UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR FISCAL YEAR ENDED: AUGUST 31, 1996
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
For the transition period from to .
Commission File Number: 0-18942
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
(Exact name of registrant as specified in its charter)
Virginia 06-1293758
(State of organization) (I.R.S. Employer
Identification No.)
1285 Avenue of the Americas, New York, New York 10104
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (212) 713-4264
--------------
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
None None
Securities registered pursuant to Section 12(g) of the Act:
Shares of Common Stock, $.01 Par Value
(Title of class)
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ---
Shares of common stock outstanding as of August 31, 1996: 5,181,236. The
aggregate sales price of the shares sold was $51,812,356. This does not reflect
market value. There is no current market for these shares.
DOCUMENTS INCORPORATED BY REFERENCE
Documents Form 10-K Reference
Prospectus of registrant dated Parts II and IV
August 8, 1990, as supplemented
Current Report on Form 8-K Part IV
of registrant dated July 29, 1996
<PAGE>
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
1996 FORM 10-K
TABLE OF CONTENTS
Part I Page
Item 1 Business I-1
Item 2 Properties I-3
Item 3 Legal Proceedings I-4
Item 4 Submission of Matters to a Vote of Security Holders I-5
Part II
Item 5 Market for the Registrant's Shares and Related
Stockholder Matters II-1
Item 6 Selected Financial Data II-1
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations II-2
Item 8 Financial Statements and Supplementary Data II-8
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure II-8
Part III
Item 10 Directors and Executive Officers of the Registrant III-1
Item 11 Executive Compensation III-3
Item 12 Security Ownership of Certain Beneficial Owners
and Management III-3
Item 13 Certain Relationships and Related Transactions III-4
Part IV
Item 14 Exhibits, Financial Statement Schedules and Reports on
Form 8-K IV-1
Signatures IV-2
Index to Exhibits IV-3
Financial Statements and Supplementary Data F-1 to F-19
<PAGE>
PART I
Item 1. Business
PaineWebber Independent Living Mortgage Inc. II (the "Company") is a
finite-life corporation organized on February 5, 1990 in the Commonwealth of
Virginia for the purpose of making construction and participating mortgage loans
secured by rental housing complexes for independent senior citizens ("Senior
Housing Facilities"). On September 12, 1990, the Company commenced a public
offering of up to 10,000,000 shares of common stock pursuant to a Registration
Statement filed on Form S-11 under the Securities Act of 1933 (Registration
Statement No. 33-33857). On May 10, 1991, the public offering terminated. The
Company issued 5,181,236 shares, representing capital contributions of
$51,812,356, of which $200,000 represented the sale of 20,000 shares to an
affiliate, PaineWebber Group, Inc. ("PaineWebber"). As of November 1, 1996,
PaineWebber and its affiliates held 123,527 shares of the Company's common
stock. The Company has elected to qualify and be taxed as a Real Estate
Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended,
for each taxable year of operations. As a REIT, the Company is allowed a
deduction for the amount of dividends paid to its shareholders, thereby
effectively subjecting the distributed net income of the Company to taxation at
the shareholder level only. In order to qualify as a REIT, the Company must
distribute at least 95% of its taxable income on an annual basis and meet
certain other requirements.
The Company originally invested the net proceeds of the initial public
offering in six participating mortgage loans secured by Senior Housing
Facilities located in five different states. All of the loans made by the
Company were originally with Angeles Housing Concepts, Inc. ("AHC"), a company
specializing in the development, acquisition and operation of Senior Housing
Facilities. The Company entered into an Exclusivity Agreement with AHC and its
parent company, Angeles Corporation ("Angeles"), which required AHC to provide
the Company with certain specific opportunities to finance Senior Housing
Facilities and set forth the terms and conditions of the loans which were made.
The loan documents under the aforementioned Exclusivity Agreement called for
interest to be paid on construction loans at the rate of 13.3% per annum during
the construction period and for Base Interest to be paid on the permanent loans
at the rate of 10.3% per annum. In addition to the Base Interest, Additional
Interest was to be payable on the permanent loans in an amount equal to 10% of
the Gross Revenues of the Senior Housing Facilities, as defined. Under the terms
of the amended Exclusivity Agreement, Additional Interest was to be no less than
3% of the aggregate principal amount of all permanent loans outstanding for the
entire term of the investments. In the aggregate, the properties securing loans
from the Company did not generate sufficient cash flow to cover the debt service
payments owed to the Company under the amended terms of the Exclusivity
Agreement. To the extent that the properties did not generate sufficient cash
flow to make the full payments due under the loan documents, the shortfall was
funded by AHC through December 1992. The source of cash to make up these
shortfalls was from specified deficit reserve accounts, which had been funded
from the proceeds of the mortgage loans, and from contributions by Angeles.
During the quarter ended February 28, 1993, Angeles announced that it was
experiencing liquidity problems that resulted in the inability to meet its
obligations. Subsequent to such announcements, AHC defaulted on the regularly
scheduled mortgage loan payments due to the Company on March 1, 1993. Subsequent
to March 1993, payments toward the debt service owed on the Company's loans were
limited to the net cash flow of the operating investment properties. On May 3,
1993, Angeles filed for reorganization under a Chapter 11 Federal Bankruptcy
petition filed in the state of California. AHC did not file for reorganization.
The Company retained special counsel and held extensive discussions with AHC
concerning the default status of its loans. During the fourth quarter of fiscal
1993, a non-binding settlement agreement between the Company, AHC and Angeles
was reached whereby ownership of the properties would be transferred from AHC to
the Company or its designated affiliates. Under the terms of the Settlement
Agreement, the Company released AHC and Angeles from certain obligations under
the loans. On April 27, 1994, each of the properties owned by AHC and securing
the Loans was transferred (collectively, "the Transfers") to newly-created
special purpose corporations affiliated with the Company (collectively, "the
Property Companies"). The Transfers had an effective date of April 1, 1994 and
were made pursuant to the Settlement Agreement entered into on February 17, 1994
("the Settlement Agreement") between the Company and AHC which had previously
been approved by the bankruptcy court handling the bankruptcy case of Angeles.
All of the capital stock of each Property Company was held by ILM II Holding,
Inc. ("ILM Holding"), a Virginia corporation. In August 1995, each of the
Property Companies merged into ILM Holding. As a result, ownership of the Senior
Housing Facilities is now held by ILM Holding, and the Property Companies no
longer exist as separate legal entities. The capital stock of ILM Holding is
owned by the Company and PWP Holding, Inc. ("PWP Holding"), a wholly-owned
subsidiary of PaineWebber Properties Incorporated ("PWPI"). PWPI is a wholly
owned subsidiary of PaineWebber Incorporated, which is a wholly owned subsidiary
of PaineWebber Group, Inc. ("PaineWebber"). The Company holds substantially all
of the economic ownership in ILM Holding, while PWP Holding holds voting
control. As part of the fiscal 1994 settlement agreement with AHC, ILM Holding
retained AHC as the property manager for all of the Senior Housing Facilities
pursuant to the terms of a management agreement. As discussed further in Item 7,
the management agreement with AHC was terminated in July 1996.
Subsequent to the effective date of the Settlement Agreement with AHC,
management investigated and evaluated the available options for structuring the
ownership of the properties in order to maximize the potential returns to the
existing shareholders while maintaining the Company's qualification as a REIT
under the Internal Revenue Code. To retain REIT status, the Company must ensure
that 75% of its annual gross income is received from qualified sources. Under
the original investment structure, interest income from the Company's mortgage
loans was a qualified source. The properties that are now owned by an affiliate
of the Company are Senior Housing Facilities that provide tenants with more
services, such as meals, activities, assisted living, etc., than are customary
for ordinary residential apartment properties. As a result, a significant
portion of the rents paid by the tenants includes income for the increased level
of services received by them. Consequently, the rents paid by the tenants likely
would not be qualified rents for REIT qualification purposes if received
directly by the Company. Therefore, if the Company received such rents directly,
it could lose REIT status and be taxed as a regular corporation. After extensive
review, the Board of Directors determined that it would be in the best interests
of the shareholders for the Company to retain REIT status and master lease the
properties to a shareholder-owned operating company. As discussed further in
Item 7, on September 12, 1994 the Company formed a new subsidiary, ILM II Lease
Corporation, for the purpose of operating the Senior Housing Facilities. The
Senior Housing Facilities were leased to ILM II Lease Corporation effective
September 1, 1995 (see Item 7 for a description of the master lease agreement).
The Company's investments as of August 31, 1996 are described below:
Property Name Date of
and Location (1) Type of Property Investment Size
- -------------------- ---------------- ---------- ---------
The Palms
Fort Myers, FL Senior Housing Facility 7/18/90 204 Units
Crown Villa
Omaha, NE Senior Housing Facility 4/25/91 73 Units
Overland Park Place
Overland Park, KS Senior Housing Facility 4/9/92 137 Units
Rio Las Palmas
Stockton, CA Senior Housing Facility 5/14/92 162 Units
The Villa at Riverwood
St. Louis County, MO Senior Housing Facility 5/29/92 119 Units
Villa Santa Barbara (2)
Santa Barbara, CA Senior Housing Facility 7/13/92 123 Units
(1) See Notes to the Financial Statements filed with this Annual Report for a
description of the agreements through which the Company has acquired these
real estate investments.
(2) The acquisition and improvement of the Santa Barbara facility was jointly
financed by the Company and an affiliated company, PaineWebber Independent
Living Mortgage Fund, Inc. (ILM1). Any amounts generated by the operations
of the Santa Barbara property are equitably apportioned between the Company,
together with its consolidated affiliate, and ILM1, together with its
consolidated affiliate (generally 75% and 25%, respectively).
The Senior Housing Facilities are subject to competition from similar
properties in the vicinities in which they are located. The properties are
located in areas with significant senior citizen populations and, as a result,
there are, and will likely continue to be, a variety of competing projects aimed
at attracting senior residents. Such projects will generally compete on the
basis of rental rates, services, amenities and location. The Company has no real
estate investments located outside the United States. The Company is engaged
solely in the business of real estate investment. Therefore, presentation of
information about industry segments is not applicable.
The Company originally expected to liquidate its investments after a period
of approximately ten years, although under the terms of its organizational
documents property sales may occur at earlier or later dates. The Board of
Directors may defer the Company's scheduled liquidation date, if in the opinion
of a majority of the Directors, the disposition of the Company's assets at such
time would result in a material under-realization of the value of such assets;
provided, however, that no such deferral may extend beyond December 31, 2005.
The net proceeds of any sale transactions are expected to be distributed to the
Shareholders, so that the Company will, in effect, be self-liquidating.
Subject to the supervision of the Company's Board of Directors, assistance in
the management of the business of the Company is provided by PaineWebber ILM
Advisor, L.P. (the "Advisor"), a limited partnership comprised of ILM REIT
Advisor, Inc., a Virginia corporation, and Properties Associates, L.P., a
Virginia limited partnership. ILM REIT Advisor, Inc. is a wholly owned
subsidiary of PWPI. The partners of the Advisor are affiliates of PWI and
PaineWebber.
There are currently five directors of the Company, none of whom is an
affiliate of the Advisor. The directors are subject to removal by the vote of
the holders of a majority of the outstanding shares. The directors are
responsible for the general policies of the Company, but they are not required
to personally conduct the business of the Company in their capacities as
directors.
The terms of transactions between the Company and the Advisor and its
affiliates are set forth in Items 11 and 13 below to which reference is hereby
made for a description of such terms and transactions.
Item 2. Properties
As of August 31, 1996, the Company has interests in the six operating
properties referred to under Item 1 above to which reference is made for the
description, name and location of such properties.
Occupancy figures for each fiscal quarter during 1996, along with an average
for the year, are presented below for each property:
Percent Leased At
------------------------------------------------
Fiscal
1996
11/30/95 2/29/96 5/31/96 8/31/96 Average
-------- ------- ------- ------- -------
The Palms 99% 100% 99% 99% 99%
Crown Villa 98% 97% 96% 99% 98%
Overland Park Place 98% 95% 91% 91% 94%
Rio Las Palmas 75% 79% 85% 90% 82%
The Villa at Riverwood 95% 95% 93% 94% 94%
Villa Santa Barbara 59% 64% 69% 81% 68%
<PAGE>
Item 3. Legal Proceedings
On July 29, 1996, ILM II Lease Corporation and ILM II Holding, Inc. ("the
Companies") terminated the property management agreement with Angeles Housing
Concepts, Inc. ("AHC") covering the six senior housing facilities leased by ILM
II Lease Corporation from ILM II Holding, Inc., the Company's consolidated
affiliate. The management agreement was terminated for cause pursuant to
Sections 1.05 (a) (i), (iii) and (iv) of the agreement. Simultaneously with the
termination of the management agreement, the Companies filed suit against AHC in
the United States District Court for the Eastern District of Virginia for breach
of contract, breach of fiduciary duty and fraud. ILM II Lease Corporation and
ILM II Holding, Inc. allege that AHC willfully performed actions specifically in
violation of the management agreement and that such actions caused damages to
the Companies. Due to the termination of the agreement for cause, no termination
fee was paid to AHC. Subsequent to the termination of the management agreement,
AHC filed for protection under Chapter 11 of the U.S. Bankruptcy Code in its
domestic state of California. The filing was challenged by the Companies, and
the Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
November 1996, AHC filed with the Virginia District Court an Answer in response
to the litigation initiated by the Companies and a Counterclaim against ILM II
Holding, Inc. The Counterclaim alleges that the management agreement was
wrongfully terminated for cause and requests damages which include the payment
of the termination fee in the amount of $750,000, payment of management fees
pursuant to the contract from August 1, 1996 through October 15, 1996, which is
the earliest date that the management agreement could have been terminated
without cause, and recovery of attorney's fees and expenses. PaineWebber
Independent Living Mortgage Inc. II guaranteed the payment of the termination
fee at issue in these proceedings. The Companies intend to diligently prosecute
the case and to vigorously defend the counterclaims made by AHC. The eventual
outcome of this termination dispute cannot presently be determined.
