================================================================================
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
_X_ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended February 28, 1998
OR
__ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
For the transition period from ____to____.
Commission File Number: 0-18249
ILM II SENIOR LIVING, INC.
--------------------------
(Exact name of registrant as specified in its charter)
Virginia 06-1293758
- ----------------------- -------------------
(State of organization) (I.R.S. Employer
Identification No.)
28 State Street, Suite 1100, Boston, MA 02109
- -------------------------------------------------------------------------------
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code (888) 257-3550
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
- -------------------- --------------------------
Shares of Common Stock None
Securities registered pursuant to Section 12(g) of the Act:
SHARES OF COMMON STOCK
----------------------
(Title of Class)
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 ___ No _X_
Shares of common stock outstanding as of February 28, 1998: 5,181,236.
================================================================================
Page 1 of 21
<PAGE>
ILM II SENIOR LIVING, INC.
--------------------------
INDEX
Part I. Financial Information
- -------------------------------
Item 1. Financial Statements
Consolidated Balance Sheets
February 28, 1998 (Unaudited) and August 31, 1997
Consolidated Statements of Income
For the three- and six-month periods ended February 28, 1998
and 1997 (Unaudited)
Consolidated Statements of Changes in Shareholders' Equity
For the three- and six-month periods ended February 28, 1998
and 1997 (Unaudited)
Consolidated Statements of Cash Flows
For the three- and six-month periods ended February 28, 1998
and 1997 (Unaudited)
Notes to Consolidated Financial Statements (Unaudited)
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Part II. Other Information
- ----------------------------
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
Signatures
-2-
<PAGE>
ILM II SENIOR LIVING, INC.
Part I. Financial Information
- -------------------------------
Item 1. Financial Statements
(see next page)
-3-
<PAGE>
ILM II SENIOR LIVING, INC.
CONSOLIDATED BALANCE SHEETS
February 28, 1998 (Unaudited) and August 31, 1997
(In thousands, except per share amounts)
ASSETS
------
<TABLE>
<CAPTION>
February 28, 1998 August 31, 1997
----------------- ---------------
<S> <C> <C>
Operating investment properties, at cost:
Land $5,352 $5,030
Building and improvements 27,726 27,726
Furniture, fixtures and equipment 3,815 3,765
----- -----
36,893 36,521
Less: accumulated depreciation (7,023) (6,457)
------- -------
29,870 30,064
Unamortized mortgage fees 1,425 1,425
Less: Accumulated Amortization (894) (823)
----- -----
531 602
Cash and cash equivalents 1,773 2,361
Accounts receivable - related party 568 151
Prepaid expenses and other assets 121 77
Deferred rent receivable 92 100
------- --------
$32,955 $33,355
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
-------------------------------------
Accounts payable and accrued expenses $164 $147
Accounts payable - related party 50 205
------- ---------
214 352
Preferred shareholders' minority
interest in subsidiary 120 116
------- ---------
Total liabilities 334 468
Shareholders' Equity
Common stock, $0.01 par value,
12,500,000 shares authorized
5,181,236 issued and outstanding 52 52
Additional paid-in capital 44,823 44,823
Accumulated deficit (12,254) (11,988)
-------- --------
Total Shareholder's equity 32,621 32,887
-------- --------
$32,955 $33,355
======== ========
</TABLE>
See accompanying notes.
-4-
<PAGE>
ILM II SENIOR LIVING, INC.
CONSOLIDATED STATEMENTS OF INCOME
For the three- and six-month periods ended February 28, 1998
and 1997 (Unaudited) (In thousands, except per share amounts)
<TABLE>
<CAPTION>
Six Months Ended Three Months Ended
February 28 February 28
----------- -----------
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenues
Rental Income $2,446 $2,133 $1,254 $1,132
Interest Income 43 44 22 23
------ -------- -------- -------
$2,489 $2,177 1,276 1,155
Expenses
Depreciation and amortization expense 637 636 319 318
Management fees - 65 - 33
General and administrative 247 186 148 148
Directors' compensation 58 24 34 15
------ -------- -------- --------
942 911 501 514
Net Income $1,547 $1,266 $775 $641
====== ====== ==== ====
Basic earnings per share of common stock $0.30 $0.24 $0.15 $0.12
===== ===== ===== =====
Cash dividends paid per share of common stock $0.35 $0.29 $0.19 $0.16
===== ===== ===== =====
</TABLE>
The above earnings and cash dividends paid per share of common stock are
based upon the 5,181,236 shares outstanding for each period.
See accompanying notes.
