**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-K**

** **

| **x****ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     |
|--------------------------------------------------------------------------------------------------------------|
|                                                                                                         |
| **For the fiscal year ended December 31,  2007**                                                        |
|                                                                                                         |
| **or**                                                                                                       |
|                                                                                                         |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File Number 001-16817**

 

| **FIVE STAR QUALITY CARE, INC.**                       |
|--------------------------------------------------------|
| (Exact Name of Registrant as Specified in Its Charter) |
| ** **                                             |
| **Maryland**                                           | ** ** | **04-3516029** |
| (State of Incorporation)                               |   | (IRS Employer Identification No.) |

 

| **400 Centre Street, Newton, Massachusetts 02458**  |
|-----------------------------------------------------|
| (Address of Principal Executive Offices) (Zip Code) |

 

Registrantstelephone Number, Including Area Code: **617-796-8387**

 

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

 

| **Title of Each Class** | ** ** | **Name Of Each Exchange On Which Registered** |
|-------------------------|------------|-----------------------------------------------|
| Common Stock            |       | American Stock Exchange                       |

 

Securitiesregistered pursuant to Section 12(g) of the Act: **None**

 

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

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o  No x

 

Indicateby check mark whether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See definition of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):

 

Largeaccelerated filer o                                            Acceleratedfiler x

 

Non-acceleratedfiler o                                              Smallerreporting company o

(Do not checkif a smaller reporting company)

 

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

 

The aggregate marketvalue of the voting shares of the registrant held by non-affiliates was $247.9****million based on the $7.98 closing price per common shareon the American Stock Exchange on June 29, 2007. For purposes of thiscalculation, an aggregate of 642,582.6 shares of common stock are held by thedirectors and officers of the registrant and have been included in the numberof shares of common stock held by affiliates, which includes 35,000 shares ofcommon stock held by Senior Housing Properties Trust.

 

Number of the registrant’sshares of common stock outstanding as of March 4, 2008: 31,818,144.

 

 

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

 

**DOCUMENTS INCORPORATED BYREFERENCE**

** **

Certaininformation required in Items 10, 11, 12, 13 and 14 of Part III of thisAnnual Report on Form 10-K is incorporated by reference from ourdefinitive Proxy Statement for the Annual Meeting of Shareholders scheduled tobe held on May 15, 2008, or our definitive Proxy Statement.

 

**WARNINGCONCERNING FORWARD LOOKING STATEMENTS**

 

THIS ANNUAL REPORT CONTAINS STATEMENTS WHICH CONSTITUTE FORWARD LOOKINGSTATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACTOF 1995 AND OTHER FEDERAL SECURITIES LAWS. THESE FORWARD LOOKING STATEMENTS AND THEIR IMPLICATIONS ARE BASED UPONOUR PRESENT INTENT, BELIEFS OR EXPECTATIONS, BUT FORWARD LOOKING STATEMENTS ARENOT GUARANTEED TO OCCUR AND MAY NOT OCCUR.  OUR ACTUAL RESULTS MAY DIFFERMATERIALLY FROM THOSE CONTAINED IN OR IMPLIED BY OUR FORWARD LOOKING STATEMENTSAS A RESULT OF VARIOUS FACTORS.  FOREXAMPLE:

 

·      WEEXPECT TO OPERATE OUR REHABILITATION HOSPITALS PROFITABLY.  HOWEVER, WE ARE CURRENTLY EXPERIENCING LOSSESFROM THESE OPERATIONS AND WE MAY BE UNABLE TO OPERATE THESE HOSPITALSPROFITABLY.  SIXTY PERCENT OF PATIENTS AT OUR HOSPITALS ARE REQUIRED TOMEET CERTAIN MEDICARE REQUIREMENTS. WHILE WE BELIEVE THAT WE ARE IN COMPLIANCE WITH THESE MEDICARE REQUIREMENTS,AND ALTHOUGH WE EXPECT TO CONTINUE TO BE IN COMPLIANCE WITH THESE REQUIREMENTS,THE PERCENTAGE OF PATIENTS AT THESE HOSPITALS WHO MEET THESE MEDICAREREQUIREMENTS MAY NOT BE OR REMAIN AS HIGH AS WE CURRENTLY ANTICIPATE OR MAY DECLINE.  FAILURE TO REMAIN IN COMPLIANCE WILL RESULTIN OUR RECEIVING LOWER MEDICARE PAYMENTS THAN WE CURRENTLY RECEIVE AT THESEHOSPITALS AND MATERIALLY AND ADVERSELY AFFECT OUR FUTURE RESULTS OF THESEOPERATIONS.

 

·      ALTHOUGHWE EXPECT TO LEASE FROM SENIOR HOUSING PROPERTIES TRUST, OR SENIOR HOUSING, 16ADDITIONAL SENIOR LIVING COMMUNITIES WHICH SENIOR HOUSING HAS AGREED TOPURCHASE FROM THIRD PARTIES, THE DILIGENCE REGARDING THESE TRANSACTIONS HAS NOTYET BEEN COMPLETED AND WE OR SENIOR HOUSING MAY DECIDE NOT TO PROCEED WITHTHESE TRANSACTIONS. CERTAIN OF THESE PURCHASES ARE CONTINGENT UPON APPROVALSFROM THIRD PARTY MORTGAGE LENDERS AND GOVERNMENT REGULATORY AGENCIES, WHICHAPPROVALS MAY NOT BE OBTAINED. AS A RESULT, ONE OR MORE OF THESE PROPOSEDLEASES MAY NOT OCCUR.

 

OTHER RISKS THAT MAY ADVERSELY IMPACT OUR FORWARD LOOKINGSTATEMENTS AND THEIR IMPLICATIONS ARE DESCRIBED IN THIS ANNUAL REPORT UNDER “ITEM1A. RISK FACTORS.”

 

YOU SHOULD NOT PLACE UNDUE RELIANCE UPON OUR FORWARD LOOKINGSTATEMENTS.

 

EXCEPT AS REQUIRED BY LAW, WE UNDERTAKE NO OBLIGATION TO UPDATE ORREVISE ANY FORWARD LOOKING STATEMENTS AS A RESULT OF NEW INFORMATION, FUTUREEVENTS OR OTHERWISE.

 

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** **

**FIVE STAR QUALITY CARE, INC.**

** **

**2007 ANNUAL REPORT ON FORM 10-K**

** **

**Table of Contents**

 
|     |                                                                                                               | **Page**   |
|----------|--------------------------------------------------------------------------------------------------------------------|------------|
|     | **PART I**                                                                                                    | ** ** |
|     |                                                                                                               | ** ** |
| Item 1.  | Business                                                                                                           | 1          |
| Item 1A. | Risk Factors                                                                                                       | 12         |
| Item 1B. | Unresolved Staff Comments                                                                                          | 20         |
| Item 2.  | Properties                                                                                                         | 21         |
| Item 3.  | Legal Proceedings                                                                                                  | 25         |
| Item 4.  | Submission of Matters to a Vote of Security  Holders                                                               | 25         |
|     |                                                                                                               |       |
|     | **PART II**                                                                                                   |       |
|     |                                                                                                               |       |
| Item 5.  | Market For Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities | 26         |
| Item 6.  | Selected Financial Data                                                                                            | 27         |
| Item 7.  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        | 27         |
| Item 7A. | Quantitative and Qualitative Disclosures  About Market Risk                                                        | 44         |
| Item 8.  | Financial Statements and Supplementary Data                                                                        | 44         |
| Item 9.  | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                              | 44         |
| Item 9A. | Controls and Procedures                                                                                            | 44         |
| Item 9B. | Other Information                                                                                                  | 45         |
|     |                                                                                                               |       |
|     | **PART III**                                                                                                  |       |
|     |                                                                                                               |       |
| Item 10. | Directors, Executive Officers and Corporate  Governance                                                            | 46         |
| Item 11. | Executive Compensation                                                                                             | *          |
| Item 12. | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                    | 46         |
| Item 13. | Certain Relationships and Related  Transactions, and Director Independence                                         | *          |
| Item 14. | Principal Accountant Fees and Services                                                                             | *          |
|     |                                                                                                               |       |
|     | **PART IV**                                                                                                   |       |
|     |                                                                                                               |       |
| Item 15. | Exhibits and Financial Statement Schedules                                                                         | 47         |

 

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*****Incorporated by reference from our Proxy Statement for the Annual Meeting ofShareholders scheduled to be held on May 15, 2008, to be filed pursuant toRegulation 14A.

** **

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**PART I**

** **

**Item 1.  Business**

** **

**GENERAL**

** **

We operate senior livingcommunities, including independent living and congregate care communities, assistedliving communities and nursing homes.  Asof December 31, 2007, we operated 161****senior living communities with 17,906 living units,including 112 primarily independent and assisted living communities with 13,502living units and 49 nursing homes with 4,404 living units.  Of our 112 primarily independent and assistedliving communities, we leased 95 communities with 12,237 living units fromSenior Housing Properties Trust, or Senior Housing, our former parent, andwe owned or leased from parties other thanSenior Housing 17 communities with 1,265 living units.  We leased 47 of our 49 nursing homes fromSenior Housing.  Our 161 communitiesinclude 5,520 independent living apartments, 6,330 assisted living suites and6,056 skilled nursing units.  As of December 31,2007, we also operated five institutional pharmacies, and two rehabilitationhospitals that we leased from Senior Housing. Our two rehabilitation hospitals had 321 beds available for inpatientservices, three satellite locations, and 20 affiliated outpatient clinics.   Our principal executive offices are locatedat 400 Centre Street, Newton, Massachusetts 02458, and our telephone number is(617) 796-8387.

 

**OUR HISTORY**

 

Spin off from Senior Housing

 

We were created by Senior Housingin April 2000 to operate 54 nursing homes and two assisted livingcommunities repossessed or acquired from former Senior Housing tenants.  We were incorporated in Delaware in April 2000and reincorporated in Maryland on September 17, 2001. On December 31,2001, Senior Housing distributed substantially all of our outstanding shares toits shareholders and we became a separate publicly owned company listed on theAmerican Stock Exchange, or AMEX.

 

Acquisitions

 

In 2002, we commenced operationsat 51 senior living communities, including 31 communities then operated byMarriott Senior Living Services, Inc., or MSLS, a wholly owned subsidiaryof Marriott International Inc. and subsequently operated by Sunrise SeniorLiving Services, Inc., or SLS, a wholly owned subsidiary of Sunrise SeniorLiving, Inc., or Sunrise.  In 2003,we commenced operations at three senior living communities.  In 2004, we commenced operations at 47 seniorliving communities.

 

In March 2005, we acquired a 62 unitassisted living community located in Georgia for approximately $6.9million.  In June 2005, we acquiredsix assisted living communities for approximately $59.0 million.  In order to finance this acquisition, we soldfour senior living communities to Senior Housing in June 2005 for $24.0million and Senior Housing leased these communities to us for initial rent of$2.2 million per year.  In August 2005, we sold the sixcommunities we acquired in June 2005 to Senior Housing for net proceeds of$56.7 million and Senior Housing leased these communities to us for initialrent of $5.2 million per year.

 

Between September and December 2006,we leased from Senior Housing 11 senior living communities with 1,284****units which Senior Housing acquired from thirdparties.  Six of these communities areassisted living communities (three of which offer some skilled nursingservices), three are independent living communities and two are continuing careretirement communities which offer independent living, assisted living andskilled nursing services.  Our rent payableto Senior Housing for these 11 communities is $9.0 million per year, plusfuture increases calculated as a percentage of the revenue increases at thesecommunities after 2007.  We added thesecommunities to our existing lease with Senior Housing which has a term endingin 2020, with renewal options thereafter. Residents pay substantially all of our charges at these communities fromtheir private resources.

 

In April 2007, we acquired a 48 unit assisted living communitylocated in Tennessee for $5.0 million  We financed the acquisition byassuming a $4.6 million non recourse United States Department of Housing, orHUD, insured mortgage and paying the balance of the purchase price with cash onhand.  The interest rate on the assumed 

 

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HUD insured mortgage is 7.65%.  Residents pay substantially all ofour charges at this community from their private resources.

 

In January and February 2008, weleased nine senior living communities with 1,032 units which Senior Housingacquired from third parties.  Eight ofthese communities are assisted living communities (one of which offers someskilled nursing services and one of which offers some independent livingservices) and one is a continuing care retirement community which offersindependent living, assisted living and skilled nursing services.  Our rent payable to Senior Housing for thesenine communities is $10.7 million per year, plus future increases calculated asa percentage of the revenue increases for all of these communities after2009.  We added these communities to ourexisting lease with Senior Housing which has a term ending in 2020, withrenewal options thereafter.  Residentspay a majority of our charges at these communities from their private resources.

 

We currently intend to lease from SeniorHousing 15 additional senior living communities with a total of 772 units whichSenior Housing has agreed to purchase from three unrelated parties.  All of these communities are assisted livingcommunities.  We expect our rent toSenior Housing for these 15 communities to be $11.9 million per year, plusfuture increases calculated as a percentage of the revenue increases at thesecommunities after 2009.  We intend to addthese communities to our existing lease with Senior Housing which has a termending in 2020, with renewal options thereafter.  Residents pay a majority of our charges atthese communities from their private resources. Senior Housing’s purchase and our lease of these properties arecontingent upon further diligence, consent from mortgage lenders and othercustomary closing conditions.  We canprovide no assurance that we will lease these properties.

 

Pharmacies

 

Between September 2003and November 2006, we acquired six institutional pharmacies and one mailorder pharmacy located in Wisconsin, Nebraska, California, SouthCarolina and Virginia.

 

In December 2007, we decided to sell oneinstitutional pharmacy located in California and our mail order pharmacylocated in Nebraska.  The operating resultsof these two parts of our pharmacy business are now included in discontinuedoperations.

 

Rehabilitation Hospitals

 

In February 2006, we agreed to lease tworehabilitation hospitals from Senior Housing. We commenced operations at these two hospitals on October 1,2006.  Our lease with Senior Housing forthese two hospitals expires on June 30, 2026, with one renewal option foran additional 20 years.  These hospitalsprovide extensive inpatient and outpatient health rehabilitation servicesincluding some services that we believe are similar to services we currentlyprovide in some of our senior living communities.  Our rent payable to Senior Housing for thesehospitals is $10.6 million per year.

 

Termination of SLS Management Agreements

 

During 2005 and 2006, we terminatedmanagement agreements for the 30 senior living communities that SLS managed forus and began to directly operate these communities for our own account.  In connection with these terminations, we paidSLS termination fees totaling $216.1 million. We no longer pay management fees to SLS.

 

Discontinued Operations

 

During 2003, 2004 and 2005, we ceasedoperations at two skilled nursing facilities which we previously leased fromSenior Housing and eight assisted living facilities, two of which we previouslyleased from Senior Housing.

 

During 2006, we ceased operations at two skilled nursing facilitieslocated in Connecticut that we leased from Senior Housing.  Senior Housing sold these facilities in November 2006for net proceeds of approximately $5.6 million, which caused a $559,000reduction in the annual rent we pay to Senior Housing.

 

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During 2007, we agreed with Senior Housing that it should sell twoassisted living communities in Pennsylvania, which we lease from SeniorHousing.  We and Senior Housing are in the process of selling theseassisted living communities and, upon their sale, our annual rent payable toSenior Housing will decrease by approximately 9.5% of the net proceeds of the saleto Senior Housing.

 

As discussed above, in December 2007, we decided to sell oneinstitutional pharmacy located in California and our mail order pharmacylocated in Nebraska.

 

Equity and Debt Financings

 

In 2005,we issued 7,750,000 common shares in an underwritten public offering raisingnet proceeds of $55.6 million.  In2006, we issued 11,500,000 common shares in an underwritten public offeringraising net proceeds of $114.1 million and we issued $126.5 million principal amount of Convertible Senior Notes due 2026, orthe Notes.  The Notes bear interest at3.75% per annum, payable semi-annually, and will mature on October 15,2026.  We may prepay the Notes at anytimeafter October 20, 2011 and the Note holders may require that we purchaseall or a portion of these Notes on each of October 15, 2013, 2016 and2021.

 

**OUR GROWTH STRATEGY**

 

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

 

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

 

In addition to managing ourexisting operations, we intend to continue to grow our business throughacquisitions of independent and assisted living communities where residents’private resources account for a large majority of revenues. Since we became apublic company in late 2001, we have acquired and currently operate 111primarily independent and assisted living communities that as of December 31,2007 generated approximately****86% of theirrevenue from residents’ private resources, rather than from Medicare orMedicaid. We prefer to acquire communities which have achieved or are close tostabilized operations, although we occasionally purchase turn around facilitieswhich we believe are located where we can make significant improvements inoperations.  We also seek to makeacquisitions where we can realize cost savings by combining acquired operationswith our existing operations.

 

In October 2006, we began to operate tworehabilitation hospitals located in Braintree and Woburn, Massachusetts.  These hospitals offer extensive inpatient andoutpatient services.  We may seek to acquire additional rehabilitationhospitals, as well as expand our rehabilitation business at our existing seniorliving communities.

 

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

** **

**TYPES OF PROPERTIES**

** **

Our present business plan contemplates the ownership,leasing and management of independent living apartments or congregate carecommunities, assisted living communities, nursing homes and rehabilitationhospitals. Some of our properties combine more than one type of service in asingle building or campus.  We operatemost of our pharmacies and several of our outpatient rehabilitation clinicsfrom leased commercial spaces.

 

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*Independent Living Apartments or CongregateCare Communities.* Independent living apartments, orcongregate care communities, provide high levels of privacy to residents andrequire residents to be capable of relatively high degrees of independence. Anindependent living apartment usually bundles several services as part of aregular monthly charge. For example, one or two meals per day in a centraldining room, weekly maid service or services of a social director may beincluded in the base charge. Additional services are generally available fromstaff employees on a fee for service basis. In some independent livingproperties, separate parts of the community are dedicated to assisted living ornursing services.  As of December 31,2007, our business included 5,520 independent living apartments in 39 communities.

 

*Assisted Living Communities.*  Assistedliving communities are typically comprised of one bedroom units which includeprivate bathrooms and efficiency kitchens. Services bundled within one chargeusually include three meals per day in a central dining room, dailyhousekeeping, laundry, medical reminders and 24 hour availability ofassistance with the activities of daily living such as dressing and bathing.Professional nursing and healthcare services are usually available at thecommunity on call or at regularly scheduled times.  As of December 31, 2007, our businessincluded 6,330 assisted living suites in 104 communities.

 

*Nursing Homes*.  Nursinghomes generally provide extensive nursing and healthcare services similar tothose available in hospitals, without the high costs associated with operatingtheaters, emergency rooms or intensive care units. A typical purpose builtnursing home includes mostly one and two bedrooms with a separate bathroom ineach room and shared dining facilities. Nursing homes are staffed by licensed nursing professionals24 hours per day.  As of December 31,2007, our business included 6,056****skillednursing beds in 75 communities.

 

*Rehabilitation Hospitals. *Rehabilitationhospitals, also known as inpatient rehabilitation facilities, or IRFs, provideintensive physical therapy, occupational therapy and speech language pathologyservices beyond the capabilities customarily available in skilled nursingfacilities.  Patients in IRFs generallyreceive a minimum of three hours of rehabilitation services daily.  IRFs also provide onsite pharmacy, radiology,laboratory, telemetry, hemodialysis and orthotics/prosthetics services.  Outpatient satellite clinics are oftenincluded as part of the services offered by IRFs.  Our two rehabilitation hospitals had****321bedsavailable for inpatient services as of December 31, 2007 and providedservices at three satellite locations. In addition, these two hospitals operate 20 affiliated outpatientclinics where patients discharged from the hospitals can continue their therapyprograms and receive amputee, brain injury, cardio-pulmonary, orthopedic,spinal cord injury, stroke and neurorehabilitation rehabilitation services.

 

*Pharmacies. *Our institutional pharmacies are located infive leased commercial spaces and one owned commercial space containingapproximately 54,839 square feet plus parking areas for our delivery vehicles.

 

**OPERATING STRUCTURE**

 

We have four divisional officeswhich are located throughout the country. Each divisional office is responsible for multiple regions and is headedby a divisional vice president with extensive experience in the senior livingand health rehabilitation industries.  Wehave several regional offices within each division.  Each regional office is responsible formultiple communities and is headed by a regional director of operations withextensive experience in the senior living industry.  Each regional office is typically supportedby a clinical or wellness director, a rehabilitation services director, a regionalaccounts manager, a human resources specialist and a sales and marketingspecialist.  Regional staffs areresponsible for all our senior living community operations within the region,including:

 

·      resident services;

 

·      Medicare and Medicaid billing;

 

·      marketing and sales;

 

·      hiring of community personnel;

 

·      compliance with applicable legal andregulatory requirements; and

 

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·      supporting our development and acquisitionplans within their region.

 

Our home office staff performs the followingtasks:

 

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

 

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

 

·                  humanresources policies and procedures;

 

·                  informationtechnology;

 

·                  privatepay billing;

 

·                  licensingand certification maintenance;

 

·                  legalservices;

 

·                  centralpurchasing;

 

·                  budgetingand supervision of maintenance and capital expenditures;

 

·                  implementationof our growth strategy; and

 

·                  accountingand finance functions, including operations budgeting, parts of accountsreceivable and collections, accounts payable and parts of our payroll,financial reporting, and tax planning and compliance.

 

**STAFFING**

** **

***Independent and assisted livingcommunity staffing. ***Each of the independent and assisted livingcommunities we operate has an executive director responsible for the day to dayoperations of the community, including quality of care, resident services,sales and marketing, financial performance and staff supervision. The executivedirector is supported by department heads, who oversee the care and service ofthe residents, a wellness director, who is responsible for coordinating theservices necessary to meet the health care needs of our residents and amarketing director, who is responsible for selling our services.  Other important staff includes the diningservices coordinator, the activities coordinator and the property maintenancecoordinator.

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*****Nursing home staffing. *****Each of our nursing homes is managed by a statelicensed administrator who is supported by other professional personnel,including a director of nursing, an activities director, a marketing director,a social services director, a business office manager, and physical,occupational and speech therapists. Our directors of nursing are state licensednurses who supervise our registered nurses, licensed practical nurses andnursing assistants. Staff size and composition vary depending on the size andoccupancy of each nursing home and on the type of care provided by the nursinghome. Our nursing homes also contract with physicians who provide certainmedical services.

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***Rehabilitation hospitalstaffing. ***EachIRF is operated under the leadership of a hospital based chief executiveofficer with the support of senior staff, including a medical director, chieffinancial officer, director of patient care services, director ofrehabilitation and director of case management. The hospitals are also staffed with board certified physicians whoprimarily specialize in internal medicine, neurology or physiatry, as well asother licensed professionals, including rehabilitation nurses, physicaltherapists, occupational therapists, speech and language pathologists,nutrition counselors, neuropsycologists and pharmacists.  Each outpatient clinic associated with ourIRFs is managed by an outpatient director who is a registered occupational orphysical therapist.

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***Pharmacy operations andstaffing. ***Our institutional pharmacy operation providesprescriptions, medical supplies, equipment and services to operators andresidents of senior living communities. We do not sell “over the 

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**counter”to the public.  Each of our pharmacies ismanaged by an executive director, who is responsible for the day to dayoperations of each pharmacy and our mail order business, including billings,sales and marketing, financial performance, compliance with regulatory codesregarding the dispensing of controlled substances and staff supervision.  Other pharmacy personnel include licenseddispensing pharmacists, a director of pharmacy consultation, a medical recordsdirector, a nurse consultant, pharmacy technicians and billing personnel.**

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**EMPLOYEES**

** **

As of March 4, 2008, we had approximately 18,301employees, including 12,550full time equivalents. Approximately 89employees, including approximately 74 full time equivalents, are representedunder one****collective bargaining agreement, whichhas a remaining term of approximately two years.  We have no employment agreements with ouremployees except for seven contracts entered into with former owner operatorsof certain pharmacies which we acquired. We believe our relations with ourunion and non-union employees are good.

 

**GOVERNMENTREGULATION AND REIMBURSEMENT**

 

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

 

*IndependentLiving Communities.*Governmentbenefits generally are not available for services at independent livingcommunities and the resident charges in these communities are paid from privateresources. However, a number of Federal Supplemental Security Income programbenefits pay housing costs for elderly or disabled residents to live in thesetypes of residential communities. The Social Security Act requires states tocertify that they will establish and enforce standards for any category ofgroup living arrangement in which a significant number of Supplemental SecurityIncome residents reside or are likely to reside. Categories of livingarrangements which may be subject to these state standards include independentliving communities and assisted living communities. Because independent livingcommunities usually offer common dining facilities, in many locations they arerequired to obtain licenses applicable to food service establishments inaddition to complying with land use and life safety requirements. In manystates, independent living communities are licensed by state or county healthdepartments, social service agencies or offices on aging with jurisdiction overgroup residential communities for seniors. To the extent that independentliving communities include units in which assisted living or nursing servicesare provided, these units are subject to applicable state licensingregulations, and if the communities receive Medicaid or Medicare funds, tocertification standards. In some states, insurance or consumer protectionagencies regulate independent living communities in which residents payentrance fees or prepay for services.

 

*Assisted Living Communities. *According to the National Center for AssistedLiving and the National Academy for State Health Policy, or the NationalAcademy, a majority of states provide or are approved to provide Medicaidpayments for services to some residents in assisted living communities underwaivers granted by the Federal Centers for Medicare and Medicaid Services, orCMS, or under Medicaid state plans.  Mostother states are planning some Medicaid funding by preparing state planamendments or requesting waivers. State Medicaid programs control costsfor assisted living and other home and community-based services by variousmeans such as restrictive financial and functional eligibility standards,enrollment limits and waiting lists. Becauserates paid to assisted living community operators are generally lower thanrates paid to nursing home operators, some states use Medicaid funding ofassisted living as a means of lowering the cost of services for residents whomay not need the higher intensity of health related services provided innursing homes. States that administer Medicaid programs for services inassisted living communities are responsible for monitoring the services at, andphysical conditions of, the participating communities. Different states applydifferent standards in these matters, but generally we believe these monitoringprocesses are similar to the concerned states’ inspection processes for nursinghomes.

 

As a result of the large numberof states using Medicaid to purchase services at assisted living communitiesand the growth of assisted living in recent years, a majority of states haveadopted licensing standards applicable to assisted living communities. Amajority of states have licensing statutes or standards specifically using theterm “assisted living” and have requirements for communities servicing peoplewith Alzheimer’s disease or dementia. The majority of states have revised theirlicensing regulations recently or are reviewing their policies or revisingtheir regulations. State 

 

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regulatory models vary; there is no nationalconsensus on a definition of assisted living, and no uniform approach by thestates to regulating assisted living communities. Most state licensingstandards apply to assisted living communities whether or not they acceptMedicaid funding. Also, according to the National Academy, a few states requirecertificates of need from state health planning authorities before new assistedliving communities may be developed. Based on our analysis of current economicand regulatory trends, we believe that assisted living communities that becomedependent upon Medicaid or other public payments for a majority of theirrevenues may decline in value because Medicaid rates may fail to keep up withincreasing costs. We also believe that assisted living communities located instates that adopt certificate of need requirements or otherwise restrict thedevelopment of new assisted living communities may increase in value becausethese limitations upon development may help ensure higher occupancy and highernon-governmental rates.

 

The US Department of Health and Human Services, the GovernmentAccountability Office, or GAO, and the Senate Special Committee on Aging haverecently studied and reported on the development of assisted living and itsrole in the continuum of long term care and as an alternative to nursinghomes.  In 2003, the GAO recommended thatCMS strengthen its oversight of state quality assurance in Medicaid home andcommunity-based services waiver programs. Since then, CMS has commenced a series of actions to increase itsoversight of state quality assurance programs for assisted living facilitiesand has provided guidance and technical assistance to the states to improvetheir ability to monitor and improve the quality of services paid for throughMedicaid waiver programs.  Also in 2003,a working group of assisted living providers, consumers and regulatoryorganizations made recommendations to the Senate Special Committee on Aging ona range of subjects, including staffing, funding and regulation of assistedliving.  We cannot predict whether these activities and reports will result ingovernmental policy changes or new legislation, or what impact any changes mayhave. Based upon our analysis of current economic and regulatory trends, we donot believe that the federal government is likely to have a material impactupon the current regulatory environment in which the assisted living industryoperates unless it also undertakes expanded funding obligations.  Although CMS is implementing provisions ofthe Deficit Reduction Act of 2005, or the DRA, enacted in February 2006,that encourage state Medicaid programs to expand their use of home andcommunity based services as alternatives to institutional services, we do notbelieve a materially increased financial commitment from the federal governmentto fund assisted living is presently likely. However, we do anticipate thatassisted living communities will increasingly be licensed and regulated by the variousstates, and that, in the absence of federal standards, the states’ policieswill continue to vary widely.

 

*Nursing Homes-Reimbursement. *About 63% of all nursing home revenues in the U.S.in 2006 (the most recent date for which information is publicly available) camefrom publicly funded programs, including about 43% from Medicaid programs and17% from the Medicare program. Nursing homes are among the most highlyregulated businesses in the Country. The federal and state governmentsregularly monitor the quality of care provided at nursing homes. State healthdepartments conduct surveys of resident care and inspect the physical conditionof nursing home properties. These periodic inspections and occasional changesin life safety and physical plant requirements sometimes require nursing homeoperators to make significant capital improvements. These mandated capitalimprovements have in the past usually resulted in Medicare and Medicaid rateadjustments, albeit on the basis of amortization of expenditures over expecteduseful lives of the improvements. Under the Medicare prospective paymentsystem, or the PPS, capital costs are part of the prospective rate and are notcommunity specific.  The PPS and otherrecent legislative and regulatory actions with respect to state Medicaid ratesare limiting the reimbursement levels for some nursing home services. At thesame time, federal and state enforcement and oversight of nursing homes havebeen increasing, making licensing and certification of these communities morerigorous.

 

The PPS was intended to reducethe rate of growth in Medicare payments for skilled nursing communities.  Under the current Medicare payment system,skilled nursing facilities receive a fixed payment for each day of careprovided to residents who are Medicare beneficiaries. Each resident is assignedto a care group depending on that resident’s medical characteristics andservice needs.  These care groups areknown as Resource Utilization Groups, or RUGs. Per diem payment rates are established for each of these care groups.  Medicare payments cover substantially allservices provided to Medicare residents in skilled nursing communities,including ancillary services such as rehabilitation therapies.  The PPS is intended to provide incentives toproviders to furnish only necessary services and to deliver those servicesefficiently.  According to the GAO,between fiscal year 1998 and fiscal year 1999, the first full year of thechanged Medicare payment system phase in, the average Medicare payment per daydeclined by about 9%.

 

From November 1999 to January 2006,Congress and CMS provided some periodic relief from the effect of the PPS,through temporary increases in skilled nursing facility payment rates andtemporary moratoria on some therapy limitations for skilled

 

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nursingresidents covered under Medicare Part B. Effective January 1, 2006, CMS implemented changes to the paymentcategories it uses to set daily payment rates for Medicare beneficiaries inskilled nursing facilities. CMS introduced nine new payment categories formedically complex patients, increasing the number of categories from 44 to 53,and made revisions to its payment rates for current RUGS. Also effective January 1,2006, these RUG changes caused the elimination of certain temporary additionalpayments for certain skilled nursing care and rehabilitation groups.  The financial impact of these changes to theMedicare rates on our operations was to effectively eliminate an October 2005Medicare 3% rate increase; but then in October 2006 and again in October 2007,the Medicare rates were increased by 3%.

 

                Under the DRA,the federal government is slowing the growth of Medicare and Medicaid paymentsfor nursing home services by several methods. Medicare bad debt reimbursement has been reduced from 100% to 70% foruncollected cost sharing payments from Medicare beneficiaries who are noteligible for Medicaid.  Limits onMedicare payments were also implemented for outpatient therapies in 2006, withan exception process, under which beneficiaries could request an exemption fromthe cap and be granted the amount of services deemed medically necessary byMedicare.  Under the Tax Relief andHealth Care Act of 2006, enacted in December 2006, the exemption processwas extended an additional year through 2007. Under the Medicare, Medicaid and SCHIP Extension Act of 2007, enacted inDecember 2007, the exemption process for therapy services has beenextended an additional six months through June 30, 2008.  In addition, the DRA increased the “look-back”period for prohibited asset transfers that disqualify individuals from Medicaidnursing home benefits from three to five years. The period of Medicaid ineligibility begins on the date of theprohibited transfer or the date an individual has entered the nursing home andwould otherwise be eligible for Medicaid coverage, whichever occurs later,rather than on the date of the prohibited transfer, effectively extending theMedicaid penalty period and placing added burdens on nursing homes to collectcharges directly from residents and their transferees.  The DRA includes a demonstration project thatin 2007 awarded competitive grants to a majority of states to provide home andcommunity based long term care services to qualified individuals relocated fromnursing homes, providing an increased federal medical assistance percentage for12 months for each qualifying beneficiary, during a grant period of at leasttwo years.  The DRA also includes a postacute payment reform demonstration program that will compare and assess costsand outcomes of services at different long term care sites over three years.  Effective January 1,2007, states may include home and community based services as optional servicesunder their Medicaid state plans, rather than only pursuant to waivers or demonstrationprojects, and such states may cap enrollment, maintain waiting lists and offerthe services in only some regions of a state, as they may with waivers.  These initiatives will likely decrease thedemand for nursing home services and nursing home occupancy levels,which declined slightly from 2000 through 2006, may continue to decline.

 

*                Nursing Homes-Survey andEnforcement.* Twenty years ago, Congress enacted major reforms tofederal and state regulatory systems for nursing homes that participate in theMedicare and Medicaid programs, under the Omnibus Reconciliation Act of 1987,or OBRA 87.  Since then, the GAO reportsthat, while much progress has been made, substantial problems remain in theeffectiveness of federal and state regulatory activities. In July 1998, the GAO issued a report whichfound inadequate care in a significant portion of California nursinghomes.  Since 1999, the U.S. Departmentof Health and Human Services, Office of Inspector General has issued severalreports concerning quality of care in nursing homes, and the GAO has issuedseveral reports, most recently in 2007, recommending that CMS and the statesstrengthen their compliance and enforcement practices, including federaloversight of state actions, to better ensure that nursing homes provideadequate care and states act more consistently. The Senate Special Committee on Aging and other congressional committeeshave also held hearings on these issues, most recently in 2007. As a result,CMS has undertaken an initiative to increase the effectiveness of Medicare andMedicaid nursing home survey and enforcement activities.  CMS is taking steps to focus more survey andenforcement efforts on nursing homes with findings of substandard care orrepeat violations of Medicare and Medicaid standards and to identify chainoperated communities with patterns of noncompliance.  CMS is increasing its oversight of statesurvey agencies and requiring state agencies to use enforcement sanctions andremedies more promptly when substandard care or repeat violations areidentified, to investigate complaints more promptly, and to survey communitiesmore consistently. In addition, CMS adopted regulations expanding federal andstate authority to impose civil monetary penalties in instances of noncompliance.A small number of nursing homes with a history of serious qualityproblems are designated by CMS as “special focus facilities,” or SFFs,inspected more frequently and subject to more stringent enforcementactions.  Homes in the SFF initiative forsix months or longer are now listed on the Medicare website atMedicare.gov.  The GAO has recommendedseveral steps to make enforcement by CMS and the states more timely andeffective, especially for SFFs. Medicaresurvey results, including fire safety reports, and average nursing and nursingassistant staff hours per resident for each nursing home are posted on theMedicare website at www.medicare.gov. CMS issued a proposed rule

 

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in2006 that would require older nursing homes to install sprinklers.  Nursing homes that do not have sprinklers orhard-wired smoke detectors are required to install battery powered smokedetectors in the interim.  Currently allof our nursing homes except one have sprinklers and we believe the one nursinghome without sprinklers is in compliance with the current requirements becauseit has a combination of hard wired and battery operated smoke detectors.  Whendeficiencies under state licensing and Medicare and Medicaid standards areidentified, sanctions and remedies such as denials of payment for new Medicareand Medicaid admissions, civil monetary penalties, state oversight and loss ofMedicare and Medicaid participation or licensure may be imposed on nursing homeoperators. Our communities incur sanctions and penalties from time to time. Ifwe are unable to cure deficiencies which have been identified or that areidentified in the future, additional sanctions may be imposed, and if imposed,may adversely affect our ability to meet our financial obligations andnegatively affect our financial condition and results of operations.