In November 1994, a series of purported class actions (the "New York
Limited Partnership Actions") were filed in the United States District Court for
the Southern District of New York concerning PaineWebber Incorporated's sale and
sponsorship of various limited partnership interests and common stock, including
the securities offered by the Company. The lawsuits were brought against
PaineWebber Incorporated and Paine Webber Group, Inc. (together, "PaineWebber"),
among others, by allegedly dissatisfied investors. In March 1995, after the
actions were consolidated under the title In re PaineWebber Limited Partnership
Litigation, the plaintiffs amended their complaint to assert claims against a
variety of other defendants, including PaineWebber Properties Incorporated
("PWPI"), an affiliate of PaineWebber and the parent company of the general
partner of the Advisor to the Company. On May 30, 1995, the court certified
class action treatment of the claims asserted in the litigation.
The amended complaint in the New York Limited Partnership Actions alleged
that, in connection with the sale of common stock of the Company, the defendants
(1) failed to provide adequate disclosure of the risks involved; (2) made false
and misleading representations about the safety of the investments and the
Company's anticipated performance; and (3) marketed the Company to investors for
whom such investments were not suitable. The plaintiffs, who purported to be
suing on behalf of all persons who invested in the Company also alleged that
following the issuance of the Company's stock, the defendants misrepresented
financial information about the Company's value and performance. The amended
complaint alleged that the defendants violated the Racketeer Influenced and
Corrupt Organizations Act ("RICO") and the federal securities laws. The
plaintiffs sought unspecified damages, including reimbursement for all sums
invested by them in the Company's stock, as well as disgorgement of all fees and
other income derived by PaineWebber from the Company. In addition, the
plaintiffs also sought treble damages under RICO.
In January 1996, PaineWebber signed a memorandum of understanding with the
plaintiffs in the class action outlining the terms under which the parties have
agreed to settle the case. Pursuant to that memorandum of understanding,
PaineWebber irrevocably deposited $125 million into an escrow fund under the
supervision of the United States District Court for the Southern District of New
York to be used to resolve the litigation in accordance with a definitive
settlement agreement and a plan of allocation. On July 17, 1996, PaineWebber and
the class plaintiffs submitted a definitive settlement agreement which has been
preliminarily approved by the court and provides for the complete resolution of
the class action litigation, including releases in favor of the Company and
PWPI, and the allocation of the $125 million settlement fund among investors in
the various partnerships and REITs at issue in the case. As part of the
settlement, PaineWebber also agreed to provide class members with certain
financial guarantees relating to some of the partnerships and REITs. The details
of the settlement are described in a notice mailed directly to class members at
the direction of the court. A final hearing on the fairness of the proposed
settlement is scheduled to continue in December 1996.
In February 1996, approximately 150 plaintiffs filed an action entitled
Abbate v. PaineWebber Inc. in Sacramento, California Superior Court against
PaineWebber Incorporated and various affiliated entities concerning the
plaintiffs' purchases of various limited partnership investments and REIT
stocks, including those offered by the Company. The complaint alleges, among
other things, that PaineWebber and its related entities committed fraud and
misrepresentation and breached fiduciary duties allegedly owed to the plaintiffs
by selling or promoting limited partnership and REIT investments that were
unsuitable for the plaintiffs and by overstating the benefits, understating the
risks and failing to state material facts concerning the investments. The
complaint seeks compensatory damages of $15 million plus punitive damages. In
September 1996, the court dismissed many of the plaintiffs' claims as barred by
applicable securities arbitration regulations.
In June 1996, approximately 50 plaintiffs filed an action entitled
Bandrowski v. PaineWebber Inc. in Sacramento, California Superior Court against
PaineWebber Incorporated and various affiliated entities concerning the
plaintiff's purchases of various limited partnership interests and REIT stocks,
including those offered by the Company. The complaint is substantially similar
to the complaint in the Abbate action described above, and seeks compensatory
damages of $3.4 million plus punitive damages.
In July 1996, approximately 15 plaintiffs filed an action entitled Barstad
v. PaineWebber Inc. in Maricopa County, Arizona Superior Court against
PaineWebber Incorporated and various affiliated entities concerning the
plaintiffs' purchases of various limited partnership interests and REIT stocks,
including those offered by the Company. The complaint is substantially similar
to the complaint in the Abbate action described above, and seeks compensatory
damages of $752,000 plus punitive damages.
With respect to the Abbate, Bandrowski and Barstad actions described above,
the defendants' time to move against or answer the complaints has not yet
expired. In all cases, PaineWebber intends to vigorously contest the allegations
of the actions. However, the eventual outcome of this litigation and the
potential impact, if any, on the Company's shareholders cannot be determined at
the present time. Mediation hearings on the Abbate, Bandrowski and Barstad
actions are currently scheduled to be held in December 1996.
Under certain limited circumstances, pursuant to the Advisor Agreement with
the Advisor and other contractual obligations, PaineWebber affiliates could be
entitled to indemnification for expenses and liabilities in connection with the
shareholder litigation matters described above. However, PaineWebber has agreed
not to seek indemnification for any amounts it is required to pay in connection
with the settlement of the New York Limited Partnership Actions. At the present
time, neither PaineWebber nor management of the Company can estimate the impact,
if any, of any of the potential indemnification claims on the Company's
financial statements, taken as a whole.
Item 4. Submission of Matters to a Vote of Security Holders
None.
<PAGE>
PART II
Item 5. Market for the Registrant's Shares and Related Stockholder Matters
During the public offering period, which commenced August 8, 1990 and
ended May 10, 1991, the selling price of the shares of common stock was $10 per
share. At August 31, 1996 there were 3,537 record holders of the Company's
shares. There is no public market for the resale of the shares, and it is not
anticipated that a public market will develop.
The Company has a Distribution Reinvestment Plan designed to enable
shareholders to have their dividends from the Company invested in additional
shares of the Company's common stock. The terms of the Plan are outlined in
detail in the Prospectus, a copy of which Prospectus, as supplemented, in
incorporated herein by reference.
The Company makes quarterly distributions, payable within 45 days after
the end of each fiscal quarter, to shareholders of record on the record date for
such quarter as determined by the Directors. The Company intends to make
distributions to shareholders in an amount equal to at least 95% of its taxable
income in order to continue to qualify as a REIT. Reference is made to Item 6
below for the amount of cash dividends paid per share of common stock during
fiscal 1996.
Item 6. Selected Financial Data
PaineWebber Independent Living Mortgage Inc. II
For the years ended August 31, 1996, 1995, 1994, 1993 and 1992
(in thousands except per unit data)
For the years ended August 31,
1996 (1) 1995 1994 (2) 1993 (2) 1992 (2)
-------- ---- -------- -------- --------
Revenues $ 4,062 $ 11,876 $ 10,937 $ 9,026 $ 4,803
Operating income $ 2,087 $ 1,431 $ 1,188 $ 110 $ 869
Gain on sale of mortgage-
backed security - - - - $ 1,100
Gain on sale of Treasury Note- - - $ 87 -
Net income $ 2,087 $ 1,431 $ 1,188 $ 197 $ 1,969
Earnings per
share of common
stock $ 0.40 $ 0.27 $ 0.23 $ 0.04 $ 0.38
Cash dividends paid
per share of common
stock $ 0.50 $ 0.43 $ 0.40 $ 0.70 $ 1.00
Total assets $ 33,976 $ 35,552 $35,748 $36,234 $ 40,737
(1) As discussed further in Item 7, effective September 1, 1995 the operating
properties in which the Company has invested were leased by the Company's
consolidated affiliate to ILM II Lease Corporation pursuant to a master
lease agreement. The master lease is a "triple-net" lease whereby the
Lessee pays all operating expenses, governmental taxes and assessments,
utility charges and insurance premiums, as well as the costs of all
required maintenance, personal property and non-structural repairs. As a
result of the commencement of the master lease, the Company's consolidated
gross revenues and expenses declined significantly in fiscal 1996 from
prior year levels.
(2) As a result of certain restructuring plans which the Company began to
implement during fiscal 1995 (see Item 7), the financial position and
results of operations of the combined operating investment properties in
which the Company has invested have been presented on a consolidated basis
in the Company's financial statements beginning in fiscal 1995. Prior to
fiscal 1995, the Company had accounted for its interests in such
properties under the equity method. In order to present comparable
financial data, the amounts depicted above have been restated to portray
the operating properties on a consolidated basis for all years. The effect
of such restatement does not change the net income or earnings per share
amounts previously reported. See the Notes to Consolidated Financial
Statements of the Company accompanying this Annual Report for a further
discussion.
The above selected financial data should be read in conjunction with the
financial statements and related notes appearing elsewhere in this Annual
Report.
The above earnings and cash dividends paid per share of common stock are
based upon the 5,181,236 shares outstanding during each year.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Liquidity and Capital Resources
The Company offered shares of its common stock to the public from September
12, 1990 to May 10, 1991 pursuant to a Registration Statement filed under the
Securities Act of 1933. Capital contributions of $51,812,356 were received by
the Company (including $200,000 contributed by PaineWebber Group, Inc.) and,
after deducting selling expenses and offering costs and allowing for adequate
cash reserves, approximately $42.9 million was available to be invested in
participating first mortgage loans secured by Senior Housing Facilities. The
Company originally invested the net proceeds of the initial public offering in
six participating mortgage loans secured by Senior Housing Facilities located in
five different states. All of the loans made by the Company were originally with
Angeles Housing Concepts, Inc. ("AHC"), a company specializing in the
development, acquisition and operation of Senior Housing Facilities. As
previously reported, AHC defaulted on the regularly scheduled mortgage loan
payments due to the Company on March 1, 1993 as a result of the financial
problems of its parent company, Angeles Corporation ("Angeles"), which
subsequently filed for bankruptcy. In fiscal 1994, a settlement agreement was
executed whereby ownership of the properties was transferred from AHC to certain
designated affiliates of the Company. Subsequently, these affiliates were merged
into ILM II Holding, Inc. ("ILM Holding"). The capital stock of ILM Holding is
owned by the Company and PWP Holding, Inc. ("PWP Holding"), a wholly-owned
subsidiary of PaineWebber Properties Incorporated ("PWPI"). PWPI is a wholly
owned subsidiary of PaineWebber Incorporated, which is a wholly owned subsidiary
of PaineWebber Group, Inc. ("PaineWebber"). The Company holds substantially all
of the economic ownership in ILM Holding, while PWP Holding holds voting
control. As part of the fiscal 1994 settlement agreement with AHC, ILM Holding
retained AHC as the property manager for all of the Senior Housing Facilities
pursuant to the terms of a management agreement. As discussed further below, the
management agreement with AHC was terminated in July 1996.
Subsequent to the effective date of the Settlement Agreement with AHC, in
order to maximize the potential returns to the existing shareholders while
maintaining the Company's qualification as a REIT under the Internal Revenue
Code, the Company formed a new corporation, ILM II Lease Corporation, for the
purpose of operating the Senior Housing Facilities under the terms of a master
lease agreement. As of August 31, 1995, ILM II Lease Corporation, which is
taxable as a regular C Corporation and not as a REIT, was a wholly-owned
subsidiary of the Company. On September 1, 1995, after the Company received the
required regulatory approval, it distributed all of the shares of capital stock
of ILM II Lease Corporation to the holders of record of the Company's common
stock. One share of common stock of ILM II Lease Corporation was issued for each
full share of the Company's common stock held. Prior to the distribution, the
Company capitalized ILM II Lease Corporation with $500,000 from its existing
cash reserves, which was an amount estimated to provide ILM II Lease Corporation
with necessary working capital. The master lease agreement, which commenced on
September 1, 1995, is initially between the Company's consolidated affiliate,
ILM Holding, as owner of the properties and Lessor, and ILM II Lease Corporation
as Lessee. The master lease is a "triple-net" lease whereby the Lessee pays all
operating expenses, governmental taxes and assessments, utility charges and
insurance premiums, as well as the costs of all required maintenance, personal
property and non-structural repairs in connection with the operation of the
Senior Housing Facilities. ILM Holding, as the Lessor, is responsible for all
major capital improvements and structural repairs to the Senior Housing
Facilities. During the initial term of the master lease, which expires on
December 31, 2000 (December 31, 1999 with respect to the Santa Barbara
property), ILM II Lease Corporation is obligated to pay annual base rent for the
use of all of the Facilities in the aggregate amount of $3,548,700 for calendar
year 1995 (prorated based on the lease commencement date) and $4,035,600 for
calendar year 1996 and each subsequent year. Beginning in January 1997 and for
the remainder of the lease term, ILM I Lease Corporation will also be obligated
to pay variable rent for each Facility. Such variable rent will be payable
quarterly and will equal 40% of the excess, if any, of the aggregate total
revenues for the Facilities, on an annualized basis, over $13,021,000.
The assumption of ownership of the properties through ILM Holding, which
is presently a regular C corporation for tax purposes, has resulted in a
possible future tax liability which would be payable upon the ultimate sale of
the properties (the "built-in gain tax"). The amount of such tax would be
calculated based on the lesser of the total net gain realized from the sale
transaction or the portion of the net gain realized upon a final sale which is
attributable to the period during which the properties were held by in a C
corporation. The final phase of the Company's restructuring plans involves the
conversion of ILM Holding to a REIT for tax purposes. Certain changes to the
ownership structure of ILM Holding which are necessary in order for ILM Holding
to qualify as a REIT under the Internal Revenue Code are expected to be made in
time for ILM Holding to elect REIT status in conjunction with the filing of its
calendar 1996 federal tax return. Any future appreciation in the value of the
Senior Housing Facilities subsequent to the conversion of ILM Holding to a REIT
would not be subject to the built-in gain tax. The built-in gain tax would most
likely not be incurred if the properties were to be held for a period of at
least 10 years from the date of the conversion of ILM Holding to a REIT.
However, since the end of the Company's original anticipated holding period is
less than 5 years away, the properties are not expected to be held for an
additional 10 years. The Board of Directors may defer the Company's scheduled
liquidation date, if in the opinion of a majority of the Directors, the
disposition of the Company's assets at such time would result in a material
under-realization of the value of such assets; provided, however, that no such
deferral may extend beyond December 31, 2005. Based on management's current
estimate of the increase in the values of the properties which has occurred
since April 1994, as supported by independent appraisals, ILM Holding would
incur a sizable tax if the properties were sold. Based on these current
estimated market values of the operating investment properties, a sale at such
values prior to the end of the 10-year holding period could result in a built-in
gain tax of as much as $2.3 million. As the holder of a 99% economic interest in
ILM Holding, the burden of this built-in gain tax would be primarily borne by
the Company.
