F-2

         Balance Sheets as of August 31, 1998 and 1997                                                     F-3

         Statements of Operations for the years ended August 31, 1998, 1997 and 1996                       F-4

         Statements of Changes in Shareholders' Equity for the years ended August 31, 1998, 1997
           and 1996                                                                                        F-5

         Statements of Cash Flows for the years ended August 31, 1998, 1997 and 1996                       F-6

         Notes to Financial Statements                                                                     F-7
</TABLE>


     Financial statements schedules have been omitted since the required
information is not present or not present in amounts sufficient to require
submission of the schedule, or because the information required is included in
the financial statements, including the notes thereto.


                                       F-1
<PAGE>




                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


The Shareholders of
ILM I Lease Corporation:

     We have audited the accompanying balance sheets of ILM I Lease Corporation
as of August 31, 1998 and 1997, and the related statements of operations,
changes in shareholders' equity, and cash flows for each of the three years in
the period ended August 31, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of ILM I Lease Corporation at
August 31, 1998 and 1997, and the results of its operations and its cash flows
for each of the three years in the period ended August 31, 1998, in conformity
with generally accepted accounting principles.



                                                               ERNST & YOUNG LLP



Dallas, Texas
October 13, 1998


                                       F-2
<PAGE>


                             ILM I LEASE CORPORATION


                                 BALANCE SHEETS
                            August 31, 1998 and 1997
                  (Dollars in thousands, except per share data)

<TABLE>
<CAPTION>
                                                      ASSETS
                                                      ------

                                                                                                1998          1997
                                                                                              ---------     ---------
<S>                                                                                             <C>           <C>
Cash and cash equivalents                                                                       $1,897        $1,473
Accounts receivable--related party                                                                   -            93
Accounts receivable, net                                                                            56             -
Tax refunds receivable                                                                             145             -
Prepaid expenses and other assets                                                                  127           259
                                                                                                ------        ------
         Total current assets                                                                    2,225         1,825

Furniture, fixtures and equipment                                                                  999           591
Less: accumulated depreciation                                                                    (390)          (93)
                                                                                                ------        ------
                                                                                                   609           498

Deferred tax asset, net                                                                            364           310
                                                                                                ------        ------
                                                                                                $3,198        $2,633
                                                                                                ======        ======
<CAPTION>
                                        LIABILITIES AND SHAREHOLDERS' EQUITY
                                        ------------------------------------
<S>                                                                                             <C>           <C>
Accounts payable and accrued expenses                                                           $1,123        $  882
Termination fee payable                                                                            975           600
Real estate taxes payable                                                                          213           170
Accounts payable - related party                                                                   438           116
Security deposits                                                                                    7             5
                                                                                                ------        ------
         Total current liabilities                                                               2,756         1,773

Deferred rent payable                                                                               49            86
                                                                                                ------        ------
         Total liabilities                                                                       2,805         1,859

Commitments and contingencies

Shareholders' equity:
   Common stock, $0.01 par value, 20,000,000 shares authorized,
     7,519,430 shares issued and outstanding                                                        75            75
   Additional paid-in capital                                                                      625           625
   Retained earnings (deficit)                                                                    (307)           74
                                                                                                ------        ------
         Total shareholders' equity                                                                393           774
                                                                                                ------        ------
                                                                                                $3,198        $2,633
</TABLE>


                             See accompanying notes.


                                       F-3
<PAGE>


                             ILM I LEASE CORPORATION


                            STATEMENTS OF OPERATIONS
               For the years ended August 31, 1998, 1997 and 1996
                  (Dollars in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                              1998            1997           1996
                                                                           -----------     -----------    ------------
<S>                                                                          <C>              <C>            <C>
Revenues:
  Rental and other income                                                    $19,232          $18,049        $17,227
  Interest income                                                                 62               72             58
                                                                             -------          -------        -------
                                                                              19,294           18,121         17,285

Expenses:
  Master lease rent expense                                                    7,222            6,643          6,328
  Dietary and food service salaries, wages and expenses                        3,566            3,431          3,169
  Administrative salaries, wages and expenses                                  1,218            1,277          1,106
  Marketing salaries, wages and expenses                                         856              883            915
  Utilities                                                                      834              850            868
  Repairs and maintenance                                                        661              666            668
  Real estate taxes                                                              827              816            811
  Property management fees                                                       919              841            944
  Other property operating expenses                                            1,486            1,574          1,438
  General and administrative                                                   1,468              875            330
  Termination fee expense                                                        375              600              -
  Advisory fees                                                                    -               70             86
  Depreciation expense                                                           297               74             19
                                                                             -------          -------        -------
                                                                              19,729           18,600         16,682
                                                                             -------          -------        -------

Income (loss) before income taxes                                               (435)            (479)           603

Income tax expense (benefit):
  Current                                                                          -               92            267
  Deferred                                                                       (54)            (284)           (26)
                                                                             -------          -------        -------
                                                                                 (54)            (192)           241
                                                                             -------          -------        -------

Net income (loss)                                                            $  (381)         $  (287)       $   362
                                                                             =======          =======        =======

Net income (loss) per share of common stock                                  $ (0.05)         $ (0.04)       $  0.05
                                                                             =======          =======        =======
</TABLE>

The above net income (loss) per share of common stock is based upon the weighted
average number of shares outstanding for the years ended August 31, 1998, 1997
and 1996 of 7,519,430.