 

                In2000 and 2002, the Department of Health and Human Services and CMS issuedreports linking nursing staffing levels with quality of care. The Bush administrationhas indicated that it does not intend to impose minimum staffing levels or toincrease Medicare or Medicaid rates to cover the costs of increased staffing atthis time; however, CMS publishes the nurse and nursing assistant staffinglevel at each nursing home on the internet at www.medicare.gov to create marketpressure to improve nursing home operations.

 

                *RehabilitationHospital Regulations and Rate Setting.* Our two rehabilitationhospitals are subject to federal, state and local regulations that affect theirbusiness activities and determine the rates they receive for services.  These hospitals are subject to periodicinspection by governmental and non-governmental agencies to ensure continuedcompliance with various licensure and accreditation standards.  In addition, these facilities are certifiedby CMS to participate in the Medicare program and receive a significant portionof their revenues from that program.

 

                On May 7, 2004, CMS issued a rule establishingrevised Medicare standards that rehabilitation hospitals are required to meetin order to participate as IRFs in the Medicare program, known as the “75%Rule.” An IRF that failed to meet the requirements of the 75% Rule wouldbe subject to reclassification as a different type of healthcare provider; andthe effect of such reclassification would be to lower Medicare paymentrates.  Under the Medicare, Medicaid andSCHIP Extension Act of 2007, adopted in December 2007, for cost reportingperiods starting on or after July 1, 2007, the 75% requirement for IRFswas permanently rolled back to 60%, and selected secondary medical conditionsare included to qualify patients under the 60% requirement.   The rule now generally provides that,to be considered an IRF and receive reimbursement for services under the IRFprospective payment system, at least 60% of a facility’s total inpatientpopulation must require intensive rehabilitation services associated withtreatment of at least one of 13 designated medical conditions.  Under the 75% Rule, to maintain their revenuelevels many rehabilitation hospitals have needed to reduce the number ofnon-qualifying patients treated and replace them with qualifying patients,establish other sources of revenues or both. Before the 2007 amendment, the 75% Rule was being phased in over afour year period that began on July 1, 2004.  For cost reporting periods starting on andafter July 1, 2006, 60% of a facility’s inpatient population must haverequired intensive rehabilitation services for one of CMS’ designated medicalconditions.  For cost reporting periodsstarting on and after July 1, 2007, the requirement was 65%, and for costreporting periods starting on and after July 1, 2008, the requirement was75%. As a result of the rollback amendment, the requirement is now 60% forthese and future cost reporting periods. Congress has directed the Secretary of Health and Human Services toreport to it by June 2009 on Medicare beneficiaries’ access to medicallynecessary rehabilitation services, the potential effect of the 75% Rule andalternatives or refinements, and any variation in patient outcomes and costsacross settings of care. We believe our hospitals have been and are operatingin compliance with this rule and we are taking actions to assure continuedcompliance; however, we can provide no assurance that we will be able tocontinue to comply with this rule. Also pursuant to the Medicare, Medicaid andSCHIP Extension Act of 2007, the annual inflation increase factor for Medicarepayment rates for IRFs is set at zero percent for each of federal fiscal years2008 and 2009, except for payment units occurring before April 1,2008.  Our current Medicare inflationincrease factor for federal fiscal year 2008 was set at approximately fourpercent effective October 1, 2007, and we understand that this increasefactor will be reduced to zero effective as of April 1, 2008.  Although we anticipate that the effect of therate rollback may be counterbalanced and neutralized by the reduction of theprior law’s 65% and 75% minimum percentage requirements to 60% under currentlaw, the zero per cent inflation increases to our fiscal 2008 and 2009 ratesafter April 1, 2008, will affect the profitability of our rehabilitationoperations.

 

*                Certificates ofNeed.*Most states limit the number ofnursing homes and hospitals by requiring developers to obtain certificates ofneed before new communities may be built and a few states also limit the numberof assisted living facilities by requiring certificates of need.  Also, states such as California and Texasthat have eliminated certificate of need laws often have retained other meansof limiting new development, such as the use of moratoria, licensing laws or

 

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limitations upon participation in the state Medicaidprogram. We believe that these governmental limitations may make existingnursing homes and hospitals more valuable by limiting competition.

 

*                Other Matters*. Federal and state efforts to target fraud andabuse and violations of anti-kickback laws and physician referral laws byMedicare and Medicaid providers have also increased. In March 2000, theU.S. Department of Health and Human Services Office of Inspector General issuedcompliance guidelines for nursing communities to assist them in developingvoluntary compliance programs to prevent fraud and abuse.  The Office of Inspector General issuedcompliance program guidance for hospitals in 1998 and supplemental guidance in2005.  Rules governing the privacy,use and disclosure of individually identified health information took effect in2003, with civil and criminal sanctions for noncompliance. Any adversedetermination concerning any of our licenses or eligibility for Medicare orMedicaid reimbursement and the increasing costs of required compliance withapplicable federal or state regulations could adversely affect our ability tomeet our financial obligations and negatively affect our financial conditionand results of operations.

 

                Underthe Medicare Prescription Drug, Improvement and Modernization Act of 2003, orthe MPDIMA, effective January 1, 2006, Medicare beneficiaries may receiveprescription drug benefits by enrolling in private health plans or managed careorganizations, or if they remain in traditional Medicare, by enrolling in standalone prescription drug plans.  Webelieve this new law will increase the demand for pharmacy products andservices by Medicare beneficiaries.  Wealso believe that this new Medicare drug benefit may reduce the profitabilityof providing pharmacy products and services, as the Government implementsvarious cost control procedures.  Wecannot predict the net impact of this program at this time.

 

                Anumber of legislative proposals that would affect major reforms of thehealthcare system are being considered during the current Presidentialcampaign, have been introduced in the U.S. Congress and are being considered bysome state governments, such as programs for national health insurance, theoption of block grants for states rather than federal matching money forcertain state Medicaid services, additional policies encouraging state Medicaidprograms to use home and community based long term care services rather thannursing homes, laws authorizing or directing Medicare to negotiate ratereductions for prescription drugs, additional Medicare and Medicaid enforcementprocedures and federal and state cost containment measures, such asfreezing Medicare or Medicaid nursing home and rehabilitation hospital paymentrates at their current levels and reducing or eliminating annual Medicare orMedicaid inflation allowances or gradually reducing rates for nursing homes andrehabilitation hospitals.  In connection with recent fiscal pressures onstate governments and increasing costs of Medicaid funding, legislation andregulation to reduce Medicaid nursing home payment rates in some states arepossible in the future. We cannot predict whether any of these legislative orregulatory proposals will be adopted or, if adopted, what effect, if any, theseproposals would have on our business.

 

**INSURANCE**

 

                Litigationagainst senior living operators has been increasing during the past fewyears.  As a result, liability insurancecosts over the past few years has been rising. In recent years, our insurance costs for workers compensation andemployee healthcare have also increased significantly.  To partially offset these insurance costincreases, we have taken a number of actions including the following:

 

·                  we have increased the deductible or retention amounts for which we areliable under our liability insurance;

·                  we haveestablished an offshore captive insurance company which participates in ourliability insurance program. Some of our premiums for liability insurance arepaid to this company which may retain some of these amounts and the earnings onthese amounts based upon our actual claims experiences;

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

·                  we have increased theamounts which some of our employees are required to pay for health insurancecoverage and as co-payments for health services and pharmaceuticalprescriptions and decreased the amount of certain healthcare benefits;

·                  we have become fully selfinsured for all health related claims of covered employees;

 

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·                  we have hired professional advisors to help us establish programs toreduce our insured workers compensation and professional and generalliabilities, including a program to monitor and pro-actively settle liabilityclaims and to reduce workplace injuries; and

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

 

               We self insureup to certain limits for workers compensation and professional liability.  Claims in excess of these limits are insuredwith third party insurance providers up to contractual limits, over which weare self insured.  Our current insurance arrangements generally arerenewable in June 2008. We do not know if our insurance charges and selfinsurance reserve requirements will increase, and we cannot now predict theamount of any such increase, or to what extent, if at all, we may be able tooffset any increase through use of higher deductibles, retention amounts, selfinsurance or other means in the future.

 

**COMPETITION**

 

               The senior livingservices, pharmacy and the health rehabilitation businesses are highlycompetitive. We compete with service providers offering alternate types ofservices, such as home healthcare services, as well as other companiesproviding community based services and rehabilitation services.  We may expand our business with SeniorHousing; however, Senior Housing is not obligated to provide us withopportunities to lease additional properties. We have large lease obligationsand limited financeable assets. Many of our competitors have greater financialresources than we do.  Some of ourcompetitors are operated by not for profit entities which have endowment incomeand do not have the same financial pressures that we experience.  For all of these reasons and others, wecannot provide any assurance that we will be able to compete successfully forbusiness.

 

**ENVIRONMENTAL MATTERS**

 

                Under variousfederal, state and local laws, owners as well as tenants and operators of realestate may be required to investigate and clean up hazardous substancesreleased or otherwise present at a property, and may be held liable to agovernmental entity or to third parties for property damage or personalinjuries and for investigation and clean up costs incurred in connection withany such hazardous substances.  Under ourleases with Senior Housing, we have also agreed to indemnify Senior Housing forany such liabilities related to the properties we lease from Senior Housing. Inaddition, some environmental laws create a lien on a contaminated site in favorof the government for damages and costs it incurs in connection with thecontamination, which lien may be senior in priority to our debt obligations orour leases. We have reviewed environmental surveys of all of our leased andowned communities. Based upon that review we do not believe that any of theseproperties are subject to any material environmental contamination. However, noassurances can be given that a prior owner, operator or occupant of ourcommunities did not create a material environmental condition not known to uswhich might have been revealed by a more in depth study of the properties orthat future uses or conditions (including, without limitation, changes inapplicable environmental laws and regulations) will not result in theimposition of environmental liability upon us. The presence or discovery of anymaterial environmental contaminants at our communities could have a materialadverse impact on us.

 

**INTERNET WEBSITES**

** **

               Our internetwebsite address is www.fivestarqualitycare.com. Copies of our governance guidelines, code of business conduct and ethicsand the charters of our audit, quality of care, compensation and nominating andgovernance committees are posted on our website and may be obtained free ofcharge by writing to our Secretary, Five Star Quality Care, Inc., 400Centre Street, Newton, MA 02458 or at our website.  We make available, free of charge, on ourwebsite, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q,our Current Reports on Form 8-K and amendments to these reports filed orfurnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934, as amended, or the Exchange Act, as soon as reasonablypracticable after these forms are filed with, or furnished to, the Securitiesand Exchange Commission.  Any shareholderor other interested party who desires to communicate with our independentdirectors, individually or as a group, may do so by filling out a report on ourwebsite. Our board also provides a process for our security holders to sendcommunications to the entire board. Information about the process for sendingcommunications to our board can be found on our website.  Ourwebsite address and website addresses of one or more unrelated third partiesare included several times in this Annual Report

 

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on Form 10-K as textual references only and theinformation in the websites are not incorporated by reference into this AnnualReport on Form 10-K.

 

**Item 1A.  Risk Factors**

** **

Ourbusiness faces many risks. The risks described below may not be the only riskswe face. Additional risks that we do not yet know of, or that we currentlythink are immaterial, may also impair our business operations or financialresults. If any of the events or circumstances described in the following risksoccurs, our business, financial condition or results of operations could sufferand the trading price of our debt or equity securities could decline.  Investors and prospective investors shouldconsider the following risks and the information contained under the heading “WarningConcerning Forward Looking Statements” before deciding whether to invest in oursecurities.

 

**RISKSRELATED TO OUR BUSINESS**

 

**Asmall percentage decline in our revenues or increase in our expenses could havea material negative impact upon our operating results.**

 

               For the year ended December 31,2007, our revenues were $972.9 million and our operating expenses were $949.3million. A small percentage decline in our revenues or increase in our expensescould have a material negative impact upon our operating results.

 

**Wemay not achieve the anticipated benefits from our lease of the tworehabilitation hospitals and they may be subject to Medicare reclassificationsresulting in lower Medicare rates.**

 

               We are currently experiencinglosses from our operation of our two rehabilitation hospitals.  In addition, the two rehabilitation hospitalsmay be subject to retroactive rate adjustments. We may be unable to operate these hospitals profitably and we maycontinue to experience losses from our operation of these hospitals.  If we are unable to operate these hospitalssuccessfully, our reputation as a provider of health and rehabilitationservices may be damaged. Even if we successfully operate these hospitals, theseoperations may have little or no benefit to our other operations.

 

               A significant amount of therevenues at our rehabilitation hospitals is paid by Medicare and we became moredependent upon the Medicare program when we began to operate these hospitalsthan we were before we assumed these operations.  For cost reporting periods starting on andafter July 1, 2006, 60% of an IRF’s total inpatient population mustrequire intensive rehabilitation services associated with treatment of at leastone of 13 designated medical conditions. While we believe we are in compliance with the 60% requirement, and weexpect to remain in compliance with this rule, we may not be able to remain incompliance.  Such an event would resultin these hospitals being subject to Medicare reclassification to a differenttype of provider and our receiving lower Medicare payment rates.  Reductions in our Medicare payments as aresult of the reclassification of our rehabilitation hospitals would materiallyand adversely affect our financial conditions and results of operations.

 

Pursuantto the Medicare, Medicaid and SCHIP Extension Act of 2007, the annual inflationincrease factor for Medicare payment rates for IRFs is set at zero percent foreach of federal fiscal years 2008 and 2009, except for payment units occurringbefore April 1, 2008.  Our currentMedicare payment rate increase for federal fiscal year 2008 was set atapproximately 4% effective October 1, 2007, and we understand that thisincrease will be reduced to zero effective as of April 1, 2008.  Although we anticipate that the effect may be counterbalancedby the reduction of the prior law’s 65% and 75% minimum percentage requirementsto 60% under current law, the zero percent inflation increases to our fiscal2008 and 2009 rates after April 1, 2008, will affect the profitability ofour rehabilitation operations.

 

**Thefailure of Medicare and Medicaid rates to match our costs will reduce ourincome.**

 

Some of our current operations, especially our nursing homes andrehabilitation hospitals, receive significant revenues from the Medicare andMedicaid programs.  During the year endedDecember 31, 2007, approximately 34% of our senior living revenues and 69%of our hospital revenues were received fromthese programs.  The federal governmentand some states are now experiencing or projecting increasing fiscal deficits.Historically, when

 

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governmental deficits have increased, cut backs inMedicare and Medicaid funding have often followed.  These cut backs sometimes include ratereductions, but more often result in a failure of Medicare and Medicaid ratesto increase by sufficient amounts to offset increasing costs.  In 2006, there were cut backs to Medicarefunding which affected profitability of our current and continuing nursing homeoperations.  Also, for payment units onand after April 1, 2008, Medicare market basket increases to IRF rates areset at zero percent for federal fiscal years 2008 and 2009, which will affectthe profitability of our rehabilitation operations.  We cannotnow predict whether future Medicare and Medicaid rates will be sufficient tocover our future cost increases.  FutureMedicare and Medicaid rate declines or a failure of these rates to coverincreasing costs could result in our experiencing lower earnings or losses.

 

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

 

               Approximately 66% of our seniorliving revenues for the year ended December 31, 2007 were paid byresidents from their private resources. We expect to continue to rely on theability of our residents to pay for our services from their own financialresources. Inflation or other circumstances that adversely affect the abilityof the elderly to pay for our services could have a material adverse effect onour business, financial condition and results of operations.

 

**Seniors’inability to sell real estate may delay their moving into senior livingfacilities.**

 

Recenthousing price declines and reduced home mortgage availability have negativelyaffected the U.S. housing market, with certain geographic areas experiencingmore acute deterioration than others. This softening U.S. housing market, higher oil prices, stock marketvolatility, and lower consumer confidence are adversely affecting the overallU.S. economy, with many economists predicting a near-term recession and somepredicting a prolonged period with little or no economic growth. These currentdifficulties may have a negative effect on our revenues or lead toincreased reliance on Medicare and Medicaid for our revenues.  Specifically, if seniors have a difficulttime selling their homes, these difficulties could impact their ability torelocate into our senior living communities or finance their stays at ourfacilities with private resources.

 

**Thenature of our business exposes us to litigation risks. As a result, ourinsurance costs have increased and may continue to increase, and we self insurea large portion of our litigation risks.**

 

                The nature of our businessexposes us to litigation, and we are subject to lawsuits in the ordinary courseof our business. In several well publicized instances, private litigation byresidents of senior living communities for alleged abuses has resulted in largedamage awards against other operating companies. Today, some lawyers and lawfirms specialize in bringing litigation against senior living companies. As aresult of this litigation and potential litigation, our cost of liabilityinsurance has increased during the past few years. Medical liability insurancereform has become a topic of political debate and some states have enactedlegislation to limit future liability awards. However, if such reforms are notgenerally adopted, we expect our insurance costs may continue to increase. Toreduce costs, we self insure a significant amount of our litigation liabilityrisks. Although our reserves for liability self insurance have been determinedwith guidance from third party professionals, our reserves may proveinadequate. Increasing liability insurance costs and increasing self insurancereserves may materially negatively affect our results of operations or makethose results less consistent.

 

**Ourbusiness is subject to extensive regulation which increases our costs and mayresult in losses.**

 

               Licensing and Medicare andMedicaid laws require operators of senior living communities and rehabilitationhospitals to comply with extensive standards governing operations. There arealso various laws prohibiting fraud and abuse by senior living andrehabilitation hospital operators, including civil and criminal laws thatprohibit false claims for Medicare and Medicaid coverage and that regulatepatient referrals. In recent years, the federal and state governments havedevoted increased resources to monitoring the quality of care at senior livingcommunities and to anti-fraud investigations. When quality of care deficienciesare identified or improper billing is uncovered, various sanctions may beimposed, including denial of new admissions, exclusion from Medicare orMedicaid program participation, monetary penalties, governmental oversight orloss of licensure. Our communities incur sanctions and penalties from time totime. As a result of this extensive regulatory system and increasingenforcement initiatives, we have experienced increased costs for monitoringquality of care compliance and billing procedures, and we expect these costsmay continue to increase. Also, if we become subject to additional regulatorysanctions at any of our existing facilities, or as a result of

 

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purchasing facilitieswith prior deficiencies which we are unable to correct or resolve, our businessmay be adversely affected and we might experience financial losses.

 

**Ourgrowth strategy may not succeed.**

 

                Since our spin off from SeniorHousing on December 31, 2001, we have grown rapidly throughacquisitions.  Our business plan includesacquiring additional senior living communities and possibly additionalpharmacies and rehabilitation hospitals. Our growth strategy involves risks, including the following:

 

·                  we may be unable to locatesenior living communities, pharmacies or rehabilitation hospitals that receivea large percentage of their revenues from private resources;

 

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

 

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

 

·                  acquired operationsmay not perform in accord with our expectations;

 

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

 

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

 

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

 

·                  to theextent we incur acquisition debt or leases, our operating leverage may increaseand, to the extent we issue additional equity to fund our acquisitions, ourshareholders’ percentage of ownership will be diluted; and

 

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

 

For these reasons andothers:

 

·                  ourbusiness plan to grow may not succeed;

 

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

 

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

 

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

 

                When we acquire new communities,we sometimes see a decline in community occupancy and it may take a period oftime for us to stabilize acquired community operations.  Our efforts to restore occupancy or stabilizeacquired communities’ operations may not be successful.  In addition, we cannot provide any assurancethat we will not experience a decline in occupancy at the rehabilitationhospitals we recently began to operate. Although we have expanded our pharmacy businesses, we have recentlyreclassified two parts of our pharmacy business as discontinued because we donot believe we can successfully operate those parts of this business.  Rehabilitation hospitals and pharmacies arebusinesses with which we have limited experience, and our initiatives in theseareas may not be successful.

 

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**Increasesin our labor costs may have a material adverse effect on us.**

 

                Wages and employee benefitsrepresent approximately 43% of our 2007 total operating costs.  We compete with other operators of seniorliving communities and rehabilitation hospitals with respect to attracting andretaining qualified personnel responsible for the day to day operations of eachof our communities. A shortage of nurses or other trained personnel may requireus to increase the wages and benefits offered to our employees in order toattract and retain these personnel or to hire more expensive temporarypersonnel. Also, we have to compete for lesser skilled workers with numerousother employers.  Further, when weacquire new facilities, we may be required to pay increased compensation oroffer other incentives to retain key personnel and other employees. Employmentstatistics recently published by the government indicate a tight job market,despite the prospects for a general economic slowing. Historically, such statisticshave sometimes foretold increased wage pressures and we may experience suchwage pressures.  For example, recent wageincreases in Connecticut made our previous operations in that stateunprofitable. Employee benefits costs, including employee health insurance andworkers compensation insurance costs, have materially increased in recentyears. To help control these costs, we partially self insure our workerscompensation insurance and fully self insure our employee health insurance.Although our self insurance reserves have been determined with guidance fromthird party professionals, our reserves may be inadequate. Increasing employeehealth and workers compensation insurance costs and increasing self insurancereserves for labor related insurance may materially negatively affect ourearnings. No assurance can be given that our labor costs will not increase orthat any increase will be matched by corresponding increases in rates chargedto residents. Any significant failure by us to control our labor costs or topass on any increased labor costs to residents through rate increases couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

**Ourbusiness requires us to make significant capital expenditures to maintain andimprove our facilities.**

 

                Our communities sometimesrequire significant expenditures to address ongoing required maintenance and tomake them attractive to residents. Physical characteristics of senior living communities and rehabilitationhospitals are mandated by various governmental authorities; changes in theseregulations may require us to make significant expenditures.  In addition, we often are required to makesignificant capital expenditures when we acquire new facilities.  Our available financial resources may beinsufficient to fund these expenditures. In addition to capital expenditures we are making at some of our seniorliving communities, we expect that we will need to make certain capitalexpenditures at the rehabilitation hospitals we recently began to operate,which could be significant.  SeniorHousing has historically provided most of the capital we need to improve theproperties we lease from them.  However,whenever Senior Housing provides such capital, our rent increases and we may beunable to pay the increased rent without experiencing losses.

 

**Ourbusiness is highly competitive and we may be unable to operate profitably.**

 

                We compete with numerous othercompanies that provide senior living and rehabilitation hospital services,including home healthcare companies and other real estate based serviceproviders. Historically, nursing homes and rehabilitation hospitals have beensomewhat protected from competition by state laws requiring certificates ofneed to develop new communities; however, these barriers have been eliminatedin many states. Also, there are fewer barriers to competition for homehealthcare or for independent and assisted living services. Growth in theavailability of nursing home alternatives, including assisted livingcommunities, has had and may in the future have the effect of reducing theoccupancy or profitability at nursing homes, including those we operate. Manyof our existing competitors are larger and have greater financial resourcesthan us. Some of our competitors are not for profit entities which have largeendowments which allow them to operate without the financial pressures which weface.  We cannot provide any assurancesthat we will be able to attract a sufficient number of residents to ourcommunities or that we will be able to attract employees and keep wages andother employee benefits, insurance costs and other operating expenses at levelswhich will allow us to compete successfully or to operate profitably.

 

**Weare subject to possible conflicts of interest; we have engaged in, and expectto continue to engage in, transactions with related parties.**

 

Our business issubject to possible conflicts of interest as follows:

 

·                  as of December 31,2007, we leased from Senior Housing 142 of the 161 senior living communitiesthat we operated and our two rehabilitation hospitals for total annual rent ofapproximately $118.3 million and $10.6 million, respectively;

 

15

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·                  Reit Management &Research LLC, or RMR, is the manager of Senior Housing, we purchase variousmanagement services from RMR and a subsidiary of RMR leases office space to us;

 

·                  our Chief ExecutiveOfficer, Evrett W. Benton, and our Chief Financial Officer, Bruce J.Mackey Jr., are also part-time employees of RMR, our managing directors,Barry M. Portnoy and Gerard M. Martin, are directors of RMR, Mr. Portnoyis a managing trustee of Senior Housing and Mr. Portnoy also is themajority beneficial owner and the chairman of RMR; and

 

·                  under our sharedservices agreement with RMR, in the event of a conflict between Senior Housingand us, RMR may act on behalf of Senior Housing rather than on our behalf.

 

                On December 31, 2001,Senior Housing distributed substantially all of its ownership of our shares toits shareholders. Simultaneously with the spin off, we entered into agreementswith Senior Housing and RMR which, among other things, limit ownership of morethan 9.8% of our voting shares, restrict our ability to take any action thatcould jeopardize the tax status of Senior Housing as a real estate investmenttrust and limit our ability to acquire real estate of types which are owned bySenior Housing or other real estate investment trusts managed by RMR. As aresult of these agreements, our leases with Senior Housing and our sharedservices agreement with RMR, Senior Housing, RMR and their respectiveaffiliates have significant roles in our business and we do not anticipate anychanges to those roles in the future. We believe our affiliations with SeniorHousing and RMR have been and will be beneficial to us.  Although we do not believe the potentialconflicts have adversely affected, or will adversely affect, our business, noteveryone may agree with our position.

 

**Thelimitations on the ownership of our shares and other anti-takeover provisionsin our governing documents and in our material agreements may prevent ourshareholders from receiving a takeover premium for their shares.**

 

                Our charter places restrictionson the ability of any person or group to acquire beneficial ownership of morethan 9.8% (in number of shares or value, whichever is more restrictive) of anyclass of our equity securities. The terms of our leases with Senior Housing andour shared services agreement with RMR provide that our rights under theseagreements may be cancelled by Senior Housing and RMR, respectively, upon theacquisition by any person or group of more than 9.8% of our voting stock, andupon other change in control events, as defined in those documents. If thebreach of these ownership limitations causes a lease default, shareholderscausing the default may become liable to us or to other shareholders fordamages. Additionally, on March 10, 2004, we entered into a rightsagreement whereby in the event a person or group of persons acquires orattempts to acquire 10% or more of our outstanding common shares, ourshareholders, other than such person or group, will be entitled to purchaseadditional shares or other securities or property at a discount. These agreementsand other provisions in our charter and bylaws may increase the difficulty ofacquiring control of us by means of a tender offer, open market purchases, aproxy fight or otherwise, if the acquisition is not approved by our board ofdirectors. Other provisions in our governing documents which may deter takeoverproposals include the following:

 

·                  staggered terms formembers of our board of directors;

 

·                  the power of our boardof directors, without a shareholders’ vote, to authorize and issue additional sharesand create classes of shares on terms that it determines;

 

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

 

·                  advance noticeprocedures with respect to nominations of directors and shareholder proposals.

 

For all of thesereasons, shareholders may be unable to cause a change of control of us or torealize a change of control premium for their shares.

 

16

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**We may be unable to access the capital necessary to repaydebts or to grow.**

 

Weare currently funding our operations and growth strategy through a combinationof capital market offerings, cash generated from operations, cash on hand,expanded leases with Senior Housing and borrowings.  Our business and growth strategies depend, in part, upon our ability toraise additional capital at reasonable cost to repay debts or fund newinvestments. This ability and cost, in turn, is subject to credit marketvolatility.   Recently there has been atightening of liquidity in debt capital markets.  This tightening has had, and may have, atleast two consequences to us:

 

·                  First, a part of our cashbalances have been historically invested in auction rate securities, orARS.  Historically we have had the optionto liquidate these investments whenever the interest rate reset auctions close,usually every 35 days or less.  Aftersuccessful auctions in January 2008, starting in February 2008 thescheduled interest rate reset auctions for these ARS have failed and through March 4,2008 we have not had the option to liquidate our holdings for approximately $63.4million of our ARS investments.  Thesecurities we hold are highly rated and issued by entities which operatestudent loan programs pursuant to the Federal Family Education Loan Program.  As a result of these failed auctions, theinterest we earn on these investments has increased. However, at this time wedo not know when we may be able to sell these securities or the price at whichthey may be sold.  At this time, wecontinue to hold approximately an additional $11.5 million of similar ARS wherereset auctions are scheduled to occur in the future, and we are unable topredict whether these auctions, or future auctions for the ARS where auctionshave failed, will be successfully completed.

 

·                  Second, our outstanding debtsecurities are not rated by any generally recognized rating agencies.  If our debt obligations were rated we do notbelieve they would achieve investment grade ratings.  We believe that, during periods of tightenedliquidity in debt capital markets, borrowings by unrated, or less thaninvestment grade rated, companies like us may be difficult to obtain andincreasingly expensive.  We do not expectthe current market conditions to adversely affect our existing $40 million revolvingcredit facility which we renewed in June 2007.  However, if the current market conditionspersist, we believe we may experience difficulty to renew this credit facilitywhen it expires in 2009 and that our costs of any such renewal may be higherthan the costs we incurred to put the current facility in effect and to borrowunder it.  Also, so long as the currentmarket conditions persist, we may be unable to increase our borrowings on termswhich are similar to our historical terms or on any terms.

 

Ifwe are unable to liquidate our holdings of ARS or to access additionalborrowings on reasonable terms as a result of a long term continuation of thecurrent debt capital market conditions or for other reasons, our business andfinancial results may be materially adversely affected.

 

**RISKSRELATED TO OUR NOTES AND COMMON SHARES**

 

**The Notes we issued in October 2006, will be effectivelysubordinated to the debts of our subsidiaries and to our secured debt.**

 

The Notes we issued in October 2006are issued by our parent company and certain of our subsidiaries.  We are a holding company and conductsubstantially all of our operations through subsidiaries. Consequently, ourability to pay debt service on the Notes will be dependent upon the cash flowof our subsidiaries and payments by those subsidiaries to us as dividends orotherwise. Our subsidiaries are separate legal entities and have their ownliabilities. Payments due on our Notes are effectively subordinated toliabilities of our non-guarantor subsidiaries. Certain of our subsidiaries guarantee our obligations under the Notesand those subsidiaries and additional subsidiaries guarantee our obligationsunder our revolving credit facility.  Inaddition, as of December 31, 2007, our non-guarantor subsidiaries hadapproximately $16.0 million of secured indebtedness outstanding, and may addadditional secured indebtedness that would effectively rank senior to theoutstanding Notes, and any new notes we may issue.  The Notes are unsecured and, as such,effectively subordinated to our secured debt.  Inaddition, non-guarantor subsidiaries have substantial additional obligations,including trade payables and lease obligations, to which the Notes are and willbe effectively subordinated.

 

Our right to receive assets of any of our subsidiariesupon its liquidation or reorganization will be structurally subordinated to theclaims of our subsidiaries’ creditors, except to the extent that we arerecognized as a creditor of such subsidiary, in which case our claims would stillbe subordinated to any security interests in the assets of such subsidiaries

 

17

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and any indebtedness of our subsidiaries that is seniorto that held by us. In the event of our insolvency, bankruptcy, liquidation,reorganization, dissolution or winding up, we and the subsidiaries thatguarantee our outstanding Notes, or any new notes we may issue, may not havesufficient assets to pay amounts due on any or all such notes.

 

**We may be required toprepay our debts at the option of Note holders or upon a change of control.**

 

In certain change of controlcircumstances or if our common shares are no longer traded on a nationalsecurities exchange or on an established over the counter market in the UnitedStates, holders of our outstanding Notes may have the right to require us topurchase their Notes at their principal amount plus accrued interest.  Holders of these Notes alsohave the right to require us to purchase for cash all or a portion of theirNotes on each of October 15, 2013, October 15, 2016 and October 15,2021; however, we may not have sufficient financial resources at those times topay the repurchase price and our then existing indebtedness could restrict orprohibit the repurchase.  Any notes we mayissue in the future may have similar or even more onerous terms.

 

**If we redeem the Notesbefore maturity, our Note holders may be unable to reinvest proceeds at thesame or a higher rate.**

 

We may redeem all or a portionof our outstanding Notes after a certain amount of time.  Generally, the redemption price will equalthe principal amount being redeemed, plus any accrued and unpaid interest to,but excluding the redemption date.  If aredemption occurs, holders of these Notes may be unable to reinvest the moneythey receive in the redemption at a rate that is equal to or higher than therate of return on the redeemed Notes. Notes we may issue in the future may also permit redemption beforematurity and create similar risks.

 

**There may be no publicmarket for our Notes.**

 

Although our outstanding Notesare traded in the Private Offerings, Resale and Trading through AutomatedLinkages, or PORTAL, Market of the National Association of Securities Dealers, Inc.,these Notes are not listed on any securities exchange.  We can provide no assurance that an activetrading market for these Notes will exist in the future.  Also the limited liquidity of the tradingmarket for our existing Notes, or any notes we may issue in the future, and themarket price quoted for such notes may be adversely affected by changes in theoverall market for fixed income securities, by changes in our financialperformance or prospects, or by changes in the prospects for the senior livingindustry generally.

 

**Increased leverage may harm ourfinancial condition and results of operations.**

 

Our total consolidated long term debt as of December 31,2007 was approximately $142.3** **millionand represented approximately 62% of our total book capitalization as of thatdate.  In addition to our indebtedness,we have substantial lease and other obligations.  The indenture governing our outstanding Notesdoes not limit the amount of additional indebtedness, including senior orsecured indebtedness, which we can create, incur, assume or guarantee, nor doesthe indenture limit the amount of indebtedness or other liabilities that oursubsidiaries can create, incur, assume or guarantee.

 

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

 

·                  it could affectour ability to satisfy our debt obligations;

 

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

 

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

 

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

 

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

 

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**Conversion rights of our outstanding Notes may be detrimentalto holders of our common shares.**

 

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

 

Theconversion of some or all of our outstanding Notes will dilute the ownershipinterests of our shareholders.  Any salesin the public market of the common shares issuable upon such conversion couldadversely affect prevailing market prices of our common shares.  In addition, the existence of the outstandingconvertible Notes may encourage short selling by market participants becausethe conversion of these Notes could depress the price of our commonshares.  These conversion rights also maymake more difficult or discourage a party from taking over our company andremoving incumbent management and may discourage or impede transactions thatmight otherwise be in the interests of our common shareholders.  Any future issuance of convertible securitiesby us may create similar risks.