As the Company has previously disclosed, the Company's restructuring plans
involve the transfer of ownership of the Senior Housing Facilities, along with
the related leasehold interests, to the Company or its wholly-owned subsidiary.
The REIT requirements had previously restricted the Company from owning more
than a minimum amount of voting stock in ILM Holding. Since ILM Holding will be
a REIT effective as of January 1, 1996, these restrictions are no longer
applicable to the Company. The restructuring plans are consistent with the
Company's consolidated accounting policy and would allow greater flexibility to
provide future liquidity to the Company and its shareholders. In accordance with
these restructuring plans and in connection with the conversion of ILM Holding
to a REIT, on November 21, 1996, the Company requested that PWPI cause PWP
Holding to sell all of the stock held by PWP Holding in ILM Holding to the
Company for a price equal to the fair market value of the 1% economic interest
in ILM Holding represented by the stock and that the sale be completed as soon
as possible. PWPI has not taken a position with respect to this request. Should
PWPI determine not to agree to the Company's request to comply with the
previously disclosed restructuring plans, the Company will consider any and all
courses of action available to it with respect to PWPI.
ILM Holding has acquired the respective operating properties subject to,
and assumed the obligations under, the mortgage loans payable to the Company,
pursuant to the Settlement Agreement with AHC. The principal balance of each
loan was modified to reflect the estimated fair value of the related operating
property as of the date of the transfer of ownership. The modified loans require
interest-only payments on a monthly basis at a rate of 7% from April 1, 1994
through December 1, 1994, 9% for the period from January 1 through December 31,
1995, 11% for the period January 1 through December 31, 1996, 12% for the period
January 1 through December 31, 1997, 13% for the period January 1 through
December 31, 1998, 13.5% for the period January 1, 1999 through December 31,
1999 and 14% for the period January 1, 2000 through maturity. Since ILM Holding
is consolidated with the Company in the accompanying financial statements, the
mortgage loans and related interest expense have been eliminated in
consolidation. Because the ownership of the assets of ILM Holding was expected
to be transferred to the Company or its wholly-owned subsidiary, ILM Holding was
capitalized with funds to provide it with working capital only for a limited
period of time. At the present time, ILM Holding is not expected to have
sufficient cash flow during fiscal 1997 to (i) meet its obligations to make the
debt service payments due under the loans, (ii) pay for capital improvements and
structural repairs in accordance with the terms of the master lease, and (iii)
pay for costs that may be incurred in defending AHC's Counterclaim against ILM
Holding, as discussed further below. The liquidation of ILM Holding in
connection with the Company's restructuring plans would eliminate the existence
of the outstanding mortgage loans between the Company and ILM Holding. If,
however, the Company is unable to complete its restructuring plans due to PWPI's
refusal to cause PWP Holding to sell to the Company its voting stock in ILM
Holding, the Company may incur substantial additional costs and suffer other
adverse consequences.
On July 29, 1996, ILM II Lease Corporation and ILM Holding ("the
Companies") terminated the property management agreement with AHC covering the
eight senior housing facilities leased by ILM II Lease Corporation from ILM
Holding. The management agreement was terminated for cause pursuant to the terms
of the contract. Simultaneously with the termination of the management
agreement, the Companies filed suit against AHC in the United States District
Court for the Eastern District of Virginia for breach of contract, breach of
fiduciary duty and fraud. ILM II Lease Corporation and ILM Holding allege that
AHC willfully performed actions specifically in violation of the management
agreement and that such actions caused damages to the Companies. Due to the
termination of the agreement for cause, no termination fee was paid to AHC.
Subsequent to the termination of the management agreement, AHC filed for
protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic state of
California. The filing was challenged by the Companies, and the Bankruptcy Court
dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed
with the Virginia District Court an Answer in response to the litigation
initiated by the Companies and a Counterclaim against ILM Holding. The
Counterclaim alleges that the management agreement was wrongfully terminated for
cause and requests damages which include the payment of the termination fee in
the amount of $750,000, payment of management fees pursuant to the contract from
August 1, 1996 through October 15, 1996, which is the earliest date that the
management agreement could have been terminated without cause, and recovery of
attorney's fees and expenses. PaineWebber Independent Living Mortgage Inc. II
guaranteed the payment of the termination fee at issue in these proceedings. The
Companies intend to diligently prosecute the case and to vigorously defend the
counterclaims made by AHC. The eventual outcome of this termination dispute
cannot presently be determined. Accordingly, no provision for any liability
which might result from the Company's guaranty of the termination fee has been
recorded in the accompanying financial statements.
ILM II Lease Corporation has retained Capital Senior Management 2, Inc.
("Capital") of Dallas, Texas to be the new manager of the Senior Housing
Facilities pursuant to a Management Agreement which commenced on July 29, 1996.
Under the terms of the Agreement, Capital will earn a Base Management Fee equal
to 4% of the Gross Operating Revenues of the Senior Housing Facilities, as
defined. Capital will also be eligible to earn an Incentive Management Fee equal
to 25% of the amount by which the average monthly Net Cash Flow of the Senior
Housing Facilities, as defined, for the twelve month period ending on the last
day of each calendar month exceeds a specified Base Amount. Each August 31,
beginning on August 31, 1997, the Base Amount will be increased annually based
on the percentage increase in the Consumer Price Index. PaineWebber Independent
Living Mortgage Inc. II has guaranteed the payment of all fees due to Capital
under the terms of the Management Agreement.
The six properties in which the Company has invested averaged 93%
occupancy as of August 31, 1996. As previously reported, a property renovation
and assisted-living conversion program has been in progress at Villa Santa
Barbara for the past two years. Phase one of the renovations at the Santa
Barbara facility, which was completed during fiscal 1995, included renovation of
the lobby, dining room, library, activities room, television and game room and
the laundry rooms. Phase two of the renovation program, which was substantially
completed during the first quarter of fiscal 1996, involved interior unit
improvements, hallway upgrades and the conversion of existing studio units to
assisted living units. The total cost of the renovation program was
approximately $1.2 million, which has been funded 75% by the Company and 25% by
PaineWebber Independent Living Mortgage Fund, Inc. ("ILM1") from funds
previously reserved for such improvements. Leasing gains at Villa Santa Barbara
have been slowed by delays in completing the capital improvements and in
obtaining the required regulatory licensing to begin leasing the new assisted
living units. During the quarter ended May 31, 1996, ILM II Lease Corporation
received the required assisted living licenses. Leasing of the 38 new assisted
living units is now well underway. Overall occupancy of Villa Santa Barbara
averaged 81% for the fourth quarter of fiscal 1996.
The Company's net operating cash flow is expected to be relatively stable
and predictable now that the master lease structure is in place. The annual base
rental payments owed to ILM Holding increased to $4,035,600 effective January 1,
1996 and will remain at that level for the remainder of the lease term. In
addition, the Senior Housing Facilities are currently generating gross revenues
which are slightly in excess of the specified threshold in the variable rent
calculation, as discussed further above, which becomes effective in January
1997. Accordingly, the Company expects that ILM Holding will receive variable
rent payments in fiscal 1997. As a result of the status of the Company's net
operating cash flow under the current master lease arrangement, the Company is
expected to be able to increase its quarterly dividend payment from $0.125 per
share to $0.1625 per share effective with the dividend to be paid in January
1997 for the quarter ended November 30, 1996. This expected increase would raise
the dividend payment to the equivalent of a 6.5% annual return on the original
offering price of the Company's common stock. As noted above, ILM Holding, as
Lessor, is responsible for capital improvements and structural repairs to the
Senior Housing Facilities. Management is currently reviewing with the new
property management team annual operating budgets and capital expenditure plans
which include an ongoing program to replace air-conditioning units at the Santa
Barbara facility, planned roof repairs at Overland Park Place and The Palms and
the completion of a program to upgrade the common areas at the Rio Las Palmas
property. In addition, management plans to continue its investigation of the
potential for the expansion of the assisted living capacities of the properties
in certain markets where demand for assisted living units is particularly high.
Depending on the extent of any assisted living expansions deemed appropriate,
such plans could result in the need for substantial capital improvement funds.
At August 31, 1996, the Company had cash and cash equivalents of
$1,694,000. Such amounts will be used for the working capital requirements of
the Company, along with the possible investment in the properties owned by the
Company's consolidated affiliate for certain capital improvements, and for
dividends to the shareholders. Future capital improvements could be financed
from operations or through borrowings, depending on the magnitude of the
improvements, the availability of financing and the Company's incremental
borrowing rate. The source of future liquidity and dividends to the shareholders
is expected to be through master lease payments from ILM II Lease Corporation,
interest income earned on invested cash reserves and proceeds from the future
sales of the underlying operating investment properties. Such sources of
liquidity are expected to be adequate to meet the Company's operating
requirements on both a short-term and long-term basis. The Company generally
will be obligated to distribute annually at least 95% of its taxable income to
its Shareholders in order to continue to qualify as a REIT under the Internal
Revenue Code.
Results of Operations
1996 Compared to 1995
Net income increased by $656,000 for fiscal 1996 when compared to the
prior year. A primary reason for this increase in net income is the commencement
of the master lease between the Company's consolidated affiliate and ILM II
Lease Corporation effective September 1, 1995, as discussed further above and in
the notes to the accompanying financial statements. The Company, through its
consolidated affiliate, now receives master lease rental income from ILM II
Lease Corporation rather than the revenues from the individual tenants of the
Senior Housing Facilities. In addition, under the terms of the master lease, all
property operating expenses are now the responsibility of the Lessee. The master
lease rental income earned by the Company during fiscal 1996 was $305,000 more
than the excess of rental income earned from the Senior Housing Facilities over
property management fees and property operating expenses during the prior year.
In addition, net income increased as a result of decreases in professional fees
and management and advisory fees. Professional fees decreased by $290,000 as a
result of the significant amount of legal and tax advisory services incurred in
the prior year in connection with the evaluation, selection and implementation
of the master lease property ownership structure described above. Management and
advisory fees decreased by $83,000 as a result of the advisory fees charged to
the Company's consolidated affiliate during fiscal 1995. Such fees were equal to
0.5% of the Gross Operating Revenues of the Senior Housing Facilities. These
advisory fees were no longer charged to ILM Holding effective September 1, 1995
upon the commencement of the master lease.
A decrease of $29,000 in interest income partially offset the favorable
changes to net income described above. Interest income decreased due to a
decline in the average amount of cash and cash equivalents outstanding when
compared to the prior year. The decline in outstanding cash reserves was
primarily the result of the Company's funding of the $500,000 initial working
capital investment in ILM II Lease Corporation on September 1, 1995.
1995 Compared to 1994
The Combined Facilities generated rental revenues of $11,789,000 for
fiscal 1995, as compared to $10,863,000 for the prior year. This increase of
$926,000, or 9%, was the primary reason that the Company's net income improved
from $1,188,000 for fiscal 1994 to $1,431,000 for fiscal 1995. The increase in
rental revenues was mainly the result of increased occupancy at Villa Santa
Barbara and an increase in effective rental rates at certain of the Facilities.
Overall portfolio occupancy increased slightly from an average of 87% for fiscal
1994 to 88% for fiscal 1995. The biggest leasing gain was achieved at Villa
Santa Barbara, which despite its slower than anticipated leasing pace, did
improve from an average occupancy of 48% for fiscal 1994 to an average occupancy
of 59% for fiscal 1995. In addition, slight leasing gains were achieved at the
Overland Park and Riverwood properties during fiscal 1995. Average occupancy at
Overland Park improved to 96% for fiscal 1995 from an average level of 95% for
the prior year. Likewise, average occupancy at Riverwood increased to 96% from
95% over the same period. The occupancy level at the Rio Las Palmas property
dropped during fiscal 1995 to an average of 73% from a level of 75% for the
prior year. With the exception of Rio Las Palmas and Villa Santa Barbara, the
other four properties all maintained average occupancy levels of 95% or better
during each of the past two years. However, revenues were up at these stabilized
properties in fiscal 1995 because management was able to implement rental rate
increases while maintaining stable occupancy levels.
Property operating expenses increased by $384,000, or 5%, for fiscal 1995,
partially offsetting the improvement in revenues. The increase in property
operating expenses was primarily attributable to higher variable food service,
housekeeping, activities and assisted living costs associated with the overall
increase in the portfolio occupancy level. However, the change in property
operating expenses also reflected a decrease in marketing costs at certain of
the Facilities that had achieved stabilized occupancy levels and the effects of
certain operating efficiencies implemented at most of the Facilities subsequent
to the transfers of ownership to the Property Companies. Increases in management
and advisory fees and professional fees for fiscal 1995, aggregating $232,000,
also served to offset the increase in revenues from the Senior Housing
Facilities. Management and advisory fees increased as a result of the new
advisory agreement between ILM Holding and an affiliate of PWPI. Such agreement,
which was effective from April 1, 1994 through August 31, 1995, called for fees
equal to 0.5% of the Gross Operating Revenues of the Facilities in return for
certain administrative services. Professional fees increased mainly as a result
of certain legal and tax advisory services required in connection with the
evaluation, selection and implementation of the master lease property ownership
structure described above.
1994 Compared to 1993
The transfer of ownership of the Senior Housing Facilities in fiscal 1994
resulted in no gain or loss recognition by the Company for financial reporting
purposes. As previously reported, under generally accepted accounting
principles, the Company had always accounted for its investments in acquisition
and construction loans under the equity method, as if such investments were
equity interests in a joint venture. Accordingly, the carrying values of such
investments had been reduced from inception by non-cash depreciation charges and
by payments from AHC, prior to the default in fiscal 1993, in excess of the net
cash flow generated by the Senior Housing Facilities received pursuant to the
guaranty agreement between the Company and AHC. As a result of this accounting
treatment, the carrying values of the Company's investments had been reduced
below management's estimate of the fair market value of the Senior Housing
Facilities as of the effective date of the transfer of ownership. Accordingly,
for financial reporting purposes the Company continued to employ its historical
cost basis in accounting for these investments subsequent to the Transfers and
continued to record its share of the operating results of the properties in its
statement of income. For federal income tax purposes, the investments had always
been carried at the contractually stated principal balances of the participating
mortgage loans. For tax purposes only, a loss was recognized by the Company in
1994 in the amount by which the stated principal balances of the loans were
reduced as of the date of the transfer of ownership.
