<PAGE>   1
 
   [PAGES 10 THROUGH 16 OF THE COMPANY'S 1996 ANNUAL REPORT TO SHAREHOLDERS]
                                                                    EXHIBIT 13.1
 
                            MANAGEMENT'S DISCUSSION
 
OVERVIEW
 
     The Company is an indefinite life REIT which was incorporated in Maryland
on March 31, 1994. The Company commenced operations on June 30, 1994, with the
receipt of proceeds from the sale of 5,980,000 shares of common stock. The
Company invests in a diversified portfolio of income-producing, healthcare-
related real estate, which it leases, and provides mortgage financing to
healthcare operators. The Company believes that it is an important source of
capital for the healthcare industry and intends to continue investing in a high
quality portfolio of properties managed by established operators of
rehabilitation, alternate-site care, long-term care, and acute-care facilities.
The Company diversifies its portfolio by operator, geography, facility type and
healthcare industry segment. The Company's primary objective is to provide
current income for distribution to stockholders.
 
     The Company incurs operating and administrative expenses, principally
compensation expense for its officers and other employees, office rent and
occupancy costs, and various expenses incurred in connection with acquiring
additional facilities or providing additional mortgage financing. The Company is
self-administered and managed by its executives and staff, and does not engage a
separate advisor for administrative or investment services, although the Company
does engage legal, accounting, tax, and financial advisors from time to time.
All taxes, maintenance, and other operating costs associated with leased
properties are generally paid by the lessees. The Company intends to continue to
declare and pay quarterly dividends to its stockholders in amounts not less than
the amounts required to maintain REIT status under the Internal Revenue Code.
The Company's ability to pay dividends will depend upon its cash available for
distribution.
 
RESULTS OF OPERATIONS
 
  Year Ended 1996 compared to the Year Ended 1995
 
     In 1996, the Company reported net income of $18.9 million, or $1.71 primary
net income per common share, compared to $9.7 million, or $1.55 primary net
income per common share in 1995. The increase in net income is attributable to
increases in rental and mortgage income from property acquisitions and
additional mortgage fundings, while total interest expense experienced only a
minor increase due to conversions of the Company's Convertible Subordinated
Debentures (Debentures) to common stock and a decrease in the weighted average
interest rate of the unsecured line of credit (Bank Credit Facility) during
1996.
 
     Total income increased $11.3 million, or 45.5%, to $36.0 million in 1996
over the previous year's total income of $24.7 million. The increase is due
primarily to rental income increasing $9.2 million in 1996 to $32.0 million from
1995's total of $22.8 million. The Company acquired eight additional properties
during the year and also recognized a full year's rental income on the twelve
properties acquired in 1995. Additionally, mortgage interest income increased
$1.4 million, or 73.6%, to $3.2 million in 1996 from $1.8 million in 1995, due
to additional mortgage fundings of $14.5 million during 1996.
 
     Total expenses in 1996 were $17.0 million compared to $15.0 million in
1995, an increase of $2.0 million or 13.6%. This is primarily attributable to an
increase in depreciation expense of $1.8 million in 1996 resulting from the
Company's acquisition of eight properties during the year and the recognition of
a full year's depreciation expense on the twelve properties that were acquired
in 1995. Interest expense experienced only a slight increase for 1996 due to
$26.3 million in conversions of the Company's Debentures to common stock and to
a decrease in the weighted average interest rate of the Bank Credit Facility.
 
  Year ended December 31, 1995, compared to the period from June 30, 1994,
(inception) through December 31, 1994.
 
     Revenues for the year ended December 31, 1995 totaled $24.7 million,
increasing $16.5 million, over 1994 revenues of $8.2 million. The increase in
revenues is primarily attributable to the recognition of a full year of revenues
from investments made during the partial year of 1994 and the revenues from
additional
<PAGE>   2
 
investments made during 1995. Specifically, a full year of revenues from 1994
investments added $11.1 million to revenues, and revenues from investments made
in 1995 added an additional $5.4 million.
 
     Interest expense for the year ended December 31, 1995, totaled $8.8
million, increasing $7.4 million, over 1994 interest expense of $1.4 million.
The increase in interest expense is attributable to an increase of $3.5 million
in interest expense related to a full year of interest expense on amounts
borrowed under the Bank Credit Facility during 1994 and the interest expense on
amounts borrowed under the Bank Credit Facility during 1995. Additionally, $3.9
million of the increase in interest expense is due to interest expense related
to the issuance of $52 million of convertible debentures issued in March 1995.
 