 

**Future issuances of common shares andhedging activities may depress the trading price of our common shares.**

 

We may issue equity securities in the future for a numberof reasons, including to finance our operations and growth strategy, to adjustour ratio of debt to equity, to satisfy our obligations upon the exercise ofoutstanding warrants or options or for other reasons.  Any issuance of equity securities, includingthe issuance of shares upon conversion of our outstanding Notes as describedabove, could dilute the interests of our existing shareholders, and couldsubstantially decrease the trading price of our common shares and of theNotes.  In addition, the price of ourcommon shares could also be affected by possible sales of our common shares byinvestors who view our outstanding Notes as a more attractive means of equityparticipation in us and by hedging or arbitrage trading activity involving bothour outstanding Notes and common shares. This hedging or arbitrage could, in turn, lower the trading price of ouroutstanding Notes and of our common shares.

 

**We do not intend to pay cash dividendson our common shares in the foreseeable future.**

 

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

 

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

 

The market price of our common shares has fluctuated andcould fluctuate significantly in the future in response to various factors andevents, including, but not limited to, the risks set out in this Annual Report,as well as:

 

·                  the liquidity of the market for our common shares;

 

·                  changes in our operating results;

 

·                  changes from analysts’ expectations; and

 

·                  general economic and industry trends and conditions.

 

Inaddition, the stock market in recent years has experienced broad price andvolume fluctuations that often have been unrelated to the operating performanceof particular companies.  These marketfluctuations may also cause the market

 

19

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priceof our common shares to decline. Shareholders may be unable to resell our common shares at or above priceat which they purchased our shares.

 

**Item 1B.  Unresolved Staff Comments**

 

**               **None

 

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**Item 2.  Properties**

 

**OUR SENIOR LIVING COMMUNITIES**

** **

Asof December 31, 2007, we operated 161senior living communities which we have categorized into two groups as follows:

 
| ** **                                  | ** ** | ** **                   | ** ** | **Type of units**         | ** ** | ** **                  | ** ** | ** **              | ** ** | **Revenues for**    | ** ** | **Percent of  revenues**                                        | ** ** |
|---------------------------------------------|------------|------------------------------|------------|---------------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|----------------------------------------------------------------------|------------|
| **Type of community**             | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.** | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home  beds** | ** ** | **Total  living  units** | ** ** | **Occupancy for  the year ended  Dec. 31, 2007** | ** ** | **the year ended  Dec. 31, 2007  (in thousands)** | ** ** | **from  private  resources** | ** ** |
| Independent and assisted living communities |       | 112                          |       | 5,454                     |       | 6,330                       |       | 1,718                   |       | 13,502                   |       | 91.1                                                                 | %          | $ | 549,622 |   | 86 | % |
| Skilled nursing facilities                  |       | 49                           |       | 66                        |       | —                      |       | 4,338                   |       | 4,404                    |       | 87.8                                                                 | %          | 254,756 |   | 23 | % |
| Totals:                                     |       | 161                          |       | 5,520                     |       | 6,330                       |       | 6,056                   |       | 17,906                   |       | 90.3                                                                 | %          | $ | 804,378 |   | 66 | % |

 

**Independentand Assisted Living Communities**

** **

As of December 31, 2007, we operated 112 independent and assisted livingcommunities.  We lease 95 of thesecommunities from Senior Housing and four of these communities from Health CareProperty Investors, or HCPI, and we own the remaining 13 communities.  These communities have 13,502 living unitsand are located in 24 states.  Thefollowing table provides additional information about these communities andtheir operations as of December 31, 2007:

 
| ** **         | ** ** | ** **                   | ** ** | **Type of units**         | ** ** | ** **                  | ** ** | ** **              | ** ** | **Revenues for**    | ** ** | **Percent of  revenues**                                             | ** ** |
|--------------------|------------|------------------------------|------------|---------------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|---------------------------------------------------------------------------|------------|
| **Location**       | ** ** | **No. of  Communities** | ** ** | **Indep.  living  apts.** | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home  beds** | ** ** | **Total  living  units** | ** ** | **Occupancy for  the year ended  Dec. 31, 2007** | ** ** | **the year ended  Dec. 31, 2007   (in thousands)** | ** ** | **from   private  resources** | ** ** |
| 1. Alabama         |       | 6                            |       | —                    |       | 256                         |       | —                  |       | 256                      |       | 94.9                                                                      | %          | $ | 8,185 |   | 100 | % |
| 2. Arizona         |       | 4                            |       | 471                       |       | 263                         |       | 196                     |       | 930                      |       | 86.2                                                                      | %          | 36,141 |   | 81 | % |
| 3. California      |       | 4                            |       | 502                       |       | 140                         |       | 59                      |       | 701                      |       | 88.9                                                                      | %          | 29,240 |   | 92 | % |
| 4. Delaware        |       | 5                            |       | 336                       |       | 173                         |       | 367                     |       | 876                      |       | 92.8                                                                      | %          | 51,900 |   | 74 | % |
| 5. Florida         |       | 8                            |       | 1,229                     |       | 537                         |       | 155                     |       | 1,921                    |       | 91.3                                                                      | %          | 67,528 |   | 82 | % |
| 6. Georgia         |       | 10                           |       | 111                       |       | 475                         |       | 40                      |       | 626                      |       | 93.8                                                                      | %          | 21,715 |   | 97 | % |
| 7. Illinois        |       | 1                            |       | 110                       |       | —                      |       | —                  |       | 110                      |       | 85.2                                                                      | %          | 1,803 |   | 100 | % |
| 8. Indiana         |       | 1                            |       | 118                       |       | 30                          |       | 74                      |       | 222                      |       | 96.4                                                                      | %          | 13,848 |   | 70 | % |
| 9. Kansas          |       | 2                            |       | 249                       |       | 30                          |       | 60                      |       | 339                      |       | 96.3                                                                      | %          | 13,741 |   | 83 | % |
| 10. Kentucky       |       | 9                            |       | 492                       |       | 281                         |       | 183                     |       | 956                      |       | 94.3                                                                      | %          | 38,976 |   | 85 | % |
| 11. Massachusetts  |       | 1                            |       | —                    |       | 124                         |       | —                  |       | 124                      |       | 97.3                                                                      | %          | 7,417 |   | 100 | % |
| 12. Maryland       |       | 6                            |       | 270                       |       | 331                         |       | —                  |       | 601                      |       | 95.5                                                                      | %          | 25,883 |   | 100 | % |
| 13. Mississippi    |       | 2                            |       | —                    |       | 129                         |       | —                  |       | 129                      |       | 74.6                                                                      | %          | 3,349 |   | 100 | % |
| 14. Missouri       |       | 1                            |       | 119                       |       | —                      |       | —                  |       | 119                      |       | 72.2                                                                      | %          | 1,980 |   | 100 | % |
| 15. Nebraska       |       | 1                            |       | —                    |       | 69                          |       | —                  |       | 69                       |       | 91.8                                                                      | %          | 2,258 |   | 100 | % |
| 16. North Carolina |       | 5                            |       | —                    |       | 457                         |       | —                  |       | 457                      |       | 92.7                                                                      | %          | 18,771 |   | 99 | % |
| 17. New Jersey     |       | 1                            |       | 211                       |       | 140                         |       | 60                      |       | 411                      |       | 80.3                                                                      | %          | 15,117 |   | 73 | % |
| 18. New Mexico     |       | 1                            |       | 114                       |       | 35                          |       | 60                      |       | 209                      |       | 95.5                                                                      | %          | 12,169 |   | 83 | % |
| 19. Ohio           |       | 1                            |       | 143                       |       | 113                         |       | 60                      |       | 316                      |       | 88.6                                                                      | %          | 16,807 |   | 80 | % |
| 20. Pennsylvania   |       | 4                            |       | —                    |       | 426                         |       | —                  |       | 426                      |       | 86.3                                                                      | %          | 12,635 |   | 100 | % |
| 21. South Carolina |       | 13                           |       | —                    |       | 630                         |       | 104                     |       | 734                      |       | 94.0                                                                      | %          | 27,731 |   | 88 | % |
| 22. Tennessee      |       | 11                           |       | 81                        |       | 572                         |       | —                  |       | 653                      |       | 92.3                                                                      | %          | 19,485 |   | 100 | % |
| 23. Texas          |       | 5                            |       | 898                       |       | 342                         |       | 300                     |       | 1,540                    |       | 90.7                                                                      | %          | 72,580 |   | 81 | % |
| 24. Virginia       |       | 10                           |       | —                    |       | 777                         |       | —                  |       | 777                      |       | 91.6                                                                      | %          | 30,363 |   | 100 | % |
| Totals:            |       | 112                          |       | 5,454                     |       | 6,330                       |       | 1,718                   |       | 13,502                   |       | 91.1                                                                      | %          | $ | 549,622 |   | 86 | % |

** **

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** **

**Skilled Nursing Communities**

** **

Asof December 31, 2007, we operated 49 skilled nursing communities.  We lease 47 of these communities from SeniorHousing and we own the other two communities. These communities have 4,404 livingunits and are located in 11 states.  Thefollowing table provides additional information about these communities andtheir operations as of December 31, 2007:

 
| ** **    | ** ** | ** **                   | ** ** | **Type of units**         | ** ** | ** **                  | ** ** | ** **              | ** ** | **Revenues for**    | ** ** | **Percent of  revenues**                                    | ** ** |
|---------------|------------|------------------------------|------------|---------------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|------------------------------------------------------------------|------------|
| **Location**  | ** ** | **No. of  communities** | ** ** | **Indep.  living  apts.** | ** ** | **Assist.  living  suites** | ** ** | **Nursing  home  beds** | ** ** | **Total  living  units** | ** ** | **Occupancy  for the year  ended  Dec. 31, 2007** | ** ** | **the year ended  Dec. 31, 2007  (in thousands)** | ** ** | **from  private  resources** | ** ** |
| 1. Arizona    |       | 1                            |       | —                    |       | —                      |       | 119                     |       | 119                      |       | 83.8                                                             | %          | $ | 6,584 |   | 19 | % |
| 2. California |       | 4                            |       | —                    |       | —                      |       | 396                     |       | 396                      |       | 94.1                                                             | %          | 28,805 |   | 18 | % |
| 3. Colorado   |       | 7                            |       | 47                        |       | —                      |       | 774                     |       | 821                      |       | 87.3                                                             | %          | 50,171 |   | 28 | % |
| 4. Georgia    |       | 3                            |       | —                    |       | —                      |       | 329                     |       | 329                      |       | 94.0                                                             | %          | 16,892 |   | 6 | % |
| 5. Iowa       |       | 7                            |       | 19                        |       | —                      |       | 486                     |       | 505                      |       | 87.3                                                             | %          | 27,765 |   | 17 | % |
| 6. Kansas     |       | 1                            |       | —                    |       | —                      |       | 58                      |       | 58                       |       | 96.5                                                             | %          | 2,784 |   | 33 | % |
| 7. Michigan   |       | 2                            |       | —                    |       | —                      |       | 271                     |       | 271                      |       | 89.1                                                             | %          | 24,619 |   | 17 | % |
| 8. Missouri   |       | 2                            |       | —                    |       | —                      |       | 186                     |       | 186                      |       | 86.3                                                             | %          | 7,669 |   | 22 | % |
| 9. Nebraska   |       | 14                           |       | —                    |       | —                      |       | 807                     |       | 807                      |       | 85.8                                                             | %          | 37,352 |   | 31 | % |
| 10. Wisconsin |       | 6                            |       | —                    |       | —                      |       | 722                     |       | 722                      |       | 87.2                                                             | %          | 43,753 |   | 24 | % |
| 11. Wyoming   |       | 2                            |       | —                    |       | —                      |       | 190                     |       | 190                      |       | 78.0                                                             | %          | 8,362 |   | 27 | % |
| Totals:       |       | 49                           |       | 66                        |       | —                      |       | 4,338                   |       | 4,404                    |       | 87.8                                                             | %          | $ | 254,756 |   | 23 | % |

** **

**OUR INPATIENTREHABILITATION HOSPITALS**

** **

As of December 31, 2007, we operated twoinpatient rehabilitation hospitals that we lease from Senior Housing.  These hospitals are located inMassachusetts.  We commenced operationsat these two hospitals on October 1, 2006. These two hospitals have****321 bedsavailable for inpatient services and provide services at three satellitelocations.  In addition, these twohospitals operate 20****affiliatedoutpatient clinics.  The hospitals hadrevenues of $102.0 million in the year ended December 31, 2007 andoccupancy was 63%.  During the year endedDecember 31, 2007 approximately 65% of the revenues at these hospitalscame from the Medicare program, 4% came from the Medicaid program and the 31%balance came from health insurance companies or other sources.

 

**OUR SENIOR HOUSING LEASES**

** **

We have six leases with Senior Housing.  Four of these leases are for 112 skillednursing facilities and independent and assisted living communities that weoperate, one of these leases is for the 30 communities previously managed bySLS that we now operate and one lease is for the two rehabilitation hospitalsthat we operate.  The followingis a summary of the material terms of our leases.  Because it is a summary, it does not containall of the information that may be important to you.  If you would like more information, youshould read the leases which are among the exhibits listed in Item 15 of thisAnnual Report on Form 10-K and incorporated herein by reference.

 

The following table is a summary of our leases:

 
| ** **                                                                                         | ** ** | **Number of  properties** | ** ** | **Annual  minimum rent as of  December 31, 2007** | ** **    | **Initial expiration  date** | ** **              | **Renewal terms**                                                | ** **                   |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|----------------------------------------------------------------------------|---------------|-----------------------------------|-------------------------|-----------------------------------------------------------------------|------------------------------|
|                                                                                               |       |                           |       |                                                                       |          |                              |                    |                                                                  |                         |
| 1. Four leases for skilled nursing facilities and independent and  assisted living communities (1) |       | 112                            |       | $                                                                          | 51.7 million  |                              | December 31,  2020 |                                                                  | One 15-year renewal  option. |   |
|                                                                                               |       |                           |       |                                                                       |          |                              |                    |                                                                  |                         |
| 2. One lease for communities previously managed by SLS                                             |       | 30                             |       | 66.6 million                                                               |          | December 31,  2017           |                    | Two consecutive renewal  options for 10 and 5 years (15 years total). |                         |
|                                                                                               |       |                           |       |                                                                       |          |                              |                    |                                                                  |                         |
| 3. One lease for rehabilitation hospitals                                                          |       | 2                              |       | 10.6 million                                                               |          | June 30,  2026               |                    | One 20-year renewal  option.                                          |                         |
| Totals                                                                                             |       | 144                            |       | $                                                                          | 128.9 million |                              |                    |                                                                  |                         |   |

 

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(1)                                  Three of these four leases exist to accommodate mortgage financings ineffect at the time Senior Housing acquired the leased properties; we haveagreed to combine all four of these leases into one lease when these mortgagesare paid.

 

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*Percentage rent.* All of our senior living community leases with Senior Housing requireus to pay additional rent equal to 4% of the amount by which gross revenues ofthe communities we operate exceed gross revenues in a base year.  Different base years apply to thesecommunities, which is generally set at the first full calendar year after eachcommunity is leased.

 

*Operating costs.*  Each lease is a so-called“triple-net” lease which requires us to pay all costs incurred in the operationof the properties, including the costs of personnel, services to residents,insurance and real estate and personal property taxes.

 

*Rent during renewal term.*  Rent during each renewal term isthe same as the minimum rent and percentage rent payable during the initialterm.

 

*Licenses.* Our leases require us to obtain, maintain andcomply with all applicable permits and licenses necessary to operate the leasedproperties.

 

*Maintenance and alterations.*  We are required to operatecontinuously and maintain, at our expense, the leased properties in good orderand repair, including structural and nonstructural components. We may requestSenior Housing to fund amounts needed for repairs and renovations in return forrent adjustments to provide Senior Housing a return on its investment accordingto formulas. At the end of each lease term, we are required to surrender theleased properties in substantially the same condition as existed on thecommencement date of the lease, subject to any permitted alterations andordinary wear and tear.

 

*Assignment and subletting.*  Senior Housing’s consent isgenerally required for any direct or indirect assignment or sublease of any ofthe properties.  Also, in the event ofany assignment or subletting, we remain liable under the applicable lease.

 

*Indemnification and insurance.*  With limited exceptions, we arerequired to indemnify Senior Housing from all liabilities which may arise fromthe ownership or operation of the leased properties. We generally are requiredto maintain commercially reasonable insurance, including captive selfinsurance, for:

 

·                  “all-risk” property insurance, in an amount equal to 100% of the fullreplacement cost of the properties;

·                  business interruption insurance;

·                  comprehensive general liability insurance, including bodily injury andproperty damage, in amounts as are generally maintained by companies providingsenior living services;

·                  flood insurance, if any property is located in whole or in part in aflood plain;

·                  workers compensation insurance, if required by law; and

·                  such additional insurance as may be generally maintained by companiesproviding senior living services, including professional and general liabilityinsurance.

 

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Eachlease requires that Senior Housing be named as an additional insured underthese insurance policies.

 

*Damage, destruction, condemnation andenvironmental matters.*  If any of the leased properties is damaged byfire or other casualty or taken for a public use, we are generally obligated torebuild unless the community cannot be restored. If the property cannot berestored, Senior Housing will generally receive all insurance or taking proceedsand we are liable to Senior Housing for the amount of any deductible ordeficiency between the replacement cost and the insurance proceeds, and ourrent will be adjusted pro rata.  We arealso required to remove and dispose of any hazardous substance at the leasedproperties in compliance with all applicable environmental laws andregulations.

 

*Events of default.*  Events of default under eachlease include the following:

 

·                  our failure to pay rent or any money due under the lease when it is due;

·                  our failure to maintain the insurance required under such lease;

·                  any person or group acquiring ownership of 9.8% or more of ouroutstanding voting stock or any change in our control or sale of a materialportion of our assets without Senior Housing’s consent;

·                  the occurrence of certain events with respect to our insolvency ordissolution;

·                  our default under indebtedness which gives the holder the right toaccelerate;

·                  our being declared ineligible to receive reimbursement under Medicare orMedicaid programs for any of the leased properties which participate in suchprograms or the revocation of any material license required for our operations;and

·                  our failure to perform any terms, covenants or agreements of the leasesand the continuance thereof for a specified period of time after writtennotice.

* *

*Remedies.*  Upon the occurrence of any eventof default, each lease provides that, among other things, Senior Housing may,to the extent legally permitted:

 

·                  accelerate the rents;

·                  terminatethe leases in whole or in part;

·                  enter the property and take possession of any and all our personalproperty and retain or sell the same at a public or private sale;

·                  make any payment or perform any act required to be performed by us underthe leases; and

·                  rent the property and recover from us the difference between the amountof rent which would have been due under the lease and the rent received fromthe re-letting.

 

We areobligated to reimburse Senior Housing for all costs and expenses incurred inconnection with any exercise of the foregoing remedies.

 

*Management.*  We may not enter into any newmanagement agreement affecting any leased property without the prior writtenconsent of Senior Housing.

 

*Lease subordination.*  Our leases may be subordinatedto any mortgages on properties leased from Senior Housing.

 

*Financing limitations; security.*  Without Senior Housing’s consentwe may not incur debt secured by our investments in our tenant subsidiaries.Further, our tenant subsidiaries are prohibited from incurring liabilitiesother than operating liabilities incurred in the ordinary course of business,liabilities secured by our accounts receivable or purchase money debt. We havepledged 100% of the equity interests of certain of our tenant subsidiaries toSenior Housing and to certain of its lenders, and we may pledge interests inour leases only if the pledge is approved by Senior Housing.

 

***Non economic circumstances.***  If we determine that continued operations ofone or more properties is not economical, we may negotiate with Senior Housingto close or sell that community, including Senior Housing’s ownership in theproperty. In the event of such a sale, Senior Housing receives the net proceedsand our rent for the remaining properties in the affected lease is reducedaccording to formulas.

** **

**24**

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** **

**Item 3.    Legal Proceedings**

** **

In the ordinarycourse of business we are involved in litigation incidental to our business;however, we are not aware of any material pending legal proceeding affecting usfor which we might become liable or the outcome of which we expect to have amaterial impact on us.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

** **

**None.**

** **

**25**

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** **

**PART II**

** **

**Item 5.  Market for Registrant’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities**

** **

Our common sharesare traded on the AMEX (symbol: FVE). The following table sets forth for theperiods indicated the high and low sale prices for our common shares asreported by the AMEX:

 
| ** **     | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------|------------|------------|------------|------------|------------|
| 2006           | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter  |       | $          | 12.10      |       | $          | 7.70 |   |
| Second Quarter |       | 11.64      |       | 9.20       |       |
| Third Quarter  |       | 11.95      |       | 8.75       |       |
| Fourth Quarter |       | 11.25      |       | 9.43       |       |
|           |       |       |       |       |       |
| 2007           |       |       |       |       |       |
| First Quarter  |       | 12.46      |       | 9.60       |       |
| Second Quarter |       | 11.01      |       | 7.28       |       |
| Third Quarter  |       | 8.60       |       | 6.07       |       |
| Fourth Quarter |       | 10.20      |       | 7.55       |       |
|                |            |            |            |            |            |  |  |

 

The closing priceof our common shares on the AMEX on March 4, 2008, was $6.90 per share.

 

As of March 4,2008, there were 3,000 shareholders of record, and we estimate that as of suchdate there were in excess of 35,300 beneficial owners of our common shares.

 

We have not paidany dividends in the past and do not expect to pay dividends in the future.

 

We issued unregisteredshares during the fourth quarter as follows: on November 19, 2007,pursuant to our stock option and stock incentive plan, we issued 111,300 sharesof common stock, par value $0.01 per share, valued at $8.90 per share (theclosing price of our common shares on the AMEX on that day) to certainemployees and others who provide services to us.  We issued these grants pursuant to anexemption from registration contained in section 4(2) of the SecuritiesAct of 1933, as amended.

 

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**Item 6.    Selected Financial Data**

 

The following table sets forth selected financial datafor the periods and dates indicated.** **Our comparative results areimpacted by community acquisitions and dispositions during the periodsshown.  This data should be read inconjunction with, and is qualified in its entirety by reference to,management’s discussion and analysis of financial condition and results ofoperations and the consolidated financial statements and accompanying notesincluded in this Annual Report on Form 10-K.

 
| ** **                                   | ** ** | **Year ended December 31,**          | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | **(in thousands, except per share data)** | ** ** |
| Operating data:                              | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total revenues                               |       | $                                         | 972,924    |   | $ | 815,586 |   | $ | 727,659 |   | $ | 597,824 |   | $ | 545,380 |   |
| Net income (loss) from continuing operations |       | 26,095                                    |       | (109,587 | ) | (79,691 | ) | 5,181 |   | (5,079 | ) |
| Net loss from discontinued operations        |       | (2,769                                    | )          | (7,078 | ) | (4,468 | ) | (1,890 | ) | (2,860 | ) |
| Net income (loss)                            |       | $                                         | 23,326     |   | $ | (116,665 | ) | $ | (84,159 | ) | $ | 3,291 |   | $ | (7,939 | ) |
| Basic net income (loss) per share:           |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations     |       | $                                         | 0.82       |   | $ | (3.83 | ) | $ | (5.35 | ) | $ | 0.59 |   | $ | (0.60 | ) |
| Loss from discontinued operations            |       | (0.08                                     | )          | (0.25 | ) | (0.30 | ) | (0.22 | ) | (0.34 | ) |
| Net income (loss)                            |       | $                                         | 0.74       |   | $ | (4.08 | ) | $ | (5.65 | ) | $ | 0.37 |   | $ | (0.94 | ) |
| Diluted net income (loss) per share:         |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations     |       | $                                         | 0.75       |   | $ | (3.83 | ) | $ | (5.35 | ) | $ | 0.59 |   | $ | (0.60 | ) |
| Loss from discontinued operations            |       | (0.07                                     | )          | (0.25 | ) | (0.30 | ) | (0.22 | ) | (0.34 | ) |
| Net income (loss)                            |       | $                                         | 0.68       |   | $ | (4.08 | ) | $ | (5.65 | ) | $ | 0.37 |   | $ | (0.94 | ) |
| Balance sheet data (as of December 31): |       |                                      |       |   |   |   |   |   |   |   |   |
| Total assets                                 |       | $                                         | 360,454    |   | $ | 366,411 |   | $ | 228,940 |   | $ | 222,985 |   | $ | 147,370 |   |
| Total indebtedness                           |       | 142,510                                   |       | 171,271 |   | 45,329 |   | 42,581 |   | 10,436 |   |
| Other long term obligations                  |       | 27,259                                    |       | 28,098 |   | 24,465 |   | 18,065 |   | 16,196 |   |
| Total shareholders’ equity              |       | $                                         | 86,822     |   | $ | 67,430 |   | $ | 68,804 |   | $ | 95,904 |   | $ | 64,427 |   |

 

**Item 7.    Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

** **

**GENERAL INDUSTRY TRENDS**

** **

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

 

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

 

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Rehabilitation hospitalsprovide intensive medical services, including physical therapy, occupationaltherapy and speech language services beyond the capability customarilyavailable in skilled nursing facilities. We believe that if we are successful in our operation of ourrehabilitation hospitals, our reputation in the rehabilitation business(including providing outpatient rehabilitation services) will be enhanced.  A reputation for providing high qualityrehabilitation services may help create opportunities to acquire additionalIRFs or to provide increasing amounts of rehabilitation services at our seniorliving communities.

 

Institutional pharmaciesprovide large quantities of drugs at locations where patients with recurringpharmacy requirements are concentrated. The business rationale for an institutional pharmacy is to deliver drugsand pharmacy services more efficiently and at lower costs than from expensiveretail locations which cater to short term requirements.  The aging of the population and recentpharmacological innovations have created rapidly growing demand for pharmacydrugs and services.  We believe theMPDIMA will also increase the demand for pharmacy products and services byMedicare beneficiaries but may reduce profitability, as the governmentimplements various cost control procedures. We cannot predict the net impact ofthe MPDIMA at this time.

 

We earn our senior livingrevenue primarily by providing housing and services to our senior livingresidents.  During 2007, approximately34% of our senior living revenues came from the Medicare and Medicaid programsand 66% of our senior living revenues came from residents’ private resources.  We bill all private pay residents in advancefor the housing and services to be provided in the following month.

 

Our material expenses were:

 

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

 

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

 

·                  Hospital expenses– includes wages and benefits for our hospital based staff and other operatingexpenses related to our hospital business.

 

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

 

·                  Rent expense –we lease 142 of our 161 senior living communities and two rehabilitationhospitals from Senior Housing and four senior living communities from HCPI.

 

·                  General andadministrative expenses – principally wage related costs for headquarters andregional staff supporting our communities, hospitals and pharmacies.

 

·                  Depreciationand amortization expense – we incur depreciation expense on buildings andfurniture and equipment that we own, and we incur amortization expense oncertain identifiable intangible assets related to our pharmacy acquisitions.

 

·                  Interest andother expenses – primarily includes interest on outstanding debt andamortization of deferred financing costs.

 

Our reportable segmentsconsist of our senior living community business and our rehabilitation hospitalbusiness that we began to operate in October 2006.   In the senior living community segment, weoperate independent living and congregate care communities, assisted livingcommunities and nursing homes.  Ourrehabilitation hospital segment provides inpatient health rehabilitationservices at our two hospital locations and three satellite locations andoutpatient health rehabilitation services at 20 outpatient clinics.  Wedid not report our rehabilitation hospital business as a separate segment in2006 since we only began to operate these hospitals in October 2006.  We do not consider ourpharmacy operations to be a significant, separately reportable segment of ourbusiness but we report our pharmacy revenues and expense as separate itemswithin our corporate and other activities. All of our operations and assets are located in the United States.

 

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We use segment operatingprofit as an important measure to evaluate our performance and for businessdecision making purposes.  Segmentoperating profit excludes interest and other income, interest expense andcertain corporate expenses.

 

**Year ended December 31, 2007 versus year ended December 31,2006**

 

Thefollowing tables present an overview comparison of our operations for the yearsended December 31, 2007 and 2006:

 

Seniorliving communities:

 
| ** **                                                      | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in thousands, except per day  amounts)**             | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
| ** **                                                      |       |                                      |       |   |   |   |   |   |   |
| Senior living revenue                                           |       | $                                         | 809,934    |   | $ | 744,897 |   | $ | 65,037 |   | 9 | % |
| Senior living wages and benefits                                |       | 410,447                                   |       | 382,093 |   | 28,354 |   | 7 | % |
| Other senior living  operating expenses                         |       | 202,194                                   |       | 186,396 |   | 15,798 |   | 8 | % |
| Management fees to SLS                                          |       | —                                    |       | 8,744 |   | (8,744 | ) | -100 | % |
| Termination expense for  certain SLS management agreements      |       | —                                    |       | 129,913 |   | (129,913 | ) | -100 | % |
| Rent expense                                                    |       | 118,902                                   |       | 106,781 |   | 12,121 |   | 11 | % |
| Depreciation and amortization                                   |       | 9,386                                     |       | 7,704 |   | 1,682 |   | 22 | % |
| Interest and other expense                                      |       | 1,454                                     |       | 2,768 |   | (1,314 | ) | -47 | % |
| Gain on extinguishment of  debt                                 |       | 4,491                                     |       | — |   | 4,491 |   | — |   |
| Senior living income from  continuing operations                |       | 72,042                                    |       | (79,502 | ) | 151,544 |   | 191 | % |
|                                                            |       |                                      |       |   |   |   |   |   |   |
| No. of communities (end of period)                         |       | 161                                       |       | 160 |   | — |   | 1 |   |
| No. of living units (end of period)                        |       | 17,906                                    |       | 17,935 |   | — |   | -29 |   |
| Occupancy                                                       |       | 90.3                                      | %          | 90.9 | % | — |   | 0.6 | % |
| Average daily rate                                              |       | $                                         | 137        |   | $ | 125 |   | $ | 12 |   | 10 | % |
| Percent of senior living  revenue from Medicare                 |       | 15                                        | %          | 14 | % | — |   | 1 | % |
| Percent of senior living  revenue from Medicaid                 |       | 19                                        | %          | 19 | % | — |   | — |   |
| Percent of senior living revenue from private and other sources |       | 66                                        | %          | 67 | % | — |   | -1 | % |

 

ComparableCommunities (communities that we operated continuously since January 1,2006):

 
| ** **                                                      | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in thousands, except per day  amounts)**             | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
| ** **                                                      |       |                                      |       |   |   |   |   |   |   |
| Senior living revenue                                           |       | $                                         | 772,602    |   | $ | 735,122 |   | $ | 37,480 |   | 5 | % |
| Senior living community expenses                                |       | $                                         | 581,624    |   | $ | 561,000 |   | $ | 20,624 |   | 4 | % |
| No. of communities (end of period)                         |       | 149                                       |       | 149 |   | — |   | — |   |
| No. of living units (end of period)                        |       | 16,594                                    |       | 16,594 |   | — |   | — |   |
| Occupancy                                                       |       | 90.8                                      | %          | 91.1 | % | — |   | -0.3 | % |
| Average daily rate                                              |       | $                                         | 140        |   | $ | 133 |   | $ | 7 |   | 5 | % |
| Percent of senior living  revenue from Medicare                 |       | 16                                        | %          | 14 | % | — |   | 2 | % |
| Percent of senior living  revenue from Medicaid                 |       | 19                                        | %          | 19 | % | — |   | — |   |
| Percent of senior living revenue from private and other sources |       | 65                                        | %          | 67 | % | — |   | -2 | % |

 

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Rehabilitation hospitals:

 
| ** **                               | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands)**              | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
| ** **                               |       |                                      |       |   |   |   |   |   |   |
| Hospital revenue                         |       | $                                         | 102,005    |   | $ | 25,494 |   | $ | 76,511 |   | 300 | % |
| Hospital expenses                        |       | 92,449                                    |       | 22,954 |   | 69,495 |   | 303 | % |
| Rent expense                             |       | 10,288                                    |       | 2,475 |   | 7,813 |   | 316 | % |
| Depreciation and amortization            |       | 1,085                                     |       | 102 |   | 983 |   | 964 | % |
|                                     |       |                                      |       |   |   |   |   |   |   |
| Hospital loss from continuing operations |       | (1,817                                    | )          | (37 | ) | (1,780 | ) | 4,811 | % |
|                                          |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

Corporate and Other (1):

 
| ** **                                          | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands)**                         | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
|                                                |       |                                      |       |   |   |   |   |   |   |
| Pharmacy revenue                                    |       | $                                         | 60,985     |   | $ | 45,195 |   | $ | 15,790 |   | 35 | % |
| Pharmacy expenses                                   |       | 58,012                                    |       | 44,579 |   | 13,433 |   | 30 | % |
| Depreciation and amortization                       |       | 3,124                                     |       | 2,045 |   | 1,079 |   | 53 | % |
| General and administrative (2)                      |       | 43,373                                    |       | 33,829 |   | 9,544 |   | 28 | % |
| Interest and other income                           |       | 6,152                                     |       | 6,806 |   | (654 | ) | -10 | % |
| Interest and other expense                          |       | 5,348                                     |       | 1,596 |   | 3,752 |   | 235 | % |
| Provision for income taxes                          |       | 1,410                                     |       | — |   | 1,410 |   | — |   |
| Corporate and Other loss from continuing operations |       | (44,130                                   | )          | (30,048 | ) | (14,082 | ) | 47 | % |
|                                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

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(1)          Corporate and other includesoperations that we do not consider a significant, separately reportable segmentof our business and income and expenses that are not attributable to a specificsegment.

(2)          General and administrativeexpenses are not attributable to a specific segment and include items such ascorporate payroll and benefits and third party service expenses.

 

Consolidated:

 
| ** **                                            | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands)**                           | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
|                                                  |       |                                      |       |   |   |   |   |   |   |
| Summary of revenue:                                   |       |                                      |       |   |   |   |   |   |   |
| Senior living revenue                                 |       | $                                         | 809,934    |   | $ | 744,897 |   | $ | 65,037 |   | 9 | % |
| Hospital revenue                                      |       | 102,005                                   |       | 25,494 |   | 76,511 |   | 300 | % |
| Corporate and Other                                   |       | 60,985                                    |       | 45,195 |   | 15,790 |   | 35 | % |
| Total revenue                                         |       | $                                         | 972,924    |   | $ | 815,586 |   | $ | 157,338 |   | 19 | % |
| Summary of income (loss)  from continuing operations: |       |                                      |       |   |   |   |   |   |   |
| Senior living communities                             |       | $                                         | 72,042     |   | $ | (79,502 | ) | $ | 151,544 |   | 191 | % |
| Rehabilitation hospitals                              |       | (1,817                                    | )          | (37 | ) | (1,780 | ) | 4,811 | % |
| Corporate and Other                                   |       | (44,130                                   | )          | (30,048 | ) | (14,082 | ) | 47 | % |
| Income from continuing operations                     |       | $                                         | 26,095     |   | $ | (109,587 | ) | $ | 135,682 |   | 124 | % |

 

Yearended December 31, 2007, Compared to year ended December 31, 2006

 

Seniorliving communities:

 

The 9%increase in senior living revenues is due primarily to revenues from the 11communities we acquired in the third and fourth quarters of 2006, the onecommunity we acquired in April 2007 and higher per diem charges toresidents, partially offset by a decrease in occupancy. The 5% increase insenior living revenue at the communities that we have operated continuouslysince January 1, 2006 is due primarily to higher per diem charges toresidents, partially offset by a decrease in occupancy.

