ILM II SENIOR LIVING INC /VA, 10-K/A, 1999-11-22

ILM II SENIOR LIVING INC /VA
10-K/A, 1999-11-22
REAL ESTATE INVESTMENT TRUSTS

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

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

FOR FISCAL YEAR ENDED: AUGUST 31, 1998
OR

/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

For the transition period from _____ to _____.

Commission File Number: 0-18942

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.)

8180 Greensboro Drive, Suite 850, McLean, VA 22102
- ------------------------------------------------ -----
(Address of principal executive office) (Zip Code)

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

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

NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
- ------------------- ---------------------
None None

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

SHARES OF COMMON STOCK $.01 PAR VALUE
-------------------------------------
(Title of class)

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

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

Shares of common stock outstanding as of August 31, 1998: 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/A REFERENCE
--------- ---------------------
Prospectus of registrant dated Parts II, Part IV
August 8, 1990, as supplemented
[33 Act filing #33-33857]

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

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ILM II SENIOR LIVING, INC.

1998 FORM 10-K-A

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
<S> <C> <C>
PART I

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

Item 2 Properties........................................................................... I-6

Item 3 Legal Proceedings.................................................................... I-7

Item 4 Submission of Matters to a Vote of Security Holders.................................. I-8

PART II

Item 5 Market for the Registrant's Shares and Related
Stockholder Matters........................................................ II-1

Item 6 Selected Financial Data.............................................................. II-2

Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................................. II-3

Item 8 Financial Statements and Supplementary Data.......................................... II-9

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

PART III

Item 10 Directors and Executive Officers of the Registrant................................... III-1

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

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

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

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-34
</TABLE>

<PAGE>

PART I

ITEM 1. BUSINESS

ILM II Senior Living, Inc. (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 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
"Prospectus"). 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 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. As a REIT, the Company is allowed a deduction for
the amount of dividends paid to shareholders of the Company ("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 ("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.

The Company entered into an exclusivity agreement, as amended, 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% per
annum during the construction period and for base interest to be paid on the
permanent loans at the rate of 10% per annum. In addition to the base interest,
additional interest was to be paid 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 thorough 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.

I-1

<PAGE>

ITEM 1. BUSINESS (CONTINUED)

"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
subsidiary and 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.

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 qualifications as a REIT under the Internal Revenue Code. 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.

All responsibility for day-to-day management of the Senior Housing
Facilities, including administration of the property management agreement with
AHC, was transferred to Lease II. On July 29, 1996, the management agreement
with AHC was terminated and Lease II retained Capital Senior Management 2, Inc.
("Capital") to be the new property manager of its Senior Housing Facilities
pursuant to a management agreement (the "Management Agreement") which commenced
on July 29, 1996. Lawrence A. Cohen, who, through July 28, 1998 served as
President, Chief Executive Officer and Director of the Company and a Director of
Lease II, has also served as Vice Chairman and Chief Financial Officer of
Capital Senior Living Corporation, an affiliate of Capital, since November 1996.
As a result, through July 28, 1998, Capital was considered a related party.
Under the terms of the Management Agreement, Capital earns a base management fee
equal to 4% of the gross operating revenues of the Senior Housing Facilities, as
defined. Capital also earns an incentive management fee equal to 25% of the
amount by which net cash flow of the Senior Housing Facilities, as defined,
exceeds a specified base amount. Each August 31, beginning on August 31, 1997,
the base amount is increased based on the percentage increase in the Consumer
Price Index as well as 15% of Facility expansion costs. The Company has
guaranteed the payment of all fees due to Capital under the terms of the
Management Agreement. Lease II is a public company subject to the reporting
obligations of the Securities and Exchange Commission.

ILM II Holding holds title to the six Senior Housing Facilities which
comprise the balance of 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 on March 25, 1994.
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.

I-2

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ITEM 1. BUSINESS (CONTINUED)

The Company completed its restructuring plans by converting ILM II Holding
to a REIT for tax purposes effective for Calendar year 1996. 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, representing a
$35,000 increase in fair value. This increase in fair value is based on the
increase in values of the Senior Housing Facilities which occurred between April
1994 and January 1996, as supported by independent appraisals.

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 Preferred
Stock"). 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. The Company recorded the contribution of the
Preferred Stock in ILM II Holding to the charitable organizations at the amount
of the initial liquidation preference of $111,000. Such amount is included in
general and administrative expenses in the accompanying consolidated statement
of income for the year ended August 31, 1997. Cumulative dividends accrued as of
August 31, 1998 on the Preferred Stock in ILM II Holding totaled $14,000.

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 I Senior Living, Inc. ("ILM I"), by
means of a controlled auction to be conducted by PaineWebber, at no additional
compensation, 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, NatWest Securities, a disinterested, independent
investment banking firm with expertise in healthcare REITs 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 banking firm 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 banking firm. The Boards declined to seek an immediate
sale of the properties because, in the Boards' 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 several
years prior to their scheduled termination dates.

I-3

<PAGE>

ITEM 1. BUSINESS (CONTINUED)

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

I-4

<PAGE>

ITEM 1. BUSINESS (CONTINUED)

The Company's investments as of August 31, 1998 are described below:

<TABLE>
<CAPTION>
Year
Property Name Date of Facility Rentable Resident
and Location (1) Type of Property Investment Built Units (3) Capacities (3)
- --------------------- ---------------- ---------- ----- --------- --------------
<S> <C> <C> <C> <C> <C>
The Palms
Fort Myers, FL Senior Housing Facility 7/18/90 1988 205 255

Crown Villa
Omaha, NE Senior Housing Facility 4/25/91 1992 73 73

Overland Park Place
Overland Park, KS Senior Housing Facility 4/9/92 1984 141 153

Rio Las Palmas
Stockton, CA Senior Housing Facility 5/14/92 1988 164 190

The Villa at Riverwood
St. Louis County, MO Senior Housing Facility 5/29/92 1986 120 140

Villa Santa Barbara (2)
Santa Barbara, CA Senior Housing Facility 7/13/92 1979 125 125
</TABLE>

(1) See Note 4 to the consolidated 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 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 75% by ILM II Holding and 25% by ILM Holding, Inc.
as tenants in common. Upon the sale of ILM I or the Company, arrangements
would be made to transfer the Santa Barbara facility to the non-selling
joint tenant (or one of its subsidiaries). The property was extensively
renovated in 1995.

(3) Rentable units represent the number of apartment units and is a measure
commonly used in the real estate industry. Resident capacity equals the
number of bedrooms contained within the apartment units and corresponds
to measures commonly used in the healthcare industry.

I-5

<PAGE>

ITEM 1. BUSINESS (CONTINUED)

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 $4,035,600.
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 for
the years ended August 31, 1998 and 1997 was $984,000 and $412,000,
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 the
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 net proceeds
of any sale transactions are expected to be distributed to the Shareholders, so
that the Company will, in effect, be self-liquidating.

Through June 18, 1997, and subject to the supervision of the Company's
Board of Directors, assistance in the management of the business of the Company
was provided by PaineWebber. PaineWebber resigned from this position effective
as of June 18, 1997, although PaineWebber agreed to provide certain
administrative services to the Company and its affiliates through August 31,
1997. Through the date of its resignation, PaineWebber performed the day-to-day
operations of the Company and acted as the investment advisor and consultant for
the Company. PaineWebber provided cash management, accounting, tax preparation,
financial reporting, investor communications and relations as well as asset
management services to the Company. These services are now being provided to the
Company, subject to the supervision of the Company's Board of Directors, by
various companies and consultants including Greenberg Traurig, Fleet Bank, Ernst
& Young LLP, and MAVRICC Management Systems, Inc.

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

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

I-6

<PAGE>

ITEM 2. PROPERTIES

As of August 31, 1998, 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.

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

<TABLE>
<CAPTION>
Average Quarterly Occupancy
--------------------------------------------------------------------------
Fiscal 1998
11/30/97 2/28/98 5/31/98 8/31/98 Average
-------- ------- ------- ------- ------------
<S> <C> <C> <C> <C> <C>
The Palms 92% 97% 97% 97% 96%

Crown Villa 97% 98% 97% 97% 97%

Overland Park Place 99% 99% 99% 99% 99%

Rio Las Palmas 88% 90% 89% 90% 89%

The Villa at Riverwood 94% 93% 95% 94% 94%

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

I-7

<PAGE>

ITEM 3. LEGAL PROCEEDINGS

TERMINATION OF MANAGEMENT CONTRACT WITH AHC

On July 29, 1996, Lease II and ILM II Holding (collectively for this Item
3, 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 alleged, among other things, that AHC willfully performed actions
specifically in violation of the management agreement and that such actions
caused damages to the Companies. Due to the termination of the Agreement for
cause, no termination fee was paid to AHC. Subsequent to the termination of the
management agreement, AHC filed for protection under Chapter 11 of the U.S.
Bankruptcy Code in its domestic state of California. The filing was challenged
by the Companies, and the Bankruptcy Court dismissed AHC's case effective
October 15, 1996. In November 1996, AHC filed with the Virginia District Court
an answer in response to the litigation initiated by the Companies and a
counterclaim against ILM II Holding. The counterclaim alleged that the agreement
was wrongfully terminated for cause and requested damages which include the
payment of the termination fee in the amount of $750,000, payment of management
fees pursuant to the agreement from August 1, 1996 through October 15, 1996,
which is the earliest date that the agreement could have been terminated without
cause, and recovery of attorney's fees and expenses.

