UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------------------------
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 1997
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 : 0-25878
ILM I LEASE CORPORATION
-----------------------
(Exact name of registrant as specified in its charter)
Virginia 04-3248637
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
265 Franklin Street, Boston, MA 02110
- ------------------------------- -----
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (800) 225-1174
--------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|.
Shares on common stock outstanding as of May 31, 1997: 7,519,430. The
aggregate sales price of the shares sold was $700,000. This does not reflect
market value. There is no current market for these shares.
<PAGE>
ILM I LEASE CORPORATION
BALANCE SHEETS
May 31, 1997 and August 31, 1996 (Unaudited)
(In thousands)
ASSETS
May 31 August 31
------ ---------
Cash and cash equivalents $ 2,154 $ 2,185
Accounts receivable 245 77
Prepaid expenses and other assets 149 267
--------- --------
Total current assets 2,548 2,529
Furniture, fixtures and equipment 434 261
Less: accumulated depreciation (56) (19)
--------- --------
378 242
Deferred tax asset, net - 26
--------- --------
$ 2,926 $ 2,797
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Accounts payable and accrued expenses $ 883 $ 863
Real estate taxes payable 345 300
Accounts payable - affiliates 395 445
Security deposits 5 5
--------- --------
Total current liabilities 1,628 1,613
Deferred tax liability, net 2 -
Deferred rent payable 95 123
--------- --------
Total liabilities 1,725 1,736
Shareholders' equity 1,201 1,061
--------- --------
$ 2,926 $ 2,797
========= ========
See accompanying notes.
<PAGE>
ILM I LEASE CORPORATION
STATEMENTS OF INCOME
For the three and nine months ended May 31, 1997 and 1996 (Unaudited)
(In thousands, except per share amounts)
Three Months Ended Nine Months Ended
May 31, May 31,
------------------ -----------------
1997 1996 1997 1996
---- ---- ---- ----
Revenues:
Rental and other income $ 4,568 $ 4,331 $13,394 $12,871
Interest income 24 17 62 42
------- ------- ------- -------
4,592 4,348 13,456 12,913
Expenses:
Master lease rent expense 1,710 1,582 4,945 4,746
Dietary salaries, wages
and food service expenses 881 765 2,532 2,294
Administrative salaries,
wages and expenses 322 253 918 807
Marketing salaries, wages
and expenses 216 217 653 650
Utilities 191 218 620 632
Repairs and maintenance 163 177 475 493
Real estate taxes 193 207 616 607
Property management fees 222 239 637 709
Other property operating expenses 350 346 1,108 1,053
General and administrative 438 35 615 89
Advisory fees 23 22 67 64
Depreciation expense 14 - 37 -
------- ------- ------- -------
4,723 4,061 13,223 12,144
------- ------- ------- -------
Income (loss) before taxes (131) 287 233 769
Income tax expense (benefit):
Current (61) 127 65 343
Deferred 9 (12) 28 (36)
------- ------- ------- -------
(52) 115 93 307
------- ------- ------- -------
Net income (loss) $ (79) $ 172 $ 140 $ 462
======= ======= ======= =======
Earnings (loss) per share
of common stock $(0.01) $0.02 $0.02 $0.06
====== ===== ===== =====
The above earnings (loss) per share of common stock is based upon the 7,519,430
shares outstanding for each period.
See accompanying notes.
<PAGE>
ILM I LEASE CORPORATION
STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
For the nine months ended May 31, 1997 and 1996 (Unaudited)
(In thousands)
Common Stock Additional
$.01 Par Value Paid-in Accumulated
Shares Amount Capital Earnings Total
------ ------ ------- -------- -----
Balance at August 31, 1995 15 $ - $ 1 $ (1) $ -
Issuance of common stock 7,504 75 624 - 699
Net income - - - 462 462
----- ----- ----- ------ -------
Balance at May 31, 1996 7,519 $ 75 $ 625 $ 461 $ 1,161
===== ===== ===== ====== =======
Balance at August 31, 1996 7,519 $ 75 $ 625 $ 361 $ 1,061
Net income - - - 140 140
----- ----- ----- ------ -------
Balance at May 31, 1997 7,519 $ 75 $ 625 $ 501 $ 1,201
===== ===== ===== ====== =======
See accompanying notes.
<PAGE>
ILM I LEASE CORPORATION
STATEMENTS OF CASH FLOWS
For the nine months ended May 31, 1997 and 1996 (Unaudited)
Increase (Decrease) in Cash and Cash Equivalents
(In thousands)
1997 1996
---- ----
Cash flows from operating activities:
Net income $ 140 $ 462
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation expense 37 -
Changes in assets and liabilities:
Accounts receivable (168) (148)
Prepaid expenses and other assets 118 (168)
Deferred tax asset, net 26 (36)
Accounts payable and accrued expenses 20 518
Accounts payable - affiliates (50) 22
Real estate taxes payable 45 338
Deferred rent payable (28) 132
Deferred tax liability 2 -
Income taxes payable - 307
-------- -------
Total adjustments 2 965
-------- -------
Net cash provided by operating activities 142 1,427
Cash flows from investing activities:
Additions to furniture, fixtures and equipment (173) -
-------- -------
Net cash used in investing activities (173) -
Cash flows from financing activities:
Proceeds from issuance of common stock - 699
-------- -------
Net cash provided by financing activities - 699
-------- -------
Net (decrease) increase in cash and cash equivalents (31) 2,126
Cash and cash equivalents, beginning of period 2,185 -
-------- -------
Cash and cash equivalents, end of period $ 2,154 $ 2,126
======== =======
Supplemental disclosure:
Cash paid during the period for income taxes $ 110 $ 274
======== =======
See accompanying notes.