 

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Our 7% increase in senior living wages and benefitscosts is primarily due to wages and benefits at the 11 communities we acquiredin the third and fourth quarters of 2006, the one community we acquired in April 2007and wage increases.  The 8% increase inother senior living operating expenses, which include utilities, housekeeping,dietary, maintenance, insurance and community level administrative costs,primarily results from the operating expenses at the 11 communities we acquiredin the third and fourth quarters of 2006, the one community we acquired in April 2007,  and increased charges from thirdparties.  The senior living communityexpenses for the senior living communities that we have operated continuouslysince January 1, 2006 have increased by 4%, principally due to wage andbenefit increases. Management fees to SLS were eliminated after our terminationof the last of our management agreements with SLS in 2006.  The 11% rent expense increase in 2007 over2006 is due to the communities that we began to lease in 2006, percentage rentpayment in 2007 and our payment of additional rent for senior living communitycapital improvements purchased by Senior Housing since January 1, 2006.

 

The 22% increase in depreciation and amortization forthe year ended December 31, 2007 is primarily attributable to our purchaseof furniture and fixtures for our communities as well as the one community weacquired in April 2007.

 

Our interest and other expense decreased by 47%because in February 2007 we prepaid six HUD insured mortgages that weresecured by five of our communities.  Werecognized a net gain of $3.6 million on extinguishments of these mortgagesthat consisted of the elimination of $4.3 million of debt premium offset by$725,000 in prepayment penalties.  In April 2007,we prepaid an additional HUD insured mortgage that was secured by one of ourcommunities.  We recognized a net gain of$934,000 on extinguishment of this mortgage that consisted of the eliminationof $1.0 million of debt premium offset by $116,000 in prepaymentpenalties.  This decrease was partiallyoffset by interest we incurred on a $4.6 million HUD insured mortgage that weassumed in connection with the community we acquired in April 2007.

 

Rehabilitation hospitals:

 

Theincrease in hospital revenues, hospital expenses, rent expense and depreciationand amortization expense from our hospitals in 2007 over 2006 is a result ofour beginning operations at our hospitals in October 2006.  We are currently experiencing losses from ouroperation of these rehabilitation hospitals, and we may be unable to operatethese hospitals profitably.   Thepercentage of patients at one of our hospitals who are required to meet certainMedicare criteria increased to 65% on July 1, 2007 and this percentagerequirement was scheduled to increase to 65% at the other hospital on January 1,2008, and to 75% at both of our hospitals in the future.  However, this Medicare requirement hasrecently been rolled back to 60% for both hospitals for fiscal years startingon and after July 1, 2007.  Webelieve that we are in compliance with these current Medicarerequirements.  Effective for paymentunits on and after April 1, 2008, Medicare rate increases for these hospitalsare set at zero percent for federal fiscal years 2008 and 2009.  We believe the recent roll back may allow usto operate these hospitals profitably, but expect this profit if it occurs tobe modest, because of zero Medicare rate increases scheduled for 2008 and 2009.

 

Corporateand other:

 

The35% and 30% in 2007 increase in revenues and expenses, respectively from ourpharmacies is primarily the result of our acquiring one pharmacy in each of May 2006and November 2006.

 

The28% increase in general and administrative expenses for the year ended December 31,2007 over the same period in 2006 results from our acquisition of 11communities in the third and fourth quarters of 2006, from the communities webegan to operate in 2006 that were previously managed for us by SLS and fromthe rehabilitation hospitals we began to operate in October 2006.

 

The53% increase in depreciation and amortization expense for the year ended December 30,2007 over the same period in 2006 is primarily attributable to increases inassets associated with our pharmacy acquisitions.

 

Our interest and otherincome decreased by $654,000, or 10%, for the year ended December 31,2007, compared to the year ended December 31, 2006, primarily as a resultof a $2.4 million payment from HealthSouth in 2006 to settle numeroustransition matters and claims related to our assumption of the operations ofthe two rehabilitation hospitals, offset by interest income on higher levels ofinvestable cash in 2007 resulting from our Notes offering.

 

31

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Our interest and other expense increased in 2007 by$3.8 million, due to the issuance of the Notes in October 2006.

 

For the year ended December 31, 2007, werecognized taxes of $1,410, which includes $1,171 of alternative minimum taxesand certain state taxes that are payable without regard to our tax loss carryforwards and $239 of a deferred tax liability arising from the amortization ofgoodwill for tax purposes but not for book purposes.

 

Discontinuedoperations:

 

Loss from discontinued operations for the year ended December 31,2007 decreased $4.3 million to $2.8 million, compared to a loss of $7.1 millionfor the year ended December 31, 2006. The losses in both years are primarily due to operating expenses weincurred as a result of our shutting down operations at two communities in eachof 2007 and 2006 and two pharmacies in 2007. These losses were lower in 2007 because we sold two of the communitieswhich incurred losses in 2006, in 2006.

 

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

 

The following tables present an overview comparison ofour operations for the years ended December 31, 2006 and 2005:

 

Seniorliving communities:

 
| ** **                                                      | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in thousands, except per day  amounts)**             | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **$** | **Variance** | ** ** | **Change** | ** ** |
| ** **                                                      |       |                                      |       |   |   |   |   |   |   |
| Senior living revenue                                           |       | $                                         | 744,897    |   | $ | 698,012 |   | $ | 46,885 |   | 7 | % |
| Senior living wages and benefits                                |       | 382,093                                   |       | 356,068 |   | 26,025 |   | 7 | % |
| Other senior living  operating expenses                         |       | 186,396                                   |       | 178,786 |   | 7,610 |   | 4 | % |
| Management fees to SLS                                          |       | 8,744                                     |       | 21,256 |   | (12,512 | ) | -59 | % |
| Termination expense for  certain SLS management agreements      |       | 129,913                                   |       | 86,286 |   | 43,627 |   | 51 | % |
| Impairment of assets                                            |       | —                                    |       | 1,940 |   | -1,940 |   | -100 | % |
| Rent expense                                                    |       | 106,781                                   |       | 97,508 |   | 9,273 |   | 10 | % |
| Depreciation and amortization                                   |       | 7,704                                     |       | 5,870 |   | 1,834 |   | 31 | % |
| Interest and other expense                                      |       | 2,768                                     |       | 2,427 |   | 341 |   | 14 | % |
| Senior living income from  continuing operations                |       | (79,502                                   | )          | (52,129 | ) | (27,373 | ) | -53 | % |
|                                                            |       |                                      |       |   |   |   |   |   |   |
| No. of communities (end of period)                         |       | 160                                       |       | 149 |   | — |   | 11 |   |
| No. of living units (end of period)                        |       | 17,935                                    |       | 16,618 |   | — |   | 1,317 |   |
| Occupancy                                                       |       | 90.9                                      | %          | 90.1 | % | — |   | 0.8 | % |
| Average daily rate                                              |       | $                                         | 125        |   | $ | 128 |   | $ | (3 | ) | -2 | % |
| Percent of senior living  revenue from Medicare                 |       | 14                                        | %          | 15 | % | — |   | -1 | % |
| Percent of senior living  revenue from Medicaid                 |       | 19                                        | %          | 20 | % | — |   | -1 | % |
| Percent of senior living revenue from private and other sources |       | 67                                        | %          | 65 | % | — |   | 2 | % |
|                                                                 |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

ComparableCommunities (communities that we operated continuously since January 1,2005):

 
| ** **                                                       | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands, except per day amounts)**              | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **$****Variance** | ** ** | **Change** | ** ** |
| ** **                                                       |       |                                      |       |   |   |   |   |   |   |
| Senior living revenue                                            |       | $                                         | 709,322    |   | $ | 683,463 |   | $ | 25,859 |   | 4 | % |
| Senior living community  expenses                                |       | $                                         | 536,551    |   | $ | 522,382 |   | $ | 14,169 |   | 3 | % |
| No. of communities  (end of period)                         |       | 144                                       |       | 144 |   | — |   | — |   |
| No. of living units  (end of period)                        |       | 16,160                                    |       | 16,160 |   | — |   | — |   |
| Occupancy                                                        |       | 90.4                                      | %          | 90.4 | % | — |   | — |   |
| Average daily rate                                               |       | $                                         | 133        |   | $ | 128 |   | $ | 5 |   | 4 | % |
| Percent of senior living revenue from Medicare                   |       | 14                                        | %          | 15 | % | — |   | -1 | % |
| Percent of senior living revenue from Medicaid                   |       | 20                                        | %          | 20 | % | — |   | — |   |
| Percent of senior living  revenue from private and other sources |       | 66                                        | %          | 65 | % | — |   | 1 | % |

 

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Rehabilitation hospitals:

 
| ** **                               | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands)**              | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **$ ****Variance** | ** ** | **Change** | ** ** |
| ** **                               |       |                                      |       |   |   |   |   |   |   |
| Hospital revenue                         |       | $                                         | 25,494     |   | $ | — |   | $ | 25,494 |   | — |   |
| Hospital expenses                        |       | 22,954                                    |       | — |   | 22,954 |   | — |   |
| Rent expense                             |       | 2,475                                     |       | — |   | 2,475 |   | — |   |
| Depreciation and amortization            |       | 102                                       |       | — |   | 102 |   | — |   |
| Hospital loss from continuing operations |       | (37                                       | )          | — |   | (37 | ) | — |   |
|                                          |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

Corporate and Other (1):

 
| ** **                                          | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands)**                         | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **$ ****Variance** | ** ** | **Change** | ** ** |
|                                                |       |                                      |       |   |   |   |   |   |   |
| Pharmacy revenue                                    |       | $                                         | 45,195     |   | $ | 29,647 |   | $ | 15,548 |   | 52 | % |
| Pharmacy expenses                                   |       | 44,579                                    |       | 28,233 |   | 16,346 |   | 58 | % |
| Depreciation and amortization                       |       | 2,045                                     |       | 1,093 |   | 952 |   | 87 | % |
| General and administrative (2)                      |       | 33,829                                    |       | 28,221 |   | 5,608 |   | 20 | % |
| Interest and other income                           |       | 6,806                                     |       | 1,543 |   | 5,263 |   | 341 | % |
| Interest and other expense                          |       | 1,596                                     |       | 1,205 |   | 391 |   | 32 | % |
| Provision for income taxes                          |       | —                                    |       | — |   |   |   |   |   |
| Corporate and Other loss from continuing operations |       | (30,048                                   | )          | (27,562 | ) | (2,486 | ) | -9 | % |
|                                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

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(1)          Corporate and other includesoperations that we do not consider a significant, separately reportable segmentof our business and income and expenses that are not attributable to a specificsegment.

(2)          General and administrativeexpenses are not attributable to a specific segment and include items such ascorporate payroll and benefits and outside service expenses.

 

Consolidated:

 
| ** **                                            | ** ** | **For the years ended December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **(dollars in  thousands)**                           | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **$ ****Variance** | ** ** | **Change** | ** ** |
|                                                  |       |                                      |       |   |   |   |   |   |   |
| Summary of revenue:                                   |       |                                      |       |   |   |   |   |   |   |
| Senior living revenue                                 |       | $                                         | 744,897    |   | $ | 698,012 |   | $ | 46,885 |   | 7 | % |
| Hospital revenue                                      |       | 25,494                                    |       | — |   | 25,494 |   | — |   |
| Corporate and Other                                   |       | 45,195                                    |       | 29,647 |   | 15,548 |   | 52 | % |
| Total revenue                                         |       | $                                         | 815,586    |   | $ | 727,659 |   | $ | 87,927 |   | 12 | % |
| Summary of income (loss)  from continuing operations: |       |                                      |       |   |   |   |   |   |   |
| Senior living communities                             |       | $                                         | (79,502    | ) | $ | (52,129 | ) | $ | (27,373 | ) | -53 | % |
| Rehabilitation hospitals                              |       | (37                                       | )          | — |   | (37 | ) | — |   |
| Corporate and Other                                   |       | (30,048                                   | )          | (27,562 | ) | (2,486 | ) | -9 | % |
| Income from continuing  operations                    |       | $                                         | (109,587   | ) | $ | (79,691 | ) | $ | (29,896 | ) | -38 | % |

 

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Yearended December 31, 2006, Compared to year ended December 31, 2005

 

Seniorliving communities:

 

The 7% increase in senior living revenues is dueprimarily to revenues from the six communities we acquired in June 2005,the 11 communities we acquired in the third and fourth quarter of 2006, higherper diem charges to residents and a slight increase in occupancy. The 4%increase in senior living revenue at the communities that we have operatedcontinuously since January 1, 2005 is due primarily to higher per diemcharges to residents.

 

Our 7% increase in senior living wages and benefitscosts is primarily due to wages and benefits at the six communities we acquiredin June 2005, the 11 communities we acquired in the third and fourthquarter of 2006 and wage increases.  The4% increase in other senior living operating expenses, which include utilities,housekeeping, dietary, maintenance, insurance and community leveladministrative costs, primarily results from the other operating expenses atthe six communities we acquired in June 2005, the 11 communities weacquired in the third and fourth quarters of 2006 and increased charges fromthird parties.  The senior livingcommunity expenses for the senior living communities that we have operatedcontinuously since January 1, 2005 have increased by 3%, principally dueto wage and benefit increases. Management fees to SLS decreased due to ourtermination of 12 management agreements in November 2005, one agreement inFebruary 2006, 10 agreements in June 2006 and seven agreements in December 2006.  The 10% rent expense increase is primarilydue to the communities that we began to lease in 2005 and 2006 and our paymentof additional rent for senior living community capital improvements purchasedby Senior Housing since January 1, 2005.

 

In April 2006, we sent notices to SLS toterminate management agreements for 10 of the 17 senior living communities thatSLS then managed for us.  On June 1,2006, we paid SLS termination fees totaling $89.8 million and terminated theSLS management agreements for these 10 communities.  In December 2006, we terminated the lastseven agreements under which SLS managed senior living communities for us andpaid SLS termination fees totaling $40.1 million.  We no longer pay management fees to SLS.

 

The 31% increase in depreciation and amortization forthe year ended December 31, 2006 over the same period in 2005 is primarilyattributable to our purchase of furniture and fixtures for our communities.

 

Our interest and other expense increased in 2006 by14% primarily due to the mortgages we assumed in connection with certainacquisitions.

 

Rehabilitation hospitals:

 

Theincrease in hospital revenues, hospital expenses, rent expense and depreciationand amortization expense from our hospitals in 2006 over 2005 is a result ofour beginning operations at our hospitals in October 2006.

 

Corporateand other:

 

The52% and 58% increase in revenues and expenses, respectively from our pharmaciesis primarily the result of our acquiring one pharmacy in each June 2005, December 2005,May 2006 and November 2006.

 

The20% increase in general and administrative expenses for the year ended December 31,2006 over the same period in 2006 results from the six communities we acquiredin June 2005, the 11 communities in the third and fourth quarters of 2006,from the communities we began to operate in 2006 that were previously managedfor us by SLS and from the rehabilitation hospitals we began to operate in October 2006.

 

The87% increase in depreciation and amortization expense for the year ended December 30,2006 is primarily attributable to increases in assets associated with ourpharmacy acquisitions.

 

Our interest and other income increased by $5.3 million or 341%, forthe year ended December 31, 2006, compared to the year ended December 31,2005, as a result of a payment from HealthSouth to settle numerous transitionmatters and claims related to our assumption of the operations of the tworehabilitation hospitals.  The amount ofthis

 

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settlement was approximately $2.4 million.  Interest and other income also increased as aresult of higher levels of investable cash and increased yields on our cash andinvestments.

 

Our interest and other expense increased by 32%, dueto the issuance of the Notes in October 2006.

 

We did not recognize any federal taxes for the year endedDecember 31, 2006.

 

Discontinuedoperations:

 

Loss from discontinued operations for the year ended December 31,2006 increased $2.6 million to $7.1 million, compared to a loss of $4.5 millionfor the year ended December 31, 2005. The losses in both years are primarily due to operating expenses weincurred as a result of our shutting down operations at two communities in eachof 2005 and 2006.

 

**LIQUIDITY AND CAPITAL RESOURCES**

** **

Webelieve that a combination of our cash on hand, our efforts to increaserevenues and contain costs, our ability to borrow on our revolving creditfacility and our ability to sell to Senior Housing certain capital improvementsmade to communities that we lease from Senior Housing will be sufficient tomeet our working capital needs, operating expenses, rent payments to SeniorHousing, debt service and capital expenditures for the next 12 months and theforeseeable future.

 

**RecentDevelopments:  Investments**

 

At December 31, 2007,we had $61.8 million invested in ARS, which we classified as current assets and$500,000 in ARS included in our self insurance reserves classified asrestricted investments on our balance sheet. As of February 28, 2008, we have $74.9 million and $500,000 of ARSin these accounts, respectively.  Aftersuccessful auctions in January 2008, starting in February 2008, as aresult of recent changes in the capital markets, auctions affectingapproximately $43.3 million of our ARS failed to close on their settlementdates.  We do not know if auctionsaffecting the balance of our ARS; or future auctions for the ARS securitieswhich have failed, will successfully close on future auction settlement dates.

 

Our ARS consists primarilyof bonds issued by various entities to fund student loans pursuant to theFederal Family Education Loan Program. The maturities of our ARS range from 2032 to 2047.  However, historically we have had the optionto liquidate our investments in the ARS whenever the interest rates are resetat auctions, usually every 35 days.  Allof our ARS were rated “AAA” by at least one nationally recognized debt ratingagency when we made these investments, and, to our knowledge, none of theseratings have been reduced.  Pursuant tothe terms of our ARS, whenever reset auctions fail to close, the interestpayable to us on these ARS increases.  Weare presently monitoring developments in the ARS markets together with thebroker dealer who has marketed the ARS which we own, but based upon ouranalysis of impairment factors, we have determined that our ARS are notimpaired at this time and that the value of these investments is approximatelyequal to their carrying value.

 

The funds which we investedin ARS were funds we were holding to invest in potential acquisitions which wehave not yet identified or to satisfy longer term self insuranceobligations.  Accordingly, these fundsare not needed to fund our current operations and we do not expect that thefailure of auctions affecting our ARS holdings to have a material adverse impactupon us, unless the ARS market remains illiquid for an extended period, ourARS’ ratings are reduced and/or the value of these securities declines.  Nonetheless, the current illiquidity of theseinvestments may mean we are unable to take advantage of other investmentopportunities which would grow our operating businesses.

 

**Assets and Liabilities**

 

Our total current assets at December 31, 2007 were$186.0 million, compared to $205.8****million at December 31,2006.  At December 31, 2007 and December 31,2006, we had cash and cash equivalents of $31.0 million and $46.2****million, respectively. Our current liabilities were $104.1****million at December 31,2007, compared to $132.9****million at

 

35

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December 31, 2006.  Thedecrease in both current assets and current liabilities is primarily the resultof our prepayment of seven mortgages in 2007.

 

**Our Leases with Senior Housing**

 

As of December 31, 2007, we leased 142senior living communities and two rehabilitation hospitals from Senior Housingunder six leases.  Our leases with SeniorHousing require us to pay minimum rent of $128.9****millionannually and percentage rent for most of senior living communities but not ourrehabilitation hospitals. We paid approximately $2.1 million and $1.1 millionin percentage rent to Senior Housing for the years ended December 31, 2007and 2006, respectively.

 

Upon our request, Senior Housing reimburses our capital expendituresmade at the communities we lease from Senior Housing and increases our rentpursuant to contractual formulas.  SeniorHousing reimbursed us $47.7millionduring the year ended December 31, 2007 for capital expenditures made atthese leased communities and increased our annual rent by $4.5 million.

 

The terms of our leases with Senior Housingcontain provisions whereby Senior Housing may cancel our rights under theseagreements upon the acquisition by any person or group of more than 9.8% of ourvoting stock and upon other “change of control” events.  These leases also limit our ability tocreate, incur, assume or guarantee indebtedness.  As of March 4, 2008, we believe we arein compliance with the terms of our leases with Senior Housing.

 

**Our Revenues**

 

Our revenues from services to residents at oursenior living communities and patients of our rehabilitation hospitals andclinics are our primary source of cash to fund our operating expenses,including rent, principal and interest payments on our debt and our capitalexpenditures.

 

At some of our communities, operatingrevenues for nursing home services are received from the Medicare and Medicaidprograms.  Medicare and Medicaid revenuesfrom senior living services were earned primarily at our 49 nursing homes.  We derived 34% and 33% of our senior livingrevenues from these programs for the years ended December 31, 2007 and2006, respectively.

 

Our net Medicare revenues from services tosenior living community residents totaled $124.5****millionand $103.7 million for theyears ended December 31, 2007 and 2006,respectively.  In October 2007 and2006, our senior living community Medicare rates increased by approximately3.6% and 3.3%, respectively, over the prior period. Our net Medicaid revenuesfrom services to senior living community residents totaled $147.1 million and$141.7 million for theyears ended December 31, 2007 and 2006,respectively.  The Bush administrationand certain members of the Senate and the House of Representatives haveproposed Medicare and Medicaid policy changes and rate reductions to be phasedin during the next several years.  Inaddition, some of the states in which we operate either have not raisedMedicaid rates by amounts sufficient to offset increasing costs or are expectedto reduce Medicaid funding.  Themagnitude of the potential Medicare and Medicaid rate reductions and the impacton us of the failure of these programs to increase rates to match increasingexpenses, as well as the impact on us of the potential Medicare and Medicaidpolicy changes, cannot currently be estimated, but they may be material to ouroperations and may affect our future results of operations.

 

We began to operate two rehabilitation hospitals in October 2006.  Approximately 69% and 72% of our revenuesfrom these hospitals came from the Medicare and Medicaid programs for the yearended December 31, 2007 and three months ended December 31, 2006,respectively.  In October 2007, ourrehabilitation hospital Medicare rates increased by approximately 3.5% over theprior period.  However, forpayment units on and after April 1, 2008, Medicare rate increases forthese hospitals are set at zero per cent for federal fiscal years 2008 and2009.  InMay 2004, CMS issued a rule establishing revised Medicare criteriathat rehabilitation hospitals are required to meet in order to participate asIRFs in the Medicare program.  Asrecently amended, the rule requires that for cost reporting periodsstarting on and after July 1, 2006, 60% of a facility’s inpatientpopulation must require intensive rehabilitation services for one of the CMS’sdesignated medical conditions.  An IRFthat fails to meet the requirements of this rule is subject toreclassification as a different type of healthcare provider; and the effect ofsuch reclassification would be to lower Medicare payment rates. As of December 31,2007 and March 4, 2008, we believe we are in compliance with the CMSrequirements to remain an IRF.  However,the actual percentage of patients at these hospitals who meet these Medicare

 

36

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 requirements may not be or remain as high aswe believe or, anticipate or may decline. Our failure to remain in compliance, if it occurs, will result in ourreceiving lower Medicare rates than we currently receive at our hospitals.

 

**Terminationof SLS Management Agreements**

 

To better understand the results of our ongoing operating business forthe years ended December 31, 2006 and 2005 and to enable investors to morereadily compare our operating results from those years to prior periods, aswell as future years, we believe it may be useful to consider what our resultsof operations would have been in 2006 and 2007, excluding our terminationpayments to SLS.  The information in thefollowing chart should not be considered as an alternative to income (loss)from continuing operations or income (loss) from continuing operations pershare or any other operating or performance measure established by accountingprinciples generally accepted in the United States.

 
| ** **                                                             | ** ** | **For the year ended  December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| Loss from continuing operations                                        |       | $                                         | (109,587   | ) | $ | (79,691 | ) |
|                                                                   |       |                                      |       |   |   |   |   |
| Exclude termination expense for certain  Sunrise management agreements |       | 129,913                                   |       | 86,286 |   |
|                                                                   |       |                                      |       |   |   |
| Income from continuing operations excluding  termination charges       |       | $                                         | 20,326     |   | $ | 6,595 |   |

 

**Insurance**

 

Recent increases in the costs of insurance,especially tort liability insurance, workers compensation and employee healthinsurance, have had an adverse impact upon our results of operations.  Although we self insure a large portion ofthese costs, our costs have increased as a result of the higher costs that weincur to settle claims and to purchase re-insurance for claims in excess of theself insurance amounts.  These increasedcosts may continue in the future.

 

**Acquisitions and Related Financings**

 

Between September and December 2006, we agreed to lease fromSenior Housing 11 senior living communities with 1,284****unitswhich Senior Housing acquired from third parties.  Three of these communities are assistedliving communities, three are assisted living communities which offer someskilled nursing services, three are only independent living communities and twoare continuing care retirement communities which offer independent living,assisted living and skilled nursing services. Our rent payable to Senior Housing for these 11 communities is $9.0million per year, plus future increases calculated as a percentage of therevenue increases at these communities after 2007.  We added these communities to our existinglease with Senior Housing which has a term ending in 2020, with renewal optionsthereafter.  Residents pay substantiallyall of our charges at these communities from their private resources.

 

In April 2007, we acquired a 48 unit assisted living communitylocated in Tennessee for $5.0 million  We financed the acquisition byassuming a $4.6 million non recourse United States Department of Housing, orHUD, insured mortgage and paying the balance of the purchase price with cash onhand.  The interest rate on the assumed HUD insured mortgage is7.65%.  Residents pay substantially all of our charges at this communityfrom their private resources.

 

In January and February 2008, we leased nine senior livingcommunities with 1,032 units which Senior Housing acquired from third parties.  Eight of these communities are assisted livingcommunities (one of which offers some skilled nursing services and one of whichoffers some independent living services) and one is a continuing careretirement community which offers independent living, assisted living andskilled nursing services.  Our rentpayable to Senior Housing for these nine communities is $10.7 million per year,plus future increases calculated as a percentage of the revenue increases forall of these communities after 2009.  Weadded these communities to our 

 

37

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existing leasewith Senior Housing which has a term ending in 2020, with renewal optionsthereafter.  Residents pay a majority ofour charges at these communities from their private resources.

 

We currently intend to lease from Senior Housing 15 additional seniorliving communities with a total of 772 units which Senior Housing has agreed topurchase from  three unrelatedparties.  All of these communities areassisted living communities.  We expectour rent to Senior Housing for these 15 communities to be $11.9 million peryear, plus future increases calculated as a percentage of the revenue increasesat these communities after 2009.  Weintend to add these communities to our existing lease with Senior Housing whichhas a term ending in 2020, with renewal options thereafter.  Residents pay a majority of our charges atthese communities from their private resources. Senior Housing’s purchase and our lease of these properties are contingentupon further diligence, consent from mortgage lenders and other customaryclosing conditions.  We can provide noassurance that we will lease these properties.

 

**Pharmacies**

 

Between September 2003 and November 2006,we acquired six institutional pharmacies and one mail order pharmacy located inWisconsin, Nebraska, California, South Carolina and Virginia.  Our total purchase price for these pharmacieswas $15.8 million, including $5.9 million in 2006.

 

**Rehabilitation Hospitals**

 

We commenced operations at our two hospitals on October 1,2006.  Our lease with Senior Housing forthese two hospitals expires on June 30, 2026, with one renewal option foran additional 20 years.  Our rent payableto Senior Housing for these hospitals is $10.6 million per year.

 

**Discontinued Operations**

 

During 2007, we agreed with Senior Housing that it should sell twoassisted living communities in Pennsylvania, which we currently lease.  Weand Senior Housing are in the process of selling these assisted livingcommunities and, upon their sale, our annual rent payable to Senior Housingwill decrease by 9.5% of the net proceeds of the sale to Senior Housing.  As of December 31, 2007, we havedisposed of substantially all of our assets and settled all liabilities relatedto two senior living communities in Pennsylvania.

 

In December 2007, we decided to sell our institutional pharmacylocated in California and our mail order pharmacy located in Nebraska.  The assets and liabilities related to thesetwo pharmacies that we expect to sell are presented separately in theconsolidated balance sheet.

 

We have reclassified the consolidated statement of operations for allperiods presented to show the results of operations of the communities andpharmacies which have been sold or are expected to be sold asdiscontinued.  A summary of the operatingresults of these discontinued operations included in the financial statementsfor the years ended December 31, 2007 and 2006 is:

 
| ** ** | ** ** | **For the years ended December 31,** | ** ** |
|------------|------------|-------------------------------------------|------------|
| ** ** | ** ** | **2007**                                  | ** ** | **2006** | ** ** |
| Revenues   |       | $                                         | 12,910     |   | $ | 30,829 |   |
| Expenses   |       | 15,679                                    |       | 37,907 |   |
| Net loss   |       | $                                         | (2,769     | ) | $ | (7,078 | ) |

 

**Equity and DebtFinancings**

 

In August and September 2005, weissued 7,750,000 common shares in an underwritten public offering raising netproceeds of $55.6 million.  We used aportion of the proceeds raised in this offering to pay off a $24.0 millionfirst mortgage line of credit with Senior Housing and to reduce amountsoutstanding under our revolving credit facility, and we added the remainder toavailable cash balances.  InApril 2006, we issued 11,500,000 common shares in an underwritten publicoffering raising net proceeds of $114.0 million.  We used a portion of the proceeds raised inthis

 

38

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 offering to pay $89.8 million intermination fees for 10 SLS management agreements we terminated in June 2006,and we added the remainder to available cash balances.  In October 2006, we issued $126.5 million principal amount of our Notes.  Weused the proceeds raised to pay $40.1 million in termination fees for theremaining 20 management agreements with SLS, and we added the remainder toavailable cash balances. In April 2007, we financed the acquisitionof a 48 unit assisted living community located in Tennessee for $5.0 million byassuming a $4.5 million non recourse HUD insured mortgage and paying thebalance of the purchase price with cash on hand.  The coupon interest rateon the assumed HUD insured mortgage is 7.65% and its effective market rate is5.75%.

 

**Contractual Obligations Table**

 

 As of December 31, 2007, our contractualobligations were as follows (dollars in thousands):

 
| **Contractual Obligations**                                     | ** ** | **Payment due by period** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                      | ** ** | **Total**                 | ** ** | **Less than 1   year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than   5 years** | ** ** |
| Debt Obligations (1)                                            |       | $                         | 142,510    |   | $ | 200 |   | $ | 375 |   | $ | 447 |   | $ | 141,488 |   |
| Operating Lease Obligations (2)                                 |       | 1,541,984                 |       | 130,080 |   | 260,160 |   | 260,160 |   | 891,584 |   |
| Other Long Term Liabilities Reflected on  our Balance Sheet (3) |       | 24,100                    |       | — |   | 14,468 |   | 5,163 |   | 4,469 |   |
| Total                                                           |       | $                         | 1,708,594  |   | $ | 130,280 |   | $ | 275,003 |   | $ | 265,770 |   | $ | 1,037,541 |   |

 

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(1)                            DebtObligations are the amounts due under several HUD insured mortgages as well asour outstanding Notes.

 

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

 

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

** **

**Debt Instruments and Covenants**

** **

In June 2007,we amended our revolving line of credit. The amendment increased the line from$25.0 million to $40.0 million, extended the termination date to May 8,2009 and reduced the annual interest charged by 25 basis points. Our revolvingline of credit is available for acquisitions, working capital and generalbusiness purposes.  The amount we areable to borrow at any time is subject to limitation based upon qualifyingcollateral.  We are the borrower underthis revolving credit facility and certain of our subsidiaries guarantee ourobligations under the facility, which is secured by our and our guarantorsubsidiaries’ accounts receivable, deposit accounts and related assets.  The facility contains covenants requiring usto maintain collateral, minimum net worth and certain other financial ratios,places limits on our ability to incur or assume debt or create liens withrespect to certain of our properties and has other customary provisions.  In certain circumstances and subject toavailable collateral and lender approvals, the maximum amount which we may drawunder this credit facility may be increased to $80.0 million. The terminationdate may be extended twice, in each case by twelve months, subject to lenderapproval, our payment of extension fees and other conditions.  As of December 31, 2007 and March 4,2008, no amounts were outstanding under this credit facility.  As of December 31, 2007 and March 4,2008, we believe we are in compliance with all applicable covenants under thisrevolving credit facility.

 

In 2007, we prepaid seven mortgages that were secured by six of oursenior living communities.  We paid $28.9million to retire these seven mortgages, which consisted of approximately $28.0million in principal and interest and $840,000 in prepayment penalties.  Because we had carried these mortgages at apremium to their face value, we recognized a net gain of $4.5 million inconnection with the early extinguishment of debt.

 

At December 31,2007, four of our communities remained encumbered by five HUD insured mortgagestotaling $16.0.  The weighted averageinterest rate on these mortgages is 6.6%. Payments of principal and interest are due monthly until maturities atvarying dates ranging from January 2038 to May 2039.  These mortgages contain standard HUD mortgagecovenants.  As of December 31, 2007and March 4, 2008, we believe we are in compliance with all covenants ofthese mortgages.

 

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In October 2006, we issued $126.5million principal amount of Notes. Our net proceeds from this issuancewere approximately $122.6 million.  TheseNotes are convertible into our common shares at any time.  The initial conversion rate, which is subjectto adjustment in certain circumstances, is 76.9231 common shares per $1,000principal amount of notes, which represents an initial conversion price of$13.00 per share.

 

The Notes bear interest at a rate of 3.75% per annum, payablesemi-annually in arrears on April 15 and October 15 of each year,starting on April 15, 2007.  TheNotes mature on October 15, 2026. On or after October 20, 2011, we may redeem the Notes, in whole orin part, at a redemption price in cash equal to 100% of the principal amount ofthe Notes we redeem, plus any accrued and unpaid interest.  On each of October 15, 2013, October 15,2016 and October 15, 2021, holders of the Notes may require us to purchaseall or a portion of their Notes at a purchase price in cash equal to 100% of theprincipal amount of the Notes to be purchased, plus any accrued and unpaidinterest.  If a “fundamental change,” asdefined in the indenture governing the Notes, occurs, holders of the Notes mayrequire us to repurchase all or a portion of their Notes for cash at arepurchase price equal to 100% of the principal amount of the Notes to berepurchased, plus any accrued and unpaid interest and, in certaincircumstances, plus a make whole premium as defined in the indenture governingthe Notes.  A holder that surrendersNotes for conversion in connection with a “make whole fundamental change,” asdefined in the indenture governing the Notes, that occurs before October 20,2011 may in some circumstances be entitled to an increased conversion rate(i.e. a lower per share conversion price).The Notes are guaranteed by certainof our wholly owned subsidiaries.  Oursubsidiary guarantors may be released from their obligations under certaincircumstances.  As of December 31,2007 and March 4, 2008, we believe we are in compliance with all covenantsof the indenture pursuant to which these Notes were issued.

 

**Off Balance Sheet Arrangements**

** **

**As of December 31, 2007, we had no off balance sheetarrangements, commercial paper, derivatives, swaps, hedges, third party guarantees,material joint ventures or partnerships.**

** **

**Related Person Transactions**

** **

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

 

·                  solong as Senior Housing remains a real estate investment trust, or a REIT, wemay not waive the share ownership restrictions in our charter on the ability ofany person or group to acquire more than 9.8% of any class of our equity shareswithout the consent of Senior Housing;

 

·                  solong as we are a tenant of Senior Housing, we will not permit nor take anyaction that, in the reasonable judgment of Senior Housing, might jeopardize thetax status of Senior Housing as a REIT;

 

·                  SeniorHousing has the option, upon the acquisition by a person or group of more than9.8% of our voting stock and upon other change in control events affecting us,as defined, to cancel all of our rights under the leases we have with SeniorHousing; and

 

·                  solong as we have a shared services agreement with RMR we will not acquire orfinance any real estate without first giving Senior Housing or any otherpublicly owned REIT or other entity managed by RMR, the opportunity to acquireor finance real estate investments of the type in which Senior Housing or anyother publicly owned REIT or other entity managed by RMR, respectively,invests.