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

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

I-8

<PAGE>

ITEM 3. LEGAL PROCEEDINGS (CONTINUED)

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

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

OTHER LITIGATION

On May 8, 1998 Andrew A. Feldman and Jeri Feldman, as Trustees for the
Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990, commenced a
purported class action on behalf of that trust and all other Shareholders of 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. On July 8, 1998, the Company
joined with all other defendants to dismiss the complaint on all accounts.

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

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At the Annual Meeting of Shareholders held on July 28, 1998, J. William
Sharman, Jr., Jeffry R. Dwyer and Carl J. Schramm were elected to serve as
Directors of the Company until the 1999 Annual Meeting, and the designation of
Ernst & Young LLP as auditors for the fiscal year ending August 31, 1998, was
ratified. J. William Sharman, Jr., and Jeffry R. Dwyer have served as Directors
since ILM II Senior Living, Inc.'s inception. Carl J. Schramm has served as a
Director since December 1996.

I-9

<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, 1998 there were 3,113 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. While shares of the Company were
designed for long-term holding, they may possibly be traded through a secondary
market resale. The shares do not trade on an established exchange and the only
market that has developed is an informal secondary market; therefore little
resale activity occurs. Although PaineWebber and others may endeavor to assist
Shareholders desiring to sell their shares by attempting to match requests to
sell shares with requests to purchase shares, such transfers are not expected to
be frequent. In addition, the Company's Articles of Incorporation restrict
ownership of more than 9.8% of the Company's outstanding shares by one investor.
These restrictions are designed to ensure that the Company does not violate
certain share accumulation restrictions imposed by the Internal Revenue Code on
REITs.

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 1998.

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, which response was amended on
July 7, 1998, 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.

II-1

<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

ILM II SENIOR LIVING, INC.
For the years ended August 31, 1998, 1997, 1996, 1995 and 1994
(Dollars in thousands, except per share data)

<TABLE>
<CAPTION>
For the years ended August 31,
------------------------------
1998 1997(1) 1996 1995 1994
---- ------- ----- ---- ----
<S> <C> <C> <C> <C> <C>
Revenues ....................... $ 5,065 $ 4,515 $ 46 $ 87 $ 72

Operating income (loss) ........ $ 2,907 $ 2,184 $ (587) $ (877) $ (769)

Equity in income from properties
securing mortgage loans ...... -- -- $ 2,674 $ 2,308 $ 1,957

Net income ..................... $ 2,907 $ 2,184 $ 2,087 $ 1,431 $ 1,188
=========== =========== =========== =========== ===========

Earnings per
share of common stock ........ $ 0.56 $ 0.42 $ 0.40 $ 0.27 $ 0.23
=========== =========== =========== =========== ===========

Cash dividends paid
per share of common stock .... $ 0.73 $ 0.61 $ 0.50 $ 0.43 $ 0.40
=========== =========== =========== =========== ===========

Total assets ................... $ 32,383 $ 33,355 $ 33,973 $ 35,052 $ 35,382

Shares outstanding ............. 5,181,236 5,181,236 5,181,236 5,181,236 5,181,236
</TABLE>

(1) 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 1997.
Prior to fiscal 1997, the Company had accounted for its interests in such
properties under the equity method as a result of the Company not holding
majority voting control of ILM Holding.

The above selected financial data should be read in conjunction with the
consolidated financial statements and related notes to the consolidated
financial statements appearing in item 14(a) of this annual report.

II-2

<PAGE>

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) 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 regularly 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 only 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.

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 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 of the Senior Housing Facilities in the aggregate amount
$4,035,600. 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 equals 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 fiscal
year 1998 and 1997 was $984,000 and $412,000, respectively.

The assumption of ownership of the properties through ILM II Holding, which
was a regular C corporation for tax purposes at the time of the assumption, may
result 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 a C
corporation.

II-3

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)

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. 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 non-voting, 8% cumulative preferred stock issued to the
Company. 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 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 are 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. The Company recorded the contribution of the Preferred
Stock in ILM II Holding to the charitable organizations at the amount of the
initial liquidation preference of $111,000. Such amount is included in general
and administrative expenses in the accompanying consolidated statement of income
for the year ended August 31, 1997. Cumulative dividends accrued as of August
31, 1998 on the Preferred Stock in ILM II Holding totaled $14,000.

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 as defined in the Articles of
Incorporation is December 31, 2001, the properties may not 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, a sale of the Senior
Housing Facilities within ten years of the date of the conversion of ILM II
Holding 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.

II-4

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)

ILM II Holding has acquired the respective operating properties subject to,
and assumed the obligations under, the mortgage loans payable to the Company,
pursuant to the 1997 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 II
Holding is consolidated with the Company in the accompanying consolidated
financial statements for fiscal year 1998 and 1997, the mortgage loans and
related interest expense have been eliminated in consolidation.

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 1999 to (i) meet its obligations to make the
debt service payments due under the loans and (ii) pay for capital improvements
and structural repairs in accordance with the terms of the master lease.
Although ILM II Holding is not expected to fully fund its scheduled debt service
payments to the Company, the current values of the Senior Housing Facilities are
well in excess of the mortgage principal amounts plus accrued interest at August
31, 1998. As a result, the Company is expected to recover the full amount that
would be due under the loans upon the sale of the Facilities.

Lease II retained Capital to be the new property manager of its Senior
Housing Facilities pursuant to a Management Agreement which commenced on July
29, 1996. Lawrence A. Cohen, who, through July 28, 1998 served as President,
Chief Executive Officer and Director of the Company and a Director of Lease II,
has also served as Vice Chairman and Chief Financial Officer of Capital Senior
Living Corporation, an affiliate of Capital, since November 1996. As a result,
through July 28, 1998, Capital was considered a related party. Under the terms
of the Management Agreement, Capital earns a base management fee equal to 4% of
the gross operating revenues of the Senior Housing Facilities, as defined.
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 as well as 15% of Facility expansion costs. The Company has
guaranteed the payment of all fees due to Capital under the terms of the
Management Agreement.

II-5

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)

fees either advanced to Capital or accrued on the financial statements of Lease
I and Lease II totaled approximately $519,000, although the final amount to be
reimbursed to Capital has not yet been determined.

The six properties in which the Company has invested averaged 96% occupancy
for the year ended August 31, 1998. The City of Stockton has announced plans to
build a railroad underpass on the street located immediately adjacent to Rio Las
Palmas in Stockton, California. The City plans to use a portion of the Rio Las
Palmas property for a temporary bypass during the expected 18-month construction
process. Although this road construction would not directly affect facility
operations, it would eliminate several parking spaces and would result in
increased noise and traffic during the construction period while the traffic is
re-routed closer to the facility. Negotiations with the City are currently
underway to minimize any disruption to the operations of Rio Las Palmas and to
secure a settlement that will pay for any damages.

The Company's net operating cash flow is expected to be relatively stable
and predictable due to the master lease structure. The annual base rental
payments owed to ILM II Holding are $4,035,600 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. Accordingly, ILM II Holding received variable
rent payments in fiscal 1998 and 1997 in the amounts of $984,000 and $412,000,
respectively. As a result of the status of the Company's net operating cash flow
under the current master lease arrangement, the Company increased its quarterly
dividend payment from $.1625 per share to $.1875 per share effective with the
dividend paid in January 1998 for the quarter ended November 30, 1997.
Subsequent to fiscal year end, the Company increased its quarterly dividend
payment to $0.2125 per share effective with the dividend paid on October 15,
1998, for the quarter ended August 31, 1998. As noted above, ILM II Holding, as
lessor, is responsible for major capital improvements and structural repairs to
the Senior Housing Facilities.

The Company and Lease II have been pursuing the potential for future
expansion 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 year 1998 for approximately $135,000. During the second
quarter of fiscal year 1998, a one-half acre parcel of vacant land adjacent to
the Stockton facility was purchased for approximately $136,000. Also included in
Land on the accompanying consolidated balance sheet are significant costs
incurred at existing facilities for possible future expansions. Although no
expansion of the Stockton facility is being considered at this time, the
additional land will provide needed parking spaces and improved access to the
existing facility as well as future expansion potential. 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 1997, the Company decided not to pursue the St. Louis County expansion
and allowed the agreement to expire. The Fort Myers facility includes a vacant
land parcel of approximately one and one-half acres, which could accommodate an
expansion of the existing 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 Myers.

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. Depending on the extent of any expansions deemed appropriate, such
plans could result in the need for substantial capital. The Company has
finalized negotiations with a major bank to provide a construction loan facility
that will provide the Company with up to $8.8 million to fund the capital costs
of these potential expansion programs. The construction loan facility will be
secured by a first mortgage of the Company's properties and collateral
assignment of the Company's leases of such properties. The loan will have a
three-year term with interest accruing at a rate equal to LIBOR plus 1.10% or
Prime plus 0.5%. The loan term could be extended for an additional two years
beyond its maturity date with monthly payments of principal and interest on a
25-year amortization schedule.

II-6

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)

At August 31, 1998, the Company had cash and cash equivalents of
$1,896,000. 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 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, the eventual outcome of this litigation cannot
presently be determined. 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.

YEAR 2000

The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs or hardware that have date-sensitive software or embedded
chips may recognize the year 2000 as a date other than the year 2000. This could
result in a system failure or miscalculations causing disruptions of operations
including, among other things, a temporary inability to process transactions,
send invoices or engage in similar normal business activities.

The Company has assessed its exposure to operating equipment, and such
exposure is not significant due to the nature of the Company's business.