The Company's net income increased by approximately $990,000 for fiscal
1994, as compared to fiscal 1993. This favorable change in net income was mainly
due to an increase in the combined rental revenues of the Company's Senior
Housing Facilities and a decrease in depreciation expense. The increase in
rental revenues was attributable to the lease-up achieved at certain of the
Facilities and the reduction in rental concessions used at the Facilities that
have achieved stabilized occupancy levels. Combined revenues increased by
approximately $2,084,000, or more than 23%, in fiscal 1994, which exceeded the
increase in combined property operating expenses and property management fees.
Average portfolio occupancy increased from 75% for the year ended June 30, 1993
to 85% for the year ended June 30, 1994. Significant leasing gains were achieved
at all six of the Facilities over this two-year period. The biggest leasing
gains were achieved at The Palms, Crown Villa and Rio Las Palmas, each of which
experienced a better than 20-point improvement in occupancy levels during this
two-year span. The decrease in depreciation expense, of approximately $138,000,
resulted from the reduction in the carrying values of the Facilities upon the
assumption of title by the Property Companies. The Property Companies recorded
the depreciable basis of the properties based on the historical cost basis of
the Company's investments in the operating properties as of April 1, 1994. Such
basis was significantly lower than the historical cost basis of AHC, mainly due
to the reduction in basis recognized by the Company as a result of payments made
by AHC pursuant to its guaranty agreement with the Company. As noted above, the
Company's net historical cost basis was lower than management's estimate of the
fair market value of the investment properties as of the effective date of the
transfer of ownership.
The favorable change in the operating results of the Senior Housing
Facilities during fiscal 1994 was partially offset by an increase in
professional fees of $187,000 and a decrease in interest income of $173,000. The
decrease in interest income resulted from the Company's temporary investment
during fiscal 1993 in a United States Government Treasury Note, which was sold
in August of 1993 at a gain of approximately $87,000. The increase in
professional fees was primarily due to legal fees related to the AHC loan
defaults and management's efforts to protect the Company's interest in the
underlying collateral. This was partially offset by a reduction in management
fee expense. Management fee expense decreased by approximately $32,000 in fiscal
1994 due to the reduction in the quarterly dividend, beginning with the quarter
ended February 28, 1993, from $0.25 per share to $0.10 per share. The dividend
reduction, resulting from the circumstances described above with respect to the
loan defaults, reduced the shareholders' rate of return on original
shareholders' equity to below 10% per annum. Despite subsequent increases in the
quarterly dividend rates, the rate of return remains below this 10% threshold on
original equity. Accordingly, the Advisor has not earned any incentive
management fees since the first quarter of fiscal 1993.
Inflation
The Company completed its fifth full year of operations in fiscal 1996.
The effects of inflation and changes in prices on the Company's operating
results to date have not been significant.
Inflation in future periods is likely to cause increases in the Company's
expenses, which may be partially offset by increases in revenues from the
Company's investments in the Senior Housing Facilities. Under the terms of the
master lease, as discussed further above, the Company, through its consolidated
affiliate, ILM Holding, will earn additional rental income based on increases in
the gross revenues of the related operating properties beginning in January
1997. Such gross revenues may tend to rise with inflation since the rental rates
on the tenant leases, which are short-term in nature, can be adjusted to keep
pace with inflation as market conditions allow.
<PAGE>
Item 8. Financial Statements and Supplementary Data
The financial statements and supplementary data are included under Item 14
of this Annual Report.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
<PAGE>
PART III
Item 10. Directors and Executive Officers of the Registrant
There are currently five directors of the Company, none of whom is an
affiliate of the Advisor. The directors are subject to removal by the vote of
the holders of a majority of the outstanding shares. The directors are
responsible for the general policies of the Company, but they are not required
to personally conduct the business of the Company in their capacities as
directors.
(a) and (b) The names and ages of the directors and executive officers
of the Company are as follows:
Date
elected
Name Office Age to Office
---- ------ --- ---------
Lawrence A. Cohen President, Chief Executive
Officer and Director 43 5/15/91
Jeffry R. Dwyer Director 50 2/12/90*
J. William Sharman, Jr. Director 56 2/12/90*
Carl J. Schramm Director 50 12/5/96
Julien G. Redele' Director 61 12/5/96
Walter V. Arnold Senior Vice President, Chief
Financial Officer
and Treasurer 49 2/12/90*
James A. Snyder Senior Vice President 51 7/06/92
C. David Carlson Vice President 48 12/11/95
Dorothy F. Haughey Secretary 70 2/12/90*
* The date of incorporation of the Company.
(c) ILM REIT Advisor, Inc., the general partner of the Advisor, assists
the directors and officers of the Company in the management and control of
the Company's affairs. ILM REIT Advisor, Inc. is a wholly-owned subsidiary
of PaineWebber Properties Incorporated ("PWPI"). The principal executive
officers of ILM REIT Advisor, Inc. are as follows:
Name Office Age
---- ------ ---
Bruce J. Rubin President and Chief Executive Officer 37
Walter V. Arnold Senior Vice President, Chief
Financial Officer and Treasurer 49
James A. Snyder Senior Vice President 51
C. David Carlson Vice President 48
(d) There is no family relationship among any of the foregoing directors or
officers. All of the foregoing directors and officers of the Company have been
elected to serve until the Company's next annual meeting.
(e) The business experience of each of the directors and executive
officers of the Company and ILM REIT Advisor, Inc. is as follows:
Lawrence A. Cohen has served as President, Chief Executive Officer and
Director of the Company since 1991. Mr. Cohen is also Vice Chairman and Chief
Financial Officer of Capital Senior Living Corp., an affiliate of Capital
Senior Management 2, Inc., which is the company that was contracted by ILM II
Lease Corporation in July 1996 to perform property management services for the
Senior Housing Facilities in which the Company has invested. Mr. Cohen joined
Capital Senior Living Corp. in November 1996. Mr. Cohen was President and
Chief Executive Officer of PWPI until August 1996. Mr. Cohen joined PWPI in
January 1989 as its Executive Vice President and Director of Marketing and
Sales. Mr. Cohen is also a member of the board of directors of PaineWebber
Independent Living Mortgage Fund, Inc. (ILM I), ILM I Lease Corporation, ILM
II Lease Corporation and Retail Property Investors, Inc. (RPI). Mr. Cohen
received his LL.M (in Taxation) from New York University School of Law and his
J.D. degree from St. John's University School of Law. Mr. Cohen received his
B.B.A. degree in accounting from George Washington University. He is a member
of the New York Bar and is a Certified Public Accountant.
Jeffry R. Dwyer has served as a director of the Company since its
inception in 1990. Mr. Dwyer is a partner with the law firm of Akin, Gump,
Straus, Hauer & Feld in the District of Columbia, which he joined in 1993. Prior
to joining Akin, Gump, Straus, Hauer & Feld, Mr. Dwyer was a partner with the
law firm of Morrison & Foerster from 1989 to 1993. Immediately prior to joining
Morrison & Foerster, Mr. Dwyer was a partner with the law firm of Lane & Edson.
Mr. Dwyer also presently serves as a director of ILMI, ILM I Lease Corporation
and ILM II Lease Corporation. Mr. Dwyer has written several books on real estate
financing and taught Real Estate Planning as an Adjunct Professor at the
Georgetown University Law Center. Mr. Dwyer graduated from Georgetown University
and received his law degree from the Georgetown University Law Center.
J. William Sharman, Jr. has served as a director of the Company since its
inception in 1990. Mr. Sharman is the Chairman of the Board and President of
Lancaster Hotel Management, L.C., a hotel management company, and Bayou
Equities, Inc., a hotel development company. Mr. Sharman served for ten years
as Chairman of the Board and President of The Lancaster Group, Inc., a real
estate development firm based in Houston, Texas, which is the predecessor of
Lancaster Hotel Management, L.C. and Bayou Equities, Inc. Mr. Sharman is Vice
Chairman of Small Luxury Hotels, Ltd. of the United Kingdom, an international
hotel marketing and reservations firm. Mr. Sharman also presently serves as a
director of ILMI and RPI. He has a Bachelor of Science degree in Civil
Engineering from the University of Notre Dame.
Carl J. Schramm was appointed to fill a newly created seat on the
Company's Board of Directors as of December 5, 1996. Mr. Schramm is
President of Greenspring Advisors, Inc., a consulting and investment
advisory firm serving clients in the managed care, health insurance and
health information industries. From 1993 to 1995, Mr. Schramm served as
Executive Vice President of Fortis, Inc., a diversified insurance and
financial services company. From 1987 through 1992, Mr. Schramm was
President of the Health Insurance Association of America, the national trade
association of commercial health underwriters. Mr. Schramm currently serves
on the boards of HCIA, Inc., LifeRate Systems, Inc., the Rochdale Insurance
Group, Physicians Health Corporation and Madison Information Technologies.
Mr. Schramm holds a Ph.D. in Economics from the University of Wisconsin and
received his J.D. from Georgetown University.
Julien G. Redele' was appointed to fill a newly created seat on the
Company's Board of Directors as of December 5, 1996. Mr. Redele' is one of
the original founders of SFRE, Inc., a Dutch owned real estate investment
and development firm which has served since 1963 as advisor to Dutch
institutional, corporate and individual investors active in the United
States. Mr. Redele' serves as a director of the Island Preservation
Partnership. Mr. Redele' attended Westersingel Business School, Rotterdam,
where he studied economics, law and finance.
Bruce J. Rubin was named President and Chief Executive Officer of PWPI in
August 1996. Mr. Rubin joined PaineWebber Real Estate Investment Banking in
November 1995 as a Senior Vice President. Prior to joining PaineWebber, Mr.
Rubin was employed by Kidder, Peabody and served as President for KP Realty
Advisers, Inc. Prior to his association with Kidder, Mr. Rubin was a Senior
Vice President and Director of Direct Investments at Smith Barney Shearson.
Prior thereto, Mr. Rubin was a First Vice President and a real estate workout
specialist at Shearson Lehman Brothers. Prior to joining Shearson Lehman
Brothers in 1989, Mr. Rubin practiced law in the Real Estate Group at Willkie
Farr & Gallagher. Mr. Rubin is a graduate of Stanford University and Stanford
Law School.
Walter V. Arnold is a Senior Vice President, Chief Financial Officer and
Treasurer of the Company and Senior Vice President and Chief Financial Officer
of PWPI which he joined in October 1985. Mr. Arnold joined PWI in 1983 with the
acquisition of Rotan Mosle, Inc. where he had been First Vice President and
Controller since 1978, and where he continued until joining PWPI. Mr. Arnold is
a Certified Public Accountant licensed in the state of Texas.
James A. Snyder is a Senior Vice President of the Company and a Senior Vice
President of PWPI. Mr. Snyder re-joined PWPI in July 1992 having served
previously as an officer of PWPI from July 1980 to August 1987. From January
1991 to July 1992, Mr. Snyder was with the Resolution Trust Corporation, where
he served as the Vice President of Asset Sales prior to re-joining PWPI. From
February 1989 to October 1990, he was President of Kan Am Investors, Inc., a
real estate investment company. During the period August 1987 to February 1989,
Mr. Snyder was Executive Vice President and Chief Financial Officer of Southeast
Regional Management Inc., a real estate development company.
C. David Carlson is a Vice President of the Company and a Vice President of
PWPI which he joined in December 1995. From 1987 through 1995, Mr. Carlson was
an officer in Belmont Properties, Inc., a Boston-based real estate investment,
development and advisory firm. Mr. Carlson graduated from the University of
Minnesota in 1977 and received a Master of Science in Real Estate Development
degree from the Massachusetts Institute of Technology in 1986.
Dorothy F. Haughey is Secretary of the Company, Assistant Secretary of
PaineWebber and Secretary of PWI and PWPI. Ms. Haughey joined PaineWebber in
1962.
(f) None of the directors and officers was involved in legal proceedings
which are material to an evaluation of his or her ability or integrity as a
director or officer.
(g) Compliance With Exchange Act Filing Requirements: The Securities
Exchange Act of 1934 requires the officers and directors of the Company, and
persons who own more than ten percent of the Company's outstanding common stock,
to file certain reports of ownership and changes in ownership with the
Securities and Exchange Commission. Officers, directors and ten-percent
beneficial holders are required by SEC regulations to furnish the Company with
copies of all Section 16(a) forms they file.
Based solely on its review of the copies of such forms received by it, the
Company believes that, during the year ended August 31, 1996, all filing
requirements applicable to its officers and directors and ten-percent beneficial
holders were complied with.
Item 11. Executive Compensation
The Company's Independent Directors each receive an annual fee of $12,000
and reimbursement for expenses incurred in attending meetings and as a result of
other work performed for the Company. With the exception of Lawrence A. Cohen
beginning in August 1996, the officers of the Company are also officers of PWPI
and receive compensation from PWPI which indirectly relates to services to the
Company. In addition, the Company is required to pay certain fees to the Advisor
as described in Item 13.
Item 12. Security Ownership of Certain Beneficial Owners and Management
(a) As of the date hereof, no person of record owns or is known by the
Registrant to own beneficially more than five percent of the outstanding shares
of common stock of the Company.
<PAGE>
(b) The following table sets forth the ownership of shares owned directly
or indirectly by the Directors and principal officers of the Company as of
August 31, 1996:
Amount
Beneficially Percent
Title of Class Name of Beneficial Owner Owned of Class
- -------------- ------------------------ ----- --------
Shares of Lawrence A. Cohen 540 Shares Less than 1%
Common Stock,
$.01 par value
Shares of All Directors and 540 Shares Less than 1%
Common Stock, Officers of the Company,
$.01 par value as a group
(c) There exists no arrangement, known to the Company, the operation of
which may at a subsequent date result in a change in control of the Company.