                             See accompanying notes.


                                       F-4
<PAGE>


                             ILM I LEASE CORPORATION


                  STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
               For the years ended August 31, 1998, 1997 and 1996
                  (Dollars in thousands, except per share data)

<TABLE>
<CAPTION>
                                                 Common Stock
                                                $.01 Par Value             Additional      Retained
                                          ---------------------------       Paid-in        Earnings
                                             Shares          Amount         Capital        (Deficit)          Total
                                          ------------    -----------     -----------    -------------    -------------
<S>                                        <C>             <C>              <C>            <C>               <C>
Balance at August 31, 1995                    15,000       $      -         $     1        $     (1)         $     -

Issuance of common stock                   7,504,430             75             624               -              699

Net income                                         -              -               -             362              362
                                           ---------       --------         -------        --------          -------

Balance at August 31, 1996                 7,519,430             75             625             361            1,061

Net loss                                           -              -               -            (287)            (287)
                                           ---------       --------         -------        --------          -------

Balance at August 31, 1997                 7,519,430             75             625              74              774

Net loss                                           -              -               -            (381)            (381)
                                           ---------       --------         -------        --------          -------

Balance at August 31, 1998                 7,519,430       $     75         $   625        $   (307)         $   393
                                           =========       ========         =======        ========          =======
</TABLE>


                             See accompanying notes.


                                       F-5
<PAGE>


                             ILM I LEASE CORPORATION


                            STATEMENTS OF CASH FLOWS
               For the years ended August 31, 1998, 1997 and 1996
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                              1998            1997           1996
                                                                           ----------      ----------     ----------
<S>                                                                         <C>             <C>            <C>
Cash flows from operating activities:
  Net income (loss)                                                         $  (381)        $  (287)       $   362
  Adjustments to reconcile net income (loss) to
    net cash provided by (used in) operating activities:
      Depreciation expense                                                      297              74             19
      Deferred taxes                                                            (54)           (284)           (26)
      Changes in assets and liabilities:
        Accounts receivable - related party                                      93               -              -
        Accounts receivable, net                                                (56)             77            (77)
        Tax refunds receivable                                                 (145)              -              -
        Prepaid expenses and other assets                                       132               8           (267)
        Accounts payable and accrued expenses                                   241              19            863
        Accounts payable - related party                                        322            (422)           445
        Termination fee payable                                                 375             600              -
        Real estate taxes payable                                                43            (130)           300
        Security deposits                                                         2               -              5
        Deferred rent payable                                                   (37)            (37)           123
                                                                            -------         -------        -------
          Net cash provided by (used in) operating activities                   832            (382)         1,747
                                                                            -------         -------        -------

Cash flows from investing activities:
  Additions to furniture, fixtures and equipment                               (408)           (330)          (261)
                                                                            -------         -------        -------
          Net cash used in investing activities                                (408)           (330)          (261)
                                                                            -------         -------        -------

Cash flows from financing activities:
  Proceeds from issuance of common stock                                          -               -            699
                                                                            -------         -------        -------
          Net cash provided by financing activities                               -               -            699
                                                                            -------         -------        -------

Net increase (decrease) in cash and cash equivalents                            424            (712)         2,185

Cash and cash equivalents, beginning of period                                1,473           2,185              -
                                                                            -------         -------        -------

Cash and cash equivalents, end of period                                    $ 1,897         $ 1,473        $ 2,185
                                                                            =======         =======        =======

Supplemental disclosure:
------------------------

Cash paid during the period for income taxes                                $   201         $   181        $   317
                                                                            =======         =======        =======
</TABLE>


                             See accompanying notes.


                                       F-6
<PAGE>


                             ILM I LEASE CORPORATION
                          Notes to Financial Statements

1.  Organization, Restructuring, and Nature of Operations
    -----------------------------------------------------

        ILM I Lease Corporation ("the Company") was organized as a corporation
    on September 12, 1994 under the laws of the state of Virginia. Through
    August 31, 1995, the Company had no significant operations. The Company was
    formed by ILM Senior Living, Inc. ("ILM I"), formerly PaineWebber
    Independent Mortgage Fund, Inc., to operate eight rental housing projects
    that provide independent living and assisted living services for independent
    senior citizens ("the Senior Housing Facilities") under a master lease
    agreement. ILM I initially made mortgage loans to Angeles Housing Concepts,
    Inc. ("AHC") secured by the Senior Housing Facilities between June 1989 and
    July 1992. In March 1993, AHC defaulted under the terms of such mortgage
    loans and in connection with the settlement of such default, title to the
    Senior Housing Facilities was transferred, effective April 1, 1994, to
    certain majority-owned, indirect subsidiaries of ILM I, subject to the
    mortgage loans. Subsequently, the indirect subsidiaries of ILM I were merged
    into ILM Holding, Inc. ("ILM Holding"). As part of the fiscal 1994
    settlement agreement with AHC, AHC was retained as the property manager for
    all of the Senior Housing Facilities pursuant to the terms of a management
    agreement which was assigned to the Company as of September 1, 1995. As
    discussed further in Note 6, the agreement with AHC was terminated in July
    1996.