The Company is not aware of any external agent with a Year 2000 issue that
would materially impact the Company's results of operations, liquidity or
capital resources. However, the Company has no means of determining whether or
ensuring those external agents will be Year 2000 ready. The inability of
external agents to complete their Year 2000 resolution process in a timely
fashion could impact the Company.

Management of the Company believes it has an effective program in place to
resolve the Year 2000 issue in a timely manner. As noted above, the Company has
substantially completed all necessary phases of its Year 2000 program. In
addition, disruptions in the economy generally resulting from Year 2000 issues
could also adversely affect the Company. Although the amount of potential
liability and lost revenue cannot be reasonably estimated at this time, in a
worst case situation, if Capital, the Company's most significant third party
contractor, were to experience a year 2000 problem, it is likely that Lease II
would not receive rental income as it became due from Senior Living Facility
residents. Lease II in turn would fail to pay ILM II Holding lease payments as
they arise under the master lease, and ILM II Holding in turn would fail to pay
the Company mortgage payments due it. However, the Company believes that given
the nature of its business, such problem would be temporary and easily
remediable with a simple accounting.

RESULTS OF OPERATIONS

1998 COMPARED TO 1997

Net income increased $723,000 or 33.1% for fiscal year 1998 compared to
fiscal year 1997. Total revenue was $5,065,000 representing an increase in
revenue of $550,000 or 12.2% when compared to the prior fiscal year. Rental and
other income increased by $572,000 or 13% from $4,416,000 in fiscal year 1997 to
$4,988,000 in fiscal

II-7

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)

year 1998 as a result of increased rental income earned pursuant to the terms of
the master lease agreement. Interest income decreased $22,000 or 22.2% as a
result of a decrease in the average balances of cash and cash equivalents in
fiscal year 1998 versus fiscal year 1997. Total expenses decreased $173,000 or
7.4% when compared to 1997. General and administrative expenses decreased
$341,000 or 60.6% due, in part, to reimbursable costs and ILM II Holding
restructuring costs of the prior year. This decrease in expenses in fiscal year
1998 was offset by a $232,000 or 75.3% increase in professional fees associated
with restructuring advice provided by the independent investment banking firm
and increased legal fees as well as a $29,000 or 35.4% increase in Director's
compensation as a result of more frequent Board of Directors meetings.

1997 COMPARED TO 1996

Net income increased by $97,000 or 4.6% for fiscal year 1997 when compared
to fiscal year 1996. Revenue increased by $4,469,000 or 9,715.2% of which
$4,416,000 or 100% was due to the consolidation of ILM II Holding in fiscal year
1997 including an improvement in master lease rentals of $412,000 from the
property leases owing to improved overall occupancies and revenues of the
lessee. Interest income increased $53,000 or 115.2% as a result of an increase
in the average balances of cash and cash equivalents in fiscal year 1997 versus
fiscal year 1996. General and administrative and professional fee expenses
increased $392,000 or 81% of which $242,000 or 50% of the increase was due, in
part, to expenses associated with purchasing the remaining controlling interest
in ILM II Holding, increased expenses associated with higher legal expenses and
the expense of restructuring cost studies carried out by the independent
investment banking firm. The remaining $151,000 or 31% increase in general and
administrative and professional fee expenses is due to the consolidation of ILM
II Holding in fiscal year 1997 which includes $116,000 associated with the
charitable contribution of ILM II Holding's Preferred Stock. Director's
compensation also increased in the current year by $58,000 or 241.7%, due to an
increase in the number of Directors and meetings. Depreciation and amortization
expense increased $1,275,000 or 100% due to the consolidation of ILM II Holding
in fiscal year 1997. Equity in income of properties securing mortgage loans
decreased by $2,674,000 or 100% as a result of the consolidation of ILM II
Holding in fiscal year 1997.

INFLATION

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

Inflation in future periods is likely to cause increases in the Company's
expenses, which may be partially offset by increases in revenues from the
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 II Holding, earned 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.

II-8

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)

FORWARD-LOOKING INFORMATION

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

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

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

II-9

<PAGE>

ILM II SENIOR LIVING, INC.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

There are currently three Directors of the Company. 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 during fiscal 1998 are as follows:

<TABLE>
<CAPTION>
Name Office Age Dates of Office
---- ------ --- ---------------
<S> <C> <C> <C>
J. William Sharman, Jr. President and Director 58 6/9/89 **-present
Jeffry R. Dwyer Secretary and Director 52 6/9/89*-present
Carl J. Schramm Director 52 12/5/96-present

Lawrence A. Cohen President, CEO and Director 45 5/15/91-7/28/98
Julien G. Redele Director 63 12/5/96-7/28/98
</TABLE>

* The date of incorporation of the Company.

** The date of incorporation of the Company as Director; July 28,
1998 as President.

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

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

J. WILLIAM SHARMAN, JR. has served as a Director of the Company since its
inception in 1990 and and was appointed President, succeeding Mr. Cohen, on July
28, 1998. Mr. Sharman is the Chairman of the Board and Chief Executive Officer
of Lancaster Hotels and Resorts, Inc., a hotel management company. Mr. Sharman
served for ten years as Chairman of the Board and President of The Lancaster
Group, Inc., a real estate development firm based in Houston, Texas, which is
the predecessor of Lancaster Hotel Management, L.C. and Bayou Equities, Inc. Mr.
Sharman serves as a Director of Small Luxury Hotels, Ltd. of the United Kingdom,
an international hotel marketing and reservations firm, and also serves on the
Board of Trustees of St. Edwards University in Austin, Texas. Mr. Sharman also
presently serves as a President and Director of ILM I, and Director of Lease I
and Lease II. He has a Bachelor of Science degree from the University of Notre
Dame.

JEFFRY R. DWYER has served as Secretary and a Director of the Company since
its inception in 1990. Mr. Dwyer has been a shareholder of the law firm of
Greenberg Traurig since June 1997. In May 1997, Greenberg Traurig began acting
as Counsel to the Company and its affiliates. From 1993 to 1997, Mr. Dwyer was a
partner with the law firm of Akin, Gump, Strauss, Hauer & Feld in the District
of Columbia. Prior to joining Akin, Gump, Strauss, Hauer & Feld, Mr. Dwyer was a
partner with the law firm of Morrison & Foerster from 1989 to 1993. Mr. Dwyer
also presently serves as Secretary and a Director of ILM I, Lease I and Lease
II. Mr. Dwyer has written several law review articles and a major treatise on
real estate financing and has 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.

III-1

<PAGE>

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (CONTINUED)

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., the Rochdale Insurance Group,
Health Process Management and Post Acute Care, L.L.C. Mr. Schramm holds a Ph.D.
in Economics from the University of Wisconsin and received his J.D. from
Georgetown University. Mr. Schramm also presently serves as a Director of ILM I.

LAWRENCE A. COHEN served as President, Chief Executive Officer and Director
of the Company from 1991 until July 28, 1998. In November 1996, he also became
Vice Chairman and Chief Financial Officer of Capital Senior Living Corporation,
an affiliate of Capital, which is the company that was contracted by Lease II in
July 1996 to perform property management services for the Senior Housing
Facilities in which the Company has invested. Mr. Cohen was President and Chief
Executive Officer of PaineWebber Properties Incorporated until August 1996. Mr.
Cohen joined PaineWebber in January 1989 as its Executive Vice President and
Director of Marketing and Sales. Mr. Cohen had also been a Director of Lease I
and Lease II and President, Chief Executive Officer and Director of ILM I until
July 28, 1998. Mr. Cohen received his LL.M. (in Taxation) from New York
University School of Law and his J.D. degree from St. John's University School
of Law. Mr. Cohen received his B.B.A. degree in accounting from George
Washington University. He is a member of the New York Bar and is a Certified
Public Accountant.

JULIEN G. REDELE was a Director of the Company until July 28, 1998. He had
been 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. Mr. Redele now serves as
President and Director of Lease I and Lease II and as Vice President and
Director of ILM Holding and ILM II Holding.

(e) None of the current Directors and Officers were involved in legal
proceedings which are material to an evaluation of his or her ability or
integrity as a Director or Officer, except for the Feldman litigation
described in Item 3.

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

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

ITEM 11. EXECUTIVE COMPENSATION

The Company's Directors each receive an annual fee of $12,000 (except for
J. William Sharman, Jr., President and Director, who receives $27,000) plus $500
for attending each Board of Directors meeting and reimbursement for expenses
incurred in attending meetings and as a result of other work performed for the
Company. Officers of the Company are not compensated. Jeffry R. Dwyer is a
shareholder of and receives compensation from Greenberg Traurig, which acts as
Counsel to the Company and its affiliates. The former officers of the Company
who were also officers of PaineWebber received compensation from PaineWebber
which

III-2

<PAGE>

ITEM 11. EXECUTIVE COMPENSATION (CONTINUED)

indirectly related to services to the Company because the Company was required
to pay certain fees to PaineWebber as described in Item 13. When PaineWebber
resigned as advisor to the Companies, the former officers resigned effective the
same date, therefore no services were provided by such persons subsequent to
June 18, 1997. Lawrence A. Cohen, who was President, Chief Executive Officer and
a Director of the Company until July 28, 1998, also received compensation from
Capital Senior Living Corporation, an affiliate of Capital, a related party.
.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

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

(b) The Directors and Officers of the Company do not have any direct or
indirect ownership of shares of

(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 was provided by PaineWebber.

PaineWebber received fees and compensation determined on a 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 PaineWebber under the terms of the
advisory agreement was as follows.