 

At the time of our spin off from SeniorHousing, all of the persons serving as our directors were trustees of SeniorHousing.  One of our managing directors, Mr. Portnoy,is currently a managing trustee of Senior Housing.

 

Of the 161 senior living communities weoperated on December 31, 2007, 142 are leased from Senior Housing fortotal annual rent of $118.3 million. In addition, we also lease our two rehabilitation hospitals from SeniorHousing for a total minimum rent of $10.6 million.

 

40

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Since January 1, 2007, we have enteredinto several transactions with Senior Housing, including:

 

·                  In March 2007,we agreed with Senior Housing that it should sell two assisted livingcommunities in Pennsylvania, which we lease from Senior Housing.  We andSenior Housing are in the process of selling these assisted living communitiesand, upon their sale, our annual rent payable to Senior Housing will decreaseby 9.5% of the net proceeds of the sale to Senior Housing in accordance withthe terms of the lease.

 

·                  During 2007, as permitted by ourleases with Senior Housing, we sold to Senior Housing, at cost, approximately$47.7 million of improvements made to properties leased from Senior Housing,and, as a result, our annual rent payable to Senior Housing increased byapproximately $4.5 million.

 

·                  In January andFebruary 2008, we leased nine senior living communities with 1,032 unitswhich Senior Housing acquired from third parties.  Eight of these communities are assistedliving communities (one of which offers some skilled nursing services and oneof which offers some independent living services) and one is a continuing careretirement community which offers independent living, assisted living andskilled nursing services.  Our rentpayable to Senior Housing for these nine communities is $10.7 million per year,plus future increases calculated as a percentage of the revenue increases forall of these communities after 2009.  Weadded these communities to our existing lease with Senior Housing which has aterm ending in 2020, with renewal options thereafter.  Residents pay a majority of our charges at thesecommunities from their private resources.

 

·                  We currentlyintend to lease from Senior Housing 15 additional senior living communitieswith a total of 772 units which Senior Housing has agreed to purchase fromthree unrelated parties.  All of thesecommunities are assisted living communities. We expect our rent to Senior Housing for these 15 communities to be$11.9 million per year, plus future increases calculated as a percentage of therevenue increases at these communities after 2009.  We intend to add these communities to ourexisting lease with Senior Housing which has a term ending in 2020, withrenewal options thereafter.  Residentspay a majority of our charges at these communities from their privateresources.  Senior Housing’s purchase andour lease of these properties are contingent upon further diligence, consentfrom mortgage lenders and other customary closing conditions.  We can provide no assurance that we willlease these properties.

 

RMR provides certain management and administrative services to us undera shared services agreement. RMR is compensated at an annual rate equal to 0.6%of our total revenues. Aggregate fees earned by RMR for services during 2007,2006 and 2005, were $6.1 million, $4.9 million and $4.7 million,respectively.  RMR also provides theinternal audit function for us and for other publicly owned companies to whichit provides management services.  Ouraudit committee appoints our director of internal audit, and our compensationcommittee approves his salary.  Ourcompensation committee also approves the costs we pay with respect to ourinternal audit function.  Our share ofRMR’s costs in providing that function for the years ended 2007, 2006 and 2005was $169,000, $173,000 and $106,938, respectively.  The fact that RMR has responsibilities toother entities, including our most significant landlord, Senior Housing, couldcreate conflicts; and in the event of such conflicts between Senior Housing andus, our shared services agreement with RMR allows RMR to act on behalf ofSenior Housing rather than on our behalf. RMR is beneficially owned by Messrs. Barry M.Portnoy, one of our managing directors, and his son, Adam D. Portnoy, who isPresident and Chief Executive Officer and a director of RMR and a managingtrustee of Senior Housing.  Messrs. BarryPortnoy and Gerard Martin, our managing directors, are directors of RMR.

 

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

 

RMR is the owner of the buildings in whichour corporate headquarters is located. This lease expires in 2011. We recorded rent, which includes ourproportional share of utilities and real estate taxes, under this lease during2007, 2006 and 2005 of $1.3 million, $938,000 and $711,000, respectively.  This lease has been amended at various timesto take into account our needs for increasing space and all amendments to thislease have been approved by our independent directors.

 

41

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One of our hospitals’ outpatient clinicsleases space from HRPT Properties Trust, or HRPT, a REIT managed by RMR.  We recorded rent, which includes ourproportional share of utilities and real estate taxes, under this lease during2007 and 2006 of $52,275 and $8,388, respectively.

 

In December 2006, we began leasing spacefor a regional office in Atlanta, Georgia from HRPT.  This lease expires in 2011.  We recorded rent, which includes ourproportional share of utilities and real estate taxes, under this lease during2007 and 2006 of $61,000****and $5,000,respectively.

 

We believe that all our transactions withrelated parties are on reasonable commercial terms.  We also believe that our relationship withSenior Housing and RMR benefits us and, in fact, provide us competitiveadvantages in operating and growing our businesses.  Moreover, all transactions between us andrelated parties, including Senior Housing and RMR, are approved by ourindependent directors.

 

**Critical Accounting Policies**

** **

Ourcritical accounting policies concern revenue recognition, our assessment of thenet realizable value of our accounts receivable, the realizable value of long termassets, accounting for long term care contracts, accounting for businesscombinations, our assessment of reserves related to our self insurance programsand our evaluation of impairment factors affecting our ARS.

 

Ourrevenue recognition policies involve judgments about Medicare and Medicaid ratecalculations.  These judgments are basedprincipally upon our experience with these programs and our knowledge ofcurrent rules and regulations applicable to these programs.  We recognize revenues when services areprovided and these amounts are reported at their estimated net realizableamounts.  Some Medicare and Medicaidrevenues are subject to audit and retroactive adjustment, and sometimesretroactive legislative changes.

 

Ourpolicies for valuing accounts receivable involve significant judgments basedupon our experience, including consideration of the age of the receivables, theterms of the agreements with our residents, their third party payors or otherobligors, the residents or payors stated intent to pay, the residents or payorsfinancial capacity and other factors which may include litigation or rate andpayment appeal proceedings.

 

Weregularly evaluate whether events or changes in circumstances have occurredthat could indicate impairment in the value of our long lived assets.  If there is an indication that the carryingvalue of an asset is not recoverable, we determine the amount of impairmentloss, if any, by comparing the historical carrying value of the asset to itsestimated fair value.  We determineestimated fair value through an evaluation of recent financial performance,recent sales of similar assets, market conditions and projected discounted cashflows of properties using standard industry valuation techniques.  This process requires that estimates be madeand errors in our judgments or estimates could have a material effect on ourfinancial statements.

 

At oneof our communities, we offer continuing care contracts under which residentsmay pay admission fees in exchange for reduced charges during theiroccupancy.  These fees may be refundableor non-refundable, or partially refundable and partially non-refundable.  We record these fees as obligations on ourbalance sheet and amortize the non-refundable amounts into revenue over the actuarially determined remaining lives of theindividual residents which are the expected periods of occupancy.  Actuarially determined remaining lives areestimates based upon general demographic samplings and averages.  Our decision to amortize the non-refundablefees over actuarially determined lives is based upon our estimates that theseresidents will remain at our facilities for that period.  The actual remaining lives and the actualperiod of occupancy of the individual residents who pay the non-refundable feesmay differ materially from these estimates. In the future, if we find that such differences are material, we maychange the actuarial tables which we use and we may change our estimates thatthese residents will remain at our facilities for these periods; and thesechanges could have a material impact upon our financial statements.

 

Eachof our acquisitions has been accounted for as a purchase business combinationin accordance with Statement of Financial Accounting Standards No. 141.  Purchase accounting requires that we makecertain judgments and estimates based on our experience, including determiningthe fair value and useful lives of assets acquired and the fair value ofliabilities assumed.  Some of our judgmentsand estimates are also based upon published industry statistics and in somecases third party appraisals.

 

42

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Determiningreserves for the self insurance portions of our insurance programs involvessignificant judgments based upon our experience, including projectedsettlements for pending claims, known incidents which we expect may result inclaims, estimates of incurred but not yet reported claims, claims experience,estimated litigation costs and other factors. We also periodically receive and rely upon recommendations fromprofessional consultants in establishing these reserves; however, thesereserves may prove to be materially inaccurate.

 

Werecently evaluated our ARS to determine if they have been impaired and weexpect to do so regularly hereafter.  Ifthere is an indication that the carrying value of our ARS is less than itsestimated fair value, we would record a loss in our consolidated statement ofoperations.  We determine the estimatedfair value of our ARS by reviewing the ratings of the securities we hold.  We also review any guarantors of our ARS, ifapplicable.  Some of our judgments andestimates are based upon published industry statistics and in some cases thirdparty professionals and any errors in our estimates or judgments could have amaterial effect on our financial statements.

 

In thefuture we may need to revise the judgments, estimates and assessments we use toformulate our critical accounting policies to incorporate information which isnot now known.  We cannot predict theeffect changes to these premises underlying our critical accounting policiesmay have on our future results of operations, although such changes could bematerial and adverse.

###  

### **RecentlyAnnounced Accounting Pronouncements**

###  

In September 2006, the Financial Accounting Standards Board, orthe FASB, issued Statement of Financial Accounting Standards “Fair ValueMeasurements”, or SFAS 157.  SFAS 157replaces multiple existing definitions of fair value with a single definition,establishes a consistent framework for measuring fair value and expandsfinancial statement disclosures regarding fair value measurements. SFAS 157applies only to fair value measurements that already are required or permittedby other accounting standards and does not require any new fair valuemeasurements. SFAS 157 will be effective beginning with the first quarter of2008.  We do not expect the adoption ofSFAS 157 will have a material impact on our financial position or results ofoperations.

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities – Including anamendment to FASB Statement No. 115”, or SFAS 159.  SFAS 159 allowscompanies to choose to measure eligible assets and liabilities at fair valuewith changes in value recognized in earnings.  Fair value treatment foreligible assets and liabilities may be elected either prospectively uponinitial recognition, or when an event triggers a new basis of accounting for anexisting asset or liability.  SFAS 159 will be effective beginning withthe first quarter of 2008.  We do notexpect at this time to elect to re-measure any of our existing financial assetsor liabilities under the provisions of SFAS 159.

 

**Inflation and Deflation**

** **

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

 

Deflation would likely have a negative impact uponus.  A large component of our expensesconsists of our minimum rental obligations to Senior Housing and HCPI.  Accordingly we believe that a general declinein price levels which could cause our charges to residents to decline wouldlikely not be fully offset by a decline in our expenses.

 

**Seasonality**

 

Oursenior living business is subject to modest effects of seasonality.  During the calendar fourth quarter holidayperiods, nursing home and assisted living residents are sometimes discharged tojoin family celebrations and admission decisions are often deferred. The firstquarter of each calendar year usually coincides with increased illness amongnursing home and assisted living residents which can result in increased costsor discharges to hospitals. As a result of these factors, nursing home andassisted living operations sometimes produce greater earnings in the second andthird quarters of a calendar year and lesser earnings in the first and fourthquarters. We do not believe that this

 

43

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 seasonalitywill cause fluctuations in our revenues or operating cash flow to such anextent that we will have difficulty paying our expenses, including rent, whichdo not fluctuate seasonally.

 

**Item 7A.  Quantitative and Qualitative DisclosuresAbout Market Risk**

** **

We areexposed to risks associated with market changes in interest rates.  We manage our exposure to this market risk bymonitoring available financing alternatives. Our strategy to manage exposure to changes in interest rates isunchanged from December 31, 2006. Other than as described below, we do not foresee any significant changesin our exposure to fluctuations in interest rates or in how we manage thisexposure in the near future.

 

 Changes in market interest rates also affectthe fair value of our fixed rate debt; increases in market interest ratesdecrease the fair value of our fixed rate debt, while decreases in marketinterest rates increase the fair value of our fixed rate debt.   For example: based upon discounted cash flowanalysis, if prevailing interest rates were to increase by 10%, the marketvalue of our $142.5 million mortgage debt and Notes outstanding on December 31,2007 would decline by about $5.2 million; and, similarly, if prevailinginterest rates were to decline by 10% and other credit market considerationsremained unchanged, the market value of our $142.5 million mortgage debt andNotes outstanding on December 31, 2007, would increase by about $5.6****million

 

Our revolving credit facility bears interest atfloating rates and matures in May 2008.  As of December 31, 2007 and March 4,2008, no amounts were outstanding under this credit facility.  We borrow in U.S. dollars and borrowingsunder our revolving credit facility requires annual interest at LIBOR plus 125basis points.  Accordingly, we are vulnerableto changes in U.S. dollar based short term, interest rates, specificallyLIBOR.  A change in interest rates wouldnot affect the value of any outstanding floating rate debt but could affect ouroperating results.  For example, if themaximum amount of $40.0 million were drawn under our credit facility andinterest rates decreased or increased by 1% per annum, our interest expensewould decrease or increase by $400,000 per year, or $0.01 per share, based oncurrently outstanding common shares.  Ifinterest rates were to change gradually over time, the impact would occur overtime.

 

Our exposure to fluctuations in interest rates mayincrease in the future if we incur debt to fund acquisitions or otherwise.

 

**Item 8. FinancialStatements and Supplementary Data**

 

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

 

**Item 9. Changes in andDisagreements with Accountants on Accounting and Financial Disclosure**

** **

None.

 

**Item 9A.  Controls and Procedures**

** **

As of the end ofthe period covered by this report, our management carried out an evaluation,under the supervision and with the participation of our President and ChiefExecutive Officer and our Treasurer and Chief Financial Officer of theeffectiveness of our disclosure controls and procedures pursuant to ExchangeAct Rules 13a-15 and 15d-15.  Basedupon that evaluation, our President and Chief Executive Officer and ourTreasurer and Chief Financial Officer concluded that our disclosure controlsand procedures are effective.

 

There have been no changes in our internal controlover financial reporting during the quarter ended December 31, 2007 thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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

 

We areresponsible for establishing and maintaining adequate internal control overfinancial reporting. Our internal control system is designed to providereasonable assurance to our management and board of directors regarding thepreparation and fair presentation of published financial statements. Allinternal control systems, no matter how well designed, have inherent limitations.Therefore, even those systems determined to be effective can provide onlyreasonable assurance with respect to financial statement preparation andpresentation.

 

Our managementassessed the effectiveness of our internal control over financial reporting asof December 31, 2007. In making this assessment, it used the criteria setforth by the Committee of Sponsoring Organizations of the Treadway Commissionin *Internal Control Integrated Framework*.Based on our assessment, we believe that, as of December 31, 2007, ourinternal control over financial reporting is effective.

 

Ernst & Young LLP, the independent registeredpublic accounting firm that audited our 2007 consolidated financial statementsincluded in this Annual Report on Form 10-K, has issued an attestationreport on our internal control over financial reporting. The report appearselsewhere herein.

 

**Item 9B.  Other Information**

** **

**None.**

 

**45**

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**PART III**

 

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

 

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

 

Theremainder of the information required by Item 10 is incorporated by referenceto our definitive Proxy Statement, which will be filed not later than 120 daysafter the end of our fiscal year.

 

**Item11.  Executive Compensation**

 

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

 

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

 

Equity Compensation PlanInformation.  We maygrant options and common shares to our officers, directors, employees and otherindividuals who render services to us, subject to vesting requirements underour 2001 Stock Option and Stock Incentive Plan, as amended, or the Plan.  In addition, each of our directors receives4,000 shares per year as part of his or her annual compensation for serving asa director and such shares may be awarded under the Plan.  The terms of grants made under the Plan aredetermined by our board of directors or a committee thereof at the time of thegrant.  The following table is as of December 31,2007.

 
| ** **                                                  | ** ** | **Number of securities   to be issued upon   exercise of   outstanding options,  warrants and rights** | ** ** | **Weighted-average exercise price of outstanding options, warrants and  rights** | ** ** | **Number of securities   remaining available for future issuance under equity   compensation plans (excluding securities reflected in  column (a))** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                     | ** ** | **(b)**                                                                          | ** ** | **(c)**                                                                                                                                                   | ** ** |
| Equity compensation plans approved by  security holders     |       | None                                                                                                        |       | None                                                                             |       | 2,509,490                                                                                                                                                 | (1)        |
| Equity compensation plans not approved by  security holders |       | None                                                                                                        |       | None                                                                             |       | None                                                                                                                                                      |       |
| Total                                                       |       | None                                                                                                        |       | None                                                                             |       | 2,509,490                                                                                                                                                 |       |

 

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 (1) Pursuant to the terms of the Plan, inno event shall the number of shares issued exceed 3,000,000.

 

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

 

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

 

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

 

**Item 14. Principal Accountant Fees and Schedules**

 

The information required by Item 14 is incorporated by reference to ourdefinitive Proxy Statement, which will be filed not later than 120 days afterthe end of our fiscal year.

 

46

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**Item 15.  Exhibits and FinancialStatement Schedules**

** **

(a)  Index to FinancialStatements

 
| ** **                                                                                                     | **Page**      |
|----------------------------------------------------------------------------------------------------------------|---------------|
| **Consolidated  Financial Statements of Five Star Quality Care, Inc.**                                    | ** **    |
| ** **                                                                                                     | ** **    |
| Reports of Independent Registered Public  Accounting Firm                                                      | **F-1 / F-2** |
|                                                                                                           | ** **    |
| Consolidated Balance Sheet at  December 31, 2007 and 2006                                                 | **F-3**       |
|                                                                                                           | ** **    |
| Consolidated Statement of Operations for  the years ended December 31, 2007, 2006 and 2005                | **F-4**       |
|                                                                                                           | ** **    |
| Consolidated Statement of Shareholders’  Equity for the years ended December 31, 2007, 2006 and 2005 | **F-5**       |
|                                                                                                           | ** **    |
| Consolidated Statement of Cash Flows for  the years ended December 31, 2007, 2006 and 2005                | **F-6**       |
|                                                                                                           | ** **    |
| Notes to Consolidated Financial Statements                                                                     | **F-7**       |

 

All other schedules for whichprovision is made in the applicable accounting regulations of the Securitiesand Exchange Commission are not required under the related instructions, or areinapplicable, and therefore have been omitted.

 

(b)         Exhibits

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2.1                  |       | Transaction Agreement, dated as of December 7, 2001, by and  among Senior Housing Properties Trust, certain subsidiaries of Senior Housing  Properties Trust party thereto, the Company, certain subsidiaries of the  Company party thereto, FSQ, Inc., Hospitality Properties Trust, HRPT  Properties Trust and Reit Management & Research LLC. (*Incorporated by reference to Senior Housing  Properties Trust’s Current Report on Form 8-K dated December 13,  2001.*) |
| 3.1                  |       | Composite copy of Articles of Amendment and Restatement of the  Company. (*Incorporated by reference to the  Company’s Current Report on Form 8-K dated March 31, 2006*.)                                                                                                                                                                                                                                                                                                                         |
| 3.2                  |       | Composite copy of Amended and Restated Bylaws of the Company. (*Incorporated by reference to the Company’s Current  Report on Form 8-K dated March 10, 2004*.)                                                                                                                                                                                                                                                                                                                                    |
| 3.3                  |       | Articles Supplementary, as corrected by Certificate of Correction  dated as of March 19, 2004. *(Incorporated  by reference to the Company’s Form 8-A dated March 19, 2004 and the  Company’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2004, respectively.)*                                                                                                                                                                                            |
| 4.1                  |       | Specimen Certificate for shares of common stock of the Company. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-69846, as amended  on November 8, 2001*.)                                                                                                                                                                                                                                                                                     |
| 4.2                  |       | Description of Capital Stock of the Company. *(Contained in Exhibits 3.1 and 3.2.)*                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.3                  |       | Rights Agreement, dated as of March 10, 2004, by and between the  Company and Equiserve Trust Company, N.A. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated  March 10, 2004.)*                                                                                                                                                                                                                                                                                |
| 4.4                  |       | Appointment of Successor Rights Agent, dated as of December 13,  2004, by and between the Company and Wells Fargo Bank, National Association,  a national banking association. (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated  December 13, 2004*.)                                                                                                                                                                                                          |
| 4.5                  |       | Indenture related to 3.75% Convertible Senior Notes due 2026, dated  as of October 18, 2006, by and among the Company, each of the guarantors  named therein and U.S. Bank National Association, as Trustee.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 24, 2006.)*                                                                                                                                                                               |
| 4.6                  |       | Registration Rights Agreement, dated as of October 18, 2006, by  and among the Company, each of the guarantors named therein and the Initial  Purchasers named therein.*(Incorporated by  reference to the Company’s Current Report on Form 8-K dated  October 24, 2006.)*                                                                                                                                                                                                                   |
| 10.1†           |       | 2001 Stock Option and Stock Incentive Plan of the Company, as  amended. (*Incorporated by reference to the  Company’s Current Report on Form 8-K dated May 25, 2006.*)                                                                                                                                                                                                                                                                                                                            |
| 10.2†#          |       | Form of Restricted Share Agreement. *(Incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the quarter ended June 30, 2003.)*                                                                                                                                                                                                                                                                                                                                       |

 

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| 10.3†# |   | Representative Indemnification Agreement. *(Filed herewith.)*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4†  |   | Summary of Director Compensation. (*Incorporated  by reference to the Company’s Current Report on Form 8-K dated  May 25, 2006.*)                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.5        |   | Shared Services Agreement, dated as of January 2, 2002, by and  between the Company and Reit Management & Research LLC. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-83648, as amended  on December 5, 2001*.)                                                                                                                                                                                                                                                                          |
| 10.6        |   | Amendment No. 1 to Shared Services Agreement, dated as of  January 14, 2002, by and between the Company and Reit  Management & Research LLC. (*Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-83648*.)                                                                                                                                                                                                                                                                                     |
| 10.7        |   | Amendment No. 2 to Shared Services Agreement, dated as of  March 10, 2004, by and between the Company and Reit  Management & Research LLC. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated March 10,  2004.)*                                                                                                                                                                                                                                                                                                   |
| 10.8        |   | Mortgage, dated as of April 19, 2004, between Five Star Quality  Care-Howell, LLC and Love Funding Corporation. *(Incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the quarter ended March 31,  2004.)*                                                                                                                                                                                                                                                                                                                    |
| 10.9        |   | Second Amended and Restated Lease Agreement, dated as of  November 19, 2004, by and among, Ellicott City Land I LLC, Ellicott  City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five  Star Quality Care Trust, as Tenant. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)* |
| 10.10       |   | First Amendment to Second Amended and Restated Lease Agreement, dated  as of May 17, 2005, by and among Ellicott City Land I LLC, Ellicott City  Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust, SPTIHS  Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated  June 3, 2005.)*                                                   |
| 10.11       |   | Second Amendment to Second Amended and Restated Lease Agreement,  dated as of June 3, 2005, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant. *(Incorporated  by reference to the Company’s Current Report on Form 8-K dated  June 3, 2005.)*                                                  |
| 10.12       |   | Third Amendment to Second Amended and Restated Lease Agreement, dated  as of October 31, 2005, by and among Ellicott City Land I LLC, Ellicott  City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust, SPTIHS  Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA Properties  Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star Quality Care  Trust, as Tenant. *(Incorporated by  reference to the Company’s Current Report on Form 8-K dated  November 4, 2005.)*                                           |
| 10.13       |   | Third [Fourth] Amendment to Second Amended and Restated Lease  Agreement, dated as of December 30, 2005, by and among Ellicott City  Land I LLC, Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS  Properties Trust, SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR  Properties Trust, SNH/LTA Properties Trust and SNH/LTA Properties GA LLC, as  Landlord, and Five Star Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 5, 2006.)*                                    |
| 10.14       |   | Letter Agreement, dated as of March 13, 2006, by and between  Senior Housing Properties Trust and Five Star Quality Care Trust.*(Incorporated by reference to the Company’s  Current Report on Form 8-K dated October 5, 2006.)*                                                                                                                                                                                                                                                                                                                             |
| 10.15       |   | Fifth Amendment to Second Amended and Restated Lease Agreement, dated  as of September 1, 2006, by and among Ellicott City Land I LLC, Ellicott  City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust, SPTIHS  Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Current Report on Form 8-K  dated October 5, 2006.)*                                             |
| 10.16       |   | Sixth Amendment to Second Amended and Restated Lease Agreement, dated  as of October 1, 2006, by and among Ellicott City Land I LLC, Ellicott  City Land II LLC, HRES2 Properties Trust, SNH                                                                                                                                                                                                                                                                                                                                                                                |

 

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|   |   | CHS Properties Trust, SPTIHS Properties Trust, SPT-Michigan Trust,  SPTMNR Properties Trust, SNH/LTA Properties Trust and SNH/LTA Properties GA  LLC, as Landlord, and Five Star Quality Care Trust, as Tenant. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated October 5, 2006.)*                                                                                                                                                                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17  |   | Seventh Amendment to Second Amended and Restated Lease Agreement,  dated as of October 1, 2006, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Current Report on Form 8-K  dated October 11, 2006.)*                      |
| 10.18  |   | Eighth Amendment to Second Amended and Restated Lease Agreement,  dated as of November 1, 2006, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the quarter ended September 30, 2006.)* |
| 10.19  |   | Ninth Amendment to Second Amended and Restated Lease Agreement, dated  as of November 1, 2006, by and among Ellicott City Land I LLC, Ellicott  City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust, SPTIHS  Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2006.)*         |
| 10.20  |   | Tenth Amendment to Second Amended and Restated Lease Agreement, dated  as of November 6, 2006, by and among Ellicott City Land I LLC, Ellicott  City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust, SPTIHS  Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2006.)*         |
| 10.21  |   | Eleventh Amendment to Second Amended and Restated Lease Agreement,  dated as of December 22, 2006, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2006.)*     |
| 10.22  |   | Twelfth Amendment to Second Amended and Restated Lease Agreement,  dated as of January 1, 2007, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Incorporated by reference to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2006.)*        |
| 10.23  |   | Thirteenth Amendment to Second Amended and Restated Lease Agreement,  dated as of January 4, 2008, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Filed  herewith.)*                                                                                                                |
| 10.24  |   | Fourteenth Amendment to Second Amended and Restated Lease Agreement,  dated as of February 7, 2008, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Filed  herewith.)*                                                                                                               |
| 10.25  |   | Fifteenth Amendment to Second Amended and Restated Lease Agreement,  dated as of February 17, 2008, by and among Ellicott City Land I LLC,  Ellicott City Land II LLC, HRES2 Properties Trust, SNH CHS Properties Trust,  SPTIHS Properties Trust, SPT-Michigan Trust, SPTMNR Properties Trust, SNH/LTA  Properties Trust and SNH/LTA Properties GA LLC, as Landlord, and Five Star  Quality Care Trust, as Tenant.*(Filed  herewith.)*                                                                                                               |
| 10.26  |   | Guaranty Agreement, dated as of December 31, 2001, made by the Company,  as Guarantor, for the                                                                                                                                                                                                                                                                                                                                                                                                                                                        |

 

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|   |   | benefit of the Landlord under the Second Amended and Restated Master  Lease Agreement, dated as of November 19, 2004, by and among certain  affiliates of Senior Housing Properties Trust, as Landlord, and Five Star  Quality Care Trust, as Tenant, as amended. (*Incorporated  by reference to Senior Housing Properties Trust’s Current Report on  Form 8-K dated December 31, 2001*.)                                                                                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.27  |   | Security Agreement, dated as of December 31, 2001, by and among  Five Star Quality Care Trust and the Landlord under the Second Amended and  Restated Master Lease Agreement, dated as of November 19, 2004, by and  among certain affiliates of Senior Housing Properties Trust, as Landlord, and  Five Star Quality Care Trust, as Tenant, as amended. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-83648, as amended  on December 5, 2001*.) |
| 10.28  |   | First Amendment to Security Agreement, dated as of April 19,  2004, by and among Five Star Quality Care Trust and the Landlord under the  Second Amended and Restated Master Lease Agreement, dated as of  November 19, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and Five Star Quality Care Trust, as Tenant,  as amended. *(Incorporated by reference to  the Company’s Annual Report on Form 10-K for the year ended  December 31, 2006.)*            |
| 10.29  |   | Second Amendment to Security Agreement, dated as of May 17,  2005, by and among Five Star Quality Care Trust and the Landlord under the  Second Amended and Restated Master Lease Agreement, dated as of  November 19, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and Five Star Quality Care Trust, as Tenant,  as amended. *(Incorporated by reference to  the Company’s Current Report on Form 8-K dated June 3, 2005.)*                                |
| 10.30  |   | Guaranty Agreement, dated as of October 25, 2002, made by the  Company, as Guarantor, for the benefit of SNH CHS Properties Trust and Senior  Housing Properties Trust. (*Incorporated by  reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2002*.)                                                                                                                                                                                                                   |
| 10.31  |   | Guaranty Agreement, dated as of October 25, 2002, made by Five  Star Quality Care-MD, LLC, Five Star Quality Care-NC, LLC and Five Star Quality  Care-VA, LLC, as Guarantors, for the benefit of SNH CHS Properties Trust. (*Incorporated by reference to the Company’s Report  on Form 10-K for the year ended December 31, 2002*.)                                                                                                                                                                        |
| 10.32  |   | Security Agreement, dated as of October 25, 2002, by and between  FVE-CHS LLC and SNH CHS Properties Trust. (*Incorporated  by reference to the Company’s Report on Form 10-K for the year ended  December 31, 2002*.)                                                                                                                                                                                                                                                                                      |
| 10.33  |   | Security Agreement, dated as of October 25, 2002, by and among  Five Star Quality Care-MD, LLC, Five Star Quality Care-NC, LLC, Five Star  Quality Care-VA, LLC and SNH CHS Properties Trust. (*Incorporated by reference to the Company’s Report  on Form 10-K for the year ended December 31, 2002*.)                                                                                                                                                                                                     |
| 10.34  |   | Amended and Restated Pledge of Shares of  Beneficial Interest Agreement, dated as of May 6, 2005, made by  FSQ, Inc. for the benefit of the Landlord under the Second Amended and  Restated Lease Agreement, dated as of November 19, 2004, by and among  certain affiliates of Senior Housing Properties Trust, as Landlord, and Five  Star Quality Care Trust, as Tenant, as amended. *(Incorporated by reference to the Company’s Current Report on  Form 8-K dated June 3, 2005.)*            |
| 10.35  |   | Confirmation of  Guarantees and Confirmation and Amendment of Other Incidental Documents,  dated as of June 3, 2005, by and among the Company, certain affiliates  of the Company and certain affiliates of Senior Housing Properties Trust. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated June 3, 2005.)*                                                                                                                                                                 |
| 10.36  |   | Confirmation of  Guarantees and Confirmation and Amendment of Other Incidental Documents,  dated as of October 31, 2005, by and among the Company, certain  affiliates of the Company and certain affiliates of Senior Housing Properties  Trust. *(Incorporated by reference to the  Company’s Current Report on Form 8-K dated November 4, 2005.)*                                                                                                                                                        |
| 10.37  |   | Confirmation of Guarantees and Confirmation and Amendment of Other  Incidental Documents, dated as of September 1, 2006, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust.*(Incorporated by  reference to the Company’s Current Report on Form 8-K dated  October 5, 2006.)*                                                                                                                                                         |
| 10.38  |   | Confirmation of Guarantees and Confirmation and Amendment of Other  Incidental Documents, dated as of October 1, 2006, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust.*(Incorporated by  reference to the Company’s Current*                                                                                                                                                                                                                 |

 

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|   |   | *Report on Form 8-K dated  October 5, 2006.)*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.39  |   | Confirmation of Guarantees and Confirmation and Amendment of Other  Incidental Documents, dated as of November 1, 2006, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust. *(Incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended September 30, 2006.)*                                                                                                                                                      |
| 10.40  |   | Partial Termination and Confirmation of Guarantees and Other  Incidental Documents, dated as of November 1, 2006, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust. *(Incorporated by  reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2006.)*                                                                                                                                                                   |
| 10.41  |   | Confirmation of Guarantees and Confirmation and Amendment of Other  Incidental Documents, dated as of November 6, 2006, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust. *(Incorporated by  reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2006.)*                                                                                                                                                             |
| 10.42  |   | Confirmation of Guarantees and Confirmation and Amendment of Other  Incidental Documents, dated as of December 22, 2006, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust. *(Incorporated by  reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2006.)*                                                                                                                                                            |
| 10.43  |   | Confirmation of Guarantees and Confirmation and Amendment of Other  Incidental Documents, dated as of January 1, 2007, by and among the  Company, certain affiliates of the Company and certain affiliates of Senior  Housing Properties Trust. *(Incorporated by  reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2006.)*                                                                                                                                                              |
| 10.44  |   | Amended Master Lease Agreement, dated as of January 11, 2002, by  and among certain affiliates of Senior Housing Properties Trust, as Landlord,  and FS Tenant Holding Company Trust and FS Tenant Pool III Trust, as  Tenant. (*Incorporated by reference to  Senior Housing Properties Trust’s Current Report on Form 8-K dated  December 31, 2001*.)                                                                                                                                                                   |
| 10.45  |   | First Amendment to Amended Master Lease Agreement, dated as of  October 1, 2002, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and FS Tenant Holding Company Trust and FS  Tenant Pool III Trust, as Tenant. (*Incorporated  by reference to the Company’s Annual Report on Form 10-K for the year  ended December 31, 2002*.)                                                                                                                                                             |
| 10.46  |   | Second Amendment to Amended Master Lease Agreement, dated as of  March 1, 2004, by and among certain affiliates of Senior Housing  Properties Trust, as Landlord, and FS Tenant Holding Company Trust and FS  Tenant Pool III Trust, collectively as Tenant. *(Incorporated by reference to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2004 .)*                                                                                                                                                 |
| 10.47  |   | Letter  Agreement, dated as of March 13, 2006, by and among Senior Housing  Properties Trust, as Landlord, and FS Tenant Holding Company Trust and FS  Tenant Pool III Trust, collectively as Tenant. *(Incorporated by reference to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2006.)*                                                                                                                                                                                                         |
| 10.48  |   | Guaranty Agreement, dated as of January 11, 2002, made by the  Company, as Guarantor, for the benefit of the Landlord under the Amended  Master Lease Agreement, dated January 11, 2002, by and among certain  affiliates of Senior Housing Properties Trust, as Landlord, and FS Tenant  Holding Company Trust and FS Tenant Pool III Trust, as Tenant. (*Incorporated by reference to Senior Housing Properties  Trust’s Current Report on Form 8-K dated December 31, 2001*.)                                     |
| 10.49  |   | Pledge of Shares of Beneficial Interest Agreement, dated as of  January 11, 2002, made by FSQ, Inc. for the benefit of the Landlord  under the Amended Master Lease Agreement, dated January 11, 2002, by and  among certain affiliates of Senior Housing Properties Trust, as Landlord, and  FS Tenant Holding Company Trust and FS Tenant Pool III Trust, as Tenant. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-83648, as amended  on December 5, 2001*.) |
| 10.50  |   | Security Agreement, dated as of January 11, 2002, by and among  FS Tenant Holding Company Trust and the Landlord under the Amended Master  Lease Agreement, dated January 11, 2002, by and among certain affiliates  of Senior Housing Properties Trust, as Landlord, and FS Tenant Holding  Company Trust and FS Tenant Pool III Trust, as Tenant. (*Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-83648, as amended  on December 5, 2001*.)                         |
| 10.51  |   | Lease Agreement, dated as of November 19, 2004, by and among  certain affiliates of Senior Housing Properties Trust, as Landlord, and  certain affiliates of the Company as Tenant. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)*                                                                                                                                                                                            |