-5-
<PAGE>
ILM II SENIOR LIVING, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the three- and six- month periods ended February 28,
1998 and 1997 (Unaudited)
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
Common Stock
$.01 Par Value Additional
-------------- Paid-In Accumulated
Shares Amount Capital Deficit Total
------ ----- ---------- ----------- -----
<S> <C> <C> <C> <C> <C>
Shareholders' equity
at August 31, 1996 5,181 $52 $44,823 $(10,999) $33,876
Cash dividends paid -- -- -- (1,490) (1,490)
Net Income -- -- -- 1,266 1,266
------ ---- -------- -------- -------
Shareholders' equity
at February 28, 1997 5,181 $52 $44,823 $(11,223) $33,652
===== === ======= ========= =======
Shareholders' equity
at August 31, 1997 5,181 $52 $44,823 $(11,988) $32,887
Cash dividends paid -- -- -- (1,813) (1,813)
Net income -- -- -- 1,547 1,547
------ ---- ------- -------- -------
Shareholders' equity
at February 28, 1998 5,181 $52 $44,823 $(12,254) $32,621
===== === ======= ========= =======
</TABLE>
See accompanying notes.
-6-
<PAGE>
ILM II SENIOR LIVING, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the six months ended February 28, 1998 and 1997 (Unaudited)
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Cash flows from operating activities:
Net income $1,547 $1,266
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation and amortization expense 637 636
Charitable Contribution of Preferred Stock in ILM Holding -- 111
Changes in assets and liabilities:
Accounts receivable - related party (417) (8)
Interest and other receivables -- (23)
Deferred rent receivable 8 16
Prepaid expenses and other assets (44) (22)
Accounts payable - affiliates (155) --
Accounts payable and accrued expenses 17 10
Preferred shareholder's minority interest 4 --
------- -------- -
Total adjustments 50 720
------- --------
Net cash provided by operating activities $1,597 1,986
Cash flows from investing activities:
Funding of initial working capital to ILM II Lease Corporation -- --
Additions to operating investment properties (372) (23)
------- --------
Net cash used in investing activities (372) (23)
Cash flows from financing activities:
Cash dividends paid to shareholders (1,813) (1,490)
------- --------
Net (decrease) increase in cash and cash equivalents (588) 473
Cash and cash equivalents, beginning of period 2,361 1,694
------- -------
Cash and cash equivalents, end of period $1,773 $2,167
======= =======
</TABLE>
See accompanying notes.
-7-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited)
1. General
-------
The accompanying consolidated financial statements, footnotes and
discussions should be read in conjunction with the consolidated financial
statements and footnotes contained in the Company's Annual Report for the year
ended August 31, 1997. In the opinion of management, the accompanying interim
consolidated financial statements, which have not been audited, reflect all
adjustments necessary to present fairly the results for the interim period. All
of the accounting adjustments reflected in the accompanying interim consolidated
financial statements are of a normal recurring nature.
The accompanying consolidated 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 February 28, 1998 and August 31, 1997
and revenues and expenses for each of the six- and three-month periods ended
February 28, 1998 and 1997. Actual results could differ from the estimates and
assumptions used. Certain numbers in the prior period's financial statements
have been reclassified to conform to the current period's presentation.
ILM II Senior Living, Inc. (the "Company"), formerly PaineWebber Independent
Mortgage Inc. II, 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 the final prospectus as amended, incorporated into 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 at that time, PaineWebber Group, Inc. ("PaineWebber"). For discussion
purposes, PaineWebber will refer to PaineWebber Group, Inc., and all affiliates
that provided services to the Company in the past. 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.
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 ("Senior Housing Facilities"). All
of the loans made by the Company were originally to Angeles Housing Concepts,
Inc. ("AHC"), a company specializing in the development, acquisition and
operation of senior housing facilities.
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.
-8-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited)
1. General (continued)
-------------------
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 was
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 II Holding"), a Virginia corporation. In
August 1995, each of the Property Companies merged into ILM II Holding, which is
majority owned by the Company. As a result, ownership of the Senior Housing
Facilities is now held by ILM II Holding and the Property Companies no longer
exist as separate legal entities.
ILM II Holding holds title to the six Senior Housing Facilities, which
comprise the operating investment properties on the accompanying consolidated
balance sheets, subject to certain mortgage loans payable to the Company. Such
mortgage loans and the related interest expense are eliminated in consolidation.
The capital stock of ILM II Holding was originally owned by the Company and
PaineWebber. ILM II Holding had issued 100 shares of Series A Preferred Stock to
the Company in return for a capital contribution in the amount of $495,000 and
had issued 10,000 shares of common stock to PaineWebber in return for a capital
contribution in the amount of $5,000. The common stock represented approximately
99 percent of the voting power and 1 percent of the economic interest in ILM II
Holding, while the preferred stock represented approximately 1 percent of the
voting power and 99 percent of the economic interest in ILM II Holding.