<PAGE>
ILM I LEASE CORPORATION
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
1. General
The accompanying financial statements, footnotes and discussions should be
read in conjunction with the financial statements and footnotes contained in
the Company's Annual Report for the year ended August 31, 1996. In the
opinion of management, the accompanying financial statements, which have not
been audited, reflect all adjustments necessary to present fairly the results
for the interim period. All of the accounting adjustments reflected in the
accompanying interim financial statements are of a normal recurring nature.
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 May 31, 1997 and August 31, 1996 and
revenues and expenses for each of the three- and nine-month periods ended May
31, 1997 and 1996. Actual results could differ from the estimates and
assumptions used.
The Company was formed by PaineWebber Independent Living Mortgage Fund,
Inc. ("ILM") to operate eight rental housing projects for independent senior
citizens ("the Senior Housing Facilities") under a master lease arrangement.
ILM has elected to be taxed as a Real Estate Investment Trust ("REIT") under
the Internal Revenue Code of 1986, as amended ("the Code"), for each taxable
year of operations. In order to maintain its status as a REIT, 75% of ILM's
annual gross income must be Qualified Rental Income as defined by the Code.
The rent paid by the residents of the Facilities likely would not be deemed
to be Qualified Rental Income because of the extent of services provided to
residents. Consequently, the operation of the Facilities by ILM or its
subsidiaries over an extended period of time could adversely affect ILM's
status as a REIT. Therefore, ILM formed the Company to operate the Senior
Housing Facilities, and by means of a distribution, transferred the ownership
of the common stock of the Company to the holders of ILM common stock on
September 1, 1995. Because the Company, which is taxed as a regular C
corporation, is no longer a subsidiary of ILM, it can receive service-related
income without endangering the REIT status of ILM.
At a meeting of the ILM Board on January 10, 1997, the Advisor
recommended the immediate sale of the senior housing facilities held by ILM
and an affiliated entity, PaineWebber Independent Living Mortgage Inc. II
("ILM2"), 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 Advisor also stated that if PaineWebber 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 and ILM in evaluating the Advisor's proposal, a
disinterested, independent investment banker with expertise in healthcare
REITs and independent/assisted living financings was engaged. Following a
comprehensive analysis, the investment banker recommended that ILM decline
the Advisor's proposal and instead investigate expansion and restructuring
alternatives. After analyzing the Advisor's proposal and the recommendations
and other information provided by the independent investment banker, the
Boards of ILM and ILM2 voted unanimously to decline the Advisor's proposal
and to explore the alternatives recommended by the independent investment
banker. The Boards declined to seek an immediate sale of the properties
because, in the Boards' view, the liquidation price would not reflect the
"going concern" value of ILM and ILM2 and, therefore, would not maximize
shareholder value. In addition, the Boards did not consider it advisable to
liquidate ILM and ILM2 on the suggested terms three years prior to their
scheduled termination date.
The Advisor had indicated to the Board in its January 10, 1997 proposal
that it would not wish to continue to serve as advisor to ILM, ILM2 and their
affiliates if they declined to accept the Advisor's proposal. ILM and ILM2
have accepted the resignation of the Advisor, effective as of June 18, 1997.
The Advisor has agreed to continue to provide certain administrative services
to ILM, ILM2 and their affiliates through August 31, 1997, pursuant to the
terms of a transition services agreement to be entered into with ILM, ILM2
and their affiliates. The Company, ILM, ILM2 and their affiliates have also
accepted, effective as of June 18, 1997, the resignations of those officers
and directors who are employees of or otherwise affiliated with the Advisor
or its affiliates. ILM and ILM2 are currently evaluating various strategic
alternatives, including the possibility of becoming self-managed.
In addition, the Company and ILM continue to review various
restructuring alternatives. The Company and ILM are analyzing a merger of ILM
with ILM Holding and are also considering possibly merging ILM with ILM2 and
the Company with ILM II Lease Corporation. In addition, ILM is exploring
listing its shares on an exchange or, alternatively, having them trade
through NASDAQ. The independent investment banker is also in the process of
developing a new reorganization proposal. The Company has not fully evaluated
any of these alternatives and is not in a position at this time to recommend
any actions to the shareholders. There can be no assurance that the Company
will recommend taking any of such actions.