(i) Under the former advisory agreement, PaineWebber had specific
management responsibilities--to perform day-to-day operations of the
Company and to act as the investment advisor and consultant for the
Company in connection with general policy and investment decisions.
PaineWebber received 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. PaineWebber
earned base management fees totaling $0, $103,000 and $130,000 for
the years ended August 31, 1998, 1997 and 1996, respectively. 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, PaineWebber
received mortgage placement fees equal to 2% of the capital
contributions. Mortgage placement fees of approximately $1,000,000
were earned by PaineWebber 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 sheet.

(iii) For its administrative services with respect to all loans,
PaineWebber received loan servicing fees equal to 1% of capital
contributions. Loan servicing fees totaling $425,141 were earned by
PaineWebber 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 sheet.

III-3

<PAGE>

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)

(iv) In connection with the construction of Senior Housing Facilities,
PaineWebber received a fee, paid directly by AHC, equal to 1% of the
principal amount of each construction loan for administering
construction loans made by the Company. Such fees received by
PaineWebber totaled $431,000 during the Company's investment
acquisition period.

(v) Under the former advisory agreement, PaineWebber was entitled to
receive 1% of disposition proceeds, as defined, until the
shareholders 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 PaineWebber received an aggregate of 5% of
disposition proceeds; and, thereafter, 5% of disposition proceeds.

PaineWebber was 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, 1998, 1997 and 1996 is $0, $118,000 and $107,000, respectively,
representing reimbursements to PaineWebber for providing certain financial,
accounting and investor communication services to the Company.

Mitchell Hutchins Institutional Investors, Inc. ("Mitchell Hutchins")
provided 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
$0, $5,000 and $6,000 (included in general and administrative expenses) for
managing the Company's cash assets during fiscal 1998, 1997 and 1996,
respectively.

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

Lease II has retained Capital 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. Lawrence A. Cohen, who, through July 28, 1998, served as President,
Chief Executive Officer and Director of the Company and a Director of Lease I,
has also served as Vice Chairman and Chief Financial Officer of Capital Senior
Living Corporation, an affiliate of Capital, since November 1996. As a result,
through July 28, 1998, Capital was considered a related party. Capital earned
property management fees from Lease II of $899,000 and $707,000 for the years
ended August 31, 1998 and 1997, respectively.

III-4

<PAGE>

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)

legal fees and costs incurred by Capital thereafter, not to exceed $500,000. At
August 31, 1998, the amount of legal fees either advanced to Capital or accrued
on the financial statements of Lease I and Lease II totaled approximately
$519,000, although the final amount to be reimbursed to Capital has not yet been
determined.

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 expansion of several of the Senior Housing Facilities.
Capital Senior Development, Inc. will receive a fee equal to 7% of the total
development costs of these expansions if they are pursued. The Company will
reimburse Lease II for all costs related to these potential expansions including
fees to Capital Senior Development, Inc. For the years ended August 31, 1998 and
1997, Capital Senior Development, Inc. earned fees from the Company of $73,000
and $0, respectively, for managing pre-construction development activities for
potential expansions of the Senior Housing Facilities.

Jeffry R. Dwyer, Secretary and Director of the Company, is a shareholder of
Greenberg Traurig, which began acting as Counsel to the Company and its
affiliates in late fiscal year 1997. Greenberg Traurig earned fees from the
Company of $233,000 and $57,000 for the years ended August 31, 1998 and 1997,
respectively.

III-5

<PAGE>

ILM II SENIOR LIVING, INC.

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 August 21, 1998
reporting the Company's settlement of the AHC litigation.

On June 4, 1998, an unsolicited tender offer was filed on Schedule
14D-1 to purchase up to 700,000 outstanding shares of the Company's
common stock representing approximately 9.3% of the outstanding
shares.

On June 17, 1998, the Company filed a response to the unsolicited
tender offer on Schedule 14D-9 which response was amended on July 7,
1998 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.

The Company filed a Current Report on Form 8-K dated August 14, 1997
reporting the Company's name change.

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.

IV-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.

ILM II SENIOR LIVING, INC.

By: /s/ J. WILLIAM SHARMAN, JR.
------------------------------
J. William Sharman, Jr.
President

Dated: NOVEMBER 16, 1999
--------------------------

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

By: /s/ J. WILLIAM SHARMAN, JR. Date: NOVEMBER 16, 1999
------------------------------ -------------------------
J. William Sharman, Jr.
Director

By: /s/ JEFFRY R. DWYER Date: NOVEMBER 12, 1999
------------------------------ -------------------------
Jeffry R. Dwyer
Director

By: /s/ CARL J. SCHRAMM Date: NOVEMBER 16, 1999
------------------------------ -------------------------
Carl J. Schramm
Director

IV-2

<PAGE>

ILM II SENIOR LIVING, INC.

ANNUAL REPORT ON FORM 10-K/A
ITEM 14(a)(3)

INDEX TO EXHIBITS

<TABLE>
<CAPTION>
Page Number in the Report or
Exhibit No. Description of Document Other Reference
- ---------- ----------------------- -----------------------------
<S> <C> <C>
(3) and (4) Prospectus of the Registrant dated August 8, 1990, Filed with the Commission pursuant to
as supplemented, with particular reference to the Rule 424(c) and incorporated herein
Restated Certificate and Agreement of Limited by reference.
Partnership.

Material contracts previously filed as exhibits to Filed with the Commission pursuant to
(10) registration statements and amendments thereto of Section 13 or 15(d) of the Securities
the registrant together with all such contracts Exchange Act of 1934 and incorporated
filed as exhibits of previously filed Forms 8-K and herein by reference.
Forms 10-K are hereby incorporated herein by
reference.

Contracts regarding retention by ILM II Filed as Exhibits 1 and 2 to the
Lease Corporation of Capital Senior Current Report on Form 8-K dated July 18, 1996
Management 2, Inc., as property manager. and incorporated herein by reference.

(13) Annual Reports to Stockholders No Annual Report for the year ended
August 31, 1998 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 Schedules required by Item 14.
</TABLE>

IV-3
<PAGE>

ILM II SENIOR LIVING, INC.

ANNUAL REPORT ON FORM 10-K/A
ITEM 14(a)(1) AND (2) AND 14(d)

INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES

<TABLE>
<CAPTION>
REFERENCE
<S> <C>
ILM II SENIOR LIVING, INC. :

Report of Independent Auditors F-2

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

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

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

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

Notes to Consolidated Financial Statements F-7

ILM II HOLDING, INC. :

Report of Independent Auditors F-20

Balance Sheet as of August 31, 1996 F-21

Statements of Operations for the year ended August 31, 1996 F-22

Statements of Changes in Shareholders' Equity (Deficit)
for the year ended August 31, 1996 F-23

Statements of Cash Flows for the year ended August 31, 1996 F-24

Notes to Financial Statements F-25

SCHEDULE:

Schedule III - Real Estate and Accumulated Depreciation F-33
</TABLE>

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.

F-1

<PAGE>

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Shareholders of
ILM II Senior Living, Inc.

We have audited the accompanying consolidated balance sheets of ILM II
Senior Living, Inc. and subsidiary, as of August 31, 1998 and 1997, 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, 1998. 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
ILM II Senior Living, Inc. and subsidiary, at August 31, 1998 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended August 31, 1998, 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.

ERNST & YOUNG LLP

Dallas, Texas
October 13, 1998

F-2

<PAGE>

ILM II SENIOR LIVING, INC.

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

<TABLE>
<CAPTION>
ASSETS
1998 1997
---- ----
<S> <C> <C>
Operating investment properties, at cost:
Land ................................................................... $ 5,518 $ 5,030
Building and improvements .............................................. 27,726 27,726
Furniture, fixtures and equipment ...................................... 3,815 3,765
-------- --------
37,059 36,521
Less: accumulated depreciation ......................................... (7,599) (6,457)
-------- --------
29,460 30,064

Real estate investments:
Unamortized mortgage fees .............................................. 1,425 1,425
Less: accumulated amortization ........................................ (966) (823)
-------- --------
459 602

Loan origination fees, net ................................................ 72 --

Cash and cash equivalents ................................................. 1,896 2,361
Accounts receivable - related party ....................................... 273 151
Prepaid expenses and other assets ......................................... 154 77
Deferred rent receivable .................................................. 69 100
-------- --------
$ 32,383 $ 33,355
======== ========

LIABILITIES AND SHAREHOLDERS' EQUITY

Accounts payable and accrued expenses ..................................... $ 220 $ 147

Accounts payable - related party .......................................... -- 205
-------- --------
220 352
Preferred shareholders'
minority interest in consolidated subsidiary ........................... 125 116
-------- --------
Total liabilities .......................................... 345 468

Commitments and contingencies

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 ............................................. 44,823 44,823
Accumulated deficit .................................................... (12,837) (11,988)
-------- --------
Total shareholders' equity ....................................... 32,038 32,887
======== ========
$ 32,383 $ 33,355
======== ========
</TABLE>

See accompanying notes.

F-3

<PAGE>

ILM II SENIOR LIVING, INC.

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

<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
REVENUES:
Rental and other income ........................... $ 4,988 $ 4,416 $ --
Interest income earned on cash equivalents ........ 77 99 46
------- ------- -------
5,065 4,515 46
EXPENSES:
Depreciation ...................................... 1,142 1,132 --
Amortization ...................................... 143 143
Management fees ................................... -- 103 130
General and administrative ........................ 222 563 246
Professional fees ................................. 540 308 233
Director compensation ............................. 111 82 24
------- ------- -------
2,158 2,331 633
------- ------- -------
Operating income (loss) .............................. 2,907 2,184 (587)

Equity in income of properties securing mortgage loans -- -- 2,674
------- ------- -------

NET INCOME ........................................... $ 2,907 $ 2,184 $ 2,087
======= ======= =======
Earnings per share of common stock ................... $ 0.56 $ 0.42 $ 0.40
======= ======= =======
Cash dividends paid per share of common stock ........ $ 0.73 $ 0.61 $ 0.50
======= ======= =======
</TABLE>

The above earnings and cash dividends paid per share of common stock are
based upon the 5,181,236 shares outstanding during the year.