 

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| 10.52 |   | Lease Agreement, dated as of November 19, 2004, by and among  certain affiliates of Senior Housing Properties Trust, as Landlord, and  certain affiliates of the Company as Tenant. *(Incorporated  by reference to the Company’s Registration Statement on Form S-1, File  No. 333-119955, as amended on November 29, 2004.)* |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.53 |   | Guaranty Agreement, dated as of November 19, 2004, made by the  Company in favor of the Beneficiaries named therein. *(Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-119955, as amended  on November 29, 2004.)*                                                                |
| 10.54 |   | Guaranty Agreement, dated as of November 19, 2004, made by the  Company in favor of the Beneficiaries named therein. *(Incorporated by reference to the Company’s  Registration Statement on Form S-1, File No. 333-119955, as amended  on November 29, 2004.)*                                                                |
| 10.55 |   | Amended and Restated Master Lease Agreement, dated as of  October 1, 2006, by and among HRES1 Properties Trust, as landlord, and  FS Patriot LLC and FS Commonwealth LLC, jointly and severally as tenant. *(Incorporated by reference to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2006.)*         |
| 10.56 |   | Amended and Restated Guaranty Agreement, dated as of October 1,  2006, by the Company for the benefit of Senior Housing Properties Trust and  HRES1 Properties Trust. *(Incorporated by  reference to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2006.)*                                             |
| 10.57 |   | Amended and Restated Security Agreement, dated as of October 1,  2006, between FS Patriot LLC and FS Commonwealth LLC, as tenant, and HRES1  Properties Trust, as secured party. *(Incorporated  by reference to the Company’s Annual Report on Form 10-K for the year  ended December 31, 2006.)*                                  |
| 10.58 |   | Amended and Restated  Pledge Agreement, dated as of October 1, 2006, by FSQ, Inc. for the  benefit of HRES1 Properties Trust. *(Incorporated  by reference to the Company’s Annual Report on Form 10-K for the year  ended December 31, 2006.)*                                                                                |
| 10.59 |   | Credit and Security  Agreement, dated as of May 9, 2005, by and among the Company, each of  the Guarantors party thereto and Wachovia Bank, National Association. *(Incorporated by reference to the Company’s Current  Report on Form 8-K dated May 13, 2005.)*                                                                    |
| 10.60 |   | First Amendment to Credit and Security Agreement, dated as of  July 22, 2005, by and among the Company, each of the Guarantors party  thereto and Wachovia Bank, National Association. *(Incorporated by reference to the Company’s Current Report on  Form 8-K dated August 23, 2005.)*                                            |
| 10.61 |   | Second Amendment to Credit and Security Agreement, dated as of  August 15, 2005, by and among the Company, each of the Guarantors party  thereto and Wachovia Bank, National Association. *(Incorporated by reference to the Company’s Current Report on  Form 8-K dated August 23, 2005.)*                                         |
| 10.62 |   | Third Amendment to Credit and Security Agreement, dated as of  July 11, 2006, by and among the Company, each of the Guarantors party  thereto and Wachovia Bank, National Association.*(Incorporated by reference to the Company’s Current Report on  Form 8-K dated July 17, 2006.)*                                               |
| 10.63 |   | Fourth Amendment to Credit and Security Agreement, dated as of  October 11, 2006, by and among the Company, each of the Guarantors party  thereto and Wachovia Bank, National Association.*(Incorporated by reference to the Company’s Current Report on  Form 8-K dated October 11, 2006.)*                                        |
| 10.64 |   | Fifth Amendment to Credit and Security Agreement, dated as of June 18,  2007, by and among the Company, each of the Guarantors party thereto and  Wachovia Bank, National Association.*(Incorporated by reference to the Company’s Current Report on Form 8-K  dated June 20, 2007.)*                                               |
| 12.1  |   | Computation of Ratio of Earnings to Fixed Charges. *(Filed herewith.)*                                                                                                                                                                                                                                                                                  |
| 21.1  |   | Subsidiaries of the Company. *(Filed  herewith.)*                                                                                                                                                                                                                                                                                                       |
| 23.1  |   | Consent of Ernst & Young LLP. *(Filed herewith.)*                                                                                                                                                                                                                                                                                              |
| 31.1  |   | Rule 13a-14(a) Certification of Chief Executive Officer. *(Filed herewith.)*                                                                                                                                                                                                                                                                  |
| 31.2  |   | Rule 13a-14(a) Certification of Chief Financial Officer. *(Filed herewith.)*                                                                                                                                                                                                                                                                  |
| 32.1  |   | Section 1350 Certification of Chief Executive Officer and Chief  Financial Officer. *(Furnished herewith.)*                                                                                                                                                                                                                                        |

 

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| † | Indicates a management contract or a compensatory plan, contract or  arrangement.              |
|--------|------------------------------------------------------------------------------------------------|
|   |                                                                                           |
| #      | Agreement filed is illustrative of numerous other agreements to which  the Company is a party. |

 

52

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**Report of Independent Registered PublicAccounting Firm**

** **

To the Board of Directors andShareholders of Five Star Quality Care, Inc.

 

We have audited theaccompanying consolidated balance sheets of Five Star Quality Care, Inc.,as of December 31, 2007 and 2006, and the related consolidated statementsof operations, shareholders’ equity and cash flows for each of the three yearsin the period ended December 31, 2007. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.   An audit also includesassessing the accounting principles used and significant estimates made bymanagement, 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 financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of Five Star Quality Care, Inc. at December 31,2007 and 2006, and the consolidated results of their operations and their cashflows for each of the three years in the period ended December 31, 2007,in conformity with U.S. generally accepted accounting principles.

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Five Star Quality Care, Inc.’sinternal control over financial reporting as of December 31, 2007, basedon criteria established in Internal Control – Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission and ourreport dated February 28, 2008 expressed an unqualified opinion thereon.

 

 
|                   | /s/  Ernst & Young, LLP |
|------------------------|----------------------------------|
| Boston,  Massachusetts |                             |
| February 28, 2008 |                             |

 

F-1

----

 

**Report of Independent Registered PublicAccounting Firm**

 

To the Board of Directors andShareholders of Five Star Quality Care, Inc.

 

We have audited Five****Star Quality Care, Inc.’s internal control overfinancial reporting as of December 31, 2007, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). Five****Star Quality Care, Inc.’s management is responsiblefor maintaining effective internal control over financial reporting, and forits assessment of the effectiveness of internal control over financialreporting included in Item 9A of Five Star Quality Care Inc.’s Annual Report onForm 10-K. Our responsibility is to express an opinion on the company’sinternal control over financial reporting based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,assessing the risk that a material weakness exists, testing and evaluating thedesign and operating effectiveness of internal control based on the assessedrisk, and performing such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

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

 

In our opinion, Five****Star Quality Care, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2007, based on****the COSO criteria**.**

 

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balance sheets of Five Star Quality Care, Inc. as of December 31, 2007 and 2006, andthe related consolidated statements of operations, shareholders’ equity, andcash flows for each of the three years in the period ended December 31,2007 of Five Star QualityCare, Inc. and our report dated February 28, 2008 expressed an unqualified opinion thereon.

 

 
|                   | /s/ Ernst & Young LLP |   |
|------------------------|--------------------------------|--------|
|                   |                           |
| Boston, Massachusetts  |                           |
| February 28, 2008 |                           |

 

F-2

----

 

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATED BALANCE SHEET**

*(dollarsin thousands, except share data)*

 
| ** **                                                                                                                                                              | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **ASSETS**                                                                                                                                                              |       |                  |       |   |   |
| Current assets:                                                                                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                               |       | $                     | 30,999     |   | $ | 46,241 |   |
| Accounts receivable, net of allowance of $4,836 and $5,005 at  December 31, 2007 and 2006, respectively                                                            |       | 58,803                |       | 67,791 |   |
| Prepaid expenses                                                                                                                                                        |       | 9,041                 |       | 16,112 |   |
| Investment securities:                                                                                                                                                  |       |                  |       |   |   |
| Investment in trading  securities                                                                                                                                       |       | 61,800                |       | 46,100 |   |
| Investment in available  for sale securities                                                                                                                            |       | 7,455                 |       | 4,334 |   |
| Restricted cash                                                                                                                                                         |       | 3,655                 |       | 7,968 |   |
| Restricted investments                                                                                                                                                  |       | 3,946                 |       | 2,448 |   |
| Other current assets                                                                                                                                                    |       | 7,140                 |       | 14,766 |   |
| Assets of discontinued operations                                                                                                                                       |       | 3,178                 |       | — |   |
| Total current assets                                                                                                                                                    |       | 186,017               |       | 205,760 |   |
|                                                                                                                                                                    |       |                  |       |   |   |
| Property and equipment, net                                                                                                                                             |       | 131,705               |       | 114,898 |   |
| Restricted cash                                                                                                                                                         |       | 2,568                 |       | 8,560 |   |
| Restricted investments                                                                                                                                                  |       | 10,375                |       | 6,262 |   |
| Goodwill and other intangible assets                                                                                                                                    |       | 21,877                |       | 22,611 |   |
| Other long term assets                                                                                                                                                  |       | 7,912                 |       | 8,320 |   |
|                                                                                                                                                                    |       | $                     | 360,454    |   | $ | 366,411 |   |
|                                                                                                                                                                    |       |                  |       |   |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                           |       |                  |       |   |   |
|                                                                                                                                                                    |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                    |       |                  |       |   |   |
| Accounts payable                                                                                                                                                        |       | $                     | 19,135     |   | $ | 22,805 |   |
| Accrued expenses                                                                                                                                                        |       | 15,222                |       | 13,540 |   |
| Accrued compensation and benefits                                                                                                                                       |       | 30,103                |       | 24,503 |   |
| Due to Senior Housing Properties Trust (“Senior Housing”)                                                                                                     |       | 11,242                |       | 9,988 |   |
| Mortgage notes payable                                                                                                                                                  |       | 200                   |       | 33,317 |   |
| Accrued real estate taxes                                                                                                                                               |       | 7,352                 |       | 6,035 |   |
| Security deposit liability                                                                                                                                              |       | 13,361                |       | 15,097 |   |
| Other current liabilities                                                                                                                                               |       | 7,229                 |       | 7,644 |   |
| Liabilities of discontinued operations                                                                                                                                  |       | 219                   |       | — |   |
| Total current liabilities                                                                                                                                               |       | 104,063               |       | 132,929 |   |
|                                                                                                                                                                    |       |                  |       |   |   |
| Long term liabilities:                                                                                                                                                  |       |                  |       |   |   |
| Mortgage notes payable                                                                                                                                                  |       | 15,810                |       | 11,454 |   |
| Convertible senior notes                                                                                                                                                |       | 126,500               |       | 126,500 |   |
| Continuing care contracts                                                                                                                                               |       | 3,159                 |       | 3,649 |   |
| Other long term liabilities                                                                                                                                             |       | 24,100                |       | 24,449 |   |
| Total long term liabilities                                                                                                                                             |       | 169,569               |       | 166,052 |   |
| Commitments and contingencies                                                                                                                                           |       |                  |       |   |   |
| Shareholders’ equity:                                                                                                                                              |       |                  |       |   |   |
| Preferred stock, par value $0.01: 1,000,000 shares authorized, none  issued                                                                                             |       | —                |       | — |   |
| Common stock, par value $0.01: 50,000,000 shares authorized,  31,818,144 and 31,682,134 shares issued and outstanding at December 31,  2007 and 2006, respectively |       | 318                   |       | 316 |   |
| Additional paid-in capital                                                                                                                                              |       | 286,734               |       | 286,344 |   |
| Accumulated deficit                                                                                                                                                     |       | (196,109              | )          | (219,435 | ) |
| Unrealized (loss) gain on investments                                                                                                                                   |       | (4,121                | )          | 205 |   |
| Total shareholders’ equity                                                                                                                                         |       | 86,822                |       | 67,430 |   |
|                                                                                                                                                                    |       | $                     | 360,454    |   | $ | 366,411 |   |

 

See accompanyingnotes.

 

F-3

----

 

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

(*in thousands, except per share data)*

 
| ** **                                                                    | ** ** | **For the year ended December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2007**                                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                          |       |                                                         |       |   |   |   |   |
| Revenues:                                                                     |       |                                                         |       |   |   |   |   |
| Senior living revenue                                                         |       | $                                                            | 809,934    |   | $ | 744,897 |   | $ | 698,012 |   |
| Hospital revenue                                                              |       | 102,005                                                      |       | 25,494 |   | — |   |
| Pharmacy revenue                                                              |       | 60,985                                                       |       | 45,195 |   | 29,647 |   |
| Total revenues                                                                |       | 972,924                                                      |       | 815,586 |   | 727,659 |   |
|                                                                          |       |                                                         |       |   |   |   |   |
| Operating expenses:                                                           |       |                                                         |       |   |   |   |   |
| Senior living wages and benefits                                              |       | 410,447                                                      |       | 382,093 |   | 356,068 |   |
| Other senior living operating expenses                                        |       | 202,194                                                      |       | 186,396 |   | 178,786 |   |
| Hospital expenses                                                             |       | 92,449                                                       |       | 22,954 |   | — |   |
| Pharmacy expenses                                                             |       | 58,012                                                       |       | 44,579 |   | 28,233 |   |
| Management fee to Sunrise Senior Living Services, Inc. (“SLS”) |       | —                                                       |       | 8,744 |   | 21,256 |   |
| Termination expense for SLS management agreements                             |       | —                                                       |       | 129,913 |   | 86,286 |   |
| Rent expense                                                                  |       | 129,190                                                      |       | 109,256 |   | 97,508 |   |
| General and administrative                                                    |       | 43,373                                                       |       | 33,829 |   | 28,221 |   |
| Depreciation and amortization                                                 |       | 13,595                                                       |       | 9,851 |   | 6,963 |   |
| Impairment of assets                                                          |       | —                                                       |       | — |   | 1,940 |   |
| Total operating expenses                                                      |       | 949,260                                                      |       | 927,615 |   | 805,261 |   |
|                                                                          |       |                                                         |       |   |   |   |   |
| Operating income (loss)                                                       |       | 23,664                                                       |       | (112,029 | ) | (77,602 | ) |
| Interest and other income                                                     |       | 6,152                                                        |       | 6,806 |   | 1,543 |   |
| Interest and other expense                                                    |       | (6,802                                                       | )          | (4,364 | ) | (3,632 | ) |
| Gain on extinguishment of debt                                                |       | 4,491                                                        |       | — |   | — |   |
|                                                                          |       |                                                         |       |   |   |   |   |
| Income (loss) from continuing operations before income taxes                  |       | 27,505                                                       |       | (109,587 | ) | (79,691 | ) |
| Provision for income taxes                                                    |       | 1,410                                                        |       | — |   | — |   |
| Income (loss) from continuing operations                                      |       | 26,095                                                       |       | (109,587 | ) | (79,691 | ) |
|                                                                          |       |                                                         |       |   |   |   |   |
| Loss from discontinued operations                                             |       | (2,769                                                       | )          | (7,078 | ) | (4,468 | ) |
|                                                                          |       |                                                         |       |   |   |   |   |
| Net income (loss)                                                             |       | $                                                            | 23,326     |   | $ | (116,665 | ) | $ | (84,159 | ) |
|                                                                          |       |                                                         |       |   |   |   |   |
| Weighted average shares outstanding - basic                                   |       | 31,710                                                       |       | 28,605 |   | 14,879 |   |
|                                                                          |       |                                                         |       |   |   |   |   |
| Weighted average shares outstanding - diluted                                 |       | 41,441                                                       |       | 28,605 |   | 14,879 |   |
|                                                                          |       |                                                         |       |   |   |   |   |
| Basic income (loss) per share from:                                           |       |                                                         |       |   |   |   |   |
| Continuing operations                                                         |       | $                                                            | 0.82       |   | $ | (3.83 | ) | $ | (5.35 | ) |
| Discontinued operations                                                       |       | (0.08                                                        | )          | (0.25 | ) | (0.30 | ) |
| Net income (loss) per share                                                   |       | $                                                            | 0.74       |   | $ | (4.08 | ) | $ | (5.65 | ) |
|                                                                          |       |                                                         |       |   |   |   |   |
| Diluted income (loss) per share from:                                         |       |                                                         |       |   |   |   |   |
| Continuing operations                                                         |       | $                                                            | 0.75       |   | $ | (3.83 | ) | $ | (5.35 | ) |
| Discontinued operations                                                       |       | (0.07                                                        | )          | (0.25 | ) | (0.30 | ) |
| Net income (loss) per share                                                   |       | $                                                            | 0.68       |   | $ | (4.08 | ) | $ | (5.65 | ) |

 

See accompanying notes*.*

 

F-4

----

 

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ EQUITY**

*(dollarsin thousands, except share data)*

 
| ** **                                     | ** ** | ** **         | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | **Gain (Loss)** | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|--------------------|------------|------------|------------|----------------|------------|-----------------|------------|----------------------|------------|------------|------------|
| ** **                                     | ** ** | **Number of** | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Accumulated** | ** ** | **on**               | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Shares**         | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **Investments**      | ** ** | **Total**  | ** ** |
| Balance at December 31, 2004                   |       | 12,096,634         |       | $          | 121        |           | $          | 114,434         |       | $                    | (18,611    | )          | $          | (40 | ) | $ | 95,904 |   |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Comprehensive income:                          |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Net loss                                       |       | —             |       | —     |       | —         |       | (84,159         | )          | —               |       | (84,159    | )          |
| Unrealized loss on investments                 |       | —             |       | —     |       | —         |       | —          |       | (139                 | )          | (139       | )          |
| Total comprehensive income                     |       | —             |       | —     |       | —         |       | (84,159         | )          | (139                 | )          | (84,298    | )          |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Stock grants                                   |       | 84,300             |       | 1          |       | 584            |       | —          |       | —               |       | 585        |       |
| Issuance of stock, pursuant to equity offering |       | 7,880,000          |       | 79         |       | 56,534         |       | —          |       | —               |       | 56,613     |       |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Balance at December 31, 2005                   |       | 20,060,934         |       | 201        |       | 171,552        |       | (102,770        | )          | (179                 | )          | 68,804     |       |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Comprehensive income:                          |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Net loss                                       |       | —             |       | —     |       | —         |       | (116,665        | )          | —               |       | (116,665   | )          |
| Unrealized gain on investments                 |       | —             |       | —     |       | —         |       | —          |       | 384                  |       | 384        |       |
| Total comprehensive income                     |       | —             |       | —     |       | —         |       | (116,665        | )          | 384                  |       | (116,281   | )          |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Stock grants                                   |       | 121,200            |       | 1          |       | 1,276          |       | —          |       | —               |       | 1,277      |       |
| Issuance of stock, pursuant to equity offering |       | 11,500,000         |       | 114        |       | 113,516        |       | —          |       | —               |       | 113,630    |       |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Balance at December 31, 2006                   |       | 31,682,134         |       | 316        |       | 286,344        |       | (219,435        | )          | 205                  |       | 67,430     |       |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Comprehensive income:                          |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Net income                                     |       | —             |       | —     |       | —         |       | 23,326          |       | —               |       | 23,326     |       |
| Unrealized loss on investments                 |       | —             |       | —     |       | —         |       | —          |       | (4,326               | )          | (4,326     | )          |
| Total comprehensive income                     |       | —             |       | —     |       | —         |       | 23,326          |       | (4,326               | )          | 19,000     |       |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Stock grants                                   |       | 136,010            |       | 2          |       | 390            |       | —          |       | —               |       | 392        |       |
|                                           |       |               |       |       |       |           |       |            |       |                 |       |       |       |
| Balance at December 31, 2007                   |       | 31,818,144         |       | $          | 318        |           | $          | 286,734         |       | $                    | (196,109   | )          | $          | (4,121 | ) | $ | 86,822 |   |

 

See accompanying notes*.*

 

F-5

----

 

**FIVE STARQUALITY CARE, INC.**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

(*dollars in thousands)*

* *
| ** **                                                                                      | ** ** | **For the year ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2007**                                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                           |       |                                                         |       |   |   |   |   |
| Net income (loss)                                                                               |       | $                                                            | 23,326     | ** ** | $ | (116,665 | ) | $ | (84,159 | ) |
| Adjustments to reconcile net income (loss) to cash provided by (used  in) operating activities: |       |                                                         | ** ** |   |   |   |   |
| Depreciation and amortization                                                                   |       | 13,595                                                       | ** ** | 9,851 |   | 6,963 |   |
| Gain on extinguishment of debt                                                                  |       | (4,491                                                       | )          | — |   | — |   |
| Impairment of assets                                                                            |       | —                                                       | ** ** | — |   | 1,940 |   |
| Loss from discontinued operations                                                               |       | (2,769                                                       | )          | (7,078 | ) | (4,468 | ) |
| Provision for losses on receivables, net                                                        |       | (169                                                         | )          | (1,119 | ) | 845 |   |
| Changes in assets and liabilities:                                                              |       |                                                         |       |   |   |   |   |
| Accounts receivable                                                                             |       | 9,157                                                        |       | (20,232 | ) | (8,234 | ) |
| Prepaid expenses and other assets                                                               |       | 15,751                                                       |       | (16,334 | ) | (280 | ) |
| Investment securities                                                                           |       | (18,821                                                      | )          | (49,802 | ) | (632 | ) |
| Accounts payable and accrued expenses                                                           |       | (1,988                                                       | )          | 11,142 |   | 1,185 |   |
| Accrued compensation and benefits                                                               |       | 5,600                                                        |       | 2,256 |   | 4,075 |   |
| Due to Senior Housing                                                                           |       | 1,254                                                        |       | 1,329 |   | 698 |   |
| Due (from) to SLS                                                                               |       | —                                                       |       | (7,185 | ) | 6,876 |   |
| Other current and long term liabilities                                                         |       | (1,673                                                       | )          | 5,159 |   | 13,835 |   |
| Cash provided by (used in) operating activities                                                 |       | 38,772                                                       |       | (188,678 | ) | (61,356 | ) |
|                                                                                            | ** ** | ** **                                                   | ** ** |   | ** ** | ** ** | ** ** |
| Net cash (provided by) used in discontinued operations                                          |       | (190                                                         | )          | 7,078 |   | 4,861 |   |
|                                                                                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                           | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Withdrawals from (deposits into) restricted cash and investment  accounts, net                  |       | 760                                                          |       | (926 | ) | (10,050 | ) |
| Acquisition of property and equipment                                                           |       | (73,423                                                      | )          | (51,134 | ) | (105,473 | ) |
| Acquisition of pharmacies, net of cash acquired                                                 |       | —                                                       |       | (5,968 | ) | (4,880 | ) |
| Proceeds from sales of property and equipment                                                   |       | —                                                       |       | — |   | 80,678 |   |
| Proceeds from disposition of property and equipment held for sale                               |       | 47,668                                                       |       | 23,729 |   | 15,470 |   |
| Withdrawals from restricted cash for purchases of property and  equipment                       |       | —                                                       |       | 4,531 |   | 8,614 |   |
| Cash used in investing activities                                                               |       | (24,995                                                      | )          | (29,768 | ) | (15,641 | ) |
|                                                                                            |       |                                                         |       |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                           |       |                                                         |       |   |   |   |   |
| Proceeds from issuance of common stock, net                                                     |       | —                                                       |       | 115,291 |   | 56,613 |   |
| Proceeds from borrowings on revolving credit facility                                           |       | —                                                       |       | 38,000 |   | 32,000 |   |
| Repayments of borrowings on revolving credit facility                                           |       | —                                                       |       | (38,000 | ) | (32,000 | ) |
| Proceeds from first mortgage line of credit                                                     |       | —                                                       |       | — |   | 24,000 |   |
| Repayments of first mortgage line of credit                                                     |       | —                                                       |       | — |   | (24,000 | ) |
| Proceeds from convertible senior notes payable                                                  |       | —                                                       |       | 126,500 |   | — |   |
| Proceeds from mortgage note payable                                                             |       | —                                                       |       | — |   | 3,485 |   |
| Repayments of mortgage notes payable                                                            |       | (28,829                                                      | )          | (558 | ) | (737 | ) |
| Cash (used in) provided by financing activities                                                 |       | (28,829                                                      | )          | 241,233 |   | 59,361 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| Change in cash and cash equivalents                                                             |       | (15,242                                                      | )          | 29,865 |   | (12,775 | ) |
| Cash and cash equivalents at beginning of year                                                  |       | 46,241                                                       |       | 16,376 |   | 29,151 |   |
| Cash and cash equivalents at end of year                                                        |       | $                                                            | 30,999     |   | $ | 46,241 |   | $ | 16,376 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| SUPPLEMENTAL CASH FLOW INFORMATION:                                                             |       |                                                         |       |   |   |   |   |
| Cash paid for interest                                                                          |       | $                                                            | 5,852      |   | $ | 2,702 |   | $ | 2,634 |   |
|                                                                                            |       |                                                         |       |   |   |   |   |
| NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                    |       |                                                         |       |   |   |   |   |
| Issuance of common stock                                                                        |       | 392                                                          |       | 1,277 |   | 585 |   |
| Real estate acquisition                                                                         |       | 5,025                                                        |       | — |   | — |   |
| Assumption of mortgage note payable                                                             |       | 4,559                                                        |       | — |   | — |   |

 

See accompanying notes*.*

 

F-6

----

 

**FIVE STARQUALITY CARE, INC.**

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

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

 

**1. Organization and Business**

** **

Wewere organized in 2000 as a wholly owned subsidiary of Senior HousingProperties Trust, or Senior Housing.  On December 31,2001, Senior Housing distributed substantially all of our common shares to itsshareholders.  Concurrent with ourspin-off, we entered into agreements with Senior Housing and others toestablish our initial capitalization and other matters.

 

As of December 31,2007, we operated 161 senior livingcommunities with 17,906 living units, including 112 primarily independent andassisted living communities with 13,502 living units and 49 nursing homes with4,404 living units.  Of our 112 primarilyindependent and assisted living communities, we leased 95 communities with12,237 living units from Senior Housing, our former parent, and we owned or leased from parties other than SeniorHousing 17 communities with 1,265 living units. We leased 47 of our 49 nursing homes from Senior Housing.  Our 161 communities included 5,520independent living apartments, 6,330 assisted living suites and 6,056 skillednursing units.  As of December 31,2007, we also operated five institutional pharmacies, and two rehabilitationhospitals that we leased from Senior Housing. Our two rehabilitation hospitals had 321 beds available for inpatientservices, three satellite locations, and 20 affiliated outpatient clinics.

 

**2.  Summary ofSignificant Accounting Policies**

** **

*Basis ofPresentation.*  Theaccompanying consolidated financial statements include our accounts and thoseof all of our subsidiaries. All intercompany transactions have been eliminated.

 

*Use ofEstimates.*  Preparationof these financial statements in conformity with accounting principlesgenerally accepted in the United States requires us to make estimates andassumptions that may affect the amounts reported in these financial statementsand related notes.  Some significantestimates include our self insurance reserves and the allowance for doubtfulaccounts and contractual allowances.  Theactual results could differ from our estimates. Estimates and assumptions are reviewed periodically, and the effects ofchanges, if any, are reflected in the consolidated financial statements in theperiod that they are determined.

 

*Cash andcash equivalent*s.  Cashand cash equivalents, consisting of money market funds with original maturitiesof three months or less at the date of purchase, are carried at cost plusaccrued interest, which approximates market.

 

*Investment securities. * Investments securities are held principallyfor resale in the near term.  Theseinvestments are classified as trading and are carried at fair value, withchanges in fair value recorded in earnings. Trading investments at December 31, 2007 consist of auction ratesecurities, or ARS.  Interest anddividends are included in net interest income. In 2007 and 2006, these investments generated interest income of $3,634and $330, respectively (see Note 19).

 

Securitiesnot classified as trading are classified as available for sale and carried atfair value, with unrealized gains and losses reported as a separate componentof shareholders’ equity.  Available forsale investments at December 31, 2007 and 2006 consisted of corporatebonds, preferred securities and variable rate demand obligations.  At December 31, 2007, these investmentshad a fair value of $7,455 and an unrealized holding loss of $1,501.  At December 31, 2006, these investmentshad a fair value of $4,334 and an unrealized holding gain of $213

 

*Restricted cash.*  Restricted cash asof December 31, 2007 and 2006 includes cash that we deposited as securityfor letters of credit which secure obligations arising from our self insuranceprograms and other amounts for which we are required to establish escrows,including: Florida regulatory requirements; real estate taxes and capitalexpenditures as required by our mortgages; resident security deposits; andother regulatory requirements.

 

F-7

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| ** **                                                              | ** ** | **2007**    | ** ** | **2006**           | ** ** |
|-------------------------------------------------------------------------|------------|-------------|------------|--------------------|------------|
| ** **                                                              | ** ** | **Current** | ** ** | **Long term** | ** ** | **Current** | ** ** | **Long term** | ** ** |
|                                                                    |       |        |       |               |       |   |   |   |   |
| Insurance reserves                                                      |       | $           | 780        |               | $          | 2,050 |   | $ | 3,043 |   | $ | 7,786 |   |
| Florida regulatory requirements                                         |       | —      |       | 518                |       | — |   | 518 |   |
| Real estate taxes and capital expenditures as required by our mortgages |       | 1,375       |       | —             |       | 2,870 |   | — |   |
| Resident security deposits                                              |       | 1,500       |       | —             |       | 2,055 |   | — |   |
| Other regulatory requirements                                           |       | —      |       | —             |       | — |   | 256 |   |
| **Total**                                                               |       | $           | 3,655      |               | $          | 2,568 |   | $ | 7,968 |   | $ | 8,560 |   |

 

*Restrictedinvestments.*  Ourcaptive insurance companies hold investments consisting of corporate bonds andvariable rate demand obligations that may be used to pay claims under our selfinsurance programs.  These investmentsare classified as available for sale and carried at fair value, with unrealizedgains and losses reported as a separate component of shareholders’ equity.  The unrealized loss on investments shown onthe consolidated balance sheet represents the difference between the marketvalue of these investments calculated by using quoted market prices on the datethey were acquired and on December 31, 2007.  At December 31, 2007, these investmentshad a fair value of $14,321and anunrealized loss of $2,620.  At December 31, 2006, these investmentshad a fair value of $8,710 and an unrealized loss of $8.

 

*Accountsreceivable and allowance for doubtful accounts.*  We record accounts receivable at theirestimated net realizable value.  Weestimate allowances for uncollectible amounts and contractual allowances forour rehabilitation hospitals based upon factors which include, but are notlimited to: the age of the receivable and the terms of the agreements; theresidents’, patients’ or third party payors’ stated intent to pay; theirfinancial capacity to pay; and other factors which may include likelihood andcost of litigation.  Accounts receivableallowances are estimates.  Weperiodically review and revise these estimates based on new information andthese revisions may be material.

 

During2007, 2006 and 2005, we increased our allowance for doubtful accounts by$4,865, $4,165 and $3,950, respectively, and wrote off accounts receivable of$4,994, $5,284 and $3,104, respectively.

 

Includedin accounts receivable as of December 31, 2007 and 2006 are amounts duefrom the Federal Government Medicare program of $18,910****and$32,586, respectively, and amounts due from various state Medicaid programs of$13,684 and $15,576, respectively.

 

*Deferredfinance costs*.  Wecapitalize issuance costs related to borrowings and amortize the deferred costsover the terms of the respective loans. Our unamortized balance of deferred finance costs was $4,685****and $4,897 at December 31, 2007 and 2006,respectively.  Accumulated amortizationrelated to deferred finance costs was $358 and $526 at December 31, 2007and 2006, respectively.  At December 31,2007, the weighted average amortization period remaining is approximately 20years.  The amortization expenses to beincurred during the next five years as of December 31, 2007 are $279 in2008 and $234 in each of 2009, 2010, 2011 and 2012.

 

*Propertyand equipment.* Property and equipment is stated at cost.  We record depreciation on property andequipment on a straight line basis over estimated useful lives of up to 40years for buildings, up to 15 years for building improvements and up to sevenyears for personal property.  Weregularly evaluate whether events or changes in circumstances have occurredthat could indicate impairment in the value of our long lived assets.  If there is an indication that the carryingvalue of an asset is not recoverable, we determine the amount of impairmentloss, if any, by comparing the historical carrying value of the asset to itsestimated fair value.  We determineestimated fair value through an evaluation of recent financial performance,recent sales of similar assets, market conditions and projected discounted cashflows of properties using standard industry valuation techniques.

 

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

 

F-8

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*Selfinsurance.*  We selfinsure up to certain limits for workers compensation and professionalliability.  Claims in excess of theselimits are insured by third party insurance providers up to contractual limits,over which we are self insured.  We fullyself insure all health related claims for our covered employees.  We accrue the estimated cost of self insuredamounts based on projected settlements for pending claims, known incidentswhich we expect may result in claims, estimates of incurred but not yetreported incidents and expected changes in premiums for insurance provided bythird party insurers whose policies provide for retroactive adjustments.  We periodically adjust these estimates basedupon our claims experience, recommendations from our professional consultants,changes in market conditions and other factors; such adjustments may bematerial.

 

*Continuing care contracts. *Residents at one ofour communities may enter into continuing care contracts.  We offer two forms of continuing carecontracts to new residents at this community. One form of contract provides that 10% ofthe resident admission fee becomes non-refundable upon occupancy, and theremaining 90% becomes non-refundable at therate of 1.5% per month of theoriginal amount over the subsequent 60 months. The second form of contractprovides that 30% of the resident admission fee is non-refundable upon occupancyand 70% is refundable.  Three other formsof continuing care contracts are in effect for existing residents but are notoffered to new residents.  One historical form of contract provides thatthe resident admission fee is 10% non-refundable upon occupancy and 90%refundable.  A secondhistorical form of contract provides that the resident admission fee is 100%refundable.  A third historical form of contract provides that the resident admission feeis 1% refundable and 99% non-refundable upon admission.  In each case, we amortize the non-refundable partof these fees into revenue over the actuarially determined remaining life ofthe resident, which is the expected period of occupancy by the resident.  We pay refunds of our admission fees when residentsrelocate from our communities.  Wereport the refundable amount of these admission fees as current liabilities andthe nonrefundable amount as deferred revenue, a portion of which is classifiedas a current liability.  Portions of therefundable payments are included in restricted cash in our consolidated balancesheet.  The refundable admission fees asof December 31, 2007 and 2006 were $9,486 and $10,575, respectively.

 

*Convertible senior notes. *In October 2006, we issued $126,500principal amount of 3.75% convertible senior notes, or the Notes, (see Note10).  Holders of these Notes mayconvert their Notes into shares of our common stock subject to prior maturity,redemption or repurchase. On or after October 20, 2011, we have the optionto redeem the Notes at a redemption price equal to 100% of the principal amountof the Notes, plus accrued but unpaid interest. On each of October 15,2013, 2016 and 2021, Note holders may require that we purchase all or aportion of their Notes at a purchase price in cash equal to 100% of theprincipal amount of the Notes, plus accrued but unpaid interest.  A holder that surrenders the Notes forconversion in connection with a make whole fundamental change that occursbefore October 20, 2011 may in certain circumstances be entitled to anincreased conversion rate, or the Make Whole Payment.