     Depreciation and amortization for the year ended December 31, 1995, totaled
$4.7 million, increasing $3.2 million over 1994 depreciation and amortization of
$1.5 million. $3.1 million of the increase in depreciation and amortization is
due primarily to a full year of depreciation on and amortization of investments
made in 1994 and the depreciation on and amortization of additional investments
made during 1995. Additionally, $0.2 million of the increase is due to
amortization of deferred financing costs related to the issuance of $52 million
of convertible debentures issued in March 1995.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The Company requires capital in order to fund investments in healthcare
properties through sale/leaseback transactions or mortgage financing. To fund
these investments, the Company utilizes its cash flow from operations and a
combination of long-term and short-term capital including both equity and debt.
The Company's long-term capital includes equity securities and convertible
debentures. The Company's short-term capital is obtained through the use of its
Bank Credit Facility. The Company initially funds investments and working
capital needs through borrowings under the Bank Credit Facility, existing cash
and cash equivalents, and cash flow from operations. Thereafter, the Company
raises capital through issuance of additional long-term and short-term
indebtedness or the issuance of its securities in private or public
transactions. There can be no assurance that acceptable financing for future
investments can be obtained.
 
     During the year ended December 31, 1996, the Company invested approximately
$102.4 million to acquire or construct real estate assets and invested
approximately $14.3 million in mortgage loans to healthcare providers. As of
December 31, 1996, the Company s investments totaled $354.6 million, consisting
of real estate properties of $302.6 million, real estate development projects of
$12.7 million, and mortgage notes receivable of $39.3 million. The 57 real
estate properties consist of sixteen ancillary hospital facilities, ten
physician clinics, nine skilled nursing facilities, six ambulatory surgery
facilities, four inpatient rehabilitation facilities, three outpatient
rehabilitation facilities, two comprehensive mental health hospitals, two sub-
acute care facilities, two assisted living facilities, two acute care hospitals,
and one integrated delivery facility. The real estate properties are located in
thirteen states and are leased or financed with seventeen healthcare-related
entities or their subsidiaries pursuant to long-term leases. There are eleven
real estate development projects with six healthcare operators consisting of
seven assisted living facilities, three integrated delivery facilities, and one
physician clinic. The mortgage notes receivable consist of thirteen mortgages
made to eight healthcare operators and secured by the real estate of five
long-term care facilities, three skilled nursing facilities, two acute-care
hospital facilities, two assisted living facilities, and one integrated delivery
facility.
 
   
     During March 1995, the Company sold $52 million aggregate principal amount
of 10.50% Debentures due 2002. The net offering proceeds were used to reduce the
outstanding balance of the Company's Bank Credit Facility. As of December 31,
1996, a total of $34.3 million in the principal amount of the debentures had
been converted into 2.1 million common shares resulting in a decrease of $34.3
million in the debentures and an increase of $34.3 million in stockholders
equity.  The Company intends to repay any 10.50% Debentures that remain
outstanding when such securities mature in 2002 from borrowings under the Bank
Credit Facility or from the sale of debt or equity securities.
    
 
     During October 1995, the Company filed a registration statement
("Shelf-Registration") with the Securities and Exchange commission to enable the
Company to offer up to an aggregate of $250,000,000 in debt securities,
preferred stock, and common stock at prices and terms to be determined at the
time of sale. In December 1995, the Company sold 3.45 million shares of common
stock at a per share price of $18.125. The net offering proceeds of $58.6
million were used to reduce the outstanding balance of the Company's Bank Credit
Facility. Additionally, in November 1996, the Company sold 2.68 million shares
of common stock at a
<PAGE>   3
 
per share price of $20.875. The net offering proceeds of $52.8 million were also
used to reduce the outstanding balance of the Company's Bank Credit Facility.
 
     In June 1996, the Company completed an amendment and restatement of its
Bank Credit Facility, increasing the principal amount to $150 million from its
previous principal amount of $100 million, extending the term to June 24, 1999,
from its previous term of June 22, 1997, and adjusting the determination of the
interest rate. At December 31, 1996, the outstanding balance of the Bank Credit
Facility was $68.5 million with a weighted average interest rate of 6.82%. The
maximum availability at year end was $81.5 million.
 
     The Bank Credit Facility bears interest at a rate chosen by the Company
from either the Bank's base rate or the Euro-dollar rate plus a percentage rate
ranging from 1.00 Percent to 1.625 percent depending upon the Company s senior
debt to consolidated total capital ratio for the preceding fiscal quarter. In
addition, the Company pays from 0.20 percent to 0.25 percent per annum on the
unused portion of funds available for borrowing under the Bank Credit Facility.
The commitment fee percentage is based on the Company s senior debt to total
capital ratio.
 
     The Bank Credit Facility contains certain representations, warranties and
financial, and other covenants customary in such loan agreements.
 
     The Bank Credit Facility is unsecured; however, upon the occurrence of an
event of default under the Bank Credit Facility, at the option of the lenders,
the Bank Credit Facility may become secured by a significant portion of the
assets of the Company, including certain of the leased properties and mortgage
notes receivable.
 