The Company completed its restructuring plans by converting ILM II Holding
to a REIT for tax purposes. In connection with these plans, on November 21, 1996
the Company requested that PaineWebber sell all of the stock held in ILM II
Holding to the Company for a price equal to the fair market value of the 1%
economic interest in ILM II Holding represented by the common stock. On January
10, 1997, this transfer of the common stock of ILM II Holding was completed at
an agreed upon fair value of $40,000. The accompanying consolidated financial
statements include the operations of ILM II Holding as if control had been
obtained by the Company as of September 1, 1996. With this transfer completed,
effective January 23, 1997, ILM II Holding recapitalized its common stock and
preferred stock by replacing the outstanding shares with 50,000 shares of new
common stock and 275 shares of a new class of non-voting, 8% cumulative
preferred stock issued to the Company. The number of authorized shares of
preferred and common stock in ILM II Holding were also increased as part of the
recapitalization. Following the recapitalization, the Company made charitable
gifts of one share of the preferred stock in ILM II Holding to each of 111
charitable organizations so that ILM II Holding would meet the stock ownership
requirements of a REIT as of January 30, 1997. The preferred stock has a
liquidation preference of $1,000 per share plus any accrued and unpaid
dividends. Dividends on the preferred stock will accrue at a rate of 8% per
annum on the original $1,000 liquidation preference and will be cumulative from
the date of issuance. Since ILM II Holding is not expected to have sufficient
cash flow in the foreseeable future to make the required dividend payments, it
is anticipated that dividends will accrue and be paid at liquidation. Cumulative
dividends accrued as of February 28, 1998 on the preferred stock in ILM II
Holding totaled approximately $9,620.
-9-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited) (continued)
1. General (continued)
--------------------
As part of the fiscal 1994 settlement agreement with AHC, ILM II Holding
retained AHC as the property manager for all of the Senior Housing Facilities
pursuant to the terms of a management agreement. 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. As
discussed further in Note 2, on September 12, 1994 the Company formed a new
subsidiary, ILM II Lease Corporation ("Lease II"), for the purpose of operating
the Senior Housing Facilities. All of the shares of capital stock in Lease II
were distributed to the holders of record of the Company's common stock and the
Senior Housing Facilities were leased to Lease II effective September 1, 1995
(see Note 2 for a description of the master lease agreement). Lease II is a
public company subject to the reporting obligations of the Securities and
Exchange Commission.
At a meeting of the Company's Board of Directors on January 10, 1997,
PaineWebber recommended the immediate sale of the Senior Housing Facilities held
by the Company and an affiliated entity, ILM Senior Living, Inc. ("ILM I"), by
means of a controlled auction to be conducted by PaineWebber with PaineWebber
offering to purchase the properties for $127 million, thereby guaranteeing the
Shareholders a "floor" price. The Senior Housing Facilities held by the Company
would represent approximately $52 million of this amount. After taxes and
closing costs, net proceeds to the Company would equal approximately $48 million
or approximately $9.36 per share. PaineWebber also stated that if it purchased
the properties at the specified price and were then able to resell the
properties at a higher price, PaineWebber would pay any "excess profits" to the
Shareholders. To assist the Company in evaluating PaineWebber's proposal, a
disinterested, independent investment banking firm with expertise in healthcare
REIT's and independent/assisted living financings was engaged by the Company and
Lease II, as well as by ILM I and its affiliates. Following a comprehensive
analysis, the investment banker recommended that PaineWebber's proposal should
be declined and that, instead, investigations of expansion and restructuring
alternatives should be pursued. After analyzing PaineWebber's proposal and the
recommendations and other information provided by the independent investment
banking firm, the Boards of the Company and ILM I voted unanimously to decline
PaineWebber's proposal and to explore the alternatives recommended by the
independent investment banker. The Boards declined to seek an immediate sale of
the properties because in the Board's view, the liquidation price would not
reflect the "going concern" values of the Company and ILM I and, therefore,
would not maximize Shareholder value. In addition, the Boards did not consider
it advisable to liquidate the Company and ILM I on the suggested terms three
years prior to their scheduled termination date.
PaineWebber indicated to the Board in its January 10, 1997 proposal that it
would not wish to continue to serve as advisor to the Company and its affiliates
if the Company declined to accept PaineWebber's proposal. The Company accepted
the resignation of PaineWebber, effective as of June 18, 1997. PaineWebber
agreed to continue to provide certain administrative services to the Company and
its affiliates through August 31, 1997, pursuant to the terms of a transition
services agreement entered into with the Company and its affiliates. The Company
and its affiliates also accepted, effective as of June 18, 1997, the
resignations of those officers and directors who were employees of or otherwise
affiliated with PaineWebber.