        ILM I has elected to be taxed as a Real Estate Investment Trust ("REIT")
    under the Internal Revenue Code of 1986, as amended ("the Code"), for each
    taxable year of operations. In order to maintain its status as a REIT, 75%
    of ILM I's annual gross income must be Qualified Rental Income as defined by
    the Code. The rent paid by the residents of the Senior Housing Facilities
    likely would not be deemed to be Qualified Rental Income because of the
    extent of services provided to residents. Consequently, the operation of the
    Senior Housing Facilities by ILM I or its subsidiaries over an extended
    period of time could adversely affect ILM I's status as a REIT. Therefore,
    ILM I formed the Company to operate the Senior Housing Facilities, and by
    means of a distribution, transferred the ownership of the common stock of
    the Company to the holders of ILM I common stock on September 1, 1995 (see
    Note 4). Because the Company, which is taxed as a regular C corporation, is
    no longer a subsidiary of ILM I, it can receive service-related income
    without endangering the REIT status of ILM I.

        The Company's sole business is the operations of the Senior Housing
    Facilities. The Company leases the Senior Housing Facilities from ILM
    Holding, a majority-owned and consolidated affiliate of ILM I which
    currently holds title to the Senior Housing Facilities, pursuant to a master
    lease which commenced on September 1, 1995 and expires on December 31, 1999
    (see Note 5). In July 1996, the Company terminated the property management
    agreement with AHC and entered into a property management agreement (the
    "Management Agreement") with Capital Senior Management 2, Inc. ("Capital")
    to handle the day-to-day operations of the Senior Housing Facilities. Since
    November 1996, Lawrence A. Cohen, who served as a Director of the Company
    and President, Chief Executive Officer and Director of ILM I until July 28,
    1998, has also served as Vice Chairman and Chief Financial Officer of
    Capital Senior Living Corporation, an affiliate of Capital. As a result,
    through July 28, 1998, the Management Agreement with Capital was considered
    a related party transaction (see Note 3).

2.  Use of Estimates and Summary of Significant Accounting Policies
    ---------------------------------------------------------------

        The accompanying financial statements have been prepared on the accrual
    basis of accounting in accordance with generally accepted accounting
    principles which require management to make estimates and assumptions that
    affect the reported amounts of assets and liabilities and disclosures of
    contingent assets and liabilities as of August 31, 1998 and 1997 and
    revenues and expenses for the years ended August 31, 1998, 1997 and 1996.
    Actual results could differ from the estimates and assumptions used.

        Furniture, fixtures and equipment are carried at the lower of cost,
    reduced by accumulated depreciation, or fair value in accordance with FAS
    No. 121, "Accounting for the Impairment of Long-Lived Assets and for
    Long-Lived Assets To Be Disposed Of." Depreciation expense was provided on a
    straight-line basis using an estimated useful life of 3 to 5 years. In 1998,
    the Company changed the estimated useful lives of its assets


                                       F-7
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

2.  Use of Estimates and Summary of Significant Accounting Policies (continued)
    ---------------------------------------------------------------------------

    the lease termination date of December 31, 1999, as such assets are not
    subject to repurchase by ILM Holding. This increased depreciation expense by
    $136,000 in 1998.

        Units at the Senior Housing Facilities are generally rented for terms of
    twelve months or less. The base rent charged varies depending on the unit
    size, with added fees collected for more than one occupant per unit and for
    assisted living services. Included in the amount of base rent charged are
    certain meals, housekeeping, medical and social services provided to the
    residents of each Facility.

        The Company rents the Senior Housing Facilities from ILM Holding
    pursuant to a multi-year operating lease. Rent expense is recognized on a
    straight-line basis over the term of the lease agreement. Deferred rent
    payable represents the difference between rent expense recognized on a
    straight-line basis and cash paid for rent pursuant to the terms of the
    lease agreement.

        The Company's policy is to expense all advertising costs as incurred.
    Advertising expenses were $857,000, $883,000 and $915,000 for the years
    ended August 31, 1998, 1997 and 1996, respectively.

        The cash and cash equivalents, receivables, accounts payable and accrued
    liabilities appearing on the accompanying balance sheets represent financial
    instruments for purposes of Statement of Financial Accounting Standards No.
    107, "Disclosures about Fair Value of Financial Instruments." The carrying
    amount of these assets and liabilities approximates their fair value as of
    August 31, 1998 due to the short-term nature of these instruments.

        Income tax expense is provided for using the liability method as
    prescribed by Statement of Financial Accounting Standards No. 109,
    "Accounting for Income Taxes." The Company has provided a valuation
    allowance in fiscal 1998 to recognize the effect that the lease termination
    date may have on the estimated net realizable value of the deferred tax
    asset as explained more fully in Note 7 to the accompanying financial
    statements. At August 31, 1998, a valuation allowance for deferred taxes of
    $120,000 is included in deferred taxes, net, on the accompanying balance
    sheet.

        For purposes of reporting cash flows, cash and cash equivalents include
    all highly liquid investments with original maturities of 90 days or less.

