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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
----- SECURITIES EXCHANGE ACT OF 1934
FOR FISCAL YEAR ENDED: AUGUST 31, 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
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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
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(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: 888-257-3550
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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 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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<PAGE>
ILM II SENIOR LIVING, INC.
1998 FORM 10-K
TABLE OF CONTENTS
<TABLE>
<S> <C> <C> <C>
Part I Page
- ------ ----
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-8
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.........................................................II-8
Part III
- --------
Item 10 Directors and Executive Officers of the Registrant.................................III-1
Item 11 Executive Compensation.............................................................III-2
Item 12 Security Ownership of Certain Beneficial Owners and Management.....................III-3
Item 13 Certain Relationships and Related Transactions.....................................III-3
Part IV
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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>
ILM II SENIOR LIVING, INC.
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.
During the quarter ended February 28, 1993, Angeles announced that it
was experiencing liquidity problems that resulted in the inability to meet its
obligations. Subsequent to such announcements, AHC defaulted on the regularly
scheduled mortgage loan payments due to the Company on March 1, 1993. Subsequent
to March 1993, payments toward the debt service owed on the Company's loans were
limited to the net cash flow of the operating investment properties. On May 3,
1993, Angeles filed for reorganization under a Chapter 11 Federal Bankruptcy
petition filed in the state of California. AHC did not file for reorganization.
The Company retained special counsel and held extensive discussions with AHC
concerning the default status of its loans. During the fourth quarter of fiscal
1993, a non-binding settlement agreement between the Company, AHC and Angeles
was reached whereby ownership of the properties would be transferred from AHC to
the Company or its designated affiliates. Under the terms of the settlement
agreement, the Company would release 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
I-1
<PAGE>
ILM II SENIOR LIVING, INC.
Item 1. Business (continued)
- ----------------------------
transferred (collectively, "the Transfers") to newly created special purpose
corporations affiliated with the Company (collectively, "the Property
Companies"). The Transfers had an effective date of April 1, 1994 and were made
pursuant to the settlement agreement entered into on February 17, 1994 ("the
Settlement Agreement") between the Company and AHC which had previously been
approved by the bankruptcy court handling the bankruptcy case of Angeles. All of
the capital stock of each Property Company was held by ILM II Holding, Inc.
("ILM II Holding"), a 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. 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
<PAGE>
ILM II SENIOR LIVING, INC.
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. 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, 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.
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.
I-3
<PAGE>
ILM II SENIOR LIVING, INC.
Item 1. Business (continued)
- ----------------------------
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.
The Company's investments as of August 31, 1998 are described below:
<TABLE>
<CAPTION>
Property Name Date of Rentable Resident
and Location (1) Type of Property Investment Units Capacities
- --------------------- ---------------- ---------- ----- ----------
<S> <C> <C> <C> <C>
The Palms
Fort Myers, FL Senior Housing Facility 7/18/90 205 255
Crown Villa
Omaha, NE Senior Housing Facility 4/25/91 73 73
Overland Park Place
Overland Park, KS Senior Housing Facility 4/9/92 141 153
Rio Las Palmas
Stockton, CA Senior Housing Facility 5/14/92 164 190
The Villa at Riverwood
St. Louis County, MO Senior Housing Facility 5/29/92 120 140
Villa Santa Barbara (2)
Santa Barbara, CA Senior Housing Facility 7/13/92 125 125
</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.
I-4
<PAGE>
ILM II SENIOR LIVING, INC.
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 Fleet Bank, Ernst & Young LLP,
MAVRICC Management Systems, Inc., and Smith and Company. In addition, C. David
Carlson, who was a Vice President of the Company until the date of PaineWebber's
resignation and a Vice President of PaineWebber through October 1997, where he
served as Portfolio Manager to the Company, now serves as a consultant to the
Company.
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-5
<PAGE>
ILM II SENIOR LIVING, INC.
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-6
<PAGE>
ILM II SENIOR LIVING, INC.
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-7
<PAGE>
ILM II SENIOR LIVING, INC.
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-8
<PAGE>
ILM II SENIOR LIVING, INC.
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>
ILM II SENIOR LIVING, INC.
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>
ILM II SENIOR LIVING, INC.
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>
ILM II SENIOR LIVING, INC.
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.
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.
II-4
<PAGE>
ILM II SENIOR LIVING, INC.
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.
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
II-5
<PAGE>
ILM II SENIOR LIVING, INC.
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>
ILM II SENIOR LIVING, INC.