The Company and Lease II are continuing to review various restructuring
alternatives that could further increase Shareholder value and liquidity. The
Company and Lease II are considering a merger of the Company with ILM I and
Lease II with ILM I Lease Corporation ("Lease I") as well as other business
combinations. An independent investment banking firm has been retained by the
Company to assist in analyzing these strategic alternatives. The Company has not
fully evaluated any of these alternatives and is not in a position at this time
to recommend any actions to the Shareholders. There can be no assurances that
the Company will recommend taking any of the actions which may be recommended by
its investment bankers.
-10-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited) (continued)
2. Operating Investment Properties Subject to Master Lease
--------------------------------------------------------
At February 28, 1998, through its consolidated affiliate, the Company owned
six Senior Housing Facilities. The accompanying financial statements include the
Company's investments in six Senior Housing Facilities. The name, location and
size of the properties are as set forth below:
Rentable
Name Location Units
- ---- -------- -----
The Palms Fort Myers, FL 205 Units
Crown Villa Omaha, NE 73 Units
Overland Park lace Overland Park, KS 139 Units
Rio Las Palmas Stockton, CA 164 Units
The Villa at Riverwood St. Louis County, MO 120 Units
Villa Santa Barbara (1) Santa Barbara, CA 125 Units
(1) The acquisition of Villa Santa Barbara was financed jointly by the
Company and an affiliated entity, ILM I. All amounts generated from
Villa Santa Barbara are equitably apportioned between the Company,
together with its consolidated subsidiary, and ILM I, together with its
consolidated subsidiary, generally 75% and 25%, respectively. Villa
Santa Barbara is owned 25% by ILM Holding and 75% by ILM II Holding.
As discussed in Note 1, ILM II Holding holds title to each Senior Housing
Facility subject to a first mortgage loan payable to the Company. Since ILM II
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, Lease II, for the purpose of
operating the Senior Housing Facilities under the terms of a master lease
agreement. As of August 31, 1995, Lease II, 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 Lease II to the holders of
record of the Company's common stock. One share of common stock of Lease II was
issued for each full share of the Company's common stock held. Prior to the
distribution, the Company capitalized Lease II with $500,000 from its existing
cash reserves, which was an amount estimated to provide Lease II with necessary
working capital. Lease II is a public company subject to the reporting
obligations of the Securities and Exchange Commission.
-11-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited) (continued)
2. Operating Investment Properties Subject to Master Lease (continued)
-------------------------------------------------------------------
The master lease agreement, which commenced on September 1, 1995, is
between the Company's consolidated affiliate, ILM II Holding, as owner of the
properties and lessor, and Lease II 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 II
Holding, as 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, Lease II is obligated to pay
annual base rent for the use of all of the Senior Housing 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, Lease II is also obligated to pay variable rent for each Senior Housing
Facility. Such variable rent is payable quarterly and is equal to 40% of the
excess, if any, of the aggregate total revenues for the Senior Housing
Facilities, on an annualized basis, over $13,021,000. Variable rental income
related to the second quarter of fiscal 1998 was $244,898.
3. Related Party Transactions
---------------------------
Subject to the supervision of the Company's Board of Directors, assistance
in managing the business of the Company was provided by PaineWebber. As
previously discussed in Note 1, PaineWebber resigned effective as of June 18,
1997.
Lease II has retained Capital Senior Management 2, Inc. ("Capital") of
Dallas, Texas to be the property manager of the Senior Housing Facilities and
the Company has guaranteed the payment of all fees due to Capital under the
terms of the management agreement which commenced on July 29, 1996. In November,
1996, Lawrence A. Cohen, President, Chief Executive Officer and Director of the
Company and a Director of Lease II, was also named Vice Chairman and Chief
Financial Officer of Capital Senior Living Corporation, an affiliate of Capital.
For the quarter ended February 28, 1998, Capital earned property management fees
of $238,615.
On September 18, 1997, Lease II entered into an agreement with Capital
Senior Development, Inc., an affiliate of Capital, to manage the development
process for the potential expansions of several of the Senior Housing
Facilities. Capital Senior Development, Inc. will receive a fee equal to 7% of
the total development costs of these expansions if they are pursued. The Company
will reimburse Lease II for all costs related to these potential expansions
including fees to Capital Senior Development, Inc. During the quarter ended
February 28,1998, Capital Senior Development, Inc. earned fees of $58,900 for
managing pre-construction development activities for potential expansions of the
Senior Housing Facilities.