 

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

 

*Income taxes*.  We accountfor income taxes under the provisions of Statement of Financial AccountingStandards, or SFAS, No. 109, *“Accounting for IncomeTaxes”*, or SFAS 109.  UnderSFAS No. 109, deferred tax assets and liabilities are determined based onthe difference between the financial statement and tax bases of assets andliabilities using enacted tax rates in effect for the year in which thedifferences are expected to affect taxable income. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amounts thatare expected to be realized (see Note 6).

 

We payfranchise taxes in certain states in which we have operations.  We have included franchise taxes in generaland administrative and other operating expenses in our consolidated statementof operations.

 

*Fairvalue of financial instruments. *Ourfinancial instruments are limited to cash and cash equivalents, tradingsecurities, securities held for sale, accounts receivable, accounts payable,the refundable portion of continuing care contracts, mortgage notes receivableand payable and our Notes.  Except forour Notes as of December 31, 2007, the fair value of these financialinstruments was not materially different from their carrying 

 

F-9

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values at December 31, 2007 and 2006.  As of December 31, 2007, our carryingvalue for the Notes is $126,500 and the fair value is $115,684.  We estimate the fair values using discountedcash flow analysis and current prevailing interest rates.

 

*Revenuerecognition.*  Ourrevenues are derived primarily from services to residents and patients at oursenior living communities and hospitals. We record revenues when services are provided.  Some of our services are provided with theexpectation of payment from governments or other third party payors.  We derived approximately 34%, 33% and 35% ofour senior living revenues in 2007, 2006 and 2005, respectively, from paymentsunder federal and state medical assistance programs.  For the year ended December 31, 2007 andthe three months ended December 31, 2006, approximately 69% and 72%,respectively, of our hospital revenues werereceived from these programs. Revenues under some of these programs are subject to audit andretroactive adjustment.

 

Medicarerevenues from residents totaled $124,528, $103,735 and $105,033 during 2007,2006 and 2005, respectively.  Medicaidrevenues from residents totaled $147,104, $141,661 and $136,963 during 2007,2006 and 2005, respectively.  Medicareand Medicaid revenues from our hospitals were $70,235 and $19,291 for the yearended December 31, 2007 and the three months ended December 31, 2006,respectively.  Both the FederalGovernment and some of the states in which we operate are considering plans toreduce Medicare and Medicaid funding, or to stop or reduce the projectedincreases in such funding.  We cannotestimate the magnitude of potential Medicaid and Medicare rate reductions butit may be material.  Medicaid andMedicare rates reductions or a failure of such program to increase rates tomatch our increasing costs, if they occur, may have a negative impact in ourrevenues, may decrease our net income and may cause us to incur losses.

 

*Percommon share amounts.* We computed earnings (loss) per share, or EPS, for the years ended December 31,2007, 2006 and 2005, using the weighted average number of shares outstandingduring each year.  Diluted EPS reflectsthe potential dilution that could occur if our Notes were converted into ourcommon shares and where such conversion would result in a lower EPS amount.

 

*Reclassifications.*  Reclassifications have been made to the prior years’financial statements to conform to the current year’s presentation.  Material changes are limited to reclassifyingaccrued benefits out of other current liabilities and reclassifying availablefor sale securities out of investments in trading securities.  These reclassifications had no effecton net income (loss) or shareholders’ equity.

 

*Recently issued Accounting Pronouncements*.  In September 2006, the FinancialAccounting Standards Board, or the FASB, issued Statement of FinancialAccounting Standards “Fair Value Measurements”, or SFAS 157.  SFAS 157 replaces multiple existingdefinitions of fair value with a single definition, establishes a consistentframework for measuring fair value and expands financial statement disclosuresregarding fair value measurements. SFAS 157 applies only to fair valuemeasurements that already are required or permitted by other accountingstandards and does not require any new fair value measurements. SFAS 157 willbe effective beginning with the first quarter of 2008.  We do not expect the adoption of SFAS 157will have a material impact on our financial position or results of operations.

 

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities – Including an amendment to FASBStatement No. 115”, or SFAS 159.  SFAS 159 allows companies to chooseto measure eligible assets and liabilities at fair value with changes in valuerecognized in earnings.  Fair value treatment for eligible assets andliabilities may be elected either prospectively upon initial recognition, orwhen an event triggers a new basis of accounting for an existing asset orliability.  SFAS 159 will be effective beginning with the first quarter of2008, and we do not expect at this time to elect to re-measure any of ourexisting financial assets or liabilities under the provisions of SFAS 159.

 

**3.  Property andEquipment**

** **

Propertyand equipment, at cost, as of December 31, 2007 and 2006, consists of:

 
| ** **                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
|                              |       |     |       |     |       |
| Land                              |       | $        | 7,196      |     | $          | 6,685 |   |
| Buildings and improvements        |       | 99,945   |       | 82,293   |       |
| Furniture, fixtures and equipment |       | 55,660   |       | 46,685   |       |
|                              |       | 162,801  |       | 135,663  |       |
| Accumulated depreciation          |       | (31,096  | )          | (20,765  | )          |
|                              |       | $        | 131,705    |     | $          | 114,898 |   |

** **

**F-10**

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** **

**As of December 31, 2007 and 2006, we had assetsclassified as held for sale included in our property and equipment of $25,222and $15,266, respectively. These assets include improvements acquired atproperties leased from Senior Housing that we intend to sell to Senior Housingas permitted by our leases.**

** **

**4.  Financialdata by segment**

 

Ourreportable segments consist of our senior living community business and ourrehabilitation hospital business.  In thesenior living community segment, we operate independent living and congregatecare communities, assisted living communities and nursing homes.  Our rehabilitation hospital segment providesinpatient health rehabilitation services at two hospital locations and threesatellite locations and outpatient health rehabilitation services at 20locations.  We do not consider ourpharmacy operations to be a material, separately reportable segment of ourbusiness but we report our pharmacy revenues and expense as separate itemswithin our corporate and other activities. All of our operations and assets are located in the United States.

 

Weuse segment operating profit as an important measure to evaluate ourperformance and for decision making purposes. Segment operating profit excludes interest and other income, interestand other expense and certain corporate expenses.

 

Ourrevenues by segment and a reconciliation of segment operating profit to incomefrom continuing operations before income taxes for the year ended December 31,2007 and 2006 are as follows:

 
| ** **                                                | ** ** | **Senior  Living  Communities** | ** ** | **Rehabilitation  Hospitals** | ** ** | **Corporate and  other (1)** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|----------------------------------------|------------|-----------|------------|
| **Year ended December 31, 2007**                     |       |                            |       |                          |       |                                   |       |      |       |
| Revenues                                                  |       | $                               | 809,934    |                          | $          | 102,005                                |       | $         | 60,985     |   | $ | 972,924 |   |
| Segment expenses:                                         |       |                            |       |                          |       |                                   |       |      |       |
| Operating expenses                                        |       | 612,641                         |       | 92,449                        |       | 58,012                                 |       | 763,102   |       |
| Rent expense                                              |       | 118,902                         |       | 10,288                        |       | —                                 |       | 129,190   |       |
| Depreciation and amortization                             |       | 9,386                           |       | 1,085                         |       | 3,124                                  |       | 13,595    |       |
| Total segment expenses                                    |       | 740,929                         |       | 103,822                       |       | 61,136                                 |       | 905,887   |       |
|                                                      |       |                            |       |                          |       |                                   |       |      |       |
| Segment operating profit (loss)                           |       | 69,005                          |       | (1,817                        | )          | (151                                   | )          | 67,037    |       |
| General and administrative expenses (2)                   |       | —                          |       | —                        |       | (43,373                                | )          | (43,373   | )          |
| Operating income (loss)                                   |       | 69,005                          |       | (1,817                        | )          | (43,524                                | )          | 23,664    |       |
| Interest and other income                                 |       | —                          |       | —                        |       | 6,152                                  |       | 6,152     |       |
| Interest and other expense                                |       | (1,454                          | )          | —                        |       | (5,348                                 | )          | (6,802    | )          |
| Gain on extinguishment of debt                            |       | 4,491                           |       | —                        |       | —                                 |       | 4,491     |       |
| Provision for income taxes                                |       | —                          |       | —                        |       | (1,410                                 | )          | (1,410    | )          |
| Income (loss) from continuing operations                  |       | $                               | 72,042     |                          | $          | (1,817                                 | )          | $         | (44,130    | ) | $ | 26,095 |   |
|                                                      |       |                            |       |                          |       |                                   |       |      |       |
| Total Assets as of December 31, 2007                 |       | $                               | 236,910    |                          | $          | 20,620                                 |       | $         | 102,924    |   | $ | 360,454 |   |
|                                                      |       |                            |       |                          |       |                                   |       |      |       |
| **Year ended December 31, 2006**                     |       |                            |       |                          |       |                                   |       |      |       |
| Revenues                                                  |       | $                               | 744,897    |                          | $          | 25,494                                 |       | $         | 45,195     |   | $ | 815,586 |   |
| Segment expenses:                                         |       |                            |       |                          |       |                                   |       |      |       |
| Operating expenses                                        |       | 568,489                         |       | 22,954                        |       | 44,579                                 |       | 636,022   |       |
| Management fee to SLS                                     |       | 8,744                           |       | —                        |       | —                                 |       | 8,744     |       |
| Termination expense for certain SLS management agreements |       | 129,913                         |       | —                        |       | —                                 |       | 129,913   |       |

 

F-11

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| Rent expense                              |   | 106,781 |    | 2,475  |   | —  |   | 109,256  |    |
|-------------------------------------------|--------|---------|---------|--------|--------|---------|--------|----------|---------|
| Depreciation and amortization             |   | 7,704   |    | 102    |   | 2,045   |   | 9,851    |    |
| Total segment expenses                    |   | 821,631 |    | 25,531 |   | 46,624  |   | 893,786  |    |
|                                      |   |    |    |   |   |    |   |     |    |
| Segment operating profit (loss)           |   | (76,734 | )       | (37    | )      | (1,429  | )      | (78,200  | )       |
| General and administrative expenses (2)   |   | —  |    | — |   | (33,829 | )      | (33,829  | )       |
| Operating income (loss)                   |   | (76,734 | )       | (37    | )      | (35,258 | )      | (112,029 | )       |
| Interest and other income                 |   | —  |    | — |   | 6,806   |   | 6,806    |    |
| Interest and other expense                |   | (2,768  | )       | — |   | (1,596  | )      | (4,364   | )       |
| Income (loss) from continuing operations  |   | $       | (79,502 | )      | $      | (37     | )      | $        | (30,048 | ) | $ | (109,587 | ) |
|                                      |   |    |    |   |   |    |   |     |    |
| Total Assets as of December 31, 2006 |   | $       | 253,000 |   | $      | 20,115  |   | $        | 93,296  |   | $ | 366,411 |   |

 

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(1) Corporateand Other includes operations that we do not consider significant, separatelyreportable segments of our business and income and expenses that are notattributable to a specific segment.

(2) Generaland administrative expenses are not attributable to a specific segment andinclude items such as corporate payroll and benefits and outside serviceexpenses affecting home office activities.

 

**5.**  **Goodwilland Other Intangible Assets**

 

During 2007 and 2006, werecorded $233 and $3,663, respectively,****of acquiredgoodwill related to our pharmacy acquisitions (see Note 13).  As of December 31, 2007 and 2006, we hadgoodwill of $16,659 and $16,893, respectively.

 

During2007 and 2006, we recorded $812 and $1,344, respectively, of intangible assetsthat related to customer relationships we acquired in connection with our pharmacyacquisitions. These intangible assets are subject to amortization.  As of December 31, 2007 and 2006, theunamortized balance of intangible assets was $5,218 and $5,269,respectively.  At December 31, 2007,the weighted average amortization period remaining is approximately 15years.  We amortize intangible assetsusing the straight-line method over the useful lives of the assets commencingon the date of acquisition.  Amortizationexpense associated with customer agreements totaled $478, $380 and $219 in2007, 2006 and 2005, respectively. Accumulated amortization was $1,145 and $716at December 31, 2007 and 2006, respectively.  Amortization expense is estimated to beapproximately $438 in 2008, $362 in each of 2009, 2010, 2011 and 2012.

 

**6.  Income Taxes**

** **

InJune 2006, the Financial Accounting Standards Board issued Interpretation No. 48“Accounting for Uncertainty in Income Taxes”, or FIN 48.  FIN 48 prescribes how we should recognize,measure and present in our financial statements uncertain tax positions thathave been taken or are expected to be taken in a tax return. Pursuant to FIN48, we can recognize a tax benefit only if it is “more likely than not” that aparticular tax position will be sustained upon examination or audit. To theextent the “more likely than not” standard has been satisfied, the benefitassociated with a tax position is measured as the largest amount that has agreater than 50% likelihood of being realized upon settlement. We classifyinterest and penalties related to uncertain tax positions, if any, in ourfinancial statements as a component of general and administrative expense.

 

Asrequired, we adopted FIN 48 effective January 1, 2007 and have concludedthe effect is not material to our consolidated financial statements.  Accordingly, we did not record a cumulativeeffect adjustment related to the adoption of FIN 48.  At the date of adoption and through December 31,2007, we had $785 in unrecognized tax benefits which, if recognized, wouldfavorably affect our effective tax rate. We do not believe that our unrecognized tax benefits will changesignificantly prior to December 31, 2008.

 

Becausewe have historically reported losses, we do not currently recognize the benefitof all of our deferred tax assets, including $183,374 of tax loss carryforwards that may be used to offset future taxable income.  We will, however, continue to assess ourability to generate sufficient taxable income during future periods in whichour deferred tax assets may be realized. When we believe that we will more likely than not recover our deferredtax assets, we will record deferred tax assets as an income tax benefit in theconsolidated statement of operations, which

 

F-12

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will affect our results ofoperations.  Our net operating loss carryforwards, which begin to expire in 2023 if unused, are subject to audit andadjustments by the Internal Revenue Service.Significant components of ourdeferred tax assets and liabilities as of December 31, 2007 and 2006, areas follows:

 
| ** **                                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                        |       |     |       |     |       |
| Continuing care contracts                                   |       | $        | 2,146      |     | $          | 2,324 |   |
| Allowance for doubtful accounts                             |       | 1,959    |       | 2,197    |       |
| Deferred gains on sale lease-back transactions              |       | 2,695    |       | 2,578    |       |
| Insurance reserves                                          |       | 3,761    |       | 4,040    |       |
| Tax credits                                                 |       | 2,432    |       | 1,547    |       |
| Tax loss carry forwards (including SLS termination expense) |       | 73,912   |       | 81,714   |       |
| Other                                                       |       | 1,072    |       | 799      |       |
| Total deferred tax asset before valuation allowance         |       | 87,977   |       | 95,199   |       |
| Valuation allowance:                                        |       | (84,550  | )          | (91,884  | )          |
|                                                        |       | 3,427    |       | 3,315    |       |
| Deferred tax liabilities:                                   |       |     |       |     |       |
| Depreciable assets                                          |       | (745     | )          | (656     | )          |
| Lease expense                                               |       | (1,971   | )          | (2,271   | )          |
| Goodwill                                                    |       | (710     | )          | (433     | )          |
| Other                                                       |       | (240     | )          | 45       |       |
| Total                                                       |       | (3,666   | )          | (3,315   | )          |
|                                                        |       |     |       |     |       |
| Net deferred tax liability:                                 |       | $        | (239       | )        | $          | — |   |

 

For the year ended December 31, 2007, we recognized tax expensesof $1,410.  Tax expense includes $1,171of alternative minimum taxes and certain state taxes that are payable withoutregard to our tax loss carry forwards. Tax expense also includes $239, related to a non cash deferred taxliability arising from the amortization of goodwill for tax purposes but notfor book purposes.  We may recognize thisdeferred tax liability as a reduction in the income tax provision if, in somefuture period, we expense the related items of goodwill for book purposes asthe result of its sale, other disposition or impairment.

 

Theprincipal reasons for the difference between our effective tax (benefit) rateand the U.S. Federal statutory income tax (benefit) rate are as follows:

 
| ** **                                               | ** ** | **For the years ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                     |       |                                                          |       |   |   |   |   |
| Taxes at statutory U.S. federal income tax rate          |       | 35.0                                                          | %          | (35.0 | )% | (35.0 | )% |
| State and local income taxes, net of federal tax benefit |       | 7.7                                                           | %          | (5.2 | )% | (5.2 | )% |
| Tax credits                                              |       | (2.3                                                          | )%         | (0.1 | )% | (0.3 | )% |
| Alternative Minimum Tax                                  |       | 1.5                                                           | %          | 0.0 | % | 0.0 | % |
| Change in federal statutory rate                         |       | 0.0                                                           | %          | 0.0 | % | (0.2 | )% |
| Change in valuation allowance                            |       | (29.3                                                         | )%         | 40.4 | % | 41.7 | % |
| Other differences, net                                   |       | (6.6                                                          | )%         | (0.1 | )% | (1.0 | )% |
| Effective tax rate                                       |       | 6.0                                                           | %          | 0.0 | % | 0.0 | % |

 

F-13

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** **

**7.  Earnings PerShare**

** **

BasicEPS for the year ended December 31, 2007, 2006 and 2005 is computed usingthe weighted average number of shares outstanding during the periods.  Diluted EPS for the period ended December 31,2007 reflects additional common shares that would have been outstanding ifdilutive potential common shares had been issued, as well as any adjustment toincome applicable to common shareholders that would result from their assumedissuance.  The effect the Notes have onloss from discontinued operations per share is anti-dilutive for the year endedDecember 31, 2007.

 

Thefollowing table provides a reconciliation of net income and the number ofcommon shares used in the computations of diluted EPS:

 
| ** **                                         | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **Income  (loss)**                         | ** ** | **Shares** | ** ** | **Per  Share** | ** ** | **Income  (loss)** | ** ** | **Shares** | ** ** | **Per  Share** | ** ** | **Income  (loss)** | ** ** | **Shares** | ** ** | **Per  Share** | ** ** |
| Income from continuing operations                  |       | $                                          | 26,095     |   | 31,710 |   | $ | 0.82 |   | $ | (109,587 | ) | 28,605 |   | $ | (3.83 | ) | $ | (79,691 | ) | 14,879 |   | $ | (5.35 | ) |
| Effect of the Notes                                |       | 4,960                                      |       | 9,731 |   | — |   | — |   | — |   |   |   | — |   | — |   |   |   |
| Diluted earnings (loss) from continuing operations |       | 31,055                                     |       | 41,441 |   | $ | 0.75 |   | (109,587 | ) | 28,605 |   | $ | (3.83 | ) | (79,691 | ) | 14,879 |   | $ | (5.35 | ) |
|                                               |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted loss from discontinued operations          |       | $                                          | (2,769     | ) | 41,441 |   | $ | (0.07 | ) | $ | (7,078 | ) | 28,605 |   | $ | (0.25 | ) | $ | (4,468 | ) | 14,879 |   | $ | (0.30 | ) |

** **

**8.  Line ofCredit**

** **

InJune 2007, we amended our revolving line of credit.  The amendment increased the line from $25,000to $40,000, extended the termination date to May 8, 2009 and reduced theinterest rate by 25 basis points. Our revolving line of credit is available foracquisitions, working capital and general business purposes. The amount we areable to borrow at any time is subject to limitation based upon qualifyingcollateral. We are the borrower under this revolving credit facility andcertain of our subsidiaries guarantee our obligations under the facility, whichis secured by our and our guarantor subsidiaries’ accounts receivable, depositaccounts and related assets.  Thefacility contains covenants requiring us to maintain collateral, minimum networth and certain other financial ratios, places limits on our ability to incuror assume debt or create liens with respect to certain of our properties andhas other customary provisions.  Incertain circumstances and subject to available collateral and lender approvals,the maximum amount which we may draw under this credit facility may beincreased to $80,000.  The terminationdate may be extended twice, in each case by twelve months, subject to lenderapproval, our payment of extension fees and other conditions.  As of December 31, 2007 and March 4,2008, no amounts were outstanding under this credit facility.  As of December 31, 2007 and March 4,2008 we believe we are in compliance with all applicable covenants under thisrevolving credit facility.  Interestexpense and other associated costs related to this facility and our priorrevolving credit facility were $388,****$205 and $167****for the years ended December 31, 2007, 2006 and 2005,respectively.

 

**9.  Mortgages Payable**

 

               At December 31, 2007, four of our communitieswere encumbered by five United States Department of Housing, or HUD, insuredmortgages totaling $16,010.  Thesemortgages contain standard HUD mortgage covenants. We recorded mortgagepremiums in connection with some of these HUD mortgages in order to recordassumed mortgages at their estimated fair value. The mortgage premiums arebeing amortized as a reduction of interest expense until the maturity of themortgages.

 

In 2007, we prepaid seven mortgages that were secured by six of oursenior living communities.  We paid$28,867 to retire these six mortgages, which consisted of approximately $28,027in principal and interest and $840

 

F-14

----

 

in prepayment penalties.  Because we had carried these mortgages at apremium to their face value, we recognized a net gain of $4,491 in connectionwith the early extinguishment of debt.

 

As discussed in Note 13, in April 2007, weacquired a 48 unit assisted living community located in Tennessee for$5,025.  We financed the acquisition by assuming a $4,559 non recourse HUDinsured mortgage and paying the balance of the purchase price with cash onhand.  The interest rate on the assumed HUD insured mortgage is 7.65%.

 

Mortgage interest expense, net of premiumamortization, was $1,204 and $2,768 for the years ended December 31, 2007and 2006, respectively.  Our mortgagesrequire monthly payments into escrowsfor taxes, insurance and property replacement funds; withdrawals from theseescrows require HUD approval.

 

The following table is a summary of the mortgage notespayable as of December 31, 2007:

 
| ** **             | ** ** | ** **   | ** ** | ** **    | ** ** | ** **  | ** ** | **Principal**               | ** ** | **Fair Value**         | ** ** | **Total Mortgage**     | ** ** |
|------------------------|------------|--------------|------------|---------------|------------|-------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **             | ** ** | **Cash**     | ** ** | **Effective** | ** ** | ** **  | ** ** | **Balance as of** | ** ** | **Premium as of** | ** ** | **Payable as of** | ** ** |
| ** **             | ** ** | **Interest** | ** ** | **Interest**  | ** ** | **Monthly** | ** ** | **December 31,**       | ** ** | **December 31,**       | ** ** | **December 31,**       | ** ** |
| **Maturity Date** | ** ** | **Rate**     | ** ** | **Rate**      | ** ** | **Payment** | ** ** | **2007**                    | ** ** | **2007**                    | ** ** | **2007**                    | ** ** |
| May 2039               |       | 5.55         | %          | 5.55          | %          | $           | 27         |                        | $          | 4,830                       |       | $                           | —     |   | $ | 4,830 |   |
| January 2038           |       | 8.00         | %          | 5.60          | %          | 10          |       | 1,337                       |       | 371                         |       | 1,708                       |       |
| June 2035              |       | 5.25         | %          | 5.25          | %          | 19          |       | 3,357                       |       | —                      |       | 3,357                       |       |
| June 2043              |       | 7.65         | %          | 5.75          | %          | 31          |       | 4,544                       |       | 17                          |       | 4,561                       |       |
| November 2037          |       | 8.45         | %          | 5.60          | %          | 9           |       | 1,165                       |       | 389                         |       | 1,554                       |       |
|                   |       |         |       |          |       |        |       |                        |       |                        |       |                        |       |
|                   |       | 6.55         | % (1)      |          |       | $           | 96         |                        | $          | 15,233                      |       | $                           | 777        |   | $ | 16,010 |   |

 

----

(1) Weighted average interest rate

 

Principal payments due under the terms of these five mortgages are asfollows:

 

| 2008       |   | $      | 160    |   |
|------------|--------|--------|--------|--------|
| 2009       |   | 170    |   |
| 2010       |   | 181    |   |
| 2011       |   | 192    |   |
| 2012       |   | 199    |   |
| Thereafter |   | 14,331 |   |
|       |   | $      | 15,233 |   |

** **

**10.  ConvertibleSenior Notes due 2026**

** **

InOctober 2006, we issued $126,500 principalamount of our Notes pursuant to an indenture which contains variouscustomary covenants.  Our net proceeds from this offering wereapproximately $122,600. The Notes are convertible into our common shares at anytime.  The initial conversion rate, whichis subject to adjustment, is 76.9231 common shares per $1 principal amount ofthe Notes, which represents an initial conversion price of $13.00 per share.  A holder that surrenders Notes for conversionin connection with a “make-whole fundamental change”, as defined in theindenture governing the Notes, that occurs before October 20, 2011 may insome circumstances be entitled to an increased conversion rate.

 

TheseNotes bear interest at a rate of 3.75% per annum, payable semi-annually inarrears on April 15 and October 15 of each year, starting on April 15,2007.  The Notes mature on October 15,2026.  On or after October 20, 2011,we may redeem the Notes, in whole or in part, at a redemption price in cashequal to 100% of the principal amount of the Notes we redeem, plus any accruedand unpaid interest.  On each of October 15,2013, October 15, 2016 and October 15, 2021, holders of these Notesmay require us to purchase all or a portion of their Notes at a purchase pricein cash equal to 100% of the principal amount of the Notes to be purchased,plus any accrued and

 

F-15

----

 

unpaidinterest.  If a “fundamental change”, asdefined in the indenture governing the Notes, occurs, holders of the Notes mayrequire us to repurchase all or a portion of their Notes for cash at arepurchase price equal to 100% of the principal amount of the Notes to berepurchased, plus any accrued and unpaid interest and, in certaincircumstances, plus a make whole premium as defined in the indenture governingthe Notes.  Interest expense and otherassociated costs related to the Notes was $4,960 and $1,391 for the years endedDecember 31, 2007 and 2006, respectively. The Notes are guaranteed by certain of our wholly owned subsidiaries(see Note 17).  Our subsidiary guarantorsmay be released from their obligations under certain circumstances.  As of December 31, 2007 and March 4,2008, we believe we are in compliance with all applicable covenants of thisindenture.

 

**11.  Leases**

** **

As of December 31,2007, we leased 142 communities and two hospitals under six non-cancelableleases with Senior Housing, and leased four communities under a lease withHealthcare Property Investors, Inc., or HCPI.  These leases are “triple-net” leases whichrequire that we pay for all costs incurred in the operation of the communities,including the cost of insurance and real estate taxes, maintain the communitiesand indemnify the landlord for any liability which may arise from its ownershipduring the lease term.

 

Our leases with Senior Housing for our 142 senior livingcommunities require us to pay additional rent equal to 4% of the amount bywhich gross revenues of the communities we operate exceed gross revenues in abase year.  We paid approximately $2,114and $1,137 in percentage rent to Senior Housing for the years ended December 31,2007 and 2006, respectively.

 

Senior Housing has agreed to fund amounts that we requestfor renovations and improvements to communities and hospitals we lease fromthem in return for rent increases according to formulas in the leases.  In 2007 and 2006, Senior Housing funded$47,668****and $23,729, respectively, forrenovations and improvements to some of our communities and hospitals.  As a result and in accordance with ourleases, our annual rent to Senior Housing as of December 31, 2007 and 2006increased by $4,532 and $2,340, respectively.

 

The following table is a summary of our leases:

 
| ** **                                                                                                        | ** ** | **Number of  properties** | ** ** | **Annual  minimum rent  as of  December 31,  2007** | ** ** | **Initial expiration  date** | ** **              | **Renewal terms**                                               | ** **                   |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------|-------------------------|----------------------------------------------------------------------|------------------------------|
|                                                                                                              |       |                           |       |                                                               |       |                              |                    |                                                                 |                         |
| 1. Four Senior Housing leases for skilled nursing facilities and  independent and assisted living communities (1) |       | 112                            |       | $                                                                  | 51,748     |                              | December 31,  2020 |                                                                 | One  15-year renewal option. |   |
|                                                                                                              |       |                           |       |                                                               |       |                              |                    |                                                                 |                         |
| 2. One Senior Housing lease for communities previously operated by  SLS                                           |       | 30                             |       | 66,552                                                             |       | December 31,  2017           |                    | Two  consecutive renewal options for 10 and 5 years (15 years total. | )                            |
|                                                                                                              |       |                           |       |                                                               |       |                              |                    |                                                                 |                         |
| 3. One Senior Housing lease for rehabilitation hospitals                                                          |       | 2                              |       | 10,597                                                             |       | June 30,  2026               |                    | One  20-year renewal option.                                         |                         |
|                                                                                                              |       |                           |       |                                                               |       |                              |                    |                                                                 |                         |
| 4. One HCPI lease                                                                                                 |       | 4                              |       | 1,183                                                              |       | June 30, 2014                |                    | Two 10-year renewal options.                                         |                         |
|                                                                                                              |       |                           |       |                                                               |       |                              |                    |                                                                 |                         |
| Totals                                                                                                            |       | 148                            |       | $                                                                  | 130,080    |                              |                    |                                                                 |                         |   |

 

----

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

 

F-16

----

 

Thefuture minimum rents required by our leases as of December 31, 2007, areas follows:

 

| 2008       |   | $       | 130,080   |   |
|------------|--------|---------|-----------|--------|
| 2009       |   | 130,080 |      |
| 2010       |   | 130,080 |      |
| 2011       |   | 130,080 |      |
| 2012       |   | 130,080 |      |
| Thereafter |   | 891,584 |      |
|       |   | $       | 1,541,984 |   |

** **

**12.  Shareholders’ Equity**

** **

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

 

Weissued 136,010 and 121,200 common shares in 2007 and 2006, respectively to ourdirectors, officers and others who provide services to us.  We valued the shares at the average price ofour common shares on the American Stock Exchange on the dates of issue, or$1,182 in 2007, based on an $8.78 weighted average share price and $1,277 in 2006,based on a $10.53 weighted average share price. Shares issued to directors vest immediately; shares issued to ourofficers and others vest over three to five years and are recognized in ourstatement of operations ratably.  As of December 31,2007, 2,509,490 of our common shares remain available for issuance under our2001 Stock Option and Stock Incentive Plan.

 

**13.  Acquisitions**

** **

In May 2006,we purchased a pharmacy in South Carolina for approximately $3,600.  In November 2006, we purchased another pharmacylocated in Virginia for approximately $2,300. We allocated the purchase prices of these pharmacies to working capitalassets, customer relationships and goodwill based on the fair value of theassets acquired and liabilities assumed.

 

InApril 2007, we acquired a 48 unit assisted living community located inTennessee for $5,025.  We financed the acquisition by assuming a $4,559non recourse HUD insured mortgage and paying the balance of the purchase pricewith cash on hand.  The interest rate on the assumed HUD insured mortgageis 7.65%. All of this community’s revenues come from residents’ privateresources.  We acquired this community to expand our business in highquality senior living operations where residents pay for our services withprivate resources.  We allocated thepurchase price of this community to land, building and equipment.

 

**We accounted for each of these acquisitions using thepurchase method of accounting, and we have included the results of operationsof these acquisitions in our consolidated statement of operations from thedates of acquisition.**

** **

**14.  Discontinued Operations**

** **

During 2005, we ceased operations at one assisted living community inLos Angeles, California, and one skilled nursing community in Milwaukee,Wisconsin.  We leased these communitiesfrom Senior Housing.  Senior Housing soldthe assisted living community located in California in December 2005 fornet proceeds of approximately $2,600, which caused a $260 reduction in theannual rent we pay to Senior Housing.  Senior Housing sold the skilled nursingcommunity located in Wisconsin in December 2006 for net proceeds ofapproximately $1,300, which caused a $130 reduction in the annual rent we payto Senior Housing.

 

During 2006, we ceased operations at two skilled nursing facilitieslocated in Connecticut that we leased from Senior Housing.  Senior Housing sold these facilities in November 2006for net proceeds of approximately $5,600, which caused a $559 reduction in theannual rent we pay to Senior Housing.

 

F-17

----

 

In March 2007, weagreed with Senior Housing that it should sell two assisted living communitiesin Pennsylvania which we lease from Senior Housing.  We and Senior Housingare in the process of selling these assisted living communities and, upon theirsale, our annual rent payable to Senior Housing will decrease by 9.5% of thenet proceeds of the sale to Senior Housing in accordance with the terms of thelease. In December 2007, we decided to sell one institutional pharmacylocated in California and our mail order pharmacy located in Nebraska.

 

As of December 31,2007, we have disposed of substantially all of our assets and liabilitiesrelated to the communities where we have ceased operations. The assets and liabilitiesrelated to our two pharmacies that we expect to sell are presented separatelyin the consolidated balance sheet. We have reclassified the consolidatedstatement of operations for all periods presented to show the results ofoperations of the communities and pharmacies which have been sold or areexpected to be sold as discontinued. Below is a summary of the operatingresults of these discontinued operations included in the financial statementsfor the years ended December 31, 2007, 2006 and 2005:

 

| ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
|       |       |     |       |     |       |     |       |
| Revenues   |       | $        | 12,910     |     | $          | 30,829   |       | $ | 37,600 |   |
| Expenses   |       | 15,679   |       | 37,907   |       | 42,068   |       |
| Net loss   |       | $        | (2,769     | )        | $          | (7,078   | )          | $ | (4,468 | ) |

 

**15. Related Person Transactions**

 

We were a 100% ownedsubsidiary of Senior Housing before December 31, 2001. OnDecember 31, 2001, Senior Housing distributed substantially all of ourthen outstanding shares to its shareholders. In order to effect this spin offand to govern relations after the spin off, we entered into agreements with SeniorHousing and others pursuant to which it was agreed, among other things, that:

 

·      so long as Senior Housingremains a real estate investment trust, or a REIT, we may not waive the shareownership restrictions in our charter on the ability of any person or group toacquire more than 9.8% of any class of our equity shares without the consent ofSenior Housing;

 

·      so long as we are a tenantof Senior Housing, we will not permit nor take any action that, in thereasonable judgment of Senior Housing, might jeopardize the tax status ofSenior Housing as a REIT;

 

·      Senior Housing has theoption, upon the acquisition by a person or group of more than 9.8% of ourvoting stock and upon other change in control events affecting us, as defined,to cancel all of our rights under the leases we have with Senior Housing; and

 

·      so long as we have a sharedservices agreement with Reit Management & Research, or RMR, we willnot acquire or finance any real estate without first giving Senior Housing orany other publicly owned REIT or other entity managed by RMR, the opportunityto acquire or finance real estate investments of the type in which SeniorHousing or any other publicly owned REIT or other entity managed by RMR,respectively, invests.

 

At the time of our spin offfrom Senior Housing, all of the persons serving as our directors were trusteesof Senior Housing. One of our managing directors, Mr. Portnoy, iscurrently a managing trustee of Senior Housing.

 

Of the 161 seniorliving communities we operated on December 31, 2007, 142 are leased fromSenior Housing for total annual rent of $118,300. We also lease our tworehabilitation hospitals from Senior Housing for total annual rent ofapproximately $10,597.