     The Bank Credit Facility, which is participated in by a consortium of eight
banks, will be available until June 24, 1999, and the principal balance
outstanding thereunder will mature on that date. The Company intends to renew
the Bank Credit Facility or to repay the outstanding balance thereunder at
maturity from the proceeds of a refinancing or from the sale of debt or equity
securities. There can be no assurances that the lenders will renew the Bank
Credit Facility on terms favorable to the Company or that the Company will be
able to refinance at that time.
 
   
     On June 26, 1996, the Company entered into a mortgage note with a life
insurance company for a principal amount of $23.3 million ("Mortgage Note"). The
Mortgage Note bears interest at 8.5% and is payable in 360 monthly payments of
principal and interest. The Mortgage Note is collateralized by an ancillary
hospital facility purchased in January 1996 for $30 million.
 
     The Company has committed a total of $102.8 million towards the acquisition
and construction of real estate properties and providing mortgage financing. As
of December 31, 1996, the Company had funded approximately $21.2 million towards
these commitments, with the balance of $81.6 million expected to be funded
throughout 1997. Financing for these commitments may be provided by funds from
operations, borrowings under the Bank Credit Facility, which the Company expects
to increase in 1997, or private placements or public offerings of debt or
equity.
    
 
  Special Note Regarding Forward-Looking Statements
 
     Any statement contained in this report which is not a historical fact, or
which might otherwise be considered an opinion or projection concerning the
Company or its business, whether expressed or implied, is meant as, and should
be considered, a forward-looking statement as that term is defined in the
Private Securities Litigation Reform Act of 1996. Forward-looking statements are
based on assumptions and opinions concerning a variety of known and unknown
risks, including but not necessarily limited to changes in market conditions,
natural disasters, and other catastrophic events, increased competition, changes
in availability and cost of reinsurance, changes in governmental regulations,
and general economic conditions, as well as other risks more completely
described in the Company's filings with the Securities and Exchange Commission.
If any of these assumptions or opinions may also prove materially incorrect, any
forward-looking statements made on the basis of such assumptions or opinions may
also prove materially incorrect in one or more respects.
<PAGE>   4
            [PAGE 5 OF THE COMPANY'S ANNUAL REPORT TO STOCKHOLDERS] 
                                                                   EXHIBIT 13.2 
                                                              
                           SELECTED FINANCIAL DATA


 
<TABLE>
<CAPTION>
                                                                                         FOR PERIOD FROM
                                                   YEAR ENDED          YEAR ENDED         INCEPTION TO
                                                DECEMBER 31, 1996   DECEMBER 31, 1995   DECEMBER 31, 1994
                                                -----------------   -----------------   -----------------
<S>                                             <C>                 <C>                 <C>
STATEMENT OF INCOME DATA
Revenues......................................    $ 35,952,336        $ 24,707,272        $  8,240,162
Net income....................................      18,913,689           9,708,391           4,762,734
Net income per share..........................            1.71                1.55                0.80
Weighted average shares outstanding-
  Primary.....................................      11,086,086           6,271,242           5,980,000
  Fully Diluted...............................      13,159,213           8,596,663                  --
OTHER DATA
Funds from operations (I)-
  Primary.....................................      22,632,815          12,523,303           5,628,243
  Fully diluted...............................      25,852,242          16,390,667                  --
Funds from operations per share-
  Primary.....................................            2.04                2.00                0.94
  Fully Diluted...............................            1.97                1.91                  --
Dividends distributed.........................      19,206,375          10,641,666           2,541,500
Dividends distributed per share...............            1.81                1.74               0.425
BALANCE SHEET DATA
Real estate properties, net...................     303,997,418         207,257,168         151,328,041
Mortgage notes receivable.....................      39,325,621          24,988,753          13,224,230
Total assets..................................     356,695,116         240,624,883         166,363,670
Convertible subordinated debentures...........      17,657,000          43,947,000                  --
Bank credit facility..........................      68,500,000          30,225,000          67,500,000
Mortgage Note Payable.........................      23,228,417                  --                  --
                                                  ------------        ------------        ------------
          Total stockholders' equity..........    $241,555,519        $163,746,655        $ 98,388,985
                                                  ============        ============        ============
</TABLE>
 
(1) Funds from operations is computed as net income (computed in accordance with
    generally accepted accounting principles), excluding rental income
    recognized on a straight-line basis on those leases with scheduled rent
    increases, and less book gains on the sale of assets, plus depreciation and
    amortization. Management considers funds from operations to be an
    informative measure of the performance of an equity REIT and consistent with
    measures used by analysts to evaluate equity REITs. Funds from operations
    does not represent cash generated from operating activities in accordance
    with generally accepted accounting principles, is not necessarily indicative
    of cash available to fund cash needs and should not be considered as an
    alternative to net income as an indicator of the company's operating
    performance or as an alternative to cash flow as a measure of liquidity.
<PAGE>   5
 
      [PAGES 17 TO 27 OF THE COMPANY'S 1996 ANNUAL REPORT TO SHAREHOLDERS]
                                                                    EXHIBIT 13.3
 