2. The Master Lease Agreement
The Company's sole business is the operation of the Senior Housing
Facilities. The Company has leased the Senior Housing Facilities from ILM
Holding, Inc. ("ILM Holding"), a majority-owned and consolidated subsidiary
of ILM which currently holds title to the Facilities, pursuant to a master
lease which commenced on September 1, 1995 and expires on December 31, 1999.
The Company has entered into a property management agreement with Capital
Senior Management 2, Inc. of Dallas, Texas ("Capital") to handle the
day-to-day operations of the Senior Housing Facilities. The management
contract with Capital was executed in July 1996. In November 1996, Lawrence
A. Cohen, a Director of the Company and President, Chief Executive Officer
and Director of ILM, also became Vice Chairman and Chief Financial Officer of
Capital Senior Living Corporation, an affiliate of Capital. As a result, the
management contract with Capital is considered a related party transaction
(see Note 3).
Descriptions of the properties covered by the master lease between the
Company and ILM Holding are summarized as follows:
<TABLE>
<CAPTION>
Rentable Date of
Name Location Units (1) Construction (2)
---- -------- --------- ----------------
<S> <C> <C> <C>
Independence Village of East Lansing East Lansing, MI 161 May 1989
Independence Village of Winston-Salem Winston-Salem, NC 159 February 1989
Independence Village of Raleigh Raleigh, NC 164 March 1991
Independence Village of Peoria Peoria, IL 165 November 1990
Crown Pointe Apartments Omaha, NE 135 August 1985
Sedgwick Plaza Apartments Wichita, KS 150 May 1985
West Shores Hot Springs, AR 136 June 1987
Villa Santa Barbara (3) Santa Barbara, CA 125 June 1979
</TABLE>
(1) The number of rentable units has been adjusted to account for the
new property management team's current program of placing
non-rental units back into service.
(2) Date initial construction was completed.
(3) The Company operates Villa Santa Barbara under a co-tenancy
arrangement with an affiliated company, ILM II Lease Corporation.
The Company has entered into an agreement with ILM II Lease
Corporation regarding such joint tenancy. ILM II Lease Corporation
was formed for similar purposes as the Company by an affiliated
REIT, PaineWebber Independent Living Mortgage Inc. II, a
subsidiary of which owns a portion of the Villa Santa Barbara
property. The portion of the Facility leased by the Company
represents 25% of the total project.
Terms of the Master Lease Agreement
During the term of the master lease, the Company is obligated to pay
annual base rent ("Base Rent") for the Facilities. For calendar year 1995,
the annual Base Rent was $5,886,000 (prorated according to the date of
commencement of the master lease), allocated as follows: $896,156 for the
Michigan Facility, $566,914 for the Winston-Salem, North Carolina Facility,
$1,017,659 for the Raleigh, North Carolina Facility, $892,600 for the
Illinois Facility, $893,918 for the Nebraska Facility, $855,702 for the
Kansas Facility, $623,984 for the Arkansas Facility, and $139,067 for the
California Facility. For calendar year 1996 and subsequent years, the annual
Base Rent will be $6,364,800, allocated as follows: $969,054 for the Michigan
Facility, $613,030 for the Winston-Salem, North Carolina Facility, $1,100,441
for the Raleigh, North Carolina Facility, $965,209 for the Illinois Facility,
$966,634 for the Nebraska Facility, $925,310 for the Kansas Facility,
$674,742 for the Arkansas Facility, and $150,380 for the California Facility.
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 ("Additional Rent"). ILM Holding, as the
Lessor, is responsible for major capital improvements and structural repairs
to the Senior Housing Facilities. In addition, beginning in the second
quarter of fiscal 1997 and for the remainder of the lease term, the Company
is also obligated to pay variable rent ("Variable Rent") for each Facility.
Such Variable Rent is payable quarterly and equals 40% of the excess, if any,
of the aggregate total revenues for the Facilities, on an annualized basis,
over $16,996,000. Variable rent amounted to $199,000 for the six months ended
May 31, 1997.
Under the master lease, the Company's use of the Facilities is limited to
use as a Senior Housing Facility unless the Lessor's consent to some other
use is obtained. The Company has responsibility to obtain and maintain all
licenses, certificates and consents needed to use and operate each Facility,
and to use and maintain each Facility in compliance with all local board of
health and other applicable governmental and insurance regulations. The
Facilities located in Arkansas, California and Kansas are licensed by such
states to provide assisted living services. Also, various health and safety
regulations and standards which are enforced by state and local authorities
apply to the operation of all of the Facilities. Violations of such health
and safety standards could result in fines, penalties, closure of a Facility
or other sanctions.
3. Related Party Transactions
The Advisor receives a base fee in an amount equal to 0.5% of the Gross
Operating Revenues of the Facilities operated by the Company as compensation
for its services. This fee amounted to $67,000 and $64,000 for the nine-month
periods ended May 31, 1997 and 1996, respectively. In addition, an affiliate
of the Advisor is entitled to reimbursement for expenses incurred in
providing certain financial, accounting and investor communication services
to the Company. Included in general and administrative expenses for the nine
months ended May 31, 1997 and 1996 is $58,000 and $35,000, respectively,
representing reimbursements to this affiliate of the Advisor for providing
such services to the Company.