Item 13. Certain Relationships and Related Transactions
Subject to the supervision of the Company's Board of Directors, assistance
with the management of the business of the Company is provided by PaineWebber
ILM Advisor, L.P. (the "Advisor"), a limited partnership comprised of ILM REIT
Advisor, Inc., a Virginia corporation, and Properties Associates, L.P. ("PA"), a
Virginia limited partnership. ILM REIT Advisor, Inc. is a wholly owned
subsidiary of PaineWebber Properties Incorporated ("PWPI"). In addition, the
limited partners and holders of certain assignee interests of PA are or have
been also officers of PWPI. PWPI is a wholly owned subsidiary of PaineWebber
Incorporated ("PWI"). PWI is a wholly owned subsidiary of PaineWebber Group
Inc., ("PaineWebber").
For its services in finding and recommending investments, PWPI received a
mortgage placement fee equity to 2% of the capital contributions of the company.
Mortgage placement fees totalling $1,036,248 were earned by PWPI during the
Company's investment acquisition period. In connection with construction loans,
a construction loan administration fee of 1% of each construction loan was paid
by AHC to PWPI or its affiliates for administering such loan. In connection with
acquisition loans, a due diligence fee of 1% of the principal amount of each
such loan was paid by AHC to PWPI for conducting due diligence activities. Loan
administration and due diligence fees totalling $425,141 were paid to PWPI
during the Company's investment acquisition period.
AHC received an investment fee for providing the Company with the
opportunity to invest the available proceeds of the offering in loans. The
investment fee is an amount equal to 0.75% of the offering proceeds, and was
payable on the date of the Initial Closing. Investment fees earned by AHC
totalled $388,603.
AHC received a research and analysis fee in connection with the offering
equal to 1% of the capital contributions for identifying and analyzing
development and acquisition opportunities for Senior Housing Facilities and for
reimbursements of certain expenses associated with those activities. The
research and analysis fee paid to AHC totalled $518,123.
The Advisor will be entitled to receive 1% of Disposition Proceeds, as
defined, until the shareholders have received dividends of Net Cash equal to
their Adjusted Capital Investments, as defined, plus a 12% non-compounded annual
return on their Adjusted Capital Investments; all Disposition Proceeds
thereafter until the Advisor has received an aggregate of 5% of Disposition
Proceeds; and, thereafter, 5% of Disposition Proceeds.
Under the Advisory Agreement, the Advisor has specific management
responsibilities; to perform day-to-day operations of the Company and to act as
the investment advisor and consultant for the Company in connection with general
policy and investment decisions. The Advisor will receive an annual Base Fee and
an Incentive Fee of 0.25% and 0.25%, respectively, of the capital contributions
of the Company, as defined, as compensation for such services. Incentive Fees
are subordinated to shareholders' receipt of distributions of net cash
sufficient to provide a return equal to 10% per annum. The Advisor earned base
management fees totalling $130,000 for the year ended August 31, 1996. Payment
of incentive management fees was suspended effective April 15, 1993 in
conjunction with a reduction in the Company's quarterly dividend payments.
The Advisor and its affiliates are reimbursed for their direct expenses
relating to the offering of Shares, the administration of the Company and the
acquisition and operations of the Company's real estate investments.
An affiliate of the Advisor performs certain accounting, tax preparation,
securities law compliance and investor communications and relations services for
the Company. Total costs incurred by this affiliate in providing these services
are allocated among several entities, including the Company. Included in general
and administrative expenses on the accompanying statement of income for the year
ended August 31, 1996 is $107,000, representing reimbursements to this affiliate
for providing such services to the Company.
Mitchell Hutchins Institutional Investors, Inc. ("Mitchell Hutchins")
provides cash management services with respect to the Company's cash assets.
Mitchell Hutchins is a subsidiary of Mitchell Hutchins Asset Management, Inc.,
an independently operated subsidiary of PaineWebber. Mitchell Hutchins earned
$6,000 (included in general and administrative expenses) for managing the
Company's cash assets during fiscal 1996. Fees charged by Mitchell Hutchins are
based on a percentage of invested cash reserves which varies based on the total
amount of invested cash which Mitchell Hutchins manages on behalf of PWPI.
<PAGE>
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as part of this report:
(1) and (2) Financial Statements and Schedules:
The response to this portion of Item 14 is submitted as a
separate section of this report. See Index to Financial
Statements and Financial Statement Schedules at page F-1.
(3) Exhibits:
The exhibits listed on the accompanying index to exhibits at
page IV-3 are filed as part of this Report.
(b) The Company filed a Current Report on Form 8-K dated July 29, 1996
reporting the termination by ILM II Lease Corporation of the property
management agreement with Angeles Housing Concepts, Inc. and the
retention of Capital Senior Management 2, Inc. as the new property
manager.
(c) Exhibits:
See (a)(3) above.
(d) Financial Statement Schedules:
The response to this portion of Item 14 is submitted as a
separate section of this report. See Index to Financial
Statements and Financial Statement Schedules at page F-1.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
PAINEWEBBER INDEPENDENT
LIVING MORTGAGE INC. II
By: /s/ Lawrence A. Cohen
----------------------
Lawrence A. Cohen
President and Chief Executive
Officer
By: /s/ Walter V. Arnold
---------------------
Walter V. Arnold
Senior Vice President and
Chief Financial Officer
(additionally functioning as
chief accounting officer)
Dated: December 13, 1996
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Company in the
capacity and on the dates indicated.
By:/s/ Lawrence A. Cohen Date:December 13, 1996
-------------------------------- -----------------
Lawrence A. Cohen
Director
By:/s/ Jeffry R. Dwyer Date:December 13, 1996
-------------------------------- -----------------
Jeffry R. Dwyer
Director
By:/s/ J. William Sharman, Jr. Date:December 13, 1996
------------------------------- -----------------
J. William Sharman, Jr.
Director
By:------------------------------- Date:-----------------
Carl J. Schramm
Director
By:------------------------------ Date:-----------------
Julien G. Redele'
Director
<PAGE>
ANNUAL REPORT ON FORM 10-K
Item 14(a)(3)
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
INDEX TO EXHIBITS
Page Number in the
Exhibit No. Description of Document Report or Other Reference
- ------------ ----------------------------------- ------------------------
(3) and (4) Prospectus of the Registrant Filed with the
dated Commission pursuant to
August 8, 1990, as supplemented, Rule 424(c) and
with particular reference to the incorporated herein by
Restated Certificate and reference.
Agreement of Limited Partnership.
(10) Material contracts previously Filed with the
filed as exhibits to registration Commission pursuant
statements and amendments thereto to Section 13 or
of the registrant together with 15(d) of the
all such contracts filed as Securities Exchange
exhibits of previously filed Act of 1934 and
Forms 8-K and Forms 10-K are incorporated herein
hereby incorporated herein by by reference.
reference.
Contracts regarding retention by Filed as Exhibits 1
ILM II Lease Corporation of and 2 to the Current
Capital Senior Management 2, Report on Form 8-K
Inc., as property manager. dated July 29, 1996
and incorporated
herein by reference.
(13) Annual Reports to Stockholders No Annual Report for
the year ended August
31, 1996 has been
sent to the
Stockholders. An
Annual Report will be
sent to the
Stockholders
subsequent to this
filing.
(27) Financial Data Schedule Filed as the last
page of EDGAR
submission following
the Financial
Statements and
Financial Statement
Schedule required by
Item 14.
<PAGE>
ANNUAL REPORT ON FORM 10-K
Item 14(a)(1) and (2) and 14(d)
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
Reference
PaineWebber Independent Living Mortgage Inc. II:
Report of independent auditors F-2
Consolidated balance sheets as of August 31, 1996 and 1995 F-3
Consolidated statements of income for the years ended
August 31, 1996, 1995 and 1994 F-4
Consolidated statements of changes in shareholders' equity
for the years ended August 31, 1996, 1995 and 1994 F-5
Consolidated statements of cash flows for the years ended
August 31, 1996, 1995 and 1994 F-6
Notes to consolidated financial statements F-7
Schedule III - Real Estate and Accumulated Depreciation F-18
Other schedules have been omitted since the required information is not
present or not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the consolidated
financial statements, including the notes thereto.
<PAGE>
REPORT OF INDEPENDENT AUDITORS
The Shareholders of
PaineWebber Independent Living Mortgage Inc. II:
We have audited the accompanying consolidated balance sheets of PaineWebber
Independent Living Mortgage Inc. II as of August 31, 1996 and 1995, and the
related consolidated statements of income, changes in shareholders' equity, and
cash flows for each of the three years in the period ended August 31, 1996. Our
audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
PaineWebber Independent Living Mortgage Inc. II at August 31, 1996 and 1995, and
the consolidated results of its operations and its cash flows for each of the
three years in the period ended August 31, 1996, in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
/S/ERNST & YOUNG LLP
ERNST & YOUNG LLP
Boston, Massachusetts
December 10, 1996
<PAGE>
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
CONSOLIDATED BALANCE SHEETS
August 31, 1996 and 1995
(In thousands, except per share amounts)
ASSETS
1996 1995
---- ----
Operating investment properties, at cost:
Land $ 5,030 $ 5,030
Building and improvements 28,946 28,843
Furniture, fixtures and equipment 3,765 3,765
--------- ---------
37,741 37,638
Less: accumulated depreciation (6,005) (4,736)
--------- ---------
31,736 32,902
Cash and cash equivalents 1,694 2,409
Interest and other receivables 181 46
Accounts receivable - related party 225 74
Prepaid expenses and other assets 9 121
Deferred rent receivable 131 -
--------- ---------
$ 33,976 $ 35,552
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Accounts payable and accrued expenses $ 68 $ 615
Accounts payable - affiliates 32 57
--------- ---------
Total liabilities 100 672
Shareholders' equity:
Common stock, $0.01 par value,
12,500,000 shares authorized,
5,181,236 shares issued and outstanding 52 52
Additional paid-in capital (net of offering costs) 44,823 44,823
Accumulated deficit (10,999) (9,995)
--------- --------
Total shareholders' equity 33,876 34,880
--------- --------
$ 33,976 $ 35,552
========= ========
See accompanying notes.
<PAGE>
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
CONSOLIDATED STATEMENTS OF INCOME
For the years ended August 31, 1996, 1995 and 1994
(In thousands, except per share amounts)
1996 1995 1994
---- ---- ----
Revenues:
Rental and other income $ 4,004 $ 11,789 $ 10,863
Interest income earned
on cash equivalents 58 87 74
-------- -------- --------
4,062 11,876 10,937
Expenses:
Property management fees - 644 598
Property operating expenses - 7,446 7,062
Depreciation and amortization 1,269 1,313 1,254
Management and advisory fees 130 213 130
General and administrative 294 250 270
Insurance expense 20 27 32
Professional fees 238 528 379
Director compensation 24 24 24
-------- -------- --------
1,975 10,445 9,749
-------- -------- --------
Net income $ 2,087 $ 1,431 $ 1,188
======== ======== ========
Earnings per share of common stock $0.40 $ 0.27 $0.23
===== ====== =====
Cash dividends paid per share
of common stock $0.50 $ 0.43 $0.40
===== ====== =====
The above earnings and cash dividends paid per share of common stock are
based upon the 5,181,236 shares outstanding during each year.
See accompanying notes.
<PAGE>
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the years ended August 31, 1996, 1995 and 1994
(In thousands, except per share amounts)
Common Stock Additional
$.01 Par Value Paid-in Accumulated
Shares Amount Capital Deficit Total
------ ------ ------- ------- -----
Shareholders' equity
at August 31, 1993 5,181,236 $ 52 $44,823 $ (8,764) $36,111
Cash dividends paid - - - (2,072) (2,072)
Net income - - - 1,188 1,188
---------- ------ ------- ------- -------
Shareholders' equity
at August 31, 1994 5,181,236 52 44,823 (9,648) 35,227
Cash dividends paid - - - (2,202) (2,202)
Net income - - - 1,431 1,431
Adjustment to
eliminate reporting
lag for combined
facilities'
operations (Note 4) - - - 424 424
--------- ------ ------- ------- --------
Shareholders' equity
at August 31, 1995 5,181,236 52 44,823 (9,995) 34,880
Cash dividends paid - - - (2,591) (2,591)
Distribution of
stock in ILM II
Lease Corporation
(Note 4) - - - (500) (500)
Net income - - - 2,087 2,087
--------- -------- --------- -------- --------
Shareholders' equity
at August 31, 1996 5,181,236 $ 52 $44,823 $(10,999) $ 33,876
========= ======= ======= ======== ========
See accompanying notes.
<PAGE>
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended August 31, 1996, 1995 and 1994
Increase (Decrease) in Cash and Cash Equivalents
(In thousands)
1996 1995 1994
---- ---- ----
Cash flows from operating activities:
Net income $ 2,087 $ 1,431 $ 1,188
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation and amortization 1,269 1,313 1,254
Changes in assets and liabilities:
Interest and other receivables (135) 125 (183)
Accounts receivable - related party (151) (74) -
Prepaid expenses and other assets 112 71 2,460
Deferred rent receivable (131) - -
Accounts payable - affiliates (25) (20) 45
Accounts payable and accrued
expenses (547) 178 (2,571)
------ -------- --------
Total adjustments 392 1,593 1,005
------ -------- --------
Net cash provided by operating
activities 2,479 3,024 2,193
Cash flows from investing activities:
Funding of initial working capital to
ILM II Lease Corporation (500) - -
Net proceeds from settlement of claims
with Angeles Corporation and
affiliates - 948 -
Additions to operating investment
properties (103) (1,200) (1,120)
------ -------- --------
Net cash used in investing
activities (603) (252) (1,120)
Cash flows from financing activities:
Cash dividends paid to shareholders (2,591) (2,202) (2,072)
------ ------- --------
Net cash used in financing
activities (2,591) (2,202) (2,072)
Net (decrease) increase in cash and
cash equivalents (715) 570 (999)
Net increase in cash and cash equivalents
to eliminate reporting lag of
combined facilities - 445 -
Cash and cash equivalents,
beginning of year 2,409 1,394 2,393
------- -------- --------
Cash and cash equivalents, end of year $ 1,694 $ 2,409 $ 1,394
======== ======== ========
Cash paid for state income taxes $ 3 $ 3 $ 3
======== ======== ========
See accompanying notes.