                          INDEPENDENT AUDITORS' REPORT
 
The Stockholders and Board of Directors
Capstone Capital Corporation:
 
     We have audited the accompanying consolidated balance sheets of Capstone
Capital Corporation as of December 31, 1996 and 1995, and the related
consolidated statements of income, stockholders equity, and cash flows for the
years ended December 31, 1996 and 1995 and for the period from June 30, 1994
(inception) to December 31, 1994. These financial statements are the
responsibility of the Company s management. Our responsibility is to express an
opinion on these financial statements based on our audit.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
     In our opinion, the financial statements referred to above, present fairly,
in all material respects, the financial position of Capstone Capital Corporation
as of December 31, 1996 and 1995, and the results of its operations and its cash
flows for the year ended December 31, 1996 and 1995 and for the period from June
30, 1994 (inception) to December 31, 1994, in conformity with generally accepted
accounting principles.
 
                                          KPMG PEAT MARWICK LLP
 
Birmingham, Alabama
January 20, 1997
<PAGE>   6
 
                          CAPSTONE CAPITAL CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,   DECEMBER 31,
                                                                  1996           1995
                                                              ------------   ------------
<S>                                                           <C>            <C>
                                         ASSETS
Real estate properties
  Land......................................................  $ 30,952,673   $ 24,669,023
  Land improvements.........................................     2,350,309      2,350,309
  Buildings and improvements................................   269,261,047    185,771,380
  Construction in progress..................................    12,650,780         37,409
                                                              ------------   ------------
                                                               315,214,809    212,828,121
  Less accumulated depreciation.............................   (11,217,391)    (5,570,953)
                                                              ------------   ------------
     Real estate properties, net............................   303,997,418    207,257,168
Mortgage notes receivable...................................    39,325,621     24,988,753
Cash........................................................     1,122,241        675,568
Accrued rental income.......................................     4,689,976      2,518,323
Other assets................................................     7,559,860      5,185,071
                                                              ------------   ------------
          Total assets......................................  $356,695,116   $240,624,883
                                                              ============   ============
                           LIABILITIES AND STOCKHOLDERS EQUITY
Liabilities
  Convertible subordinated debentures.......................  $ 17,657,000   $ 43,947,000
  Bank credit facility......................................    68,500,000     30,225,000
  Mortgage note payable.....................................    23,228,417             --
  Accrued expenses and other liabilities....................     5,754,180      2,706,228
                                                              ------------   ------------
          Total liabilities.................................   115,139,597     76,878,228
                                                              ============   ============
Stockholders' equity
  Preferred stock, $.001 par value, 10,000,000 shares
     authorized; none issued................................            --             --
  Common stock, $.001 par value, 50,000,000 shares
     authorized; 14,247,947 shares and 9,929,732 shares
     issued and outstanding, respectively...................        14,247          9,929
  Additional paid-in-capital................................   240,832,943    162,735,711
  Loans to officers to finance stock purchases..............      (286,944)      (286,944)
  Retained Earnings.........................................       995,273      1,287,959
                                                              ------------   ------------
          Total stockholders' equity........................   241,555,519    163,746,655
                                                              ------------   ------------
          Total liabilities and stockholders' equity........  $356,695,116   $240,624,883
                                                              ============   ============
</TABLE>
 
    The accompanying notes are an integral part of this financial statement
<PAGE>   7
 
                          CAPSTONE CAPITAL CORPORATION
 
                       CONSOLIDATED STATEMENTS OF INCOME
 
<TABLE>
<CAPTION>
                                                                                             FOR THE
                                                                                           PERIOD FROM
                                                   YEAR ENDED          YEAR ENDED         INCEPTION TO
                                                DECEMBER 31, 1996   DECEMBER 31, 1995   DECEMBER 31, 1994
                                                -----------------   -----------------   -----------------
<S>                                             <C>                 <C>                 <C>
Revenues
  Rental income...............................     $31,959,674         $22,774,371         $7,674,494
  Mortgage interest income....................       3,159,228           1,819,725            455,844
  Gain from sale of property..................         197,191                  --                 --
  Other income................................         636,243             113,176            109,824
                                                   -----------         -----------         ----------
          Total income........................      35,952,336          24,707,272          8,240,162
                                                   -----------         -----------         ----------
Expenses
  General and administrative..................       1,669,678           1,515,130            536,662
  Depreciation................................       6,021,811           4,180,868          1,416,574
  Amortization................................         293,267             515,970             85,332
  Interest (net of $552,686 capitalized in
     1996, $466,668 in 1995, and $94,858 in
     1994)....................................       8,812,170           8,786,913          1,438,860
  Property operations.........................         241,721                  --                 --
                                                   -----------         -----------         ----------
          Total expenses......................      17,038,647          14,998,881          3,477,428
                                                   -----------         -----------         ----------
Net income....................................     $18,913,689         $ 9,708,391         $4,762,734
                                                   ===========         ===========         ==========
Net Income Per Common Share...................     $      1.71         $      1.55         $     0.80
                                                   ===========         ===========         ==========
Weighted Averages Shares Outstanding..........      11,086,086           6,271,242          5,980,000
                                                   ===========         ===========         ==========
</TABLE>
 