As discussed in Note 1, ILM and ILM2 have accepted the resignation of the
Advisor effective as of June 18, 1997. The Company, ILM and ILM2 and their
affiliates and the Advisor intend to enter into a transition services
agreement pursuant to which the Advisor would continue to provide certain
administrative services to the Company, ILM, ILM2 and their affiliates
through August 31, 1997.
The Company has retained Capital Senior Management 2, Inc. ("Capital") of
Dallas, Texas to be the property manager of the Senior Housing Facilities
pursuant to a Management Agreement which commenced on July 29, 1996. The
initial term of the Management Agreement expires on December 31, 1999, which
coincides with the expiration of the master lease agreement between the
Company and ILM Holding described in Note 2. Under the terms of the
Management Agreement, in the event that the master lease agreement is
extended beyond December 31, 1999, the Management Agreement will be extended
as well, but not beyond July 29, 2001. Effective in November 1996, Lawrence
A. Cohen, a Director of the Company and President, Chief Executive Officer
and Director of ILM, was also named Vice Chairman and Chief Financial Officer
of Capital Senior Living Corporation, an affiliate of Capital. 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 be eligible to earn an Incentive Management Fee
equal to 25% of the amount by which the average monthly Net Cash Flow of the
Senior Housing Facilities, as defined, for the twelve month period ending on
the last day of each calendar month exceeds a specified Base Amount. Each
August 31, beginning on August 31, 1997, the Base Amount will be increased
based on the percentage increase in the Consumer Price Index. ILM has
guaranteed the payment of all fees due to Capital under the terms of the
Management Agreement. Capital earned total management fees of $637,000 for
the nine months ended May 31, 1997.
Accounts payable - affiliates at May 31, 1997 and August 31, 1996 includes
advances of $173,000 and $348,000, respectively, received from ILM Holding,
primarily for the purchase of personal property to operate the Senior Housing
Facilities. The remaining balance of accounts payable - affiliates at May 31,
1997 consists of variable rent payable to ILM Holding of $128,000, management
fees payable to Capital of $71,000 and advisory fees payable to the Advisor
of $23,000. The remaining balance of accounts payable - affiliates at August
31, 1996 consists of management fees of $76,000 payable to Capital and
advisory fees payable to the Advisor of $21,000.
4. Contingencies
A management agreement between ILM Holding and Angeles Housing Concepts,
Inc. ("AHC") which covered the management of all eight Senior Housing
Facilities was assigned to the Company effective September 1, 1995. On July
29, 1996, the Company and ILM Holding ("the Companies") terminated the
property management agreement with AHC. The management agreement was
terminated for cause pursuant to the terms of the contract. 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 Company and ILM Holding allege, among
other things, that AHC willfully performed actions specifically in violation
of the management agreement and that such actions caused damages to the
Companies. Due to the termination of the agreement for cause, no termination
fee was paid to AHC. Subsequent to the termination of the management
agreement, AHC filed for protection under Chapter 11 of the U.S. Bankruptcy
Code in its domestic state of California. The filing was challenged by the
Companies, and the Bankruptcy Court dismissed AHC's case effective October
15, 1996. In November 1996, AHC filed an Answer with the Virginia District
Court in response to the litigation initiated by the Companies and a
Counterclaim against ILM Holding. The Counterclaim alleges that the
management agreement was wrongfully terminated for cause and requests damages
which include the payment of a termination fee in the amount of $1,250,000,
payment of management fees pursuant to the contract from August 1, 1996
through October 15, 1996, and recovery of attorney's fees and expenses. The
aggregate amount of damages against all parties as requested in AHC's
Counterclaim exceeds $2,000,000. ILM has guaranteed the payment of the
termination fee at issue in these proceedings to the extent that any
termination fee is deemed payable by the court and in the event that the
Company fails to perform pursuant to its contractual obligations. The
discovery process is currently underway. The court initially set a trial date
of April 28, 1997 but, at AHC's request, recently rescheduled the trial for
June 23, 1997. On June 13, 1997 and July 8, 1997, the court issued Orders
purporting to enter judgment against ILM and ILM2 in the amount of
$1,000,000. In so doing, the court effectively canceled the June 23, 1997
trial date. The Orders do not contain any findings of fact or conclusions of
law. On July 10, 1997, the Company, ILM, ILM2 and ILM II Lease Corporation
filed a notice of appeal to the United State Court of Appeals for the Fourth
Circuit from the Orders. The Company intends to diligently prosecute the
appeal. The eventual outcome of this litigation cannot presently be
determined. No provision for any liability which might result from the
outcome of this matter has been recorded in the accompanying financial
statements.