See accompanying notes.

F-4

<PAGE>

ILM II SENIOR LIVING, INC.

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

<TABLE>
<CAPTION>
Common Stock
$.01 Par Value Additional
-------------- Paid-in Accumulated
Shares Amount Capital Deficit Total
------ ------ ---------- ------------ ------
<S> <C> <C> <C> <C> <C>
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 ............. -- -- -- (500) (500)

Net income .................... -- -- -- 2,087 2,087
--------- --------- --------- --------- ---------
SHAREHOLDERS' EQUITY AT
AUGUST 31, 1996 ............... 5,181,236 52 44,823 (10,999) 33,876

Cash dividends paid ........... -- -- -- (3,173) (3,173)

Net income .................... -- -- -- 2,184 2,184
--------- --------- --------- --------- ---------
SHAREHOLDERS' EQUITY AT
AUGUST 31, 1997 ............... 5,181,236 52 44,823 (11,988) 32,887

Cash dividends paid ........... -- -- -- (3,756) (3,756)

Net income .................... -- -- -- 2,907 2,907
--------- --------- --------- --------- ---------
SHAREHOLDERS' EQUITY AT
AUGUST 31, 1998 ............... 5,181,236 $ 52 $ 44,823 $ (12,837) $ 32,038
========= ========= ========= ========= =========
</TABLE>

See accompanying notes.

F-5

<PAGE>

ILM II SENIOR LIVING, INC.

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

<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income ............................................. $ 2,907 $ 2,184 $ 2,087
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Equity in income of properties securing mortgage
loans ............................................ -- -- (2,674)
Depreciation and amortization ...................... 1,285 1,275 --
Charitable contribution of subsidiary's
preferred stock and accrued dividends ............ 9 116 --
Changes in assets and liabilities:
Interest and other receivables ................... -- 178 (318)
Accounts receivable - related party .............. (122) 74 156
Prepaid expenses and other assets ................ (77) (68) 7
Deferred rent receivable ......................... 31 31 --
Accounts payable - related party ................. (205) 173 (25)
Accounts payable and accrued expenses ............ 73 82 (50)
------- ------- -------
Net cash provided by (used in) operating
activities ................................ 3,901 4,045 (817)
------- ------- -------

Cash flows (used in) from investing activities:
Initial investment in ILM II Lease Corporation ......... -- -- (500)
Additional fundings of construction loans .............. -- -- (320)
Contractual payments received on mortgage loans ........ -- -- 3,998
ILM II Holding acquired cash balance ................... -- 245 --
Additions to operating investment properties ........... (538) (205) --
------- ------- -------
Net cash (used in) provided by investing
activities ................................ (538) 40 3,178
------- ------- -------

Cash flows used in financing activities:
Loan origination fees .................................. (72) -- --
Cash dividends paid to shareholders .................... (3,756) (3,173) (2,591)
------- ------- -------
Net cash used in financing activities ....... (3,828) (3,173) (2,591)
------- ------- -------

Net increase (decrease) in cash and cash equivalents ...... (465) 912 (230)

Cash and cash equivalents, beginning of year .............. 2,361 1,449 1,679
------- ------- -------

Cash and cash equivalents, end of year .................... $ 1,896 $ 2,361 $ 1,449
======= ======= =======

Cash paid for state income taxes .......................... $ -- $ -- $ 3
======= ======= =======
</TABLE>

See accompanying notes.

F-6

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements

1. NATURE OF OPERATIONS, RESTRUCTURING, AND BASIS OF PRESENTATION

ILM II Senior Living, Inc. (the "Company), formerly PaineWebber Independent
Mortgage Fund, 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 "Prospectus"). 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 (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 ("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.

The Company entered into an exclusivity agreement, (as amended), 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 paid 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.

F-7

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

1. NATURE OF OPERATIONS, RESTRUCTURING, AND BASIS OF PRESENTATION (CONTINUED)

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 balance of 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. 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 nonvoting, 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. The Company recorded the contribution of the
preferred stock in ILM II Holding to the charitable organizations at the amount
of the initial liquidation preference of $111,000. Such amount is included in
general and administrative expense on the accompanying income statement for the
year ended August 31, 1997. Cumulative dividends accrued as of August 31, 1998
and 1997 on the preferred stock in ILM II Holding totaled approximately $14,000
and $5,000, respectively.

F-8

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

1. NATURE OF OPERATIONS, RESTRUCTURING, AND BASIS OF PRESENTATION (CONTINUED)

Note 2). As discussed further in Note 4, 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. On September 1, 1995, after the
Company received the required regulatory approval, the Company distributed all
of the shares of capital stock of Lease II to the holders of record of the
Company's common stock. The Senior Housing Facilities were leased to Lease II
effective September 1, 1995 (see Note 4 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
REITs and independent/assisted living financings was engaged by the Company and
Lease II, as well as ILM I and its affiliates. Following a comprehensive
analysis, the investment banking firm 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 banking firm. The Boards declined to
seek an immediate sale of the properties because, in the Boards' 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 several years prior to their scheduled termination date.

PaineWebber had 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.

F-9

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

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, 1998 and 1997 and revenues and expenses for
each of the three years in the period ended August 31, 1997. Actual results
could differ from the estimates and assumptions used.

The Company's significant accounting policies are summarized as follows:

A. BASIS OF PRESENTATION

The accompanying financial statements include the financial statements of
the Company and ILM II Holding. All intercompany balances and transactions
have been eliminated in consolidation.

Effective January 10, 1997, the Company purchased the remaining common
shares held by PaineWebber of ILM II Holding which provided the Company
with 100% majority voting control, for $40,000 which is included in general
and administrative expense for the year ended August 31, 1997. Accordingly,
the accounts of ILM II Holding have been consolidated with those of the
Company as though this controlling interest had been acquired at September
1, 1996. The accompanying financial statements for fiscal year 1996 account
for the Company's investment in ILM II Holding using the equity method.
Under the equity method, the Company's investment in ILM II Holding is
carried at cost, including the face amount of the mortgage loans, adjusted
for the Company's share of ILM II Holding's earnings, losses and
distributions.

B. INCOME TAXES

The Company has elected to qualify and to be taxed as a 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 ILM II Holding, 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 residents 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 residents includes income for the increased level of
services received by them. Consequently, the rents paid by the residents
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

F-10

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

2. USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

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, Lease II, for the purpose of operating the Senior Housing
Facilities. The Senior Housing Facilities were leased to Lease II effective
September 1, 1995 (see Note 4 for a description of the master lease
agreement).

The assumption of ownership of the properties through ILM II Holding, which
was a regular C corporation for tax purposes at the time of assumption, 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 a C corporation. The Company completed its
restructuring plans by converting ILM II Holding to a REIT for tax purposes
effective for calendar year 1996. 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 10 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 as defined in the Articles of
Incorporation is December 31, 2001, the properties might not be held for an
additional 10 years. Based on management's estimate of the increase in the
values of the properties which occurred between April 1994 and January
1996, as supported by independent appraisals, a sale of the Senior Housing
Facilities within ten years of the date of the conversion of ILM II Holding
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.

The Company's consolidated subsidiary, ILM II Holding, has incurred losses
for tax purposes since inception. Neither the Company nor ILM II 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. All
distributions during calendar years 1998, 1997 and 1996 were 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, 1998 or 1997. Depreciation expense is provided on a straight-line basis
using an estimated useful life of 40 years for the buildings and
improvements and five years for the furniture, fixtures and equipment.

F-11

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

2. USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

The Company reviews the carrying value of a long-lived asset if facts and
circumstances suggest that it may be impaired or that the amortization
period may need to be changed. The Company considers external factors
relating to the long-lived asset, including occupancy trends, local market
developments, changes in payments, and other publicly available
information. If these external factors indicate the long-lived asset will
not be recoverable, based upon undiscounted cash flows of the long-lived
asset over its remaining life, the carrying value of the long-lived asset
will be reduced by the estimated shortfall of discounted cash flows. The
Company does not believe there are any indicators that would require an
adjustment to the carrying value of its long-lived assets or their
remaining useful lives as of August 31, 1998.

Loan placement fees of $1,425,000 were incurred by the Company and are
included in operating investment properties in the accompanying balance
sheet. Accumulated amortization at August 31, 1998 and 1997 is $966,000 and
$823,000, respectively. Loan origination fees relating to the construction
loan financing (see Note 6.) will be amortized on the straight-line method.

E. RENTAL REVENUES

In fiscal years 1998 and 1997, rental revenues consist of payments due from
Lease II 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, 1998 and 1997 represents the difference between rental
income on a straight-line basis and rental income received under the terms
of the master lease.

F. 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.

G. NEW ACCOUNTING PRONOUNCEMENTS

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

F-12

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

3. RELATED PARTY TRANSACTIONS

Subject to the supervision of the Company's Board of Directors, the
business of the Company was managed by PaineWebber. As previously discussed in
Note 1, PaineWebber resigned effective as of June 18, 1997.

PaineWebber and its affiliates received 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 PaineWebber under the terms of the
advisory agreement was as follows.