Jeffry R. Dwyer, Secretary and director of the Company, is an employee of
Greenberg Traurig Hoffman Lipoff Rosen & Quentel, which acts as Counsel to the
Company and its affiliates. Greenberg Traurig Hoffman Lipoff Rosen & Quentel
earned fees from the Company of $64,755 for the quarter ended February 28,1998.
Accounts receivable - related party at February 28,1998 includes base and
variable rent due from Lease II in accordance with the terms of the master lease
agreement. Accounts receivable - related party at August 31, 1997 includes
variable rent due from Lease II. Accounts payable - related party at February
28,1998, includes $49,883 due to Lease II for amounts advanced by Lease II to
purchase land. At August 31, 1997, $205,422 was payable to Lease II for amounts
advanced by Lease II for capital improvements to the Senior Housing Facilities.
-12-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited) (continued)
4. Legal Proceedings and Contingencies
-----------------------------------
Termination of Management Contract with AHC
--------------------------------------------
On July 29, 1996, Lease II and ILM II Holding ("the Companies") terminated a
property management agreement with AHC covering the six Senior Housing
Facilities leased by Lease II from ILM II Holding. 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. The Companies allege, among
other things, that AHC willfully performed actions specifically in violation of
the management agreement and that such actions caused damages to the Companies.
Due to the termination of the agreement for cause, no termination fee was paid
to AHC. Subsequent to the termination of the management agreement, AHC filed for
protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic state of
California. The filing was challenged by the Companies, and the Bankruptcy Court
dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed
with the Virginia District Court an answer in response to the litigation
initiated by the Companies and a counterclaim against ILM II Holding. The
counterclaim alleges that the management agreement was wrongfully terminated for
cause and requests damages which include the payment of a 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 the
Management Agreement could have been terminated without cause, and recovery of
attorneys' fees and expenses.
The aggregate amount of damages against all parties as requested in AHC's
counterclaim exceeds $2,000,000. The Company has guaranteed the payment of the
termination fee at issue in these proceedings to the extent that any termination
fee is deemed payable by the court and in the event that Lease II fails to
perform pursuant to its obligations under the Management Agreement. The court
initially set a trial date of April 28, 1997 but, at AHC's request, rescheduled
the trial for June 23, 1997. On June 13, 1997 and July 8, 1997, the court issued
orders to enter judgment against the Company and ILM I in the amount of
$1,000,000 (the "Orders"). In so doing, the court effectively canceled the June
23, 1997 trial date. The Orders do not contain any findings of fact or
conclusions of law. On July 10, 1997, the Company, ILM I, Lease I and Lease II
filed a notice of appeal to the United States Court of Appeals for the Fourth
Circuit from the Orders. The Company intends to diligently pursue the appeal.
The eventual outcome of this litigation cannot presently be determined. However,
a provision of $400,000 for the liability which might result to the Company was
recorded in the financial statements of Lease II at August 31, 1997. The
remaining $600,000 was recorded in the financial statements of Lease I.
-13-
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (Unaudited) (continued)
4. Legal Proceedings and Contingencies (continued)
-----------------------------------------------
On February 4, 1997, AHC filed a Complaint in the Superior Court of the
State of California against Capital Senior Management 2 Inc., ("Capital"), the
new property manager, Lawrence Cohen, and others alleging that the defendants
intentionally interfered with AHC's property management agreement (the
"California litigation"). The complaint seeks damages of at least $2,000,000. On
March 4, 1997, the defendants removed the case to Federal District Court in the
Central District of California. Trial in the action is expected to occur in 1998
and discovery has begun. At a meeting on February 26, 1997, the Company's Board
of Directors concluded that since all of Mr. Cohen's actions relating to the
California litigation were taken either on behalf of the Company under the
direction of the Board or as a PaineWebber Properties employee, the Company or
its affiliates should indemnify Mr. Cohen with respect to any expenses arising
from the California litigation, subject to any insurance recoveries for those
expenses. The Company's Board also concluded that, subject to certain
conditions, the Company or its affiliates should advance up to $20,000 to pay
reasonable legal fees and expenses incurred by Capital in the California
litigation. Subsequently, the boards of directors of Lease I and Lease II voted
to increase the maximum amount of the advance to $100,000. By the end of
November 1997, Capital had incurred $100,000 of legal expenses in the California
litigation. On February 2, 1998, the amount to be advanced was increased to
include 75% of the California litigation legal fees and costs incurred by
Capital for December 1997 and January 1998, plus 75% of such legal fees and
costs incurred by Capital, thereafter not to exceed $500,000. The defendants
intend to vigorously defend the claims made against them in the California
litigation. The eventual outcome of this litigation cannot presently be
determined and, accordingly, no provision for any liability has been recorded in
the accompanying financial statements.