On February 4, 1997, AHC filed a Complaint in the Superior Court of the
State of California against Capital, Lawrence Cohen, and others alleging that
the defendants intentionally interfered with AHC's property management
agreement with ILM Holding by inducing ILM Holding to terminate the agreement
(the "California litigation"). The complaint seeks damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to federal
district court in the Central District of California. Trial in the action has
been set for January 13, 1998 and discovery has just begun. 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 Properties employee, the Company or its affiliates should
indemnify Mr. Cohen with respect to any expenses arising from the California
litigation, subject to any insurance recoveries for those expenses. The
Company's Board also concluded that, subject to certain conditions, the
Company or its affiliates should advance up to $20,000 to pay reasonable
legal fees and expenses incurred by Capital in the California litigation.
Subsequently, the Boards of the Company and ILM II Lease Corporation voted to
increase the maximum amount of the advance to $100,000. The defendants intend
to vigorously defend the claims made against them in the California
litigation. The eventual outcome of this litigation cannot presently be
determined and, accordingly, no provision for any liability has been recorded
in the accompanying financial statements.
5. Federal Income Taxes
The Company is taxable as a regular C corporation and, therefore, its
income is subject to tax at the federal and state levels. The Company reports
on a calendar year for tax purposes. Income taxes at the appropriate
statutory rates have been provided for in the accompanying financial
statements.
Deferred income tax expense (benefit) reflects the net tax effects of
temporary differences between the carrying amounts of assets and liabilities
for financial reporting purposes and the amounts used for income tax
purposes. The Company's deferred tax assets and liabilities as of May 31,
1997 and August 31, 1996 are comprised of the following amounts (in
thousands):
May 31 August 31
------ ---------
Deferred tax asset - straight-line
rent expense $ 38 $ 49
Deferred tax liability - tax over
book amortization 40 23
------ ------
Net deferred tax (liability) asset $ (2) $ 26
====== ======
<PAGE>
The components of income tax expense (benefit) for the three and nine
months ended May 31, 1997 and May 31, 1996 are as follows (in thousands):
Three Months Ended Nine Months Ended
May 31, May 31,
------------------- ------------------
1997 1996 1997 1996
---- ---- ---- ----
Current:
Federal $ (52) $ 108 $ 55 $ 292
State (9) 19 10 51
------- -------- -------- ------
Total current (61) 127 65 343
------- -------- -------- ------
Deferred:
Federal 8 (10) 24 (31)
State 1 (2) 4 (5)
------- -------- -------- ------
Total deferred 9 (12) 28 (36)
------- -------- -------- ------
$ (52) $ 115 $ 93 $ 307
======= ======== ======== ======
The reconciliation of income tax computed at U.S. federal statutory rates
to income tax expense (benefit) for the nine months ended May 31, 1997 and
1996 is as follows (in thousands):
1997 1996
------------ -----------------
Tax at U.S. statutory rates $ 793 4% $ 261 34%
State income taxes, net
of federal tax benefit 14 6% 46 6%
------ --- ------ ---
$ 93 40% $ 307 40%
====== === ====== ===
<PAGE>
ILM I LEASE CORPORATION
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Liquidity and Capital Resources
- -------------------------------
ILM I Lease Corporation (the "Company") was formed by PaineWebber
Independent Living Mortgage Fund, Inc. ("ILM"), a publicly-held, non-traded Real
Estate Investment Trust ("REIT"), for the purpose of operating eight Senior
Housing Facilities under the terms of a master lease agreement. ILM contributed
$700,000 in return for all of the issued and outstanding shares of the Company's
common stock. ILM has elected to be taxed as a REIT under the Internal Revenue
Code of 1986, as amended ("the Code"), for each taxable year of operations. In
order to maintain its status as a REIT, 75% of ILM's annual gross income must be
Qualified Rental Income as defined by the Code. The rent paid by the residents
of the Facilities likely would not be deemed to be Qualified Rental Income
because of the extent of services provided to residents. Consequently, the
operation of the Facilities by ILM or its subsidiaries over an extended period
of time could adversely affect ILM's status as a REIT. Therefore, ILM formed the
Company to operate the Facilities, and by means of a distribution, transferred
the ownership of the common stock of the Company to the holders of ILM common
stock on September 1, 1995. Because the Company, which is taxed as a regular C
corporation, is no longer a subsidiary of ILM, it can receive service-related
income without endangering the REIT status of ILM.
The Company's sole business is the operation of the Senior Housing
Facilities. The Company has leased the Senior Housing Facilities from ILM
Holding, Inc. ("ILM Holding"), a majority-owned and consolidated subsidiary of
ILM which currently holds title to the Facilities, pursuant to a master lease
which commenced on September 1, 1995 and expires on December 31, 1999. The
master lease is a "triple-net" lease whereby the Lessee pays all operating
expenses, governmental taxes and assessments, utility charges and insurance
premiums, as well as the costs of all required maintenance, personal property
and non-structural repairs in connection with the operation of the Senior
Housing Facilities. ILM Holding, as the Lessor, is responsible for major capital
improvements and structural repairs to the Senior Housing Facilities. During the
initial term of the master lease, the Company is obligated to pay annual base
rent for the use of all of the Facilities in the aggregate amount of $5,886,000
for calendar year 1995 (prorated based on the lease commencement date) and
$6,364,800 for calendar year 1996 and each subsequent year. Beginning in the
second quarter of fiscal 1997 and for the remainder of the lease term, the
Company is also obligated to pay variable rent for each Facility. Such variable
rent is payable quarterly and equals 40% of the excess, if any, of the aggregate
total revenues for the Facilities, on an annualized basis, over $16,996,000.