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.
The Company relies upon PC-based systems and does not expect to incur
material costs to transition to Year 2000 compliant systems in its internal
operations. The Company does not expect this project to have a significant
effect on operations. The Company will continue to implement systems and all new
investments are expected to be with Year 2000 compliant software.
Results of Operations
1998 Compared to 1997
- ---------------------
Net income increased $723,000 for fiscal year 1998 compared to fiscal
year 1997. Total revenue was $5,065,000 representing an increase in revenue of
$550,000 when compared to the prior fiscal year. Rental and other income
increased by $572,000 from $4,416,000 in fiscal year 1997 to $4,988,000 in
fiscal year 1998 as a result of increased rental income earned pursuant to the
terms of the master lease agreement. Interest income decreased $22,000 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 when
compared to 1997. General and administrative expenses decreased $341,000 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
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 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 for fiscal year 1997 when compared to
fiscal year 1996. Revenue increased by $4,469,000 of which $4,416,000 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 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 of which
$242,000 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 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, due to an increase in the number of Directors and meetings.
Depreciation and amortization expense
II-7
<PAGE>
ILM II SENIOR LIVING, INC.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
- -------------------------------------------------------------------------------
of Operations (continued)
- -------------------------
increased $1,275,000 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 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.
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-8
<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> <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>
ILM II SENIOR LIVING, INC.
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>
ILM II SENIOR LIVING, INC.
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 the Company's common stock as
of the date
(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>
ILM II SENIOR LIVING, INC.
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.
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
III-4
<PAGE>
ILM II SENIOR LIVING, INC.
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.
(c) Exhibits:
See (a)(3) above.
(d) Financial Statement Schedules:
The response to this portion of Item 14 is submitted
as a separate section of this report. See Index to
Financial Statements and Financial Statement Schedules
at page F-1.
IV-1
<PAGE>
ILM II SENIOR LIVING, INC.
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: December 28, 1998
---------------------
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: December 28, 1998
------------------------------ --------------------------
J. William Sharman, Jr.
Director
By: /s/ Jeffry R. Dwyer Date: December 24, 1998
------------------------------ --------------------------
Jeffry R. Dwyer
Director
By: /s/ Carl J. Schramm Date: January 3, 1999
------------------------------ --------------------------
Carl J. Schramm
Director
IV-2
<PAGE>
ILM II SENIOR LIVING, INC.
ANNUAL REPORT ON FORM 10-K
Item 14(a)(3)
ILM II SENIOR LIVING, INC.
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 Filed with the Commission pursuant to
August 8, 1990, as supplemented, with Rule 424(c) and incorporated herein
particular reference to the Restated by reference.
Certificate and Agreement of Limited
Partnership.
(10) Material contracts previously filed as Filed with the Commission pursuant to
exhibits to registration statements and Section 13 or 15(d) of the Securities
amendments thereto of the registrant Exchange Act of 1934 and incorporated
together with all such contracts filed herein by reference.
as exhibits of previously filed Forms 8-K
and 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
Management 2, Inc., as property manager. July 18, 1996 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
Item 14(a)(1) and (2) and 14(d)
ILM II SENIOR LIVING, INC.
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
========== ==========
<CAPTION>
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
<S> <C> <C>
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.
During the quarter ended February 28, 1993, Angeles announced that
it was experiencing liquidity problems that resulted in the inability to
meet its obligations. Subsequent to such announcements, AHC defaulted on
the regularly scheduled mortgage loan payments due to the Company on March
1, 1993. Subsequent to March 1993, payments toward the debt service owed on
the Company's loans were limited to the net cash flow of the operating
investment properties. On May 3, 1993, Angeles filed for reorganization
under a Chapter 11 Federal Bankruptcy petition filed in the state of
California. AHC did not file for reorganization. The Company retained
special counsel and held extensive discussions with AHC concerning the
default status of its loans. During the fourth quarter of fiscal 1993, a
non-binding settlement agreement between the Company, AHC and Angeles was
reached whereby ownership of the properties would be transferred from AHC
to the Company or its designated affiliates. Under the terms of the
settlement agreement, the Company would release AHC and Angeles from
certain obligations under the loans. On April 27, 1994, each of the
properties owned by AHC and securing the loans was transferred
(collectively, "the Transfers") to newly-created special purpose
corporations affiliated with the Company (collectively, "the Property
Companies"). The Transfers had an effective date of April 1, 1994 and were
made pursuant to the settlement agreement entered into on
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.