<PAGE>
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
Notes to Consolidated Financial Statements
1. Nature of Operations and Basis of Presentation
PaineWebber Independent Living Mortgage Inc. II (the "Company") was
organized as a corporation on February 5, 1990 under the laws of the State of
Virginia. On September 12, 1990, the Company commenced a public offering of
up to 10,000,000 shares of its common stock at $10 per share, pursuant to a
Registration Statement filed on Form S-11 under the Securities Act of 1933
(Registration Statement No. 33-33857). The public offering terminated on May
10, 1991 with a total of 5,181,236 shares issued. The Company received
capital contributions of $51,812,356, of which $200,000 represented the sale
of 20,000 shares to an affiliate, Paine Webber Group, Inc. ("PaineWebber").
As of November 1, 1996, PaineWebber and its affiliates held 123,527 shares of
the Company's common stock. The Company has elected to qualify and be taxed
as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of
1986, as amended, for each taxable year of operations (see Note 2).
The Company originally invested the net proceeds of the initial public
offering in six participating mortgage loans secured by Senior Housing
Facilities located in five different states. All of the loans made by the
Company were originally with Angeles Housing Concepts, Inc. ("AHC"), a
company specializing in the development, acquisition and operation of Senior
Housing Facilities. The Company entered into an Exclusivity Agreement with
AHC and its parent company, Angeles Corporation ("Angeles"), which required
AHC to provide the Company with certain specific opportunities to finance
Senior Housing Facilities and set forth the terms and conditions of the loans
which were made. The loan documents under the aforementioned Exclusivity
Agreement called for interest to be paid on construction loans at the rate of
13.3% per annum during the construction period and for Base Interest to be
paid on the permanent loans at the rate of 10.3% per annum. In addition to
the Base Interest, Additional Interest was to be payable on the permanent
loans in an amount equal to 10% of the Gross Revenues of the Senior Housing
Facilities, as defined. Under the terms of the amended Exclusivity Agreement,
Additional Interest was to be no less than 3% of the aggregate principal
amount of all permanent loans outstanding for the entire term of the
investments. In the aggregate, the properties securing loans from the Company
did not generate sufficient cash flow to cover the debt service payments owed
to the Company under the amended terms of the Exclusivity Agreement. To the
extent that the properties did not generate sufficient cash flow to make the
full payments due under the loan documents, the shortfall was funded by AHC
through December 1992. The source of cash to make up these shortfalls was
from specified deficit reserve accounts, which had been funded from the
proceeds of the mortgage loans, and from contributions by Angeles.
During the quarter ended February 28, 1993, Angeles announced that it was
experiencing liquidity problems that resulted in the inability to meet its
obligations. Subsequent to such announcements, AHC defaulted on the regularly
scheduled mortgage loan payments due to the Company on March 1, 1993.
Subsequent to March 1993, payments toward the debt service owed on the
Company's loans were limited to the net cash flow of the operating investment
properties. On May 3, 1993, Angeles filed for reorganization under a Chapter
11 Federal Bankruptcy petition filed in the state of California. AHC did not
file for reorganization. The Company retained special counsel and held
extensive discussions with AHC concerning the default status of its loans.
During the fourth quarter of fiscal 1993, a non-binding settlement agreement
between the Company, AHC and Angeles was reached whereby ownership of the
properties would be transferred from AHC to the Company or its designated
affiliates. Under the terms of the Settlement Agreement, the Company released
AHC and Angeles from certain obligations under the loans. On April 27, 1994,
each of the properties owned by AHC and securing the Loans was transferred
(collectively, "the Transfers") to newly-created special purpose corporations
affiliated with the Company (collectively, "the Property Companies"). The
Transfers had an effective date of April 1, 1994 and were made pursuant to
the Settlement Agreement entered into on February 17, 1994 ("the Settlement
Agreement") between the Company and AHC which had previously been approved by
the bankruptcy court handling the bankruptcy case of Angeles. All of the
capital stock of each Property Company was held by ILM II Holding, Inc. ("ILM
Holding"), a Virginia corporation. In August 1995, each of the Property
Companies merged into ILM Holding. As a result, ownership of the Senior
Housing Facilities is now held by ILM Holding, and the Property Companies no
longer exist as separate legal entities. The capital stock of ILM Holding is
owned by the Company and PWP Holding, Inc. ("PWP Holding"), a wholly-owned
subsidiary of PaineWebber Properties Incorporated ("PWPI"). PWPI is a wholly
owned subsidiary of PaineWebber Incorporated, which is a wholly owned
subsidiary of PaineWebber Group, Inc. ("PaineWebber").
The Company holds substantially all of the economic ownership in ILM
Holding, while PWP Holding holds voting control. ILM Holding issued 100
shares of Series A Preferred Stock to the Company in return for a capital
contribution in the amount of $495,000 and issued 10,000 shares of Common
Stock to PWP Holding in return for a capital contribution in the amount of
$5,000. The holders of the Series A Preferred Stock are entitled to one vote
for each share of Preferred Stock held. In addition, the holders of the
Series A Preferred Stock are entitled to receive, when and if declared by the
Board of Directors, dividends and distributions in an aggregate amount equal
to 99% of the total amount of dividends and distributions made to all
shareholders. The holders of the Common Stock are entitled to one vote for
each share of Common Stock held. The holders of the Common Stock are entitled
to receive, when and if declared by the Board of Directors, dividends and
distributions in an aggregate amount equal to 1% of the total amount of
dividends and distributions made to all shareholders. As part of the fiscal
1994 settlement agreement with AHC, ILM Holding retained AHC as the property
manager for all of the Senior Housing Facilities pursuant to the terms of a
management agreement. As discussed further in Note 5, the management
agreement with AHC was terminated in July 1996. Subsequent to the effective
date of the Settlement Agreement with AHC, management investigated and
evaluated the available options for structuring the ownership of the
properties in order to maximize the potential returns to the existing
shareholders while maintaining the Company's qualification as a REIT under
the Internal Revenue Code (see Note 2). As discussed further in Note 4, on
September 12, 1994 the Company formed a new subsidiary, ILM II Lease
Corporation, for the purpose of operating the Senior Housing Facilities. The
Senior Housing Facilities were leased to ILM II Lease Corporation effective
September 1, 1995 (see Note 4 for a description of the master lease
agreement).
The Company had accounted for its investments in mortgage loans as
investments in acquisition and construction loans from inception through
fiscal 1994 under the equity method because the loans met certain accounting
criteria which require that participating mortgage loans with certain
characteristics be accounted for as joint ventures. Such accounting criteria
are meant to apply to lending arrangements which have essentially the same
risks and potential rewards for the lender as would exist in a joint venture
partnership. Subsequent to the transfer of ownership of the Senior Housing
Facilities from AHC to ILM Holding and the initiation of the plans to master
lease the properties to a shareholder owned operating company, management of
the Company was deemed to have significant control over the operating
investment properties. As a result, the financial position, results of
operations and cash flows of ILM Holding, which has ownership title to the
properties, are presented on a consolidated basis with the Company beginning
in fiscal 1995. The fiscal 1994 financial statements have been restated to
present the combined Facilities on a consolidated basis in order for the
statements of income to be comparable. Such restatement does not affect the
net income or net shareholders' equity amounts previously reported. All
material intercompany balances and transactions have been eliminated in
consolidation. The Company's policy had been to record its equity in the
earnings or losses of the properties based on financial information of the
properties which was two months in arrears to that of the Company. As a
result of the restructuring of the property ownership discussed above, the
Company eliminated this reporting lag of the end of fiscal 1995 (see Note
4).
2. Use of Estimates and Summary of Significant Accounting Policies
The accompanying financial statements have been prepared on the accrual
basis of accounting in accordance with generally accepted accounting
principles which requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities as of August 31, 1996 and 1995 and
revenues and expenses for each of the three years in the period ended August
31, 1996. Actual results could differ from the estimates and assumptions
used.
<PAGE>
The Company's significant accounting policies are summarized as follows:
A. BASIS OF PRESENTATION
The operating cycle in the real estate industry is longer than one year
and the distinction between current and non-current is of little
relevance. Accordingly, the accompanying consolidated balance is
presented in an unclassified format.
B. INCOME TAXES
The Company has elected to qualify and to be taxed as a Real Estate
Investment Trust ("REIT") under the Internal Revenue Code of 1986, as
amended, for each taxable year of operations. As a REIT, the Company is
allowed a deduction for the amount of dividends paid to its shareholders,
thereby effectively subjecting the distributed net taxable income of the
Company to taxation at the shareholder level only, provided it
distributes at least 95% of its taxable income and meets certain other
requirements for qualifying as a real estate investment trust. In
connection with the settlement agreement described in Note 1, the
Company, through its consolidated affiliate, obtained title to the
properties securing its mortgage loan investments. To retain REIT status,
the Company must ensure that 75% of its annual gross income is received
from qualified sources. Under the original investment structure, interest
income from the Company's mortgage loans was a qualified source. The
properties that are now owned by an affiliate of the Company are Senior
Housing Facilities that provide tenants with more services, such as
meals, activities, assisted living, etc., than are customary for ordinary
residential apartment properties. As a result, a significant portion of
the rents paid by the tenants includes income for the increased level of
services received by them. Consequently, the rents paid by the tenants
likely would not be qualified rents for REIT qualification purposes if
received directly by the Company. Therefore, if the Company received such
rents directly, it could lose REIT status and be taxed as a regular
corporation. After extensive review, the Board of Directors determined
that it would be in the best interests of the shareholders for the
Company to retain REIT status and master lease the properties to a
shareholder-owned operating company. As discussed further in Note 4, on
September 12, 1994 the Company formed a new subsidiary, ILM II Lease
Corporation, for the purpose of operating the Senior Housing Facilities.
The Senior Housing Facilities were leased to ILM II Lease Corporation
effective September 1, 1995 (see Note 4 for a description of the master
lease agreement).
The assumption of ownership of the properties through ILM Holding, which
is presently a regular C corporation for tax purposes, has resulted in a
possible future tax liability which would be payable upon the ultimate
sale of the properties (the "built-in gain tax"). The amount of such tax
would be calculated based on the lesser of the total net gain realized
from the sale transaction or the portion of the net gain realized upon a
final sale which is attributable to the period during which the
properties were held by in a C corporation. The final phase of the
Company's restructuring plans involves the conversion of ILM Holding to a
REIT for tax purposes. Certain changes to the ownership structure of ILM
Holding which are necessary in order for ILM Holding to qualify as a REIT
under the Internal Revenue Code are expected to be made in time for ILM
Holding to elect REIT status in conjunction with the filing of its
calendar 1996 federal tax return. Any future appreciation in the value of
the Senior Housing Facilities subsequent to the conversion of ILM Holding
to a REIT would not be subject to the built-in gain tax. The built-in
gain tax would most likely not be incurred if the properties were to be
held for a period of at least 10 years from the date of the conversion of
ILM Holding to a REIT. However, since the end of the Company's original
anticipated holding period is less than 5 years away, the properties are
not expected to be held for an additional 10 years. The Board of
Directors may defer the Company's scheduled liquidation date, if in the
opinion of a majority of the Directors, the disposition of the Company's
assets at such time would result in a material under-realization of the
value of such assets; provided, however, that no such deferral may extend
beyond December 31, 2005. Based on management's current estimate of the
increase in the values of the properties which has occurred since April
1994, as supported by independent appraisals, ILM Holding would incur a
sizable tax if the properties were sold. Based on these current estimated
market values of the operating investment properties, a sale at such
values prior to the end of the 10-year holding period could result in a
built-in gain tax of as much as $2.3 million. As the holder of a 99%
economic interest in ILM Holding, the burden of this built-in gain tax
would be primarily borne by the Company.
The Company's consolidated affiliate, ILM Holding, has incurred losses
for tax purposes since inception. Neither the Company nor ILM Holding is
likely to be able to use these losses to offset future tax liabilities.
Accordingly, no income tax benefit is reflected in these consolidated
financial statements.
The Company reports on a calendar year basis for income tax purposes.
During calendar 1995, the Company distributed $0.45 per share in cash and
$0.14 per share in shares of ILM II Lease Corporation. The tax status of
these dividends amounted to an ordinary taxable dividend of approximately
$0.41 per share and a tax free return of capital of approximately $0.18
per share. The Company anticipates that all distributions during calendar
1996 will be ordinary taxable dividends.
C. CASH AND CASH EQUIVALENTS
For purposes of reporting cash flows, cash and cash equivalents include
all highly liquid investments with original maturities of 90 days or
less.
D. OPERATING INVESTMENT PROPERTIES
Operating investment properties are carried at the lower of cost,
reduced by accumulated depreciation, or net realizable value. The net
realizable value of a property held for long-term investment purposes is
measured by the recoverability of the owner's investment through
expected future cash flows on an undiscounted basis, which may exceed
the property's current market value. The net realizable value of a
property held for sale approximates its current market value, as
determined on a discounted basis. None of the operating investment
properties were held for sale as of August 31, 1996 or 1995.
Depreciation expense is provided on a straight-line basis using an
estimated useful life of 40 years for the buildings and improvements and
5 years for the furniture, fixtures and equipment.
The Company has reviewed FAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets To Be Disposed Of," which is
effective for financial statements for years beginning after December
15, 1995, and believes this new pronouncement will not have a material
effect on the Company's financial statements.
E. RENTAL REVENUES
Rental revenues on the accompanying income statements reflect the rental
income received by the Company's consolidated affiliate, ILM Holding. In
fiscal 1995 and 1994 this rental income consisted of payments due on the
individual tenant leases at the Senior Housing Facilities. Units at the
Facilities are generally rented for terms of twelve months or less. The
base rent charged varies depending on the unit size, with added fees
collected for more than one occupant per unit and for assisted living
services. Included in the amount of base rent charged are certain meals,
housekeeping, medical and social services provided to the residents of
each Facility. In fiscal 1996, rental revenues consist of payments due
from ILM II Lease Corporation under the terms of the master lease
described in Note 4. Base rental income under the master lease is
recognized on a straight-line basis over the term of the lease. Deferred
rent receivable on the balance sheet as of August 31, 1996 represents
the difference between rental income on a straight-line basis and rental
income received under the terms of the master lease
F. OFFERING COSTS
Offering costs consist primarily of selling commissions and other costs
such as printing and mailing costs, legal fees, filing fees and other
marketing costs associated with the offering of shares. Selling
commissions were equal to 8% of the gross proceeds raised through the
public offering. Commissions totalling $4,120,000 were paid to PWI in
connection with the sale of shares. All of the offering costs are shown
as a reduction of shareholders' equity.