Variable rent amounted to $199,000 for the six months ended May 31, 1997.
On July 29, 1996, the Company and ILM Holding ("the Companies") terminated
the property management agreement with AHC covering the eight Senior Housing
Facilities leased by the Company. The management agreement was terminated for
cause pursuant to the terms of the contract. 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 Company and ILM Holding allege, among other things, that AHC
willfully performed actions specifically in violation of the management
agreement and that such actions caused damages to the Companies. Due to the
termination of the agreement for cause, no termination fee was paid to AHC.
Subsequent to the termination of the management agreement, AHC filed for
protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic state of
California. The filing was challenged by the Companies, and the Bankruptcy Court
dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed an
Answer with the Virginia District Court in response to the litigation initiated
by the Companies and a Counterclaim against ILM Holding. The Counterclaim
alleges that the management agreement was wrongfully terminated for cause and
requests damages which include the payment of a termination fee in the amount of
$1,250,000, payment of management fees pursuant to the contract from August 1,
1996 through October 15, 1996, and recovery of attorney's fees and expenses. The
aggregate amount of damages against all parties as requested in AHC's
Counterclaim exceeds $2,000,000. ILM has guaranteed the payment of the
termination fee at issue in these proceedings to the extent that any termination
fee is deemed payable by the court and in the event that the Company fails to
perform pursuant to its contractual obligations. The court initially set a trial
date of April 28, 1997 but, at AHC's request, recently rescheduled the trial for
June 23, 1997. On June 13, 1997 and July 8, 1997, the court issued Orders
purporting to enter judgment against ILM and ILM2 in the amount of $1,000,000.
In so doing, the court effectively canceled the June 23, 1997 trial date. The
Orders do not contain any findings of fact or conclusions of law. On July 10,
1997, the Company, ILM, ILM2 and ILM II Lease Corporation filed a notice of
appeal to the United State Court of Appeals for the Fourth Circuit from the
Orders. The Company intends to diligently prosecute the appeal. The eventual
outcome of this litigation cannot presently be determined. No provision for any
liability which might result from the outcome of this matter has been recorded
in the accompanying financial statements.
Subsequent to terminating the management agreement with AHC, the Company
retained Capital Senior Management 2, Inc. ("Capital") of Dallas, Texas to be
the new manager of the Senior Housing Facilities pursuant to a Management
Agreement which commenced on July 29, 1996. The initial term of the Management
Agreement expires on December 31, 1999, which coincides with the expiration of
the master lease agreement between the Company and ILM Holding described above.
Under the terms of the Management Agreement, in the event that the master lease
agreement is extended beyond December 31, 1999, the Management Agreement will be
extended as well, but not beyond July 29, 2001. Effective in November 1996,
Lawrence A. Cohen, a Director of the Company and President, Chief Executive
Officer and Director of ILM, was also named Vice Chairman and Chief Financial
Officer of Capital Senior Living Corporation, an affiliate of Capital. Under the
terms of the 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 exceeds a specified Base Amount. Each August 31, beginning on August 31,
1997, the Base Amount will be increased based on the percentage increase in the
Consumer Price Index. ILM 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 Capital, Lawrence Cohen, and others alleging that
the defendants intentionally interfered with AHC's property management agreement
with ILM Holding by inducing ILM Holding to terminate the agreement (the
"California litigation"). The complaint seeks damages of at least $2,000,000. On
March 4, 1997, the defendants removed the case to federal district court in the
Central District of California. Trial in the action has been set for January 13,
1998 and discovery has just begun. 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 Properties employee, the
Company or its affiliates should indemnify Mr. Cohen with respect to any
expenses arising from the California litigation, subject to any insurance
recoveries for those expenses. The Company's Board also concluded that, subject
to certain conditions, the Company or its affiliates should advance up to
$20,000 to pay reasonable legal fees and expenses incurred by Capital in the
California litigation. Subsequently, the Boards of the Company and ILM II Lease
Corporation voted to increase the maximum amount of the advance to $100,000. The
defendants intend to vigorously defend the claims made against them in the
California litigation. The eventual outcome of this litigation cannot presently
be determined and, accordingly, no provision for any liability has been recorded
in the accompanying financial statements.
The eight properties which the Company leases from ILM Holding averaged
94% occupancy for the quarter ended May 31, 1997. Current annualized operating
income levels are sufficient to cover the base master lease payments at their
current annual level of $6,364,800, which will remain in effect throughout the
remaining term of the lease. As noted above, the master lease also provides for
the payment of variable rent beginning in December 1996. 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. Variable rent amounted to $199,000 for the six months ended May 31, 1997.