        The Financial Accounting Standards Board issued Statement No. 130,
    Reporting Comprehensive Income and Statement No. 131, Disclosures about
    Segments of an Enterprise and Related Information, all effective for fiscal
    1998. Statement No. 130 requires reporting and display of comprehensive
    income and its components in the financial statements. Statement No. 131
    requires reporting about operating segments and other disclosures about the
    business in its annual and interim financial statements. The Company does
    not believe adoption of these new Statements will have a material impact on
    its financial statements.

3.  Related Party Transactions
    --------------------------

        The Company entered into an advisory agreement (the "Advisory
    Agreement") with PaineWebber Lease Advisor, L.P. For discussion purposes,
    PaineWebber Lease Advisor, L.P. and all affiliates of PaineWebber will be
    collectively referred to as ("PaineWebber"). Subject to the supervision of
    and pursuant to the general policies set by the Company's Board of
    Directors, assistance in the managing of the business of the Company was
    provided by PaineWebber. Under the Advisory Agreement, the Company engaged
    PaineWebber and PaineWebber agreed to use its best efforts to manage the
    day-to-day affairs and operations of the Company and to provide
    administrative services and facilities appropriate for such management. The
    specific duties of


                                       F-8
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

3.  Related Party Transactions (continued)
    --------------------------------------

    PaineWebber under the Advisory Agreement included recommending selections of
    providers of professional and specialized services and handling other
    managerial functions with respect to the Senior Housing Facilities.
    PaineWebber was also obligated to provide office and clerical facilities
    adequate for the Company's operations and to provide, or obtain others to
    provide, accounting, custodial, funds collection and payment, stockholder
    communications, legal and other services necessary in connection with the
    Company's operations. The Advisory Agreement also obligated PaineWebber to
    handle or arrange for the handling of the Company's financial and other
    records.

        PaineWebber received a base fee in an amount equal to 0.5% of the gross
    operating revenues of the Senior Housing Facilities operated by the Company
    as compensation for its services. This fee amounted to $0, $70,000 and
    $88,000 for the years ended August 31, 1998, 1997 and 1996. In addition,
    PaineWebber was entitled to reimbursement for expenses incurred in providing
    certain financial, accounting and investor communication services to the
    Company. Included in general and administrative expenses for the year ended
    August 31, 1998, 1997 and 1996 was $0, $80,000 and $73,000, representing
    reimbursements to PaineWebber for providing such services to the Company. In
    performing its services under the Advisory Agreement, PaineWebber was
    required to pay certain employment expenses of its personnel, certain
    expenses of employees and agents of PaineWebber and of Directors, officers
    and employees of the Company who are also employees of PaineWebber, and
    certain of its overhead and miscellaneous administrative expenses relating
    to performance of its functions under the Advisory Agreement. The Company
    was responsible for reimbursing out-of-pocket expenses of Directors,
    Officers and employees of the Company incurred by them exclusively in such
    capacity and for all other costs of its operations.

        At a meeting of the Boards of Directors of ILM I and an affiliated
    entity, ILM II Senior Living, Inc. ("ILM II"), on January 10, 1997,
    PaineWebber recommended the immediate sale of the Senior Housing Facilities
    operated by the Company and held by ILM I as well as the Senior Housing
    Facilities held by ILM II, by means of a controlled auction to be conducted
    by PaineWebber, at no additional compensation, with PaineWebber offering to
    purchase the Senior Housing Facilities held by ILM I and ILM II for $127
    million, thereby guaranteeing the shareholders a "floor" price. The Senior
    Housing Facilities operated by the Company under its master lease with ILM
    Holding would represent approximately $75 million of this amount. After
    taxes and closing costs, net proceeds to ILM I would equal approximately $71
    million or approximately $9.41 per share of ILM I common stock. PaineWebber
    also stated that if it purchased the properties at the specified price and
    were then able to resell the properties at a higher price, PaineWebber would
    pay any "excess profits" to the shareholders. To assist the Company and ILM
    I in evaluating PaineWebber's proposal, a disinterested, independent
    investment banking firm with expertise in healthcare REITs and
    independent/assisted living financings was engaged by the Company, ILM I and
    ILM II and their affiliates. Following a comprehensive analysis, the
    investment banking firm recommended that PaineWebber's proposal should be
    declined and that instead, investigation of expansion and restructuring
    alternatives should be pursued. After analyzing PaineWebber's proposal and
    the recommendations and other information provided by the independent
    investment banking firm, the Boards of ILM I and ILM II voted unanimously to
    decline PaineWebber's proposal and to explore the alternatives recommended
    by the independent investment banking firm. The Boards declined to seek an
    immediate sale of the properties because, in the Board's view, the
    liquidation price would not reflect the "going concern" values of ILM I and
    ILM II and, therefore, would not maximize shareholder value. In addition,
    the Boards did not consider it advisable to liquidate ILM I and ILM II on
    the suggested terms several years prior to their scheduled termination
    dates.


                                       F-9
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

3.  Related Party Transactions (continued)
    --------------------------------------

        PaineWebber indicated to the Board in its January 10, 1997, proposal
    that it would not wish to continue to serve as advisor to ILM I, ILM II and
    their affiliates if they declined to accept PaineWebber's proposal. The
    Company, ILM Lease II Corporation ("Lease II"), ILM I and ILM II accepted
    the resignation of PaineWebber effective June 18, 1997. PaineWebber agreed
    to continue to provide certain administrative services to the Company, Lease
    II, ILM I, ILM II and their affiliates through August 31, 1997, pursuant to
    the terms of a transition services agreement entered into with ILM I, ILM II
    and their affiliates. The Company, Lease II, ILM I, ILM II and their
    affiliates also accepted, effective June 18, 1997, the resignations of those
    Officers and Directors who were employees or otherwise affiliated with
    PaineWebber.