    The accompanying notes are an integral part of this financial statement
<PAGE>   8
 
                          CAPSTONE CAPITAL CORPORATION
 
                      CONSOLIDATED STATEMENTS OF CASH FLOW
 
<TABLE>
<CAPTION>
                                                   YEAR ENDED          YEAR ENDED         INCEPTION TO
                                                DECEMBER 31, 1996   DECEMBER 31, 1995   DECEMBER 31, 1994
                                                -----------------   -----------------   -----------------
<S>                                             <C>                 <C>                 <C>
CASH FLOWS FROM OPERATING ACTIVITIES
  Net income..................................    $ 18,913,689        $  9,708,391        $  4,762,734
  Gain from sale of property..................        (197,191)                 --                  --
  Depreciation................................       6,021,811           4,180,868           1,416,574
  Amortization................................         293,267             515,970              85,332
  Increase in accrued rental income...........      (2,398,760)         (1,881,926)           (636,397)
  Construction funding deposit................        (768,423)                 --                  --
  Increase in receivables and other assets....      (1,568,075)           (282,847)           (934,482)
  Increase in accrued expenses and other
     liabilities..............................  2,129,026.....           1,800,831             474,685
                                                  ------------        ------------        ------------
          Net cash provided by operating
            activities........................      22,425,344          14,041,287           5,168,446
                                                  ------------        ------------        ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Acquisition of real estate properties.........    (102,025,229)        (60,088,309)       (152,739,813)
Proceeds from sale of properties..............       8,206,289                  --                  --
Investment in mortgage notes receivable.......     (22,769,689)        (11,764,523)        (13,224,230)
Collections on mortgage notes receivable......       2,189,430                  --                  --
Payment of earnest money deposit..............              --          (2,900,000)                 --
                                                  ------------        ------------        ------------
          Net cash used in investing
            activities........................    (114,399,199)        (74,752,832)       (165,964,043)
                                                  ------------        ------------        ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Increase (decrease) in bank credit facility...      38,275,000         (37,275,000)         67,500,000
Proceeds from mortgage note payable...........      19,907,321                  --                  --
Principal payments on mortgage note payable...         (71,583)                 --                  --
Proceeds from issuance of common stock........      56,028,500          62,531,250          97,788,000
Costs related to issuance of common stock.....      (3,263,971)         (3,882,543)         (1,427,772)
Proceeds from issuance of convertible
  subordinated debentures.....................              --          52,000,000                  --
Financing costs related to issuance of
  convertible subordinated debentures.........              --          (2,017,934)                 --
Capital contributions from minority
  interests...................................         687,611             430,711                  --
Payment of dividends..........................     (19,206,375)        (10,641,666)         (2,541,500)
Proceeds from dividend reinvestment plan......          64,025               6,108                  --
Increase in loans to finance stock
  purchases...................................              --             (94,467)           (192,477)
                                                  ------------        ------------        ------------
          Net cash provided by financing
            activities........................      92,420,528          61,056,459         161,126,251
                                                  ------------        ------------        ------------
Increase in cash..............................         446,673             344,914             330,654
Cash, beginning of period.....................         675,568             330,654                  --
                                                  ------------        ------------        ------------
Cash, end of period                               $  1,122,241        $    675,568        $    330,654
                                                  ============        ============        ============
</TABLE>
 
    The accompanying notes are an integral part of this financial statement
<PAGE>   9
 