 

Since January 1, 2007,we have entered into several transactions with Senior Housing, including:

 

·      In March 2007, we agreed with Senior Housing that itshould sell two assisted living communities in Pennsylvania, which we leasefrom Senior Housing.  We and Senior Housing are in the process of sellingthese assisted living communities and, upon their sale, our annual rent payableto Senior Housing will 

 

F-18

----

 

decrease by 9.5% of the netproceeds of the sale to Senior Housing in accordance with the terms of thelease.

 

·      During 2007, as permitted byour leases with Senior Housing, we sold to Senior Housing, at cost,approximately $47,668 of improvements made to properties leased from SeniorHousing, and, as a result, our annual rent payable to Senior Housing increasedby approximately $4,532.

 

·      In January andFebruary 2008, we leased nine senior living communities with 1,032 unitswhich Senior Housing acquired from third parties. Eight of these communitiesare assisted living communities (one of which offers some skilled nursingservices and one of which offers some independent living services) and one is acontinuing care retirement community which offers independent living, assistedliving and skilled nursing services. Our rent payable to Senior Housing forthese nine communities is $10.7 million per year, plus future increasescalculated as a percentage of the revenue increases for all of thesecommunities after 2009. We added these communities to our existing lease withSenior Housing which has a term ending in 2020, with renewal optionsthereafter. Residents pay a majority of our charges at these communities fromtheir private resources.

 

·      We currently intend to leasefrom Senior Housing 15 additional senior living communities with a total of 772units which Senior Housing has agreed to purchase from three unrelated parties.These communities are assisted living communities. We expect our rent payableto Senior Housing for these 15 communities to be $11.9 million per year, plusfuture increases calculated as a percentage of the revenue increases at thesecommunities after 2009. We intend to add these communities to our existinglease with Senior Housing which has a term ending in 2020, with renewal optionsthereafter. Residents pay a majority of our charges at these communities fromtheir private resources. Senior Housing’s purchase and our lease of theseproperties are contingent upon further diligence, obtaining mortgage lenders’consents and other customary closing conditions. We can provide no assurancethat we will lease these properties.

 

RMR provides certainmanagement and administrative services to us under a shared services agreement.RMR is compensated at an annual rate equal to 0.6% of our total revenues.Aggregate fees earned by RMR for services during 2007, 2006 and 2005, were$6,052, $4,857 and $4,663, respectively. RMR also provides the internal auditfunction for us and for other publicly owned companies to which it providesmanagement services. Our audit committee appoints our director of internalaudit, and our compensation committee approves his salary. Our compensationcommittee also approves the costs we pay with respect to our internal auditfunction. Our share of RMR’s costs in providing that function for the yearsended 2007, 2006 and 2005 was $169, $173 and $107, respectively. The fact thatRMR has responsibilities to other entities, including our most significantlandlord, Senior Housing, could create conflicts; and in the event of suchconflicts between Senior Housing and us, our shared services agreement with RMRallows RMR to act on behalf of Senior Housing rather than on our behalf. RMR isbeneficially owned by Messrs. Barry M. Portnoy, one of our managingdirectors, and his son, Adam D. Portnoy, who is President and Chief ExecutiveOfficer and a director of RMR and a managing trustee of Senior Housing.Messrs. Barry Portnoy and Gerard Martin, our managing directors, aredirectors of RMR.

 

Our Chief Executive Officerand Chief Financial Officer are also officers and employees of RMR. Theseofficers devote a substantial majority of their business time to our affairsand the remainder to RMR’s business which is separate from our business. Webelieve the compensation we paid to these officers reasonably reflects theirdivision of business time; however, periodically, these individuals may dividetheir business time differently than they do currently and their compensationfrom us may become disproportionate to this division.

 

RMR is the owner of thebuildings in which our corporate headquarters is located. This lease expires in2011. We recorded rent, which includes our proportional share of utilities andreal estate taxes, under this lease during 2007, 2006 and 2005 of $1,332, $938and $711, respectively. This lease has been amended at various times to take intoaccount our needs for increasing space and all amendments to this lease havebeen approved by our independent directors.

 

One of our rehabilitationhospitals’ outpatient clinics leases space from HRPT Properties Trust, or HRPT,a REIT managed by RMR. We recorded rent, which includes our proportional shareof utilities and real estate taxes, under this lease during 2007 and 2006 of$52 and $8, respectively.

 

F-19

----

 

In December 2006, we began leasing space fora regional office in Atlanta, Georgia from HRPT.  This lease expires in 2011.  We recorded rent which includes ourproportional share of utilities and real estate taxes, under this lease during2007 and 2006 of $61,000 and $5,000, respectively.

 

We believe that all our transactions with relatedparties are all on reasonable commercial terms. We also believe that our relationship with Senior Housing and RMRbenefits us and, in fact, provides us competitive advantages in operating andgrowing our businesses. Moreover, all transactions between us and relatedparties, including Senior Housing and RMR, are approved by our independentdirectors.

 

**16. Employee Benefit Plans**

 

We have established and have also assumed severalemployee savings plans under the provisions of Section 401(k) of theInternal Revenue Code.  All our employees are eligible to participate inat least one of our plans and are entitled upon termination or retirement toreceive their vested portion of the plan assets.  For some of our plans,we match a certain level of employee contributions.  We also pay certainexpenses related to all of our plans.  Expenses for all our plans,including our contributions, were $1,321, $193 and $244 for the years ended December 31,2007, 2006 and 2005, respectively.

 

**17.  GuarantorFinancial Information**

** **

Our Notes are guaranteed by certain of our domestic wholly ownedsubsidiaries.  Such guarantees are full,unconditional and joint and several. Condensed consolidating financialinformation related to us, our guarantor subsidiaries and our non-guarantorsubsidiaries as of December 31, 2007, 2006 and 2005 are reflected below:

 

**Condensed Consolidating Statement of Operations**

**For the year ended December 31, 2007**

 
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| Revenues:                                                    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Senior living revenue                                        |       | $          | —     |                        | $          | 342,608                           |       | $                | 467,326    |             | $          | — |   | $ | 809,934 |   |
| Hospital revenue                                             |       | —     |       | —                      |       | 102,005                           |       | —           |       | 102,005          |       |
| Pharmacy revenue                                             |       | —     |       | —                      |       | 60,985                            |       | —           |       | 60,985           |       |
| Total revenues                                               |       | —     |       | 342,608                     |       | 630,316                           |       | —           |       | 972,924          |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating expenses:                                          |       |       |       |                        |       |                              |       |             |       |             |       |
| Senior living wages and benefits                             |       | —     |       | 150,667                     |       | 259,780                           |       | —           |       | 410,447          |       |
| Other senior living operating expenses                       |       | —     |       | 101,930                     |       | 100,264                           |       | —           |       | 202,194          |       |
| Hospital expenses                                            |       | —     |       | —                      |       | 92,449                            |       | —           |       | 92,449           |       |
| Pharmacy expenses                                            |       | —     |       | —                      |       | 58,012                            |       | —           |       | 58,012           |       |
| Rent expense                                                 |       | —     |       | 66,854                      |       | 62,336                            |       | —           |       | 129,190          |       |
| General and administrative                                   |       | —     |       | -                           |       | 43,373                            |       | —           |       | 43,373           |       |
| Depreciation and amortization                                |       | —     |       | 4,790                       |       | 8,805                             |       | —           |       | 13,595           |       |
| Total operating expenses                                     |       | —     |       | 324,241                     |       | 625,019                           |       | —           |       | 949,260          |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating income (loss)                                      |       | —     |       | 18,367                      |       | 5,297                             |       | —           |       | 23,664           |       |
| Interest and other income                                    |       | —     |       | —                      |       | 6,152                             |       | —           |       | 6,152            |       |
| Interest expense                                             |       | —     |       | (250                        | )          | (6,552                            | )          | —           |       | (6,802           | )          |
| Gain on extinguishment of debt                               |       | —     |       | —                      |       | 4,491                             |       | —           |       | 4,491            |       |
| Equity in earnings of subsidiaries                           |       | 23,326     |       | —                      |       | —                            |       | (23,326          | )          | —           |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Income (loss) from continuing operations before income taxes |       | 23,326     |       | 18,117                      |       | 9,388                             |       | (23,326          | )          | 27,505           |       |
| Provision for income taxes                                   |       | —     |       | 107                         |       | 1,303                             |       | —           |       | 1,410            |       |
| Income (loss) from continuing operations                     |       | 23,326     |       | 18,010                      |       | 8,085                             |       | (23,326          | )          | 26,095           |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Loss from discontinued operations                            |       | —     |       | (14                         | )          | (2,755                            | )          | —           |       | (2,769           | )          |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Net income (loss)                                            |       | $          | 23,326     |                        | $          | 17,996                            |       | $                | 5,330      |             | $          | (23,326 | ) | $ | 23,326 |   |

** **

**F-20**

----

** **

**Condensed Consolidating Statement of Operations**

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

 
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| Revenues:                                                    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Senior living revenue                                        |       | $          | —     |                        | $          | 328,786                           |       | $                | 416,111    |             | $          | — |   | $ | 744,897 |   |
| Hospital revenue                                             |       | —     |       | —                      |       | 25,494                            |       | —           |       | 25,494           |       |
| Pharmacy revenue                                             |       | —     |       | —                      |       | 45,195                            |       | —           |       | 45,195           |       |
| Total revenues                                               |       | —     |       | 328,786                     |       | 486,800                           |       | —           |       | 815,586          |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating expenses:                                          |       |       |       |                        |       |                              |       |             |       |             |       |
| Senior living wages and benefits                             |       | —     |       | 143,329                     |       | 238,764                           |       | —           |       | 382,093          |       |
| Other senior living operating expenses                       |       | —     |       | 87,773                      |       | 98,623                            |       | —           |       | 186,396          |       |
| Hospital expenses                                            |       | —     |       | —                      |       | 22,954                            |       | —           |       | 22,954           |       |
| Pharmacy expenses                                            |       | —     |       | —                      |       | 44,579                            |       | —           |       | 44,579           |       |
| Management fee to SLS                                        |       | —     |       | 8,744                       |       | —                            |       | —           |       | 8,744            |       |
| Termination expense for SLS management agreements            |       | —     |       | 129,913                     |       | —                            |       | —           |       | 129,913          |       |
| Rent expense                                                 |       | —     |       | 65,171                      |       | 44,085                            |       | —           |       | 109,256          |       |
| General and administrative                                   |       | —     |       | —                      |       | 33,829                            |       | —           |       | 33,829           |       |
| Depreciation and amortization                                |       | —     |       | 4,192                       |       | 5,659                             |       | —           |       | 9,851            |       |
| Total operating expenses                                     |       | —     |       | 439,122                     |       | 488,493                           |       | —           |       | 927,615          |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating (loss) income                                      |       | —     |       | (110,336                    | )          | (1,693                            | )          | —           |       | (112,029         | )          |
| Interest and other income                                    |       | —     |       | 313                         |       | 6,493                             |       | —           |       | 6,806            |       |
| Interest expense                                             |       | —     |       | (24                         | )          | (4,340                            | )          | —           |       | (4,364           | )          |
| Equity in earnings of subsidiaries                           |       | (116,665   | )          | —                      |       | —                            |       | 116,665          |       | —           |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| (Loss) income from continuing operations before income taxes |       | (116,665   | )          | (110,047                    | )          | 460                               |       | 116,665          |       | (109,587         | )          |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Provision for income taxes                                   |       | —     |       | —                      |       | —                            |       | —           |       | —           |       |
| (Loss) income from continuing operations                     |       | (116,665   | )          | (110,047                    | )          | 460                               |       | 116,665          |       | (109,587         | )          |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Loss from discontinued operations                            |       | —     |       | (74                         | )          | (7,004                            | )          | —           |       | (7,078           | )          |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Net (loss) income                                            |       | $          | (116,665   | )                           | $          | (110,121                          | )          | $                | (6,544     | )                | $          | 116,665 |   | $ | (116,665 | ) |

 

**Condensed Consolidating Statement of Operations**

**For the year ended December 31, 2005**

 
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| Revenues:                                                    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Senior living revenue                                        |       | $          | —     |                        | $          | 314,990                           |       | $                | 383,022    |             | $          | — |   | $ | 698,012 |   |
| Pharmacy revenue                                             |       | —     |       | —                      |       | 29,647                            |       | —           |       | 29,647           |       |
| Total revenues                                               |       | —     |       | 314,990                     |       | 412,669                           |       | —           |       | 727,659          |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating expenses:                                          |       |       |       |                        |       |                              |       |             |       |             |       |
| Senior living wages and benefits                             |       | —     |       | 131,779                     |       | 224,289                           |       | —           |       | 356,068          |       |
| Other senior living operating expenses                       |       | —     |       | 90,368                      |       | 88,418                            |       | —           |       | 178,786          |       |
| Pharmacy expenses                                            |       | —     |       | —                      |       | 28,233                            |       | —           |       | 28,233           |       |
| Management fee to SLS                                        |       | —     |       | 21,256                      |       | —                            |       | —           |       | 21,256           |       |
| Termination expense for SLS management agreements            |       | —     |       | 86,286                      |       | —                            |       | —           |       | 86,286           |       |
| Rent expense                                                 |       | —     |       | 64,556                      |       | 32,952                            |       | —           |       | 97,508           |       |
| General and administrative                                   |       | —     |       | —                      |       | 28,221                            |       | —           |       | 28,221           |       |
| Depreciation and amortization                                |       | —     |       | 2,562                       |       | 4,401                             |       | —           |       | 6,963            |       |
| Impairment of assets                                         |       | —     |       | —                      |       | 1,940                             |       | —           |       | 1,940            |       |
| Total operating expenses                                     |       | —     |       | 396,807                     |       | 408,454                           |       | —           |       | 805,261          |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Operating (loss) income                                      |       | —     |       | (81,817                     | )          | 4,215                             |       | —           |       | (77,602          | )          |
| Interest and other income                                    |       | —     |       | 170                         |       | 1,373                             |       | —           |       | 1,543            |       |
| Interest expense                                             |       | —     |       | —                      |       | (3,632                            | )          | —           |       | (3,632           | )          |
| Equity in earnings of subsidiaries                           |       | (84,159    | )          | —                      |       | —                            |       | 84,159           |       | —           |       |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| (Loss) income from continuing operations before income taxes |       | (84,159    | )          | (81,647                     | )          | 1,956                             |       | 84,159           |       | (79,691          | )          |
| Provision for income taxes                                   |       | —     |       | —                      |       | —                            |       | —           |       | —           |       |
| (Loss) income from continuing operations                     |       | (84,159    | )          | (81,647                     | )          | 1,956                             |       | 84,159           |       | (79,691          | )          |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Loss from discontinued operations                            |       | —     |       | (272                        | )          | (4,196                            | )          | —           |       | (4,468           | )          |
|                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Net (loss) income                                            |       | $          | (84,159    | )                           | $          | (81,919                           | )          | $                | (2,240     | )                | $          | 84,159 |   | $ | (84,159 | ) |

 

F-21

----

 

**Condensed Consolidating Balance Sheet**

**As of December 31, 2007**

 
| ** **                                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| ASSETS                                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current assets:                                                           |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash equivalents                                                 |       | $          | —     |                        | $          | 5,422                             |       | $                | 25,577     |             | $          | — |   | $ | 30,999 |   |
| Accounts receivable, net                                                  |       | —     |       | 11,209                      |       | 47,594                            |       | —           |       | 58,803           |       |
| Investments                                                               |       | —     |       | —                      |       | 69,255                            |       | —           |       | 69,255           |       |
| Prepaid expenses and other current assets                                 |       | —     |       | 5,021                       |       | 18,761                            |       | —           |       | 23,782           |       |
| Assets of discontinued operations                                         |       | —     |       | —                      |       | 3,178                             |       | —           |       | 3,178            |       |
| Total current assets                                                      |       | —     |       | 21,652                      |       | 164,365                           |       | —           |       | 186,017          |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Property and equipment, net                                               |       | —     |       | 28,874                      |       | 102,831                           |       | —           |       | 131,705          |       |
| Investment in subsidiary and long term receivable from (to)  subsidiaries |       | 200        |       | —                      |       | 200                               |       | (400             | )          | —           |       |
| Intercompany                                                              |       | 229,048    |       | —                      |       | —                            |       | (229,048         | )          | —           |       |
| Other long term assets                                                    |       | —     |       | —                      |       | 42,732                            |       | —           |       | 42,732           |       |
|                                                                      |       | $          | 229,248    |                        | $          | 50,526                            |       | $                | 310,128    |             | $          | (229,448 | ) | $ | 360,454 |   |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                 |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Current liabilities:                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and other current liabilities                            |       | $          | —     |                        | $          | 27,823                            |       | $                | 75,821     |             | $          | — |   | $ | 103,644 |   |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 200                               |       | —           |       | 200              |       |
| Liabilities of discontinued operations                                    |       | —     |       | —                      |       | 219                               |       | —           |       | 219              |       |
| Total current liabilities                                                 |       | —     |       | 27,823                      |       | 76,240                            |       | —           |       | 104,063          |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Long term liabilities:                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 15,810                            |       | —           |       | 15,810           |       |
| Convertible senior notes                                                  |       | —     |       | —                      |       | 126,500                           |       | —           |       | 126,500          |       |
| Notes payable to related parties                                          |       | 200        |       | —                      |       | —                            |       | (200             | )          | —           |       |
| Other long term liabilities                                               |       | —     |       | 15,161                      |       | 12,098                            |       | —           |       | 27,259           |       |
| Total long term liabilities                                               |       | 200        |       | 15,161                      |       | 154,408                           |       | (200             | )          | 169,569          |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
| Total shareholders’ equity                                           |       | 229,048    |       | 7,542                       |       | 79,480                            |       | (229,248         | )          | 86,822           |       |
|                                                                      |       |       |       |                        |       |                              |       |             |       |             |       |
|                                                                      |       | $          | 229,248    |                        | $          | 50,526                            |       | $                | 310,128    |             | $          | (229,448 | ) | $ | 360,454 |   |

 

F-22

----

 

**Condensed Consolidating Balance Sheet**

**As of December 31, 2006**

 
| ** **                                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------|------------|------------------|------------|------------------|------------|
| ASSETS                                                                    |       |       |       |                        |       |                             |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| Current assets:                                                           |       |       |       |                        |       |                             |       |             |       |             |       |
| Cash and cash equivalents                                                 |       | $          | —     |                        | $          | 8,065                            |       | $                | 38,176     |             | $          | — |   | $ | 46,241 |   |
| Accounts receivable, net                                                  |       | —     |       | 13,209                      |       | 54,582                           |       | —           |       | 67,791           |       |
| Investment securities                                                     |       | —     |       | —                      |       | 50,434                           |       | —           |       | 50,434           |       |
| Prepaid expenses and other current assets                                 |       | —     |       | 8,353                       |       | 32,941                           |       | —           |       | 41,294           |       |
| Total current assets                                                      |       | —     |       | 29,627                      |       | 176,133                          |       | —           |       | 205,760          |       |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| Property and equipment, net                                               |       | —     |       | 23,061                      |       | 91,837                           |       | —           |       | 114,898          |       |
| Investment in subsidiary and long term receivable from (to)  subsidiaries |       | 200        |       | —                      |       | 200                              |       | (400             | )          | —           |       |
| Intercompany                                                              |       | 228,656    |       | —                      |       | —                           |       | (228,656         | )          | —           |       |
| Goodwill and other intangible assets                                      |       | —     |       | —                      |       | 22,611                           |       | —           |       | 22,611           |       |
| Other long term assets                                                    |       | —     |       | 3,072                       |       | 20,070                           |       | —           |       | 23,142           |       |
|                                                                      |       | $          | 228,856    |                        | $          | 55,760                           |       | $                | 310,851    |             | $          | (229,056 | ) | $ | 366,411 |   |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                 |       |       |       |                        |       |                             |       |             |       |             |       |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| Current liabilities:                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| Accounts payable and other current liabilities                            |       | $          | —     |                        | $          | 41,852                           |       | $                | 57,551     |             | $          | — |   | $ | 99,403 |   |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 33,317                           |       | —           |       | 33,317           |       |
| Liabilities of discontinued operations                                    |       | —     |       | —                      |       | 209                              |       | —           |       | 209              |       |
| Total current liabilities                                                 |       | —     |       | 41,852                      |       | 91,077                           |       | —           |       | 132,929          |       |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| Long term liabilities:                                                    |       | —     |       |                        |       |                             |       |             |       |             |       |
| Mortgage notes payable                                                    |       | —     |       | —                      |       | 11,454                           |       | —           |       | 11,454           |       |
| Convertible senior notes                                                  |       | —     |       | —                      |       | 126,500                          |       | —           |       | 126,500          |       |
| Notes payable to related parties                                          |       | 200        |       | —                      |       | —                           |       | (200             | )          | —           |       |
| Other long term liabilities                                               |       | —     |       | 6,431                       |       | 21,667                           |       | —           |       | 28,098           |       |
| Total long term liabilities                                               |       | 200        |       | 6,431                       |       | 159,621                          |       | (200             | )          | 166,052          |       |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
| Total shareholders’ equity                                           |       | 228,656    |       | 7,477                       |       | 60,153                           |       | (228,856         | )          | 67,430           |       |
|                                                                      |       |       |       |                        |       |                             |       |             |       |             |       |
|                                                                      |       | $          | 228,856    |                        | $          | 55,760                           |       | $                | 310,851    |             | $          | (229,056 | ) | $ | 366,411 |   |

** **

**Condensed Consolidating Cash Flow Statement**

**For the year ended December 31, 2007**

 
| ** **                                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **Cash Flows from operating activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Net income                                                                                   |       | $          | 23,326     |                        | $          | 17,996                            |       | $                | 5,330      |             | $          | (23,326 | ) | $ | 23,326 |   |
| Undistributed equity in earnings of subsidiaries                                             |       | (23,326    | )          | —                      |       | —                            |       | 23,326           |       | —           |       |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Adjustments to reconcile net income to cash provided by (used in)  operating activities, net |       | —     |       | (13,663                     | )          | 29,109                            |       | —           |       | 15,446           |       |
| Net cash provided by operating activities                                                    |       | —     |       | 4,333                       |       | 34,439                            |       | —           |       | 38,772           |       |
| Net cash (used in) provided by discontinued operations                                       |       | —     |       | 14                          |       | (204                              | )          | —           |       | (190             | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| **Cash Flows from investing activities:**                                                    |       | —     |       |                        |       |                              |       | —           |       |             |       |
| Capital expenditures                                                                         |       | —     |       | (25,978                     | )          | (47,445                           | )          | —           |       | (73,423          | )          |
| Proceeds from the sale of property and equipment                                             |       | —     |       | 15,391                      |       | 32,277                            |       | —           |       | 47,668           |       |
| Other, net                                                                                   |       | —     |       | 3,597                       |       | (2,837                            | )          | —           |       | 760              |       |
| Net cash used in investing activities                                                        |       | —     |       | (6,990                      | )          | (18,005                           | )          | —           |       | (24,995          | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| **Cash Flows from financing activities:**                                                    |       | —     |       |                        |       |                              |       | —           |       |             |       |
| Change in borrowings, net                                                                    |       | —     |       | —                      |       | (28,829                           | )          | —           |       | (28,829          | )          |
| Net cash used in financing activities                                                        |       | —     |       | —                      |       | (28,829                           | )          | —           |       | (28,829          | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Change in cash and cash equivalents                                                          |       | —     |       | (2,643                      | )          | (12,599                           | )          | —           |       | (15,242          | )          |
| Cash and cash equivalents at beginning of period                                             |       | —     |       | 8,065                       |       | 38,176                            |       | —           |       | 46,241           |       |
| Cash and cash equivalents at end of period                                                   |       | $          | —     |                        | $          | 5,422                             |       | $                | 25,577     |             | $          | — |   | $ | 30,999 |   |

** **

**F-23**

----

** **

**Condensed Consolidating Cash Flow Statement**

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

 
| ** **                                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **Cash Flows from operating activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Net loss                                                                                     |       | $          | (116,665   | )                           | $          | (110,120                          | )          | $                | (6,545     | )                | $          | 116,665 |   | $ | (116,665 | ) |
| Undistributed equity in earnings of subsidiaries                                             |       | 116,665    |       | —                      |       | —                            |       | (116,665         | )          | —           |       |
| Adjustments to reconcile net income to cash (used in) provided by  operating activities, net |       | —     |       | 118,138                     |       | (190,151                          | )          | —           |       | (72,013          | )          |
| Net cash (used in) provided by operating activities                                          |       | —     |       | 7,944                       |       | (196,622                          | )          | —           |       | (188,678         | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Net cash provided by discontinued operations                                                 |       | —     |       | 74                          |       | 7,004                             |       | —           |       | 7,078            |       |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| **Cash Flows from investing activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Capital expenditures                                                                         |       | —     |       | (17,481                     | )          | (39,621                           | )          | —           |       | (57,102          | )          |
| Proceeds from the sale of property and equipment                                             |       | —     |       | 9,425                       |       | 14,304                            |       | —           |       | 23,729           |       |
| Other, net                                                                                   |       | —     |       | 1,027                       |       | 2,578                             |       | —           |       | 3,605            |       |
| Net cash used in investing activities                                                        |       | —     |       | (7,029                      | )          | (22,739                           | )          | —           |       | (29,768          | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| **Cash Flows from financing activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Proceeds from issuance of common shares, net                                                 |       | —     |       | —                      |       | 115,291                           |       | —           |       | 115,291          |       |
| Change in borrowings, net                                                                    |       | —     |       | —                      |       | 125,942                           |       | —           |       | 125,942          |       |
| Net cash provided by financing activities                                                    |       | —     |       | —                      |       | 241,233                           |       | —           |       | 241,233          |       |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Change in cash and cash equivalents                                                          |       | —     |       | 989                         |       | 28,876                            |       | —           |       | 29,865           |       |
| Cash and cash equivalents at beginning of period                                             |       | —     |       | 7,076                       |       | 9,300                             |       | —           |       | 16,376           |       |
| Cash and cash equivalents at end of period                                                   |       | $          | —     |                        | $          | 8,065                             |       | $                | 38,176     |             | $          | — |   | $ | 46,241 |   |

** **

**Condensed Consolidating Cash Flow Statement**

**For the year ended December 31, 2005**

 
| ** **                                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
| **Cash Flows from operating activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Net loss                                                                                     |       | $          | (84,159    | )                           | $          | (81,919                           | )          | $                | (2,240     | )                | $          | 84,159 |   | $ | (84,159 | ) |
| Undistributed equity in earnings of subsidiaries                                             |       | 84,159     |       | —                      |       | —                            |       | (84,159          | )          | —           |       |
| Adjustments to reconcile net income to cash provided by (used in)  operating activities, net |       | —     |       | 80,230                      |       | (57,034                           | )          | —           |       | 23,196           |       |
| Net cash used in operating activities                                                        |       | —     |       | (1,689                      | )          | (59,274                           | )          | —           |       | (60,963          | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Net cash provided by discontinued operations                                                 |       | —     |       | 272                         |       | 4,196                             |       | —           |       | 4,468            |       |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| **Cash Flows from investing activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Capital expenditures                                                                         |       | —     |       | (19,722                     | )          | (90,631                           | )          | —           |       | (110,353         | )          |
| Proceeds from the sale of property and equipment                                             |       | —     |       | 7,769                       |       | 88,379                            |       | —           |       | 96,148           |       |
| Other, net                                                                                   |       | —     |       | 12,796                      |       | (14,232                           | )          | —           |       | (1,436           | )          |
| Net cash (used in) provided by investing activities                                          |       | —     |       | 843                         |       | (16,484                           | )          | —           |       | (15,641          | )          |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| **Cash Flows from financing activities:**                                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Proceeds from issuance of common shares, net                                                 |       | —     |       | —                      |       | 56,613                            |       | —           |       | 56,613           |       |
| Change in borrowings, net                                                                    |       | —     |       | —                      |       | 2,748                             |       | —           |       | 2,748            |       |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Net cash provided by financing activities                                                    |       | —     |       | —                      |       | 59,361                            |       | —           |       | 59,361           |       |
|                                                                                         |       |       |       |                        |       |                              |       |             |       |             |       |
| Change in cash and cash equivalents                                                          |       | —     |       | (574                        | )          | (12,201                           | )          | —           |       | (12,775          | )          |
| Cash and cash equivalents at beginning of period                                             |       | —     |       | 7,650                       |       | 21,501                            |       | —           |       | 29,151           |       |
| Cash and cash equivalents at end of period                                                   |       | $          | —     |                        | $          | 7,076                             |       | $                | 9,300      |             | $          | — |   | $ | 16,376 |   |

** **

**F-24**

----

** **

**18.  SelectedQuarterly Financial Data (Unaudited)**

** **

Thefollowing is a summary of unaudited quarterly results of operations for theyears ended December 31, 2007 and 2006:

 
| ** **                                   | ** ** | **2007**           | ** ** |
|----------------------------------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                     |       | $                  | 237,028    |   | $ | 240,138 |   | $ | 244,598 |   | $ | 251,160 |   |
| Net income (loss) from continuing operations |       | 5,480              |       | 5,146 |   | 8,592 |   | 6,879 |   |
| Net income (loss)                            |       | 4,764              |       | 4,080 |   | 7,761 |   | 6,722 |   |
| Net income (loss) per common share - Basic   |       | $                  | 0.15       |   | $ | 0.13 |   | $ | 0.24 |   | $ | 0.21 |   |
| Net income (loss) per common share - Diluted |       | $                  | 0.15       |   | $ | 0.13 |   | $ | 0.22 |   | $ | 0.19 |   |

 
| ** **                                   | ** ** | **2006**           | ** ** |
|----------------------------------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                     |       | $                  | 190,024    |   | $ | 193,132 |   | $ | 197,937 |   | $ | 234,570 |   |
| Net income from continuing operations        |       | 3,103              |       | (85,928 | ) | 5,878 |   | (32,640 | ) |
| Net income                                   |       | 1,657              |       | (87,191 | ) | 3,199 |   | (34,330 | ) |
| Net income (loss) per common share - Basic   |       | $                  | 0.08       |   | $ | (2.82 | ) | $ | 0.10 |   | $ | (1.09 | ) |
| Net income (loss) per common share - Diluted |       | $                  | 0.08       |   | $ | (2.82 | ) | $ | 0.10 |   | $ | (1.09 | ) |

** **

**19.  SubsequentEvents**

** **

In January and February 2008, we leased nine senior livingcommunities with 1,032 units which Senior Housing acquired from thirdparties.  Eight of these communities areassisted living communities (one of which offers some skilled nursing servicesand one of which offers some independent living services) and one is a continuingcare retirement community which offers independent living, assisted living andskilled nursing services.  Our rentpayable to Senior Housing for these nine communities is $10,740 per year, plusfuture increases calculated as a percentage of the revenue increases for all ofthese communities after 2009.  We addedthese communities to our existing lease with Senior Housing which has a termending in 2020, with renewal options thereafter.  Residents pay a majority of our charges atthese communities from their private resources.

 

We currently intend to lease from Senior Housing 15 additional seniorliving communities with a total of 772 units which Senior Housing has agreed topurchase from three unrelated parties. All of these communities are assisted living communities.  We expect our rent to Senior Housing forthese 15 communities to be $11,928 per year, plus future increases calculatedas a percentage of the revenue increases at these communities after 2009.  We intend to add these communities to our existinglease with Senior Housing which has a term ending in 2020, with renewal optionsthereafter.  Residents pay a majority ofour charges at these communities from their private resources.  Senior Housing’s purchase and our lease ofthese properties are contingent upon further diligence, consent from mortgagelenders and other customary closing conditions. We can provide no assurance that we will lease these properties.

 

AtDecember 31, 2007, we had $61,800 invested in ARS, which we classified ascurrent assets and $500 in ARS included in our self insurance reservesclassified as restricted investments on our balance sheet.  As of February 28, 2008, we have $74,900and $500****of ARS in these accounts.  After successful auctions in January 2008,starting in February 2008 as a result of recent changes in the capitalmarkets, auctions affecting approximately $43,300 of our ARS failed to close ontheir settlement dates.  We do not knowif auctions affecting the balance of our ARS; or future auctions for the ARS securitieswhich have failed, will successfully close on future auction settlement dates.

 

OurARS consists primarily of bonds issued by various entities to fund studentloans pursuant to the Federal Family Education Loan Program.  The maturities of our ARS range from 2032 to2047.  However, historically we have hadthe option to liquidate our investments in the ARS whenever the interest ratesare reset at auctions, usually every 35 days. All of our ARS were rated “AAA” by at least one nationally recognizeddebt rating agency when we made these investments, and, to our knowledge, noneof these ratings have been reduced. Pursuant to the terms of our ARS, whenever reset auctions fail to close,the interest payable to us on these ARS increases.  We are presently monitoring developments inthe ARS markets together with the broker dealer who has marketed the ARS whichwe own, but based upon our analysis of impairment factors, we have determinedthat our ARS are not impaired at this time and that the value of theseinvestments is approximately equal to their carrying value.

 

F-25

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Thefunds which we invested in ARS were funds we were holding to invest inpotential acquisitions which we have not yet identified or to satisfy longerterm self insurance obligations. Accordingly, these funds are not needed to fund our current operationsand we do not expect that the failure of auctions affecting our ARS holdings tohave a material adverse impact upon us, unless the ARS market remains illiquidfor an extended period, our ARS’ ratings are reduced and/or the value of thesesecurities declines.  Nonetheless, thecurrent illiquidity of these investments may mean we are unable to take advantageof other investment opportunities which would grow our operating businesses.

 

F-26

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|   | FIVE STAR QUALITY CARE, INC. |
|--------|------------------------------|
|   |                         |
|   |                         |
|   | By:                          |   /s/  Evrett W. Benton |
|   |                         | Evrett  W. Benton |
|   |                         | President  and Chief Executive Officer |

 

Dated:  March 5, 2008

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**               | ** ** | **Title**                              | ** ** | **Date**            |
|-----------------------------|------------|----------------------------------------|------------|---------------------|
| ** **                  | ** ** | ** **                             | ** ** | ** **          |
| /s/  Evrett W. Benton       |       | President  and Chief Executive Officer |       | March 5,  2008 |
| Evrett  W. Benton           |       |                                   |       |                |
|                        |       |                                   |       |                |
| /s/  Bruce J. Mackey Jr.    |       | Chief  Financial Officer and Treasurer |       | March 5,  2008 |
| Bruce  J. Mackey Jr.        |       | (Principal  Accounting Officer)        |       |                |
|                        |       |                                   |       |                |
| /s/  Barry M. Portnoy       |       | Managing  Director                     |       | March 5,  2008 |
| Barry  M. Portnoy           |       |                                   |       |                |
|                        |       |                                   |       |                |
| /s/  Gerard M. Martin       |       | Managing  Director                     |       | March 5,  2008 |
| Gerard  M. Martin           |       |                                   |       |                |
|                        |       |                                   |       |                |
| /s/  Bruce M. Gans          |       | Director                               |       | March 5,  2008 |
| Bruce  M. Gans              |       |                                   |       |                |
|                        |       |                                   |       |                |
| /s/  Barbara D. Gilmore     |       | Director                               |       | March 5,  2008 |
| Barbara  D. Gilmore         |       |                                   |       |                |
|                        |       |                                   |       |                |
| /s/  Arthur G. Koumantzelis |       | Director                               |       | March 5,  2008 |
| Arthur  G. Koumantzelis     |       |                                   |       |                |

** **

----