        The Company and ILM I are continuing to review various strategic
    alternatives to maximize shareholder value and liquidity and have engaged
    professional financial and legal advisors to formulate and present plans and
    proposals for consideration by the Board. Although no definitive plans,
    arrangements or understandings have been agreed to at this time, ILM I is
    actively reviewing the feasibility of a variety of financial transactions
    and proposals, including the reorganization of the ownership of the Senior
    Housing Facilities, business combinations with third parties and the sale of
    ILM I by means of cash and or stock-for-stock merger. There can be no
    assurance that any definitive transaction will be formulated, agreed to or
    consummated.

        The Company retained Capital to be the property manager of the Senior
    Housing Facilities pursuant to a Management Agreement which commenced on
    July 29, 1996. As discussed in Note 1, since November 1996, Lawrence A.
    Cohen, who was a Director of the Company as well as President, Chief
    Executive Officer and Director of ILM I through July 28, 1998, has also
    served as Vice Chairman and Chief Financial Officer of Capital Senior Living
    Corporation, an affiliate of Capital. Under the Management Agreement,
    Capital generally is required to perform all operational functions necessary
    to operate the Senior Housing Facilities other than certain administrative
    functions. The functions performed by Capital include periodic reporting to
    and coordinating with the Company, leasing the individual units in the
    Senior Housing Facilities, hiring and supervising on-site personnel, and
    performing maintenance. Under the terms of the Management Agreement, Capital
    earns a base management fee equal to 4% of the gross operating revenues of
    the Senior Housing Facilities, as defined. Capital also earns an incentive
    management fee equal to 25% of the amount by which the net cash flow of the
    Senior Housing Facilities, as defined, exceeds a specified base amount. Each
    August 31, beginning on August 31, 1997, the base amount is increased based
    on the percentage increase in the Consumer Price Index as well as 15% of
    Facility expansion costs. ILM I has guaranteed the payment of all fees due
    to Capital under the terms of the Management Agreement. Capital earned
    property management fees from the Company of $919,000, $841,000 and $75,000
    for the years ended August 31, 1998, 1997 and 1996, respectively.

        On February 4, 1997, AHC filed a complaint in the Superior Court of the
    State of California against Capital, the new property manager; Lawrence A.
    Cohen, who, through July 28, 1998 was a Director of the Company and
    President, Chief Executive Officer and Director of ILM I, and others
    alleging that the defendants intentionally interfered with AHC's property
    management agreement (the "California litigation"). The complaint sought
    damages of at least $2,000,000. On March 4, 1997, the defendants removed the
    case to Federal District Court in the Central District of California. At a
    Board meeting on February 26, 1997, the Company's Board of Directors
    concluded that since all of Mr. Cohen's actions relating to the California
    litigation were taken either on behalf of the Company under the direction of
    the Board or as a PaineWebber employee, the Company or its affiliates should
    indemnify Mr. Cohen with respect to any expenses arising from the California
    litigation, subject to any insurance recoveries for those expenses. Legal
    fees paid by the Company and Lease II on behalf of Mr. Cohen totaled
    $227,000 as of August 31, 1998. The Company's Board also concluded that,
    subject to certain conditions, the Company or its affiliates should advance
    up to $20,000 to pay reasonable legal fees and expenses incurred by Capital
    in the California litigation. Subsequently, the Boards of Directors of the
    Company and Lease II voted to increase the maximum amount of the advance to
    Capital to


                                      F-10
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

3.  Related Party Transactions (continued)
    --------------------------------------

    $100,000. By the end of November 1997, Capital had incurred $100,000 of
    legal expenses in the California litigation. On February 2, 1998, the amount
    to be advanced to Capital was increased to include 75% of the California
    litigation legal fees and costs incurred by Capital for December 1997 and
    January 1998, plus 75% of such legal fees and costs incurred by Capital
    thereafter, not to exceed $500,000. By August 31, 1998 Capital had incurred
    $683,000 of legal expenses in the California litigation. At August 31, 1998,
    the amount of legal fees either advanced to Capital or accrued on the
    financial statements of Lease I and Lease II for Capital's California
    litigation costs totaled approximately $519,000, although the final amount
    to be reimbursed to Capital has not yet been determined.

        On September 18, 1997, the Company entered into an agreement with
    Capital Senior Development, Inc., an affiliate of Capital, to manage the
    development process for the potential expansions of several of the Senior
    Housing Facilities. Capital Senior Development, Inc. will receive a fee
    equal to 7% of the total development costs of these expansions if they are
    pursued. ILM Holding will reimburse the Company for all costs related to
    these potential expansions including fees to Capital Senior Development,
    Inc. For the years ended August 31, 1998 and 1997, Capital Senior
    Development, Inc. earned fees from the Company of $212,000 and $0,
    respectively, for managing pre-construction development activities for
    potential expansions of the Senior Housing Facilities.