(i) Under the advisory agreement, PaineWebber 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. PaineWebber
received 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. PaineWebber
earned base management fees totaling $0, $103,000 and $130,000 for
the years ended August 31, 1998, 1997 and 1996, respectively. Payment
of incentive management fees was suspended effective April 15, 1993
in conjunction with a reduction in the Company's quarterly dividend
payments.

(iii) For its administrative services with respect to all loans,
PaineWebber received, loan servicing fees equal to 1% of the loan
amounts. Loan administration and due diligence fees totaling $425,000
were earned by PaineWebber during the Company's investment due
diligence period. Such fees have been capitalized and are included in
the cost of the operating investment properties on the accompanying
consolidated balance sheets.

(iv) PaineWebber was 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 PaineWebber has received an
aggregate of 5% of disposition proceeds; and, thereafter, 5% of
disposition proceeds.

PaineWebber was reimbursed for its 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,
1998, 1997 and 1996 is $0, $118,000 and $107,000, respectively, representing
reimbursements to PaineWebber for providing certain financial, accounting and
investor communication services to the Company.

F-13

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

3. RELATED PARTY TRANSACTIONS (CONTINUED)

Lease II has retained Capital Senior Management 2, Inc. ("Capital") 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. Lawrence A. Cohen, who,
through July 28, 1998, served as President Chief Executive Officer and Director
of the Company and a Director of Lease II, has also served as Vice Chairman and
Chief Financial Officer of Capital Senior Living Corporation, an affiliate of
Capital, since November 1996. As a result, through July 28, 1998, Capital was
considered a related party. Capital earned property management fees from Lease
II of $899,000 and $707,000 for the years ended August 31, 1998 and 1997,
respectively.

F-14

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

3. RELATED PARTY TRANSACTIONS (CONTINUED)

Jeffry R. Dwyer, Secretary and Director of the Company, is a shareholder of
Greenberg Traurig, which began acting as Counsel to the Company and its
affiliates in late fiscal year 1997. Greenberg Traurig received fees from the
Company of $224,000 and $57,000 for the years ended August 31, 1998 and 1997,
respectively.

Accounts receivable - related party at August 31, 1998 and 1997 represents
amounts due from Lease II for variable rent.

Accounts payable - related party at August 31, 1997 represents amounts owed
to Lease II for property improvements made on the Company's behalf; there were
no accounts payable - related party at August 31, 1998.

4. OPERATING INVESTMENT PROPERTIES SUBJECT TO MASTER LEASE

As of August 31, 1998, 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:

<TABLE>
<CAPTION>
Rentable Resident Date of
Name Location Units Capacities Investment (1)
---- -------- ------ ---------- --------------
<S> <C> <C> <C> <C>
The Palms Fort Myers, FL 205 255 7/18/90

Crown Villa Omaha, NE 73 73 4/25/91

Overland Park Place Overland Park, KS 141 153 4/9/92

Rio Las Palmas Stockton, CA 164 190 5/14/92

The Villa at Riverwood St. Louis County, MO 120 140 5/29/92

Villa Santa Barbara (2) Santa Barbara, CA 125 125 7/13/92
</TABLE>

(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, ILM I. All amounts generated
from the operations of 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. 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. Villa Santa Barbara is owned 75% by ILM
II Holding and 25% by ILM Holding, Inc. as tenants in common.

The cost basis of the operating investment properties reflects 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. In
accordance with generally accepted accounting principles, the Company had always
accounted for its investments in acquisition and

F-15

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

4. OPERATING INVESTMENT PROPERTIES SUBJECT TO MASTER LEASE (CONTINUED)

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.

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 II Holding. As a result, ownership of the Senior Housing
Facilities, as well as the obligation under the loans, is now held by ILM II
Holding, and the Property Companies no longer exist as separate legal entities.
Since ILM II Holding is consolidated with the Company in the accompanying
financial statements for fiscal 1998 and 1997, 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. The master lease agreement, which commenced on September 1,
1995, is between the Company's consolidated subsidiary, ILM II Holding, as owner
of the properties and lessor, and Lease II as lessee. 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. 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, which expires on December 31, 2000 (December 31, 1999 with respect
to the Santa Barbara Facility). 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 $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 fiscal years 1998 and 1997 was $984,000 and $412,000, respectively.

F-16

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

4. OPERATING INVESTMENT PROPERTIES SUBJECT TO MASTER LEASE (CONTINUED)

Condensed balance sheets as of August 31, 1998 and 1997, and condensed
statements of operations for the years ended August 31, 1998 and 1997 of Lease
II are as follows:

<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
ASSETS
Current assets $ 1,896 $ 1,454
Furniture, fixtures, and equipment, net 558 416
Other assets 279 256
------- ------
$ 2,733 $ 2,126
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities $ 1,960 $ 1,307
Other liabilities 76 100
Shareholders' equity 697 719
------- -------
$ 2,733 $ 2,126
======= =======
STATEMENT OF OPERATIONS
Revenues $15,524 $14,433
Operating expenses 15,560 14,500
Income tax benefit (14) (27)
------- ------
Net loss $ (22) $ (40)
======= =======
</TABLE>

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 $1,201,000 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 totaled 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, 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 alleged that AHC
willfully

F-17

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

5. LEGAL PROCEEDINGS AND CONTINGENCIES (CONTINUED)

performed actions specifically in violation of the Agreement and that such
actions caused damages to the Companies. Due to the termination of the
Agreement for cause, no termination fee was paid to AHC. Subsequent to the
termination of the 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 alleged that the management agreement was wrongfully terminated
for cause and requested damages which included the payment of the termination
fee in the amount of $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 agreement could have been terminated without cause, and
recovery of attorney's fees and expenses.

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

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

Subsequently, the Boards of Directors of 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 to Capital was
increased to include 75% of the California litigation legal fees and costs
incurred by Capital for December 1997 and January 1998, plus 75% of such legal
fees and costs incurred by Capital thereafter, not to exceed $500,000. At August
31, 1998, legal expense of $519,000 in total has been either advanced or accrued
on the financial statements of Lease I and Lease II for Capital's California
litigation costs, although the final amount to be reimbursed to Capital has not
yet been determined.

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

F-18

<PAGE>

ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)

5. LEGAL PROCEEDINGS AND CONTINGENCIES (CONTINUED)

a small percentage of the increases in cash flow and value achieved for the
Company and its affiliates over the past two years. At August 31, 1997, a
provision of $400,000 for the liability which might have resulted to the Company
had been recorded in the financial statements of Lease II, with the remaining
$600,000 provision recorded by Lease I. At August 31, 1998, an additional
provision of $250,000 was recorded in the financial statements of Lease II with
the remaining $375,000 recorded in the financial statements of Lease I.
Subsequent to the end of the fiscal year, on September 4, 1998, the full
settlement amounts were paid to AHC and its affiliates.

OTHER LITIGATION

On May 8, 1998 Andrew A. Feldman and Jeri Feldman, as Trustees for the
Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990, commenced a
purported class action on behalf of that trust and all other shareholders of 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. On July 8, 1998, the Company
joined with all other defendants to dismiss the complaint on all accounts.

6. CONSTRUCTION LOAN FINANCING

The Company has finalized negotiations with a major bank to provide a
construction loan facility that will provide the Company with up to $8.8 million
to fund the capital costs of these potential expansion programs. The
construction loan facility will be secured by a first mortgage of the Company's
properties and collateral assignment of the Company's leases of such properties.
The loan will have a three-year term with interest accruing at a rate equal to
LIBOR plus 1.10% or Prime plus 0.5%. The loan term could be extended for an
additional two years beyond its maturity date with monthly payments of principal
and interest on a 25-year amortization schedule.

7. SUBSEQUENT EVENTS

On September 15, 1998, the Company's Board of Directors declared a
quarterly dividend for the quarter ended August 31, 1998. On October 15, 1998, a
dividend of $0.2125 per share of common stock, totaling $1,598,000, will be made
to the shareholders of record as of September 30, 1998.

F-19

<PAGE>

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Shareholders of
ILM II Senior Living, Inc.

We have audited the accompanying balance sheet of ILM II Holding, Inc., (the
"Company"), as of August 31, 1996 and the related statements of operations,
changes in shareholders' equity (deficit), and cash flows for the year ended
August 31, 1996. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audit.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of ILM II Holding, Inc., at August
31, 1996, and the results of its operations and its cash flows for the year
ended August 31, 1996, in conformity with generally accepted accounting
principles.

ERNST & YOUNG LLP

Boston, Massachusetts
December 10, 1996

F-20

<PAGE>

ILM II HOLDING, INC.

BALANCE SHEET
August 31, 1996
(Dollars in thousands, except per share amounts)

<TABLE>
<S> <C>
ASSETS

Operating investment properties, at cost:
Land ...................................................................... $ 5,030
Building and improvements ................................................. 25,714
Furniture, fixtures and equipment ......................................... 3,964
--------
34,708
Less: accumulated depreciation ............................................ (2,768)
--------
31,940

Cash and cash equivalents ...................................................... 245
Accounts receivable - related party ............................................ 225
Deferred rent receivable ....................................................... 131
Prepaid expenses and other assets .............................................. 33
--------
$ 32,574
========

LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)

Mortgages payable .............................................................. $ 34,006
Accounts payable - related party ............................................... --
Accounts payable and accrued expenses
3
--------
Total liabilities ............................................ 34,009

Commitments and contingencies Shareholders' equity (deficit):
Preferred stock ( Series A, $1 par value, 100 shares
authorized, shares issued and outstanding) ....................... 1
Common stock ($1 par value, 10,000 shares
authorized, shares issued and outstanding) ....................... 10
Additional paid-in capital ............................................ 489
Accumulated deficit ................................................... (1,935)
--------
Total shareholders' equity (deficit) ......................... (1,435)
--------
$ 32,574
========
</TABLE>

See accompanying notes.