G. FAIR VALUE DISCLOSURES
FASB Statement No. 107, "Disclosures about Fair Value of Financial
Instruments" ("SFAS 107"), requires disclosure of fair value information
about financial instruments, whether or not recognized in the balance
sheet, for which it is practicable to estimate that value. In cases
where quoted market prices are not available, fair values are based on
estimates using present value or other valuation techniques. SFAS 107
excludes certain financial instruments and all nonfinancial instruments
from its disclosure requirements. Accordingly, the aggregate fair value
amounts presented do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in
estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amount reported on the balance
sheet for cash and cash equivalents approximates its fair value due to
the short-term maturities of such instruments.
Accounts receivable - related party: The carrying amount reported on the
balance sheet for accounts receivable - related party approximates its
fair value due to the short-term maturity of such instrument.
3. The Advisory Agreement and Related Party Transactions
Subject to the supervision of the Company's Board of Directors, the
business of the Company is managed by PaineWebber ILM Advisor, L.P. (the
"Advisor"), a limited partnership comprised of ILM REIT Advisor, Inc., a
Virginia corporation, and Properties Associates, L.P. ("PA"), a Virginia
limited partnership. ILM REIT Advisor, Inc. is a wholly owned subsidiary of
PaineWebber Properties Incorporated ("PWPI"). In addition, the limited
partners and holders of assignee interest of PA are or have been officers of
PWPI. PWPI is a wholly owned subsidiary of PaineWebber Incorporated ("PWI").
PWI is a wholly owned subsidiary of PaineWebber Group, Inc. ("PaineWebber").
The Advisor and its affiliates receive fees and compensation determined
on an agreed-upon basis, in consideration of various services performed in
connection with the sale of the shares, the management of the Company and
the acquisition, management and disposition of the Company's investments.
The type of compensation to be paid by the Company to the Advisor and its
affiliates under the terms of the Advisory Agreement is as follows.
(i)Under the Advisory Agreement, the Advisor has specific management
responsibilities; to perform day-to-day operations of the Company and to
act as the investment advisor and consultant for the Company in
connection with general policy and investment decisions. The Advisor will
receive an annual Base Fee and an Incentive Fee of 0.25% and 0.25%,
respectively, of the capital contributions of the Company, as defined, as
compensation for such services. Incentive Fees are subordinated to
shareholders' receipt of distributions of net cash sufficient to provide
a return equal to 10% per annum. The Advisor earned base management fees
totalling $130,000 for each of the years ended August 31, 1996, 1995 and
1994. Payment of incentive management fees was suspended effective April
15, 1993 in conjunction with a reduction in the Company's quarterly
dividend payments.
(ii) For its services in finding and recommending investments, PWPI received
mortgage placement fees equal to 2% of the capital contributions.
Mortgage placement fees totalling $1,036,000 were earned by PWPI during
the Company's investment acquisition period. Such fees have been
capitalized and are included in the cost of the operating investment
properties on the accompanying consolidated balance sheets.
(iii) For its administrative services with respect to all loans, PWPI
received, directly from AHC, construction loan administration or due
diligence fees equal to 1% of the loan amounts. Loan administration and
due diligence fees totalling $425,141 were earned by PWPI during the
Company's investment due diligence period.
(iv) The Advisor will be entitled to receive 1% of Disposition Proceeds, as
defined, until the shareholders have received dividends of Net Cash equal
to their Adjusted Capital Investments, as defined, plus a 12%
non-compounded annual return on their Adjusted Capital Investments; all
Disposition Proceeds thereafter until the Advisor has received an
aggregate of 5% of Disposition Proceeds; and, thereafter, 5% of
Disposition Proceeds.
AHC received a research and analysis fee in connection with the offering
equal to 1% of the capital contributions for identifying and analyzing
development and acquisition opportunities for Senior Housing Facilities and
for reimbursements of certain expenses associated with those activities. The
research and analysis fee paid to AHC totalled $518,123 and is included in
offering costs on the accompanying consolidated balance sheets.
AHC received an investment fee for providing the Company with the
opportunity to invest the available proceeds of the offering in loans. The
investment fee is an amount equal to 0.75% of the offering proceeds, and was
payable on the date of the Initial Closing. AHC earned investment fees
totalling $388,603 which are included in the cost of the operating
investment properties on the accompanying consolidated balance sheets.
Included in management and advisory fees for the year ended August 31,
1995 are advisory fees of $83,000 earned by an affiliate of PWPI for its
administration and supervision of the day-to-day operations of ILM Holding.
Such fees were equal to 0.5% of the Gross Operating Revenues of the Senior
Housing Facilities. These advisory fees were no longer charged to ILM
Holding effective September 1, 1995 upon the commencement of the master
lease described in Note 4.
The Advisor and its affiliates are reimbursed for their direct expenses
relating to the offering of Shares, the administration of the Company and
the acquisition and operations of the Company's real estate investments.
Included in general and administrative expenses on the accompanying
statements of income for the years ended August 31, 1996, 1995 and 1994 is
$107,000, $121,000 and $133,000, respectively, representing reimbursements
to an affiliate of the Advisor for providing certain financial, accounting
and investor communication services to the Company.
Mitchell Hutchins Institutional Investors, Inc. ("Mitchell Hutchins")
provides cash management services with respect to the Company's cash assets.
Mitchell Hutchins is a subsidiary of Mitchell Hutchins Asset Management,
Inc., an independently operated subsidiary of PaineWebber. Mitchell Hutchins
earned $6,000, $3,000 and $8000 (included in general and administrative
expenses) for managing the Company's cash assets during fiscal 1996, 1995
and 1994, respectively.
Accounts receivable - related party at August 31, 1996 represents
advances made to an affiliated company, ILM II Lease Corporation, primarily
for the purchase of personal property to operate the Senior Housing
Facilities. Accounts receivable - related party at August 31, 1995 consists
primarily of amounts due from an affiliated company for disbursements made
by the Company on behalf of its affiliate related to the Villa Santa Barbara
Facility, which is jointly owned.
Accounts payable - affiliates at August 31, 1996 consists of management
fees of $32,000 owed to the Advisor for the quarter ended August 31, 1996.
Accounts payable - affiliates at August 31, 1995 includes management fees of
$32,000 owed to the Advisor for the quarter ended August 31, 1995 and
$25,000 payable to an affiliate of PWPI for providing advisory services to
ILM Holding.
4. Operating Investment Properties Subject to Master Lease
As of August 31, 1996 and 1995, the Company, through its consolidated
affiliate, owned six Senior Housing Facilities. The name, location and size
of the properties and the date that the Company made its initial investment
in such assets are as set forth below:
Date of
Name Location Rentable Units Investment (1)
---- -------- -------------- --------------
The Palms Fort Myers, FL 204 Units 7/18/90
Crown Villa Omaha, NE 73 Units 4/25/91
Overland Park Place Overland Park, KS 137 Units 4/9/92
Rio Las Palmas Stockton, CA 162 Units 5/14/92
The Villa at St. Louis County, MO 119 Units 5/29/92
Riverwood
Villa Santa Barbara, CA 123 Units 7/13/92
Santa Barbara (2)
(1)Represents the date of the Company's original mortgage loan to Angeles
Housing Concepts, Inc. (see Note 1).
(2)The acquisition of the Santa Barbara Facility was financed jointly by
the Company and an affiliated entity, PaineWebber Independent Living
Mortgage Fund, Inc. ("ILM1"). All amounts generated from the operations
of Villa Santa Barbara are equitably apportioned between the Company,
together with its consolidated affiliate, and ILM1, together with its
consolidated affiliate, generally 75% and 25%, respectively. The
financial position, results of operations and cash flows presented in
these consolidated financial statements include only the 75% allocable
portion of the Company's interest in the Santa Barbara Facility.
The cost basis of the operating investment properties on the
accompanying consolidated balance sheets reflects the amounts funded under
the Company's participating mortgage loans less certain guaranty payments
received from AHC in excess of the net cash flow of the Facilities under the
terms of the Exclusivity Agreement with the Company. The transfer of
ownership of the Senior Housing Facilities from AHC in fiscal 1994 resulted
in no gain or loss recognition by the Company for financial reporting
purposes. As discussed in Note 1, in accordance with generally accepted
accounting principles, the Company had always accounted for its investments
in acquisition and construction loans under the equity method, as if such
investments were equity interests in a joint venture. Accordingly, the
carrying values of such investments were reduced from inception by non-cash
depreciation charges and by payments from AHC, prior to the default in
fiscal 1993, in excess of the net cash flow generated by the Senior Housing
Facilities received pursuant to the guaranty agreement between the Company
and AHC. As a result of this accounting treatment, the carrying values of
the Company's investments had been reduced below management's estimate of
the fair market value of the Senior Housing Facilities as of the effective
date of the transfer of ownership. For federal income tax purposes, the
investments had always been carried at the contractually stated principal
balances of the participating mortgage loans. For tax purposes only, a loss
was recognized by the Company in 1994 in the amount by which the stated
principal balances of the loans were reduced as of the date of the transfer
of ownership.
<PAGE>
As discussed in Note 1, effective April 1, 1994 each Property Company
acquired the respective operating property subject to, and assumed the
obligations, under the mortgage loan payable to the Company, pursuant to the
Settlement Agreement with AHC. The principal balance on each loan was
modified to reflect the estimated fair value of the related operating
property as of the date of the transfer of ownership. The modified loans
require interest-only payments on a monthly basis at a rate of 7% from April
1, 1994 through December 1, 1994, 9% for the period from January 1 through
December 31, 1995, 11% for the period January 1 through December 31, 1996,
12% for the period January 1 through December 31, 1997, 13% for the period
January 1 through December 31, 1998, 13.5% for the period January 1, 1999
through December 31, 1999 and 14% for the period January 1, 2000 through
maturity. In August 1995, each of the Property Companies was merged into ILM
Holding. As a result, ownership of the Senior Housing Facilities, as well as
the obligation under the loans, is now held by ILM Holding, and the Property
Companies no longer exist as separate legal entities. Since ILM Holding is
consolidated with the Company in the accompanying financial statements, the
mortgage loans and related interest expense have been eliminated in
consolidation.
Subsequent to the effective date of the Settlement Agreement with AHC,
in order to maximize the potential returns to the existing shareholders
while maintaining the Company's qualification as a REIT under the Internal
Revenue Code, the Company formed a new corporation, ILM II Lease
Corporation, for the purpose of operating the Senior Housing Facilities
under the terms of a master lease agreement. As of August 31, 1995, ILM II
Lease Corporation, which is taxable as a regular C Corporation and not as a
REIT, was a wholly-owned subsidiary of the Company. On September 1, 1995,
after the Company received the required regulatory approval, it distributed
all of the shares of capital stock of ILM II Lease Corporation to the
holders of record of the Company's common stock. One share of common stock
of ILM II Lease Corporation was issued for each full share of the Company's
common stock held. Prior to the distribution, the Company capitalized ILM II
Lease Corporation with $500,000 from its existing cash reserves, which was
an amount estimated to provide ILM II Lease Corporation with necessary
working capital. The master lease agreement, which commenced on September 1,
1995, is between the Company's consolidated affiliate, ILM Holding, as owner
of the properties and Lessor, and ILM II Lease Corporation as Lessee. The
master lease is a "triple-net" lease whereby the Lessee pays all operating
expenses, governmental taxes and assessments, utility charges and insurance
premiums, as well as the costs of all required maintenance, personal
property and non-structural repairs in connection with the operation of the
Senior Housing Facilities. ILM Holding, as the Lessor, is responsible for
all major capital improvements and structural repairs to the Senior Housing
Facilities. During the initial term of the master lease, which expires on
December 31, 2000 (December 31, 1999 with respect to the Santa Barbara
Facility). The Lessor has the right to terminate the master lease as to any
property sold by the Lessor as of the date of such sale. During the initial
term of the master lease, ILM II Lease Corporation is obligated to pay
annual base rent for the use of all of the Facilities in the aggregate
amount of $3,548,700 for calendar year 1995 (prorated based on the
commencement date of the lease) and $4,035,600 for calendar year 1996 and
each subsequent year. Beginning in January 1997 and for the remainder of the
lease term, ILM II Lease Corporation will also be obligated to pay variable
rent for each Facility. Such variable rent will be payable quarterly and
will equal 40% of the excess, if any, of the aggregate total revenues for
the Facilities, on an annualized basis, over $13,021,000.
For fiscal 1996, rental income on the accompanying income statement
reflects the rental payments due under the terms of the master lease
agreement. For fiscal 1995 and fiscal 1994, rental income reflects the
rental payments due under the terms of the individual tenant leases.
Property operating expenses in the prior periods reflect the day-to-day
costs of operating the Facilities, including the management fees payable to
AHC, in addition to the real estate taxes associated with the ownership of
the operating properties. As noted above, under the terms of the master
lease all such costs are now the responsibility of the Lessee.
<PAGE>
The Company's policy had been to record its equity in the earnings or
losses of the properties based on financial information of the properties
which was two months in arrears to that of the Company. As a result of the
restructuring of the property ownership discussed in Note 1, the Company
decided to eliminate this reporting lag as of the end of fiscal 1995.