        Jeffry R. Dwyer, Secretary and Director of the Company, is a shareholder
    of Greenberg Traurig, which began acting as Counsel to the Company and its
    affiliates in late fiscal 1997. For the years ended August 31, 1998 and
    1997, Greenberg Traurig earned fees from the Company of $168,000 and $0,
    respectively.

        Accounts receivable - related party at August 31, 1998 and August 31,
    1997 includes advances of $0 and $93,000, respectively, to ILM Holding,
    primarily to fund facility expansion costs. Accounts payable related party
    at August 31, 1998 and 1997 consists principally of variable rent payable to
    ILM Holding of $243,000 and $116,000, respectively, and expense
    reimbursements payable to ILM Holding in the amounts of $93,000 and $0,
    respectively, and to Lease II in the amounts of $102,000 and $0,
    respectively.

4.  Capital Stock
    -------------

        Prior to September 1, 1995, the Company was a wholly-owned subsidiary of
    ILM I. Pursuant to a reorganization and distribution agreement, ILM I
    capitalized the Company with $700,000, an amount estimated to provide the
    Company with necessary working capital. On September 1, 1995, Mavricc
    Management Systems, Inc., as the distribution agent, caused to be issued on
    the stock records of the Company the distributed Common Stock of the
    Company, in uncertificated form, to the holders of record of ILM I Common
    Stock at the close of business on July 14, 1995. One share of the Company's
    Common Stock was distributed for each outstanding share of ILM I Common
    Stock. No certificates or scrip representing fractional shares of the
    Company's Common Stock were issued to holders of ILM I Common Stock as part
    of the distribution. In lieu of receiving fractional shares, each holder of
    ILM I Common Stock who would otherwise have been entitled to receive a
    fractional share of the Company's Common Stock received a cash payment
    equivalent to $0.15 per share for such fractional interest.

5.  The Master Lease Agreement
    --------------------------

        ILM Holding (the "Lessor") has leased the Senior Housing Facilities to
    the Company (the "Lessee") pursuant to a master lease which commenced on
    September 1, 1995. Under the terms of the master lease, which has a
    scheduled expiration date of December 31, 1999, the Lessor has the right to
    terminate the master lease as to any Senior Housing Facility sold as of the
    date of such sale. The master lease is accounted for as an operating lease
    in the Company's financial statements.


                                      F-11
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

5.  The Master Lease Agreement (continued)
    --------------------------------------

        Descriptions of the properties covered by the master lease between the
    Company and ILM Holding are summarized as follows:

<TABLE>
<CAPTION>
                                                                          Rentable     Resident          Date of
    Name                                         Location                   Units      Capacity    Construction (1)
    ----                                         --------                   -----      --------    ----------------
    <S>                                          <C>                         <C>          <C>      <C>
    Independence Village of East Lansing         East Lansing, MI            161          162      May 1989
    Independence Village of Winston-Salem        Winston-Salem, NC           159          161      February 1989
    Independence Village of Raleigh              Raleigh, NC                 164          205      March 1991
    Independence Village of Peoria               Peoria, IL                  165          181      November 1990
    Crown Pointe Apartments                      Omaha, NE                   135          163      August 1985
    Sedgwick Plaza Apartments                    Wichita, KS                 150          170      May 1985
    West Shores                                  Hot Springs, AR             136          166      June 1987
    Villa Santa Barbara (2)                      Santa Barbara, CA           125          125      June 1979
</TABLE>

    (1) Date initial construction was completed.

    (2) The Company operates Villa Santa Barbara under a co-tenancy arrangement
        with an affiliated company, ILM II Lease Corporation ("Lease II"). The
        Company has entered into an agreement with Lease II regarding such joint
        tenancy. Lease II was formed for similar purposes as the Company by an
        affiliated REIT, ILM II, a subsidiary of which owns a portion of the
        Villa Santa Barbara property. The portion of the Facility leased by the
        Company represents 25% of the total project. Villa Santa Barbara is
        owned 25% owned by ILM Holding and 75% owned by ILM II Holding, Inc., a
        majority owned, consolidated subsidiary of ILM II.

        During the term of the master lease, the Company is obligated to pay
    annual base rent for the Senior Housing Facilities. For calendar year 1996
    and subsequent years, the annual base rent is $6,364,800, allocated as
    follows: $969,054 for the Michigan Facility, $613,030 for the Winston-Salem,
    North Carolina Facility, $1,100,441 for the Raleigh, North Carolina
    Facility, $965,209 for the Illinois Facility, $966,634 for the Nebraska
    Facility, $925,310 for the Kansas Facility, $674,742 for the Arkansas
    Facility, and $150,380 for the California Facility. The master lease is a
    "triple-net" lease whereby the Lessee pays all operating expenses,
    governmental taxes and assessments, utility charges and insurance premiums,
    as well as the costs of all required maintenance, personal property and
    non-structural repairs in connection with the operation of the Senior
    Housing Facilities. ILM Holding, as the Lessor, is responsible for major
    capital improvements and structural repairs to the Senior Housing
    Facilities. In addition, beginning in January 1997 and for the remainder of
    the lease term, the Company is also obligated to pay variable rent for each
    Facility. Such variable rent is payable quarterly and equals 40% of the
    excess, if any, of the aggregate total revenues for the Facilities, on an
    annualized basis, over $16,996,000. Variable rental expense related to
    fiscal year 1998 and 1997 was $894,000 and $315,000, respectively.