5. Subsequent Events
-----------------
On March 13, 1998, the Company's Board of Directors declared a quarterly
dividend for the quarter ended February 28, 1998. On April 15, 1998, a dividend
of $0.1875 per share of common stock, totaling approximately $971,000, was paid
to shareholders of record as of March 31, 1998.
On May 8, 1998 Andrew A. Feldman and Jeri Feldman, as Trustees for the
Andrew A. & Jeri Feldman Revocable Trust dated 9/18/90, commenced a purported
class action on behalf of that trust and all other shareholders of the Company
and ILM I in the Supreme Court of the State of New York, County of New York
against the Company, ILM I and the directors of both corporations. The class
action complaint alleges that the directors engaged in wasteful and oppressive
conduct and breached fiduciary duties in preventing the sale or liquidation of
the assets of the Company and ILM I, diverting certain of their assets and
changing the nature of the Company and ILM I. The complaint seeks damages in an
unspecified amount, punitive damages, the judicial dissolution of the Company
and ILM I, an order requiring the directors to take all steps to maximize
shareholder value, including either an auction or liquidation, and rescinding
certain agreements, and attorney's fees. The Company, ILM I and the directors
have not yet been required to respond to the complaint in this action. The
Company and ILM I believe that the action is without merit and intend vigorously
to contest this action.
-14-
<PAGE>
ILM II SENIOR LIVING, INC.
Item 2. 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) 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 AHC. As
previously reported, AHC defaulted on the scheduled mortgage loan payments due
to the Company on March 1, 1993. Its parent company, Angeles, 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 which were majority owned by the Company.
Subsequently, these affiliates were merged into ILM II Holding, which is
majority owned by the Company. ILM II Holding holds title to the six Senior
Housing Facilities which comprise the balance of operating investment properties
in the accompanying consolidated balance sheets, subject to certain mortgage
loans payable to the Company. Such mortgage loans and the related interest
expense are eliminated in consolidation. As part of the fiscal 1994 Settlement
Agreement with AHC, ILM II Holding retained AHC as the property manager for all
of the Senior Housing Facilities pursuant to the terms of the Agreement. As
discussed further below, the 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 Company's existing Shareholders
while maintaining its qualification as a REIT under the Internal Revenue Code,
the Company formed a new corporation, Lease II, for the purpose of operating the
Senior Housing Facilities under the terms of a master lease agreement. As of
August 31, 1995, Lease II, 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 Lease II to the holders of record of the
Company's common stock. One share of common stock of Lease II was issued for
each full share of the Company's common stock held. Prior to the distribution,
the Company capitalized Lease II with $500,000 from its existing cash reserves,
which was an amount estimated to provide Lease II with necessary working
capital. Lease II is a public company subject to the reporting obligations of
the Securities and Exchange Commission.
The master lease agreement, which commenced on September 1, 1995, was
initially between the Company's consolidated affiliate, ILM II Holding, as owner
of the Senior Housing Facilities and lessor, and Lease II 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 II 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), Lease II is obligated to
pay annual base rent for the use of all the Senior Housing 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, Lease II is also obligated to pay variable rent for each Senior Housing
Facility. Such variable rent will be payable quarterly and will equal 40% of the
excess, if any, of the aggregate total revenues for the Senior Housing
Facilities, on an annualized basis, over $13,021,000. Variable rental income
related to the second quarter of fiscal 1998 was $244,898.
-15-
<PAGE>
ILM II SENIOR LIVING, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)
Liquidity and Capital Resources (continued)
The Company completed its restructuring plans by converting ILM II Holding
to a real estate investment trust ("REIT") for tax purposes. In connection with
these plans, on November 21, 1996 the Company requested that PaineWebber sell
all of its stock in ILM II Holding to the Company for a price equal to the fair
market value of the 1% economic interest in ILM II Holding represented by the
common stock. On January 10, 1997, this transfer of the common stock of ILM II
Holding was completed at an agreed upon fair value of $40,000. With this
transfer completed, effective January 23, 1997, ILM Holding recapitalized its
common stock and preferred stock by replacing the outstanding shares with 50,000
shares of new common stock and 275 shares of nonvoting, 8% cumulative preferred
stock issued to the Company (the "Preferred Stock"). The number of authorized
shares of preferred stock and common stock in ILM II Holding were also increased
as part of the recapitalization. Following the recapitalization, the Company
made charitable gifts of one share of the Preferred Stock in ILM II Holding to
each of 111 charitable organizations so that ILM II Holding would meet the stock
ownership requirements of a REIT as of January 30, 1997. The Preferred Stock has
a liquidation preference of $1,000 per share plus any accrued and unpaid
dividends. Dividends on the Preferred Stock will accrue at a rate of 8% per
annum on the original $1,000 liquidation preference and will be cumulative from
the date of issuance. Since ILM II Holding is not expected to have sufficient
cash flow in the foreseeable future to make the required dividend payments, it
is anticipated that dividends will accrue and be paid at liquidation. Cumulative
dividends in arrears as of February 28, 1998 on the Preferred Stock in ILM II
Holding totaled approximately $9,620.