F-21

<PAGE>

ILM II HOLDING, INC.

STATEMENT OF OPERATIONS
(Dollars in thousands, except per share amounts)

For the Year Ended
August 31, 1996
------------------
<S> <C>
REVENUES:
Rental income ................ $ 4,004
Interest income earned
on cash equivalents ..... 13
--------
4,017
EXPENSES:
Depreciation ................. 1,127
Interest ..................... 3,998
General and administrative ... 73
--------
5,198
--------

NET LOSS .............................. $ (1,181)
========

Loss per share of common stock $(118.10)
========
</TABLE>

See accompanying notes.

F-22

<PAGE>

ILM II HOLDING, INC.

STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
For the year ended August 31, 1996
(Dollars in thousands, except per share amounts)

<TABLE>
<CAPTION>
Common Stock Preferred Stock
$.01 Par Value $.01 Par Value Additional
-------------- -------------- Paid-in Accumulated
Shares Amount Shares Amount Capital Deficit Total
------ ------ ------ ------ ---------- ----------- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Shareholders' equity
(deficit) at August 31, 1995 10,000 10 100 $ 1 $ 489 $ (754) $ (254)

Net loss .................... -- -- -- -- -- (1,181) (1,181)
------ ------ ---- ------- ------- -------- -------
Shareholders' equity
(deficit) at August 31, 1996 10,000 $ 10 100 $ 1 $ 489 $(1,935) $(1,435)
====== ======= ==== ======= ======= ======== =======
</TABLE>

See accompanying notes.

F-23

<PAGE>

ILM II HOLDING, INC.

STATEMENT OF CASH FLOWS
(In thousands)

<TABLE>
<CAPTION>
For the Year Ended
August 31, 1996
-----------------
<S> <C>
OPERATING ACTIVITIES:
Net loss ....................................... $(1,181)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation ............................... 1,127
Changes in operating assets and liabilities:
Accounts receivable ...................... 13
Accounts receivable - related party ...... (37)
Other assets ............................. 7
Deferred rent receivable ................. (131)
Accounts payable - related party ......... (83)
Accounts payable and accrued expenses .... (498)
-------
Total adjustments .............................. 398
-------
Net cash used in operating activities .......... (783)
-------

INVESTING ACTIVITIES:

Additions to operating investment properties ... (103)
-------
Net cash used in investing activities .......... (103)
-------

FINANCING ACTIVITIES:

Advances under mortgage notes .................. 320
-------
Net cash provided by financing activities ...... 320
-------

Net decrease in cash and cash equivalents at
end of period ............................... (566)
Cash and cash equivalents at beginning of year . 811
-------
Cash and cash equivalents at end of year ....... $ 245
=======
</TABLE>

See accompanying notes.

F-24

<PAGE>

ILM II HOLDING, INC.
Notes to Financial Statements
August 31, 1996

1. NATURE OF OPERATIONS, RESTRUCTURING, AND BASIS OF PRESENTATION

ILM II Senior Living, Inc., formerly PaineWebber Independent Living Mortgage,
Inc. II ("ILM II"), invested in six participating mortgage loans secured by
Senior Housing Facilities located in five different states. All of the loans
made by ILM II were originally with Angeles Housing Concepts, Inc. ("AHC"), a
company specializing in the development, acquisition, and operation of senior
housing facilities. ILM II entered into an Exclusivity Agreement with AHC and
its parent company, Angeles Corporation ("Angeles"), which required AHC to
provide ILM II 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 ILM II did not generate sufficient cash flow to cover the debt service
payments owed to ILM II 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.
ILM II 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 ILM II, AHC and Angeles was
reached whereby ownership of the properties would be transferred from AHC to ILM
II or its designated affiliates. Under the terms of the Settlement Agreement,
ILM II 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 ILM II (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 ILM II 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. (the "Company"),
a Virginia corporation. In August 1995, each of the Property Companies merged
into the Company. As a result, ownership of the Senior Housing Facilities is now
held by the Company, and the Property Companies no longer exists as separate
legal entities. The capital stock of the Company is owned by ILM II 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").

As part of the fiscal 1994 Settlement Agreement with AHC, the Company 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 8, 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. On September 12, 1994, ILM II formed a new subsidiary, ILM II Lease
Corporation, for the purpose of operating the Senior Housing

F-25

<PAGE>

ILM II HOLDING, INC.
Notes to Financial Statements (continued)

2. USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Facilities. The Senior Housing Facilities were leased to ILM II Lease
Corporation effective September 1, 1995 (see Note 7 for a description of the
master lease agreement). ILM II Lease Corporation is a public company subject to
the reporting obligations of the Securities and Exchange Commission.

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 the
years ended August 31, 1996. Actual results could differ from the estimates and
assumptions used.

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 balance sheets are presented
in an unclassified format. The Company includes its interest in the
Villa Santa Barbara property on a proportional basis in the
accompanying financial statements due to its joint tenancy agreement
and 75% interest in the property.

B. INCOME TAXES

For purposes of filing federal tax returns, the financial statements
of the Company are consolidated with those of ILM II. The Company has
incurred losses for tax purposes since inception. Neither ILM II nor
the Company is likely to be able to use these losses to offset future
tax liabilities. Accordingly, no income tax benefit is reflected in
these financial statements.

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. 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:

F-26

<PAGE>

ILM II HOLDING, INC.
Notes to Financial Statements (continued)

2. USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

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 notice 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 notice of such instrument.

ACCOUNTS PAYABLE - RELATED PARTY: The carrying amount reported on the
balance sheet for accounts payable - related party approximates its
fair value due to the short-term notice of such instruments.

MORTGAGES PAYABLE: Due to the unique nature of the debt arrangement as
described in Note 5, management is unable to determine the fair value
of mortgages payable without incurring excessive costs.

E. 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. 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 reviews the carrying value of a long-lived asset if facts
and circumstances suggest that it may be impaired or that the
amortization period may need to be changed. The Company considers
external factors relating to the long-lived asset, including occupancy
trends, local market developments, changes in payments, and other
publicly available information. If these external factors indicate the
long-lived asset will not be recoverable, based upon undiscounted cash
flows of the long-lived asset over its remaining life, the carrying
value of the long-lived asset will be reduced by the estimated
shortfall of discounted cash flows. The Company does not believe there
are any indicators that would require an adjustment to the carrying
value of its long-lived assets or their remaining useful lives as of
August 31, 1996.

F. RENTAL REVENUES

Rental revenues consist of payments due from ILM II Lease Corporation
under the terms of the master lease described in Note 7. 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-27

<PAGE>

3. THE ADVISORY AGREEMENT AND RELATED PARTY TRANSACTIONS

Subject to the supervision of ILM II's Board of Directors, the business of ILM
II and 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 ILM II and the acquisition, management and
disposition of ILM II's investments.

Accounts receivable - related party at August 31, 1996, represents advances in
the amount of $225,000 made to ILM II Lease Corporation (see Note 7) primarily
for the purchase of personal property to operate the Senior Housing Facilities.

4. OPERATING PROPERTIES

Descriptions of the Company's operating properties are summarized below:

THE PALMS, FORT MYERS, FLORIDA

In July 1990, ILM II acquired a loan with respect to an existing 204-unit
Senior Housing Facility known as The Palms, located in Fort Myers, Florida.
Construction of the Senior Housing Facility, which was 99% leased as of
August 31, 1996, was completed in October 1988.

CROWN VILLA, OMAHA, NEBRASKA

In April 1991, ILM II acquired a loan with respect to a recently completed
73-unit Senior Housing Facility known as Crown Villa, located in Omaha,
Nebraska. Construction of the Senior Housing Facility, was completed in
January 1992. As of August 31, 1996, the project was 99% leased.

OVERLAND PARK PLACE, OVERLAND PARK, KANSAS

In April 1992, ILM II acquired a loan with respect to an existing 137-unit
Senior Housing Facility known as Overland Park Place, located in Overland
Park, Kansas. Construction of the Senior Housing Facility, was completed in
June 1984. As of August 31, 1996, the project was 91% leased.

RIO LAS PALMAS, STOCKTON, CALIFORNIA

In May 1992, ILM II acquired a loan with respect to an existing 162-unit
Senior Housing Facility known as Rio Las Palmas, located in Stockton,
California. Construction of the Senior Housing Facility was completed in
June 1985. As of August 31, 1996, the project was 40% leased.

THE VILLA AT RIVERWOOD, ST. LOUIS COUNTY, MISSOURI

In May 1992, ILM II acquired a loan with respect to an existing 119-unit
Senior Housing Facility known as The Villa at Riverwood, located in St.
Louis Country, Missouri. Construction of the Senior Housing Facility was
completed in June 1985. As of August 31, 1996, the project was 94% leased.