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. As discussed
further in Note 5, the management agreement with AHC was terminated in July
1996. Subsequent to the effective date of the Settlement Agreement with
AHC, management investigated and evaluated the available options for
structuring the ownership of the properties in order to maximize the
potential returns to the existing shareholders while maintaining the
Company's qualification as a REIT under
F-8
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)
1. Nature of Operations, Restructuring, and Basis of Presentation (continued)
--------------------------------------------------------------------------
the Internal Revenue Code (see Note 2). As discussed further in Note 4, on
September 12, 1994, the Company formed a new subsidiary, ILM II Lease
Corporation ("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.
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.
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 operating cycle in the real estate industry is longer than one year
and the distinction between current and non-current is of little
relevance. Accordingly, the accompanying consolidated balance sheet is
presented in an unclassified format.
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.
(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 sheets.
(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)
--------------------------------------
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 years 1998, 1997 and 1996,
respectively.
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.
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.
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.
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
I Holding, Inc.
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
construction loans under the equity method, as if such investments were
equity interests in a joint venture.
F-15
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)
4. Operating Investment Properties Subject to Master Lease (continued)
-------------------------------------------------------------------
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>
Assets 1998 1997
--------- ---------
<S> <C> <C>
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
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
F-17
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)
5. Legal Proceedings and Contingencies (continued)
-----------------------------------------------
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 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
F-18
<PAGE>
ILM II SENIOR LIVING, INC.
Notes to Consolidated Financial Statements (continued)
5. Legal Proceedings and Contingencies (continued)
-----------------------------------------------
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.
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.
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.
8. Year 2000 (Unaudited)
---------------------
The Company relies upon PC-based systems and does not expect to incur
material costs to transition to Year 2000 compliant systems in its internal
operations. The Company does not expect this project to have a significant
effect on operations. The Company will continue to implement systems and
all new investments are expected to be with Year 2000 compliant software.
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>
<CAPTION>
ASSETS
------
<S> <C>
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
-------
<CAPTION>
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
----------------------------------------------
<S> <C>
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)
<TABLE>
<CAPTION>
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>
ILM II HOLDING, INC.
Notes to Financial Statements (continued)
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>
<CAPTION>
Assets
<S> <C>
Current assets $ 1,714
Furniture, fixtures and equipment 183
Other assets 38
-------
$ 1,935
=======
<CAPTION>
Liabilities and Shareholders' Equity
<S> <C>
Current liabilities $ 1,045
Other non-current liabilities 131
Shareholders' equity 759
-------
$ 1,935
=======
<CAPTION>
Summary of Operations
<S> <C>
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 at
The Company (2) (Removed Subsequent End of Year
---------------------- to) Acquisition of -----------------------------------------------
Buildings & Buildings & Buildings & Unamortized
Description Encumbrances(1) Land Improvements Improvements (3) Land Improvements (5) Mortgage Fees (5)
----------- --------------- ---- ------------ ---------------- ---- ---------------- -----------------
CONGREGATE CARE FACILITIES:
<S> <C> <C> <C> <C> <C> <C> <C>
Fort Myers, $ 8,700 $1,075 $11,233 $(3,268) $1,227 $ 7,602 $ 412
Florida
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
======= ====== ======= ======= ====== ======= ======
<CAPTION>
Life on Which
Depreciation in
Latest Income
Accumulated Accumulated Date of Date Statement is
Description Total Depreciation (5) Amortization (5) Construction Acquired Computed
----------- ----- ---------------- ---------------- ------------ -------- --------
CONGREGATE CARE FACILITIES:
<S> <C> <C> <C> <C> <C> <C>
Fort Myers, $ 9,241 $(2,085) $(325) 1988 7/18/90 5-40 yrs.
Florida
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)
<TABLE>
<CAPTION>
(5) Reconciliation of real estate owned:
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
======== ======== ========
<CAPTION>
(6) Reconciliation of accumulated depreciation and amortization:
<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
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
consolidated balance sheet as of August 31, 1998, and the consolidated statement
of income for the year ended August 31, 1998.
</LEGEND>
<CIK> 0000861880
<NAME> ILM II SENIOR LIVING, INC.
<MULTIPLIER> 1,000
<CURRENCY> USD
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1998
<PERIOD-START> SEP-01-1997
<PERIOD-END> AUG-31-1998
<EXCHANGE-RATE> 1
<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-PRIMARY> .56
<EPS-DILUTED> .56
</TABLE>