The assumption of ownership of the properties through ILM II Holding, which
was organized as 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 in a C
corporation. Any future appreciation in the value of the Senior Housing
Facilities subsequent to the conversion of ILM II 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 ten years
from the date of the conversion of ILM II Holding to a REIT. However, since the
end of the Company's original anticipated holding period is within three years,
the properties are not expected to be held for an additional ten years. Based on
management's current estimate of the increase in the values of the Senior
Housing Facilities which occurred between April 1994 and January 1996, as
supported by independent appraisals, ILM II Holding would incur a sizable tax if
the properties were sold. Based on this increase in values during the time ILM
II Holding was operated as a regular C corporation, a sale within ten years of
the date of conversion to a REIT could result in a built-in gain tax of as much
as $2.3 million. To avoid this built-in gain tax, the Directors are prepared at
the appropriate time to recommend to the Shareholders an amendment to the
Articles of Incorporation to extend the Company's scheduled liquidation date.
Following the termination of its advisor relationship with PaineWebber (See
"Note 1. to Notes to Consolidated Financial Statements"), the Company and Lease
II commenced a further review of various restructuring alternatives that could
further increase Shareholder value and liquidity. The Company and Lease II are
analyzing a merger of the Company with ILM I and Lease II with Lease I as well
as other business combinations. An independent investment banking firm has been
retained by the Company and its affiliates to assist in analyzing these
strategic alternatives. The Company has not fully evaluated any of these
alternatives and is not in a position at this time to recommend any actions to
the Shareholders. There can be no assurances that the Company will recommend
taking any of the actions which may be recommended by its investment advisors.
-16-
<PAGE>
ILM II SENIOR LIVING, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)
Liquidity and Capital Resources (continued)
Because the ownership of the assets of ILM II Holding was expected to be
transferred to the Company or its wholly owned subsidiary, ILM II Holding was
capitalized with funds to provide it with working capital only for a limited
period of time. At the present time, ILM II Holding is not expected to have
sufficient cash flow during fiscal 1998 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
II Holding. As a result, ILM II is not expected to receive the full amount that
would be due under the loans.
Lease II retained Capital Senior Management 2, Inc., ("Capital") to be the
property manager of its Senior Housing Facilities pursuant to a Management
Agreement which commenced on July 29, 1996. Under the terms of the Management
Agreement, Capital earns a base management fee equal to 4% of the gross
operating revenues of the Senior Housing Facilities, as defined. Capital is also
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 during
the term of the Management Agreement 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. The
Company 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 95% occupancy
for the quarter ended February 28, 1998. 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 II 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 in excess of the specified
threshold in the variable rent calculation, as discussed further above, which
became effective in January 1997.
The Company and Lease II have been pursuing additional steps to increase
Shareholder value. Several new programs were adopted during fiscal 1997 across
the Company's portfolio which are resulting in increased revenues and cash flow
from the properties. These steps include increasing the number of rentable
apartment units as live-in facility managers move from the properties and
increasing rental rates at properties that have maintained high occupancy levels
and are located in strong markets. Another program to increase revenues and cash
flow involves pursuing the potential for future expansions of several of the
facilities which are located in areas that have particularly strong markets for
senior housing. Potential expansion candidates include the facilities located in
Omaha, Nebraska; St. Louis County, Missouri; and Fort Myers, Florida. As part of
this expansion program, approximately one acre of land located adjacent to the
Omaha facility was acquired in the first quarter of fiscal 1998 for
approximately $135,000. In addition, an agreement was obtained to purchase
approximately six acres of land located adjacent to the St. Louis County
facility for approximately $900,000. In December 1998 the Company decided to not
pursue the expansion over the near term and allowed the agreement to expire. The
Fort Meyers facility includes a vacant parcel of approximately one and one-half
acres which could accommodate an expansion of the existing facility or the
construction of a new free-standing facility. Preliminary feasibility
evaluations have been completed for all of these potential expansions and
pre-construction design and construction-cost evaluations are underway for
expansions of the facilities located in Omaha and Fort Meyers. Once the
pre-construction design process is complete and projected expansion construction
costs are determined, the Company will carefully evaluate the costs and benefits
before proceeding with the construction of any of these expansions.