        Under the master lease, the Company's use of the Facilities is limited
    to use as a Senior Housing Facility unless the Lessor's consent to some
    other use is obtained. The Company has responsibility to obtain and maintain
    all licenses, certificates and consents needed to use and operate each
    Senior Housing Facility, and to use and maintain each Senior Housing
    Facility in compliance with all local board of health and other applicable
    governmental and insurance regulations. The Senior Housing Facilities
    located in Arkansas, California and Kansas are licensed by such states to
    provide assisted living services. Also, various health and safety
    regulations and standards which are enforced by state and local authorities
    apply to the operation of all of the Senior Housing Facilities. Violations
    of such health and safety standards could result in fines, penalties,
    closure of a Senior Housing Facility or other sanctions.


                                      F-12
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

6.  Legal Proceedings and Contingencies
    -----------------------------------

        A management agreement between ILM Holding and AHC which covered the
    management of all eight Senior Housing Facilities was assigned to the
    Company effective September 1, 1995. On July 29, 1996, the Company and ILM
    Holding ("the Companies") terminated the property management agreement with
    AHC. The management agreement was terminated for cause pursuant to the terms
    of the contract. Simultaneously with the termination of the management
    agreement, the Companies, together with certain affiliated entities, filed
    suit against AHC in the United States District Court for the Eastern
    District of Virginia for breach of contract, breach of fiduciary duty and
    fraud. The Company and ILM Holding alleged among other things, that AHC
    willfully performed actions specifically in violation of the agreement and
    that such actions caused damages to the Companies.

        Due to the termination of the agreement for cause, no termination fee
    was paid to AHC. Subsequent to the termination of the agreement, AHC filed
    for protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic
    state of California. The filing was challenged by the Companies, and the
    Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
    November 1996, AHC filed with the Virginia District Court an Answer in
    response to the litigation initiated by the Companies and a counterclaim
    against ILM Holding. The counterclaim alleged that the agreement was
    wrongfully terminated for cause and requested damages which include the
    payment of the termination fee in the amount of $1,250,000, payment of
    management fees pursuant to the contract from August 1, 1996 through October
    15, 1996, which is the earliest date that the management agreement could
    have been terminated without cause, and recovery of attorney's fees and
    expenses. The aggregate amount of damages against all parties as requested
    in AHC's counterclaim exceeded $2,000,000. ILM I had guaranteed the payment
    of the termination fee at issue in these proceedings to the extent that any
    termination fee would be deemed payable by the court and in the event that
    the Company fails to perform pursuant to its contractual obligations. On
    June 13, 1997 and July 8, 1997, the court issued orders to enter judgment
    against ILM I and ILM II in the amount of $1,000,000 (the "Orders"). The
    Orders did not contain any findings of fact or conclusions of law. On July
    10, 1997, the Company, ILM I, ILM II and Lease II filed a notice of appeal
    to the United States Court of Appeals for the Fourth Circuit from the
    Orders.

        On February 4, 1997, AHC filed a Complaint in the Superior Court of the
    State of California against Capital, Lawrence Cohen, and others alleging
    that the defendants intentionally interfered with AHC's Agreement (the
    "California litigation"). The Complaint sought damages of at least
    $2,000,000. On March 4, 1997, the defendants removed the case to federal
    district court in the Central District of California. At a Board meeting on
    February 26, 1997, the Company's Board of Directors concluded that since all
    of Mr. Cohen's actions relating to the California litigation were taken
    either on behalf of the Company under the direction of the Board or as a
    PaineWebber employee, the Company or its affiliates should indemnify Mr.
    Cohen with respect to any expenses arising from the California litigation,
    subject to any insurance recoveries for those expenses. Legal fees paid by
    the Company and Lease II on behalf of Mr. Cohen totaled $227,000 as of
    August 31, 1998. The Company's Board also concluded that, subject to certain
    conditions, the Company or its affiliates should advance up to $20,000 to
    pay reasonable legal fees and expenses incurred by Capital in the California
    litigation. Subsequently, the Boards of the Company and Lease II voted to
    increase the maximum amount of the advance to Capital to $100,000. By the
    end of November 1997, Capital had incurred $100,000 of legal expenses in the
    California litigation. On February 2, 1998, the amount to be advanced to
    Capital was increased to include 75% of the California litigation legal fees
    and costs incurred by Capital for December 1997 and January 1998, plus 75%
    of such legal fees and costs incurred by Capital thereafter, not to exceed
    $500,000. By August 31, 1998, Capital had incurred $683,000 of legal
    expenses in the California litigation. At August 31, 1998, $311,000 of legal
    fees have been either advanced or accrued in the Company's financial
    statements and $208,000 of legal fees have been either advanced or accred in
    Lease II's financial statements for Capital's California litigation costs,
    although the final amount to be reimbursed to Capital has not yet been
    determined.