Further improvements in operating income levels are expected upon the successful
implementation of several new programs by the new property management company.
At many properties, the management company has increased the number of rentable
units by asking the facility managers to move off site. The increased rental
revenue is expected to more than offset any additional costs of housing the
managers and providing 24-hour coverage at the front desk. The live-in assistant
manager positions at several properties are also being eliminated, which will
increase the number of rentable units. In addition, the management company is in
the process of implementing new marketing plans at several of the properties and
increasing rental rates at properties that have maintained high occupancy levels
and are located in strong markets. Property improvements to be paid for by the
Company during fiscal 1997 include dining room and lobby refurbishments at the
Winston-Salem facility. Fiscal 1997 capital expenditure plans to be funded by
ILM include an ongoing program to replace air-conditioning units at the Santa
Barbara facility and a program to upgrade the overall appearance of the Sedgwick
Plaza property. ILM is also investigating the potential for future expansions of
several of the facilities which are located in areas that have particularly
strong markets for senior housing.
As discussed in the Annual Report, the road adjacent to the Raleigh
facility is being improved, and the county Department of Transportation has
requested a temporary construction easement on the property. Although the
easement does not directly affect the operation of the facility, it has resulted
in the removal of several trees that provided a buffer between the building and
the road. To date, the facility's management team has been able to work with the
Department of Transportation and the local power company to minimize the removal
of trees as the road construction work progresses. Once the road work is
completed, negotiations with the city to secure a settlement that will pay for
any required changes to the property's landscape buffer will be finalized.
At a meeting of the ILM Board on January 10, 1997, the Advisor
recommended the immediate sale of the senior housing facilities held by ILM and
an affiliated entity, PaineWebber Independent Living Mortgage Inc. II ("ILM2"),
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
Advisor also stated that if PaineWebber 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 and ILM in evaluating the Advisor's proposal, a disinterested,
independent investment banker with expertise in healthcare REITs and
independent/assisted living financings was engaged. Following a comprehensive
analysis, the investment banker recommended that ILM decline the Advisor's
proposal and instead investigate expansion and restructuring alternatives. After
analyzing the Advisor's proposal and the recommendations and other information
provided by the independent investment banker, the Boards of ILM and ILM2 voted
unanimously to decline the Advisor's proposal and to explore the alternatives
recommended by the independent investment banker. The Boards declined to seek an
immediate sale of the properties because, in the Boards' view, the liquidation
price would not reflect the "going concern" value of ILM and ILM2 and,
therefore, would not maximize shareholder value. In addition, the Boards did not
consider it advisable to liquidate ILM and ILM2 on the suggested terms three
years prior to their scheduled termination date.
The Advisor had indicated to the Board in its January 10, 1997 proposal
that it would not wish to continue to serve as advisor to ILM, ILM2 and their
affiliates if they declined to accept the Advisor's proposal. ILM and ILM2 have
accepted the resignation of the Advisor, effective as of June 18, 1997. The
Advisor has agreed to continue to provide certain administrative services to
ILM, ILM2 and their affiliates through August 31, 1997, pursuant to the terms of
a transition services agreement to be entered into with ILM, ILM2 and their
affiliates. The Company, ILM, ILM2 and their affiliates have also accepted,
effective as of June 18, 1997, the resignations of those officers and directors
who are employees of or otherwise affiliated with the Advisor or its affiliates.
ILM and ILM2 are currently evaluating various strategic alternatives, including
the possibility of becoming self-managed.
In addition, the Company and ILM are continuing to review various
restructuring alternatives. The Company and ILM are analyzing a merger of ILM
with ILM Holding and are also considering possibly merging ILM with ILM2 and the
Company with ILM II Lease Corporation. In addition, ILM is exploring listing its
shares on an exchange or, alternatively, having them trade through NASDAQ. The
independent investment banker is also in the process of developing a new
reorganization proposal. The Company has not fully evaluated any of these
alternatives and is not in a position at this time to recommend any actions to
its shareholders. There can be no assurance that the Company will recommend
taking any of such actions.
At May 31, 1997, the Company had cash and cash equivalents of $2,154,000.
Such amounts will be used for the Company's working capital requirements. As
noted above, under the terms of the master lease the Lessor is responsible for
major capital improvements and structural repairs to the Senior Housing
Facilities. Consequently, the Company does not have any material commitments for
capital expenditures. Furthermore, the Company does not currently anticipate the
need to engage in any borrowing activities. As a result, substantially all of
the Company's cash flow will be generated from operating activities. The Company
did not pay cash dividends in fiscal 1996. The Company intends to review this
policy during the second half of fiscal 1997 and may or may not determine to pay
cash dividends in the future. Payment of dividends, if any, will be at the
discretion of the Company's Board of Directors and will depend upon such factors
as the Company's financial condition, earnings, anticipated investments and
other relevant factors. The source of future liquidity is expected to be from
operating cash flow from the Senior Housing Facilities, net of the master lease
payments to ILM Holding, and interest income earned on invested cash reserves.