-17-
<PAGE>
ILM II SENIOR LIVING, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)
Liquidity and Capital Resources (continued)
Depending on the extent of any expansions deemed appropriate, such plans
could result in the need for substantial additional capital. The Company is
currently negotiating with a major bank to provide a construction loan facility
that, if finalized, would provide the Company with up to $8.8 million to fund
the capital costs of these potential expansion programs.
Additionally, in December 1997 ILM II Holding purchased, for approximately
$140,000, a parcel of vacant land adjacent to the Stockton facility. Although no
expansion of this facility is being considered at this time, this additional
land will provide needed parking spaces and improved access to the existing
facility.
At February 28, 1998, the Company had cash and cash equivalents of
$1,773,000. Such amounts will be used for the working capital requirements of
the Company, along with the possible investment in the properties owned by ILM
II Holding 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 Lease II, 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.
While the Company has potential liabilities pending due to ongoing
litigation against the Company, or for which the Company is a guarantor, the
eventual outcome of this litigation cannot presently be determined. The court
order in the Virginia AHC litigation equals $1 million, the California
litigation by AHC seeks at least $2 million, and the purported class action
litigation seeks damages in an unspecified amount. As discussed in Note 4. Legal
Proceedings and Contingencies, the Company and Lease II have agreed to indemnify
Mr. Cohen and Lease II has agreed to advance funds to Capital to pay reasonable
legal fees and expenses in the California litigation. The Company will
vigorously defend against all claims made against it and, at this time, it is
not certain that the Company will have ultimate responsibility for any such
claims.
Results of Operations
For the Six Months Ended February 28,1998 versus the Six Months Ended February
28, 1997
Net income increased $281,000 for the six months ended February 28, 1998 as
compared to the same period in the prior year, primarily due to variable rent
earned pursuant to the master lease agreement. This increase was offset by a
$61,000 increase in general and administrative expense due principally to
increased legal fees, and a $34,000 increase in director's compensation due to
more frequent Board of Director meetings.
For the Three Months Ended February 28, 1998 versus the Three Months Ended
February 28, 1997
Net income increased $134,000 for the three months ended February 28, 1998
as compared to the same period in the prior year. This increase was offset by a
$19,000 increase in director's compensation due to more frequent Board of
Director meetings.
-18-
<PAGE>
ILM II SENIOR LIVING, INC.
PART II
Other Information
Item 1. through 4. NONE
- ------------------
Item 5. Other Information
- --------------------------
On June 4, 1998, an unsolicited tender offer was filed on Schedule 14D-1 to
purchase up to 500,000 outstanding shares of the Company's common stock
representing approximately 9.65% of the outstanding shares at $7.00 per share.
On June 11, 1998, the offer was increased to $8.00 per share. On June 17, 1998,
the Company filed a response on Schedule 14D-9 stating that the Company's Board
of Directors unanimously concluded that the offer is inadequate and not in the
best interests of the Company and its shareholders. Accordingly, the Board
unanimously recommended that the Company's shareholders reject the offer and not
tender their shares.
Item 6. Exhibits and Reports on Form 8-K
- -----------------------------------------
(a) Exhibits: 27. Financial Data Schedule
(b) Reports on Form 8-K: NONE
-19-
<PAGE>
ILM II SENIOR LIVING, INC.
SIGNATURES
Pursuant to the requirements 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.
By: ILM II SENIOR LIVING, INC.
By: /s/ Lawrence A. Cohen
---------------------------------
Lawrence A. Cohen
President
Dated: June 15, 1998
-20-
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> AUG-31-1997
<PERIOD-END> FEB-28-1998
<CASH> 1,773
<SECURITIES> 0
<RECEIVABLES> 781
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 2,554
<PP&E> 38,318
<DEPRECIATION> 7,917
<TOTAL-ASSETS> 32,955
<CURRENT-LIABILITIES> 214
<BONDS> 0
120
0
<COMMON> 56
<OTHER-SE> 32,621
<TOTAL-LIABILITY-AND-EQUITY> 32,955
<SALES> 0
<TOTAL-REVENUES> 2,489
<CGS> 0
<TOTAL-COSTS> 942
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1,547
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,547
<EPS-PRIMARY> .30
<EPS-DILUTED> .30
</TABLE>