                          CAPSTONE CAPITAL CORPORATION
 
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
 
<TABLE>
<CAPTION>
                                                                         LOANS TO
                                     COMMON STOCK        ADDITIONAL     OFFICERS TO                      TOTAL
                                 --------------------     PAID-IN      FINANCE STOCK    RETAINED     STOCKHOLDERS'
                                   SHARES     AMOUNT      CAPITAL        PURCHASES      EARNINGS        EQUITY
                                 ----------   -------   ------------   -------------   -----------   -------------
<S>                              <C>          <C>       <C>            <C>             <C>           <C>
Proceeds from initial public
  offering                        5,980,000   $ 5,980   $ 96,354,248            --              --   $ 96,360,228
Loans to finance stock
  purchases....................          --        --             --      (192,477)             --       (192,477)
Net Income.....................                                                          4,762,734      4,762,734
Dividends paid during 1994
  ($0.425 per share)...........          --        --             --            --      (2,541,500)    (2,541,500)
                                 ----------   -------   ------------     ---------     -----------   ------------
BALANCE DECEMBER 31, 1994......   5,980,000     5,980     96,354,248     $(192,477)      2,221,234     98,388,985
Shares issued in conversion of
  convertible debentures to
  common stock.................     499,404       499      8,052,384            --              --      8,052,883
Convertible debenture issuance
  costs related to conversion
  of debentures to common
  stock........................          --        --       (322,296)           --              --       (322,296)
Proceeds from sale of 3,450,000
  shares less related expenses
  of $3,882,543................   3,450,000     3,450     58,645,267            --              --     58,648,717
Proceeds from issuance of
  shares under the dividend
  reinvestment plan............         328        --          6,108            --              --          6,108
Loans to finance stock
  purchases....................          --        --             --       (94,467)             --        (94,467)
Net income.....................          --        --             --            --       9,708,391      9,708,391
Dividends paid during 1995
  ($1.74 per share)............          --        --             --            --     (10,641,666)   (10,641,666)
                                 ----------   -------   ------------     ---------     -----------   ------------
BALANCE DECEMBER 31, 1995......   9,929,732     9,929    162,735,711      (286,944)      1,287,959    163,746,655
Shares issued in conversion of
  convertible debentures to
  common stock.................   1,630,310     1,630     26,288,370            --              --     26,290,000
Convertible debenture issuance
  costs related to conversion
  of debentures to common
  stock........................                           (1,017,004)           --              --     (1,017,004)
Proceeds from sale of 2,684,700
  shares less related expenses
  of $338,827..................   2,684,700     2,685     52,761,844            --              --     52,764,529
Proceeds from issuance of
  shares under the dividend
  reinvestment plan............       3,205         3         64,022            --              --         64,025
Net income.....................          --        --             --            --      18,913,689     18,913,689
Dividends paid during 1996
  ($1.81 per share)............          --        --             --            --     (19,206,375)   (19,206,375)
                                 ----------   -------   ------------     ---------     -----------   ------------
BALANCE DECEMBER 31, 1996......  14,247,947   $14,247   $240,832,943     $(286,944)    $   995,273   $241,555,519
                                 ==========   =======   ============     =========     ===========   ============
</TABLE>
 
    The accompanying notes are an integral part of this financial statement
<PAGE>   10
 
                          CAPSTONE CAPITAL CORPORATION
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1.  ORGANIZATION
 
     Capstone Capital Corporation (the "Company") is an indefinite life real
estate investment trust ("REIT") which was incorporated in Maryland on March 31,
1994. The Company commenced operations on June 30, 1994, with the receipt of
proceeds from its initial public offering of 5,980,000 shares of common stock.
The Company owns healthcare related properties which it leases, and it also
provides mortgage financing to healthcare operators.
 
NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
     Basis of Presentation -- The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries and its majority-owned
partnerships. Inter-company accounts and transactions have been eliminated.
 
     Use of Estimates in the Preparation of Financial Statements -- The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
 
     Impairment of Assets -- In 1996 the Company adopted Statement of Financial
Accounting Standards No. 121 "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of". The Statement establishes
accounting standards for the impairment of long-lived assets, certain identified
intangibles and goodwill related to those assets. There was no effect on the
financial statements from the adoption since the Company does not consider any
of its assets to be impaired. Under provisions of the Statement, impairment
losses are recognized when expected future cash flows are less than the asset's
carrying value. Accordingly, when indicators of impairment are present, the
Company evaluates the carrying value of its properties and intangibles in
relation to the operating performance and future undiscounted cash flows of the
underlying property. The Company adjusts the net book value of the underlying
assets if the sum of the expected future cash flow is less than book value.
 
     Real Estate Properties -- Real estate properties are recorded at cost.
Acquisition costs and transaction fees are added to the purchase price. No
allowance for investment losses is considered necessary. The cost of real estate
properties acquired is allocated between land, land improvements, and buildings
and improvements based upon estimated market values at the time of acquisition.
Depreciation is provided for on a straight-line basis over an estimated useful
life of 40 years for building and improvements and 20 years for land
improvements.
 
     Federal Income Taxes -- No provision has been made for federal taxes. The
Company intends at all times to qualify as a REIT under sections 856 through 860
of the Internal Revenue Code of 1986, as amended. The Company must distribute at
least 95% of REIT taxable income to its stockholders and meet other requirements
to continue to qualify as a REIT.
 
     Rental Income -- Rental income is recognized as earned over the life of the
lease agreements. Certain of the lease agreements provide for scheduled annual
rent increases. These rent increases are recognized on a straight-line basis
over the term of the lease.
 
     Mortgage Interest Income -- Mortgage interest income is recognized based on
the interest rates and principal amounts outstanding of the mortgage notes
receivable. Certain of the mortgage notes receivable provide for scheduled
annual interest rate increases.
 
     Net Income Per Share -- Net income per share is computed using the weighted
average number of shares outstanding during the period.
<PAGE>   11
 
                          CAPSTONE CAPITAL CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Prior Year Reclassifications -- Certain classifications have been made to
the 1995 and 1994 financial statements to conform to the current year
presentation.
 