Summarized operations of the six operating investment properties for the
two-month period ended August 31, 1995, are as follows (in thousands):
1995
----
Revenues $ 2,036
Property management fees 113
Property operating expenses 1,303
Depreciation expense 196
--------
1,612
--------
Net income $ 424
========
Earnings per share of common stock $ 0.08
======
5. Legal Proceedings and Contingencies
Angeles Corporation Litigation
------------------------------
Angeles had guaranteed certain of the obligations of AHC under the terms
of the Exclusivity Agreement described in Note 1. Under the terms of the
Settlement Agreement discussed in Note 1, the Company retained a general
unsecured claim against Angeles in the amount of $1,200,658 as part of the
bankruptcy proceedings, but waived all other claims against Angeles,
including any amounts of base and additional interest owed. In addition, the
Company maintained a claim for approximately $408,000 against an affiliate of
Angeles which had made a separate guaranty to the Company. On March 17, 1995,
the Bankruptcy Court handling the Angeles bankruptcy proceedings approved a
final settlement of the Company's outstanding claims against Angeles and its
affiliates. Pursuant to the terms of this settlement, the Company received a
cash payment of $1 million on April 14, 1995 in full satisfaction of the
claims, which totalled approximately $1.6 million. This amount, net of
certain related legal expenses, was recorded as a reduction in the carrying
values of the Company's operating investment properties.
Termination of Management Contract with AHC
-------------------------------------------
On July 29, 1996, ILM II Lease Corporation and ILM II Holding, Inc. ("the
Companies") terminated the property management agreement with AHC covering
the six senior housing facilities leased by ILM II Lease Corporation from ILM
Holding, the Company's consolidated affiliate. The management agreement was
terminated for cause pursuant to Sections 1.05 (a) (i), (iii) and (iv) of the
agreement. Simultaneously with the termination of the management agreement,
the Companies, together with certain affiliated entities, filed suit against
AHC in the United States District Court for the Eastern District of Virginia
for breach of contract, breach of fiduciary duty and fraud. ILM II Lease
Corporation and ILM Holding allege that AHC willfully performed actions
specifically in violation of the management agreement and that such actions
caused damages to the Companies. Due to the termination of the agreement for
cause, no termination fee was paid to AHC. Subsequent to the termination of
the management agreement, AHC filed for protection under Chapter 11 of the
U.S. Bankruptcy Code in its domestic state of California. The filing was
challenged by the Companies, and the Bankruptcy Court dismissed AHC's case
effective October 15, 1996. In November 1996, AHC filed with the Virginia
District Court an Answer in response to the litigation initiated by the
Companies and a Counterclaim against ILM Holding. The Counterclaim alleges
that the management agreement was wrongfully terminated for cause and
requests damages which include the payment of the termination fee in the
amount of $750,000, payment of management fees pursuant to the contract from
August 1, 1996 through October 15, 1996, which is the earliest date that the
management agreement could have been terminated without cause, and recovery
of attorney's fees and expenses. PaineWebber Independent Living Mortgage Inc.
II guaranteed the payment of the termination fee at issue in these
proceedings. The Companies intend to diligently prosecute the case and to
vigorously defend the counterclaims made by AHC. The eventual outcome of this
termination dispute cannot presently be determined. Accordingly, no provision
for any liability which might result from the Company's guaranty of the
termination fee has been recorded in the accompanying financial statements.
ILM II Lease Corporation has retained Capital Senior Management 2, Inc.
("Capital") of Dallas, Texas to be the new manager of the senior housing
facilities pursuant to a Management Agreement which commenced on July 29,
1996. Under the terms of the Agreement, Capital will earn a Base Management
Fee equal to 4% of the Gross Operating Revenues of the senior housing
facilities, as defined. Capital will also be eligible to earn an Incentive
Management Fee equal to 25% of the amount by which the average monthly Net
Cash Flow of the senior housing facilities, as defined, for the twelve month
period ending on the last day of each calendar month exceeds a specified Base
Amount. Each August 31, beginning on August 31, 1997, the Base Amount will be
increased annually based on the percentage increase in the Consumer Price
Index. PaineWebber Independent Living Mortgage Inc. II has guaranteed the
payment of all fees due to Capital under the terms of the Management
Agreement.
Shareholder Matters
-------------------
In November 1994, a series of purported class actions (the "New York
Limited Partnership Actions") were filed in the United States District Court
for the Southern District of New York concerning PaineWebber Incorporated's
sale and sponsorship of various limited partnership interests and common
stock, including the securities offered by the Company. The lawsuits were
brought against PaineWebber Incorporated and Paine Webber Group, Inc.
(together, "PaineWebber"), among others, by allegedly dissatisfied investors.
In March 1995, after the actions were consolidated under the title In re
PaineWebber Limited Partnership Litigation, the plaintiffs amended their
complaint to assert claims against a variety of other defendants, including
PaineWebber Properties Incorporated ("PWPI"), an affiliate of PaineWebber and
the parent company of the general partner of the Advisor to the Company. On
May 30, 1995, the court certified class action treatment of the claims
asserted in the litigation.
The amended complaint in the New York Limited Partnership Actions alleged
that, in connection with the sale of common stock of the Company, the
defendants (1) failed to provide adequate disclosure of the risks involved;
(2) made false and misleading representations about the safety of the
investments and the Company's anticipated performance; and (3) marketed the
Company to investors for whom such investments were not suitable. The
plaintiffs, who purported to be suing on behalf of all persons who invested
in the Company also alleged that following the issuance of the Company's
stock, the defendants misrepresented financial information about the
Company's value and performance. The amended complaint alleged that the
defendants violated the Racketeer Influenced and Corrupt Organizations Act
("RICO") and the federal securities laws. The plaintiffs sought unspecified
damages, including reimbursement for all sums invested by them in the
Company's stock, as well as disgorgement of all fees and other income derived
by PaineWebber from the Company. In addition, the plaintiffs also sought
treble damages under RICO.
In January 1996, PaineWebber signed a memorandum of understanding with the
plaintiffs in the class action outlining the terms under which the parties
have agreed to settle the case. Pursuant to that memorandum of understanding,
PaineWebber irrevocably deposited $125 million into an escrow fund under the
supervision of the United States District Court for the Southern District of
New York to be used to resolve the litigation in accordance with a definitive
settlement agreement and a plan of allocation. On July 17, 1996, PaineWebber
and the class plaintiffs submitted a definitive settlement agreement which
has been preliminarily approved by the court and provides for the complete
resolution of the class action litigation, including releases in favor of the
Company and the General Partner of the Advisor, and the allocation of the
$125 million settlement fund among investors in the various partnerships and
REITs at issue in the case. As part of the settlement, PaineWebber also
agreed to provide class members with certain financial guarantees relating to
some of the partnerships and REITs. The details of the settlement are
described in a notice mailed directly to class members at the direction of
the court. A final hearing on the fairness of the proposed settlement is
scheduled to continue in December 1996.
In February 1996, approximately 150 plaintiffs filed an action entitled
Abbate v. PaineWebber Inc. in Sacramento, California Superior Court against
PaineWebber Incorporated and various affiliated entities concerning the
plaintiffs' purchases of various limited partnership investments and REIT
stocks, including those offered by the Company. The complaint alleges, among
other things, that PaineWebber and its related entities committed fraud and
misrepresentation and breached fiduciary duties allegedly owed to the
plaintiffs by selling or promoting limited partnership and REIT investments
that were unsuitable for the plaintiffs and by overstating the benefits,
understating the risks and failing to state material facts concerning the
investments. The complaint seeks compensatory damages of $15 million plus
punitive damages. In September 1996, the court dismissed many of the
plaintiffs' claims as barred by applicable securities arbitration
regulations.
In June 1996, approximately 50 plaintiffs filed an action entitled
Bandrowski v. PaineWebber Inc. in Sacramento, California Superior Court
against PaineWebber Incorporated and various affiliated entities concerning
the plaintiff's purchases of various limited partnership interests and REIT
stocks, including those offered by the Company. The complaint is
substantially similar to the complaint in the Abbate action described above,
and seeks compensatory damages of $3.4 million plus punitive damages.
In July 1996, approximately 15 plaintiffs filed an action entitled Barstad
v. PaineWebber Inc. in Maricopa County, Arizona Superior Court against
PaineWebber Incorporated and various affiliated entities concerning the
plaintiffs' purchases of various limited partnership interests and REIT
stocks, including those offered by the Company. The complaint is
substantially similar to the complaint in the Abbate action described above,
and seeks compensatory damages of $752,000 plus punitive damages.
With respect to the Abbate, Bandrowski and Barstad actions described
above, the defendants' time to move against or answer the complaints has not
yet expired. In all cases, PaineWebber intends to vigorously contest the
allegations of the actions. However, the eventual outcome of this litigation
and the potential impact, if any, on the Company's shareholders cannot be
determined at the present time. Mediation hearings on the Abbate, Bandrowski
and Barstad actions are currently scheduled to be held in December 1996.
Under certain limited circumstances, pursuant to the Advisor Agreement
with the Advisor and other contractual obligations, PaineWebber affiliates
could be entitled to indemnification for expenses and liabilities in
connection with the shareholder litigation matters described above. However,
PaineWebber has agreed not to seek indemnification for any amounts it is
required to pay in connection with the settlement of the New York Limited
Partnership Actions. At the present time, neither PaineWebber nor management
can estimate the impact, if any, of any of the potential indemnification
claims on the Company's financial statements, taken as a whole. Accordingly,
no provision for any liability which could result from the eventual outcome
of these matters has been made in the accompanying financial statements.
6. Subsequent Events
On September 15, 1996, the Company's Board of Directors declared a
quarterly dividend for the quarter ended August 31, 1996. On October 14,
1996, a dividend of $0.125 per share of common stock, totalling $648,000, was
made to Shareholders of record as of September 30, 1996. On December 13,
1996, the Board of Directors declared a quarterly dividend for the quarter
ended November 30, 1996. On January 15, 1997, a dividend of $0.1625 per share
of common stock, totalling $842,000, will be made to shareholders of record
as of January 2, 1997.
<PAGE>
<TABLE>
Schedule III - Real Estate and Accumulated Depreciation
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION
August 31, 1996
(Amounts in thousands)
<CAPTION>
Costs
Capitalized Life on Which
(Removed) Depreciation
Initial Cost Subsequent to Gross Amount at Which Carried at in Latest
TO ILM (2) Acquisition End of Year Income
Buildings & Buildings & Buildings & Accumulated Date of Date Statement
Description Encumbrances(1) Land Improvements Improvements(3)Land Improvements Total Depreciation Construction Acquired is Computed
----------- --------------- ----- ----------- --------------- --- ------------ ---- ------------ ------------ -------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
CONGREGATE CARE FACILITIES:
Fort Myers, FL $ 8,700 $ 1,075 $ 11,233 $ (3,268) $ 1,058 $ 7,982 $ 9,040 $ 1,862 1988 7/18/90 5-40 yrs.
Omaha, NE 4,950 400 5,043 (1,054) 390 3,999 4,389 732 1992 4/25/91 5-40 yrs.
Overland Park,
KS 7,850 672 6,787 22 656 6,825 7,481 1,102 1984 4/9/92 5-40 yrs.
Stockton, CA 5,700 1,507 5,628 (443) 1,496 5,196 6,692 904 1988 5/14/92 5-40 yrs.
St. Louis County,
MO 5,850 292 4,488 74 280 4,574 4,854 785 1985 5/29/92 5-40 yrs.
Santa Barbara,
California 5,094 1,160 4,322 (197) 1,150 4,135 5,285 620 1979 7/13/92 5-40 yrs.
-------- ------- -------- -------- ------- ------- ------- -------
$ 38,144 $ 5,106 $ 37,501 $ (4,866) $ 5,030 $32,711 $37,741 $ 6,005
======== ======= ======== ======== ======= ======= ======= =======
(1) Encumbrances represent first mortgage loans between ILM Holding, as
mortgagor, and ILM, as mortgagee. Such loans are eliminated in
consolidation in the accompanying financial statements (see Note 4).
(2) Initial cost to ILM represents the aggregate advances made by ILM on
the loans secured by the Facilities which were made to AHC prior to
the default and foreclosure actions described in Notes 1 and 4 to the
Consolidated Financial Statements.
(3) Costs removed subsequent to acquisition reflect the guaranty payments
received by ILM from AHC under the terms on the Exclusivity Agreement
as discussed further in Notes 1 and 4 to the Consolidated Financial
Statements.
(4) The aggregate cost of real estate owned at August 31, 1996 for Federal
income tax purposes is approximately $38,872,000.
<PAGE>
Schedule III - Real Estate and Accumulated Depreciation (continued):
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION
August 31, 1996
(Amounts in thousands)
(5) Reconciliation of real estate owned:
1996 1995 1994
---- ---- ----
Balance at beginning of period $ 37,638 $ 37,247 $ 36,127
Acquisitions and improvements - 12 months ended 8/31/96 103 - -
Acquisitions and improvements - 12 months ended 6/30 - 1,200 1,120
Improvements - 2 months ended 8/31/95 - 139 -
Net proceeds from full satisfaction
of claims against Angeles Corporation
and affiliates - (948) -
---------- ---------- ---------
Balance at end of period $ 37,741 $ 37,638 $ 37,247
========== ========== =========
(6) Reconciliation of accumulated depreciation:
Balance at beginning of period $ 4,736 $ 3,233 $ 1,985
Depreciation expense - 12 months ended 8/31/96 1,269 - -
Depreciation expense - 12 months ended 6/30 - 1,307 1,248
Depreciation expense - 2 months ended 8/31/95 - 196 -
---------- ----------- ----------
Balance at end of period $ 6,005 $ 4,736 $ 3,233
=========== =========== ==========
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Partnership's audited financial statements for the year ended August 31, 1996
and is qualified in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1996
<PERIOD-END> AUG-31-1996
<CASH> 1,694
<SECURITIES> 0
<RECEIVABLES> 406
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 2,109
<PP&E> 37,741
<DEPRECIATION> (6,005)
<TOTAL-ASSETS> 33,976
<CURRENT-LIABILITIES> 100
<BONDS> 0
0
0
<COMMON> 44,875
<OTHER-SE> (10,999)
<TOTAL-LIABILITY-AND-EQUITY> 33,976
<SALES> 0
<TOTAL-REVENUES> 4,062
<CGS> 0
<TOTAL-COSTS> 1,975
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,087
<INCOME-TAX> 0
<INCOME-CONTINUING> 2,087
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,087
<EPS-PRIMARY> 0.40
<EPS-DILUTED> 0.40
</TABLE>