F-28

<PAGE>

ILM II HOLDING, INC.
Notes to Financial Statements (continued)

4. OPERATING PROPERTIES (CONTINUED)

VILLA SANTA BARBARA, SANTA BARBARA, CALIFORNIA

In July 1992, ILM II acquired a loan with respect to an existing 123-unit
Senior Housing Facility known as Villa Santa Barbara, located in Santa
Barbara, California. The acquisition and improvement of the facility was
financed by the aforementioned loan and another loan from an affiliated
company, PaineWebber Independent Living Mortgage Fund, Inc. (ILM). Any
amounts due from Angeles Housing with regard to the mortgage loans on the
Santa Barbara property will be equitably apportioned between ILM II and ILM
(generally 75% to ILM II and 25% to ILM). ILM II and ILM have entered into
an Intercreditor Agreement to set forth their respective rights and
entitlements under the loan documents. Construction of the Senior Housing
Facility was completed in 1979. As of August 31, 1996, the project was 81%
leased. During the first quarter of fiscal 1994, ILM II committed to
release a portion of the funds set aside for capital improvements at Villa
Santa Barbara in order to improve the marketability of the property. With
the formal execution of the Settlement Agreement completed, the planned
improvement program is now moving forward toward completion. ILM II's
financing of such a program is expected to total approximately $1 million,
which it will fund from available uninvested offering proceeds.

5. MORTGAGE LOANS

The Company's operating properties were acquired subject to the participating
mortgage loans payable to ILM II. 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 Transfers. The modified loans require interest-only
payments on a monthly basis at a rate of 7% from April 1, 1994 through December
31, 1994, 9% for the period 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 through December 31, 1999 and 14% for the period
January 1, 2000 through maturity, on December 31, 2000.

F-29

<PAGE>

ILM II HOLDING, INC.
Notes to Financial Statements (continued)

5. MORTGAGE LOANS (CONTINUED)

The following loans were outstanding at August 31, 1996

<TABLE>
<CAPTION>
August 31,
Property Pledged as Collateral 1996 Date of Loan
- ------------------------------ ---- ------------
<S> <C> <C>
The Palms $ 8,700,00 7/18/90
Fort Myers, FL

Crown Villa 4,950,000 4/25/91
Omaha, NE

Overland Park Place 7,850,000 4/9/92
Overland Park, KS

Rio Las Palmas 5,700,000 5/14/92
Stockton, CA

The Villa at Riverwood 5,858,000 5/29/92
St. Louis County, MO

Villa Santa Barbara 5,094,000 7/13/92
Santa Barbara, CA -----------

38,144,000
Less discount (4,138,000)
-----------
$34,006,000
===========
</TABLE>

A discount was recorded on the long-term debt in the amount by which the
modified principal amount of the loans exceeded the historical cost basis of the
properties at the time of the Transfers.

6. SHAREHOLDERS' EQUITY

The Company has issued 100 shares of Series A Preferred Stock to ILM II in
return for a capital contribution in the amount of $495,000. 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 amount per share equal to the product of 0.1 and 99% of
the total amount of dividends and distributions made to all shareholders. The
Company has also 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 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 amount per share equal to the
product of 0.001 and 1% of the total amount of dividends and distributions made
to all shareholders.

7. LEASE ARRANGEMENTS

Beginning September 1, 1995, the Senior Housing Facilities were leased to ILM II
Lease Corporation under a master lease agreement. The master lease agreement, is
initially between the Company, 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. The Company, 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,

F-30
<PAGE>

ILM II HOLDING, INC.
Notes to Financial Statements (continued)

7. LEASE ARRANGEMENTS (CONTINUED)

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 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.

A condensed balance sheet as of August 31, 1996, and summary of operations for
the year then ended of ILM II Lease Corporation are as follows:

<TABLE>
<S> <C>
ASSETS
Current assets $ 1,714
Furniture, fixtures and equipment 183
Other assets 38
-------
$ 1,935
=======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities $ 1,045
Other non-current liabilities 131
Shareholders' equity 759
-------
$ 1,935
=======
SUMMARY OF OPERATIONS

Revenues $13,201

Operating expenses 8,764
Master lease expense 4,004
Income tax expense 173
-------
Net income $ 260
=======
</TABLE>

8. 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, ILM II 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, ILM II maintained a claim for
approximately $408,000 against an affiliate of Angeles which had made a separate
guaranty to ILM II. On March 17, 1995, the Bankruptcy Court handling the Angeles
bankruptcy proceedings approved a final settlement of ILM II's outstanding
claims against Angeles and its affiliates. Pursuant to the terms of this
settlement, ILM II received a cash payment of $1 million on April 14, 1995, in
full satisfaction of the claims, which totaled approximately $1.6 million. This
amount, net of certain related legal expenses, was recorded as a reduction in
the carrying values of ILM II's operating investment properties.

F-31

<PAGE>

SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION

ILM II SENIOR LIVING, INC.
CONSOLIDATED SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION
August 31, 1998
(Amounts in thousands)

<TABLE>
<CAPTION>
Initial Cost to Costs Capitalized Gross Amount at Which Carried
The Company(2) (Removed Subsequent at End of Year
------------------- to) Acquisition ----------------------------------------
Buildings & of Buildings & Buildings & Unamortized
Description Encumbrances(1) Land Improvements Improvements(3) Land Improvements(5) Mortgage Fees(5)
- ----------- -------------- ---- ------------ ----------------- ---- -------------- ----------------
<S> <C> <C> <C> <C> <C> <C> <C>
CONGREGATE CARE FACILITIES:
Fort Myers,
Florida ................... $ 8,700 $1,075 $11,233 $(3,268) $1,227 $ 7,602 $ 412

Omaha,
Nebraska .................. 4,950 400 5,043 (1,054) 543 3,832 183

Overland Park,
Kansas .................... 7,850 672 6,787 22 656 6,647 251

Stockton,
California ................ 5,700 1,507 5,628 (443) 1,644 5,014 240

St. Louis
County, ................... 5,850 292 4,488 74 298 4,436 161
Missouri

Santa Barbara,
California ................ 5,094 1,160 4,322 (197) 1,150 4,010 178
------- ------ ------- ------- ------ -------- ------
$38,144 $5,106 $37,501 $(4,866) $5,518 $ 31,541 $1,425
======= ====== ======= ======= ====== ======== ======
</TABLE>

<TABLE>
<CAPTION>
Life on Which
Depreciation
in Latest Income
Accumulated Accumulated Date of Date Statement is
Total Depreciation(5) Amortization(5) Construction Acquired Computed
CONGREGATE CARE FACILITIES: ----- --------------- --------------- ------------ -------- -------------
<S> <C> <C> <C> <C> <C> <C>
Fort Myers,
Florida ... ............... $ 9,241 $(2,085) $(325) 1988 7/18/90 5-40 yrs.

Omaha,
Nebraska .................. 4,558 (928) (119) 1992 4/25/91 5-40 yrs.

Overland Park,
Kansas .................... 7,554 (1,479) (161) 1984 4/9/92 5-40 yrs.

Stockton,
California ................ 6,898 (1,195) (151) 1988 5/14/92 5-40 yrs.

St. Louis
County, ................... 4,895 (1,051) (101) 1985 5/29/92 5-40 yrs.
Missouri

Santa Barbara,
California ................ 5,338 (861) (109) 1979 7/13/92 5-40 yrs.
------- ------- -----
$38,484 $(7,599) $(966)
======= ======= =====
</TABLE>

(1) Encumbrances represent first mortgage loans between ILM II Holding as
mortgagor, and the Company as mortgagee. Such loans are eliminated in
consolidation in the accompanying Consolidated Financial Statements (see
Note 4).

(2) Initial cost to the Company represents the aggregate advances made by the
Company 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 the Company from AHC under the terms of 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, 1998 for Federal
income tax purposes is approximately $39,615,000.

(5) Certain numbers have been reclassified to conform to the current year's
presentation.

F-32

<PAGE>

SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION

ILM II SENIOR LIVING, INC. AND SUBSIDIARY
SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION (continued)
August 31, 1998
(Amounts in thousands)

(5) Reconciliation of real estate owned:

<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Balance at beginning of period ............................. $37,946 $37,741 $37,638
Acquisitions and improvements - 12 months ended 8/31/98 538 -- --
Acquisitions and improvements - 12 months ended 8/31/97 -- 205 --
Acquisitions and improvements - 12 months ended 8/31/96 -- -- 103
------- ------- -------
Balance at end of period ................................... $38,484 $37,946 $37,741
======= ======= =======
</TABLE>

(6) Reconciliation of accumulated depreciation and amortization:
<TABLE>
<S> <C> <C> <C>
Balance at beginning of period ..................................... $7,280 $6,005 $4,736
Depreciation and amortization expense - 12 months ended 8/31/98 1,285 -- --
Depreciation and amortization expense - 12 months ended 8/31/97 -- 1,275 --
Depreciation and amortization expense - 12 months ended 8/31/96 -- -- 1,269
------ ------ ------
Balance at end of period ........................................... $8,565 $7,280 $6,005
====== ====== ======
</TABLE>

F-33

<PAGE>
<ARTICLE> 5
<LEGEND>
The schedule contains summary financial information extracted from the
consolidated balance sheet as of Augst 31, 1998, and the consolidated statement
of income for the year ende August 31, 1998.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1998
<PERIOD-END> AUG-31-1998
<CASH> 1,896
<SECURITIES> 0
<RECEIVABLES> 496
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 2,392
<PP&E> 37,059
<DEPRECIATION> 7,599
<TOTAL-ASSETS> 32,383
<CURRENT-LIABILITIES> 220
<BONDS> 0
0
125
<COMMON> 52
<OTHER-SE> 32,038
<TOTAL-LIABILITY-AND-EQUITY> 32,383
<SALES> 4,988
<TOTAL-REVENUES> 5,065
<CGS> 0
<TOTAL-COSTS> 2,158
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,907
<INCOME-TAX> 0
<INCOME-CONTINUING> 2,907
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,907
<EPS-BASIC> .56
<EPS-DILUTED> .56

</TABLE>