NOTE 3.  REAL ESTATE PROPERTIES
 
     As of December 31, 1996, the Company had investments in 44 leased real
estate properties totaling $302.6 million. These real estate properties consist
of sixteen ancillary hospital facilities, ten physician clinics, six ambulatory
surgery facilities, four inpatient rehabilitation facilities, three outpatient
rehabilitation facilities, two comprehensive mental health hospitals, two
sub-acute care facilities, and one skilled nursing facility. The properties are
located in thirteen states and are leased to ten healthcare-related entities or
their subsidiaries pursuant to long-term leases. In addition, the Company has
invested approximately $12.7 million in eleven development projects at various
stages of completion. The Company has remaining commitments of approximately
$67.2 million for development projects completion and expects all projects to be
completed by the end of 1997.
 
     The Company's properties are generally leased pursuant to fixed term
operating leases expiring from 2001 to 2012 and provide for options to extend
the lease terms for at least ten years. The leases generally provide the
lessees, during the terms of the leases and for a short period of time following
expiration, with the right of first refusal to purchase the leased property on
the same terms and conditions as the Company may propose to a third party.
 
     Each lease generally requires the lessee to pay base rent, additional rent
commencing after the first year based on a set percentage increase or an
increase in the consumer price index, and all taxes (including property taxes),
maintenance, and other operating costs associated with the leased property.
 
     Lessees that accounted for more than 10 percent of the Company's rental
income for the year ended December 31, 1996, were: HEALTHSOUTH Corporation,
$11.6 million and Columbia/HCA, $6.8 million.
 
     Future minimum lease payments for the next five years under the
non-cancelable operating leases as of December 31, 1996 are as follows:
 
          1997 -- $32,879,486; 1998 -- $33,295,707; 1999 -- $33,773,104;
     2000 -- $34,370,668; 2001 -- $34,022,518. These amounts include only those
     increases in lease payments related to leases that provide for set
     percentage increases or set minimum increases in the consumer price index.
     They do not include those increases in lease payments which may occur based
     on the increase in the consumer price index but without set minimums.
 
NOTE 4.  MORTGAGE NOTES RECEIVABLE
 
     As of December 31, 1996, the Company had provided $39.3 million in mortgage
financing for thirteen properties located in six states. The mortgage notes
receivable are secured by the real estate of eight skilled nursing facilities,
two assisted living facilities, two acute-care hospitals, and one integrated
delivery facility, which are operated by eight healthcare operators.
 
     Two of the facilities (one acute care hospital and one assisted living
facility) are under construction, and the Company has committed a total of $18.9
million in construction and term loans for these projects. As of December 31,
1996, the Company had advanced a total of $4.5 million toward these financing
commitments. The Company expects to disburse the remainder of the committed
funds in 1997.
 
     The Company's mortgage notes receivable require monthly installments of
principal and interest, with final payment dates ranging from 2001 to 2012, and
bear rates ranging from 9.25 percent to 11.75 percent at December 31, 1996. Each
mortgage note receivable provides for the initial interest rates to be increased
annually by either a set rate or upon an increase in the consumer price index.
<PAGE>   12
 
                          CAPSTONE CAPITAL CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
NOTE 5.  MORTGAGE NOTE PAYABLE
 
     On June 26, 1996, the Company entered into a mortgage note with a life
insurance company for a principal amount of $23.3 million ("Mortgage Note"). The
Mortgage Note bears interest at 8.5% and is payable in 360 monthly payments of
principal and interest. The Mortgage Note is collateralized by an ancillary
hospital facility purchased in January 1996 for $30 million.
 
NOTE 6.  BANK CREDIT FACILITY
 
     On June 24, 1996, the Company completed an amendment and restatement of its
unsecured line of credit ("Bank Credit Facility") which provides for an increase
to $150 million from its previous principal amount of $100 million, an extension
of the term to June 24, 1999 from June 22, 1997, and an adjustment in the
determination of the interest rate. The Bank Credit Facility is participated in
by a consortium of eight banks. At December 31, 1996, the Company had drawn
$68,500,000 against the Bank Credit Facility for the purchase of real estate
properties and the funding of mortgage loans.
 
     Borrowings under the amended and restated Bank Credit Facility bear an
interest rate chosen by the Company from either the Bank's base rate or the
Eurodollar rate plus a percentage rate ranging from 1.00 percent to 1.625
percent, depending upon the Company's senior debt to consolidated total capital
ratio for the preceding fiscal quarter. In addition, the Company pays a
commitment fee of 0.20 percent to 0.25 percent per annum on the unused portion
of funds available for borrowing under the Bank Credit Facility. The commitment
fee percentage is based on the Company's senior debt to total capital ratio.
 
     The Bank Credit Facility contains certain representations, warranties and
financial and other covenants customary in such loan agreements.
 