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.
Results of Operations
Three Months Ended May 31, 1997
- -------------------------------
The Company had a net loss of $79,000 for the three months ended May 31,
1997, as compared to net income of $172,000 for the same period in the prior
year. The decrease in net income is the result of an increase in operating
expenses of $662,000. The increase in operating expenses was mainly due to
increases dietary expenses, general and administrative expenses and master lease
rent expense of $116,000, $403,000 and $128,000, respectively. The increase in
dietary expenses primarily reflects an increase in the portfolio occupancy level
as compared to the same period in the prior year. General and administrative
expenses increased largely due to an increase in legal fees attributable to the
ongoing AHC litigation and the analysis of restructuring alternatives referred
to above. In addition, during the current three-month period the Company
incurred professional fees related to the advisory services of the independent
investment banker referred to above and for the preliminary evaluation of the
feasibility of completing expansions at certain of the facilities. Master lease
rent expense increased due to additional variable rent accrued effective for the
second quarter of fiscal 1997 in accordance with the Master Lease Agreement. The
increases in operating expenses were partially offset by an increase in rental
income from the senior housing facilities of $237,000. The increase in rental
income is due to an increase in the portfolio's average occupancy level from 92%
for the fiscal quarter ended May 1996 to 94% for the fiscal quarter ended May
1997, as well as increases in rental rates at certain of the facilities located
in strong markets. Due to the unfavorable change in the Company's net operating
results, income tax expense (benefit) improved by $167,000 for the current
three-month period.
Nine Months Ended May 31, 1997
- ------------------------------
The Company reported net income of $140,000 for the nine months ended May
31, 1997, as compared to net income of $462,000 for the same period in the prior
year. The decrease in net income is the result of an increase in operating
expenses of $1,079,000. The increase in operating expenses was mainly due to
increases in dietary expenses, general and administrative expenses and master
lease rent expense of $238,000, $526,000 and $199,000, respectively. The
increase in dietary expenses primarily reflects an increase in the portfolio
occupancy level as compared to the same period in the prior year. General and
administrative expenses increased largely due to an increase in legal fees
attributable to the ongoing AHC litigation and the analysis of restructuring
alternatives referred to above. In addition, during the current nine-month
period the Company incurred professional fees related to the advisory services
of the independent investment banker referred to above and for the preliminary
evaluation of the feasibility of completing expansions at certain of the
facilities. Master lease rent expense increased due to additional variable rent
accrued effective for the second quarter of fiscal 1997 in accordance with the
Master Lease Agreement. The increases in operating expenses were partially
offset by an increase in rental income from the senior housing facilities of
$523,000. The increase in rental income is due to an increase in the portfolio's
average occupancy level, as well as increases in rental rates at certain of the
facilities located in strong markets. Due to the decline in net income, income
tax expense declined by $214,000 for the current nine-month period.
<PAGE>
PART II
Other Information
Item 1. Legal Proceedings
In the litigation involving the Company, ILM Holding, Inc. and Angeles
Housing Concepts, Inc. that was reported in the Company's Annual Report on Form
10-K for the year ended August 31, 1996 and the Company's Quarterly Report on
Form 10-Q for the quarter ended February 28, 1997, the court, on June 13, 1997
and July 8, 1997, issued Orders purporting to enter judgment against ILM and
ILM2 in the amount of $1,000,000. In doing so, the court effectively canceled
the June 23, 1997 trial date. The Orders do not contain any findings of fact or
conclusions of law. On July 10, 1997, the Company, ILM, ILM2 and ILM II Lease
Corporation filed a notice of appeal to the United States Court of Appeals for
the Fourth Circuit from the Orders. The Company intends to diligently prosecute
the appeal. The eventual outcome of this litigation cannot presently be
determined. No provision for any liability which might result from the outcome
of this matter has been recorded in the accompanying financial statements.
Item 2. through 5. NONE
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits: NONE
(b) Reports on Form 8-K: NONE
<PAGE>
ILM I LEASE CORPORATION
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.
By: ILM LEASE CORPORATION
By: /s/ John B. Watts III
---------------------
John B. Watts III
President
Dated: July 18, 1997
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Partnership's audited financial statements for the nine months ended May 31,
1997 and is qualified in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> AUG-31-1997
<PERIOD-END> MAY-31-1997
<CASH> 2,154
<SECURITIES> 0
<RECEIVABLES> 245
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 2,548
<PP&E> 434
<DEPRECIATION> 56
<TOTAL-ASSETS> 2,926
<CURRENT-LIABILITIES> 1,628
<BONDS> 0
0
0
<COMMON> 700
<OTHER-SE> 501
<TOTAL-LIABILITY-AND-EQUITY> 2,926
<SALES> 0
<TOTAL-REVENUES> 13,456
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<TOTAL-COSTS> 13,223
<OTHER-EXPENSES> 0
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<INCOME-PRETAX> 233
<INCOME-TAX> 93
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</TABLE>