                                      F-13
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

6.  Legal Proceedings and Contingencies (continued)
    -----------------------------------------------

        On August 18, 1998, the Company and its affiliates along with Capital
    and its affiliates entered into a settlement agreement with AHC. The Company
    and Lease II agreed to pay $1,625,000 and Capital and its affiliates agreed
    to pay $625,000 to AHC in settlement of all claims, including those related
    to the Virginia litigation and the California litigation. The Company and
    its affiliates also entered into an agreement with Capital and its
    affiliates to mutually release each other from all claims that any such
    parties may have against each other, other than any claims under the
    property management agreements. The Company's Board of Directors feels that
    settling the AHC litigation is a prudent course of action because the
    settlement amount represents a small percentage of the increases in cash
    flow and value achieved for the Company and its affiliates over the past two
    years.

        Due to the Order, $1,000,000 had been recorded as a liability by the
    Company and Lease II at the end of fiscal year 1997. At August 31, 1997, a
    provision of $600,000 for the liability which might have resulted to the
    Company had been recorded on the financial statements as "termination fee
    payable", with the remaining $400,000 provision recorded on the financial
    statements of Lease II. Due to the final settlement agreement, the 1997
    provisions were increased by $625,000 at August 31, 1998, with an additional
    $375,000 recorded on the financial statements of the Company and the
    remaining $250,000 recorded on the financial statements of Lease II.
    Subsequent to the end of the fiscal year, on September 4, 1998, the full
    settlement amounts were paid to AHC and its affiliates.

7.  Federal Income Taxes
    --------------------

        The Company is taxable as a regular C corporation and, therefore, its
    income is subject to tax at the federal and state levels. The Company
    reports on a calendar year for tax purposes. Income taxes at the appropriate
    statutory rates have been provided for in the accompanying financial
    statements.

        Deferred income tax benefit reflects the net tax effects of temporary
    differences between the carrying amounts of assets and liabilities for
    financial reporting purposes and the amounts used for income tax purposes.
    The Company's deferred tax assets and liabilities as of August 31, 1998 and
    1997, are comprised of the following amounts (in thousands):

<TABLE>
<CAPTION>
                                                                                 1998           1997
                                                                              -----------     --------
             <S>                                                                 <C>            <C>
             Deferred tax asset - straight-line rent expense                     $ 19           $ 34
             Deferred tax asset (liability) - book over tax
               (tax over book) depreciation                                        54            (32)
             Deferred tax asset - book over tax amortization                       45             68
             Deferred tax asset - termination fee payable                           -            240
             Net operating loss carryforward                                      366              -
                                                                                 ----           ----
             Gross deferred tax asset                                             484            310
             Valuation allowance for deferred tax asset                          (120)             -
                                                                                 ----           ----
               Net deferred tax asset                                            $364           $310
                                                                                 ====           ====
</TABLE>

        The 1997 deferred tax provision reflects a reclassification of $240,000
    of current tax expense in 1997 which was ultimately determined to be
    deductible in 1998.

        The Company has provided a valuation allowance in fiscal 1998 to
    consider the effects that the lease termination date (December 31, 1999)
    might have on historical taxable income after giving effect to the
    non-recurring termination fee, related legal expenses and the fact that the
    net operating loss carryforward might not be utilized by the lease
    termination date. The net operating loss carryforward will expire in 2013.


                                      F-14
<PAGE>


                             ILM I LEASE CORPORATION
                    Notes to Financial Statements (continued)

7.  Federal Income Taxes (continued)
    --------------------------------

        The components of income tax expense (benefit) for fiscal 1998 and 1997
    are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                     1998        1997         1996
                                                                                   --------    --------     --------
             <S>                                                                     <C>        <C>           <C>
             Current:
               Federal                                                               $  -       $  78         $227
               State                                                                    -          14           40
                                                                                     ----       -----         ----
                      Total current                                                     -          92          267
                                                                                     ----       -----         ----

             Deferred:
               Federal                                                                (47)       (241)         (22)
               State                                                                   (7)        (43)          (4)
                                                                                     ----       -----         ----
                      Total deferred                                                  (54)       (284)         (26)
                                                                                     ----       -----         ----
                                                                                     $(54)      $(192)        $241
                                                                                     ====       ======        ====
</TABLE>

        The reconciliation of income tax computed for fiscal 1998 and 1997, at
    U.S. federal statutory rates to income tax expense (benefit) is as follows
    (in thousands):

<TABLE>
<CAPTION>
                                                   1998                      1997                     1996
                                             ------------------       --------------------    ---------------------
              <S>                             <C>          <C>         <C>         <C>             <C>         <C>
             Tax at U.S. statutory rates      $(148)       (34%)       $(163)      (34%)           $205        34%
             State income taxes, net
               of federal tax benefit           (26)         (6)         (29)        (6)             36         6
             Valuation allowance                120          33            -          -               -         -
                                              -----        ----        -----       ----            ----        --
                                              $ (54)        (7%)       $(192)      (40%)           $241        40%
                                              =====        ====        =====       ====            ====        ==
</TABLE>

8.  Year 2000 (Unaudited)
    ---------------------

     The Company relies upon PC-based systems and does not expect to incur
material costs to transition to Year 2000 compliant systems in its internal
operations. The Company does not expect this project to have a significant
effect on operations. The Company will continue to implement systems and all new
investments are expected to be with Year 2000 compliant software.

9.  Subsequent Events
    -----------------

     On February 11, 1999, the Company's Board of Directors elected Jeffry R.
Dwyer to the office of Chief Operating Officer.


                                      F-15