NOTE 7.  CONVERTIBLE SUBORDINATED DEBENTURES
 
     As of December 31, 1996, the Company had $17,657,000 aggregate principal
amount of 10.50% Convertible Subordinated Debentures ("Debentures") outstanding.
 
     The Debentures mature on April 1, 2002, unless redeemed earlier by the
Company or converted by the holders. Payments of interest to the holders of the
Debentures are required each April 1 and October 1, commencing October 1, 1995.
The Debentures are convertible into shares of common stock of the Company at the
option of the holder at any time prior to redemption or stated maturity, at a
conversion price of $16.125 per share. The Debentures are subordinated to all
existing and future senior indebtedness of the Company and subordinated to all
existing and future liabilities and obligations of subsidiaries and partnerships
of the Company. The Debentures are redeemable, at the Company's option, in
whole, or from time to time, in part, at any time from April 5, 2000, through
March 31, 2002, at redemption prices ranging from 101.5% to 103.0%, plus accrued
and unpaid interest to and including the redemption date.
 
NOTE 8.  STOCK OPTIONS
 
     During 1995, the Financial Accounting Standards Board issued Financial
Accounting Statement No. 123, "Accounting for Stock-Based Compensation", ("FAS
123"). The Statement defines a fair value based method of accounting for an
employee stock option. It also allows an entity to continue using the intrinsic
value based accounting method prescribed by APB Opinion No. 25, "Accounting for
Stock Issued to Employees". The Company has continued to use this method to
account for its stock options. However, FAS 123 requires entities electing to
remain with the intrinsic method of accounting to provide pro forma disclosures
of net income and earnings per share as if the fair value based method of
accounting had been applied. Information about the Company's stock option plan
and the related required disclosures follow.
<PAGE>   13
 
                          CAPSTONE CAPITAL CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Pursuant to the Company's 1994 stock incentive plan, 1,063,600 shares of
common stock have been reserved for issuance. Options to acquire 602,500 and
413,000 shares at an exercise price of $18.375 and $16.50, respectively, were
granted in 1995 and 1994, respectively. There is no vesting period for these
options and they may be exercised within 10 years from the grant dates. No
options had been exercised as of December 31, 1996.
 
     The pro forma information regarding net income and net income per common
share as required by FAS 123 is provided below. The fair value for these options
was estimated at the date of grant using the Roll-Geske option pricing model
with the following assumptions:
 
          Risk free interest rate -- 6.33%, Volatility factor -- 16.96% and
     Weighted average expected life of the options -- 8 years.
 
<TABLE>
<CAPTION>
                                                                 1995
                                                              ----------
<S>                                                           <C>
Net Income:
  As reported...............................................  $9,709,391
  Pro forma.................................................  $6,432,598
Net Income per common share:
  As reported...............................................  $     1.55
  Pro forma.................................................  $     1.03
</TABLE>
 
NOTE 9.  RELATED PARTY TRANSACTIONS
 
     During 1994 and 1995, the Company funded loans to certain officers for the
purpose of acquiring the Company's common stock. The loans, which are due on
demand and collateralized by the stock, totaled $286,944 at December 31, 1996,
and bear interest at the prime rate, which was 8.25% at December 31, 1996. In
addition, the Company has other loans to employees totaling $273,000 which bear
interest at the prime rate.
 
     Certain of the Company's directors are directors and/or executive officers
of HEALTHSOUTH Corporation, MedPartners Inc., and Integrated Health Services,
Inc. During 1996, the Company received rental income of $11.6 million, $6.8
million and $3.2 million from HEALTHSOUTH Corporation, MedPartners Inc. and
Integrated Health Services, Inc., respectively.
 
NOTE 10.  DIVIDENDS
 
     In order to qualify as a REIT, the Company must, among other requirements,
distribute at least 95% of its REIT taxable income to its stockholders. Per
share dividend payments by the Company were characterized in the following
manner for income tax purposes:
 
<TABLE>
<CAPTION>
                                                     1996         1995          1994
                                                     -----        -----        ------
<S>                                                  <C>          <C>          <C>
Ordinary Income....................................  $1.56        $1.54        $0.425
Return of Capital..................................   0.25         0.20            --
                                                     -----        -----        ------
          Total dividends paid.....................  $1.81        $1.74        $0.425
</TABLE>
 
     In 1995, the Company adopted a dividend reinvestment and stock purchase
plan ("Plan") and reserved 1,000,000 shares of common stock for issuance under
the Plan. Participants can automatically reinvest all or a portion of cash
dividends in shares of the Company's common stock and can make voluntary cash
payments for additional shares. The price of the shares purchased with
reinvested dividends will be at 95% of the shares market value on the dividend
payment date. Under the Plan, the Company received $64,025 during 1996 in
exchange for 3,205 shares of stock and $6,108 in exchange for 328 shares of
stock during 1995.