ILM I LEASE CORP, 10-K/A, 1999-11-22

ILM I LEASE CORP
10-K/A, 1999-11-22
REAL ESTATE INVESTMENT TRUSTS

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K/A

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

FOR FISCAL YEAR ENDED: AUGUST 31, 1998

X 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 of organization) (I.R.S. Employer
Identification No.)

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

Registrant's telephone number, including area code: 888-257-3550
------------
Securities registered pursuant to Section 12(b) of the Act:

Name of each exchange
Title of each class on which registered
- ------------------- -----------------------
None None

Securities registered pursuant to Section 12(g) of the Act:
Shares of Common Stock $.01 Par Value
-----------------------------------------------------------
(Title of class)

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

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

Shares of common stock outstanding as of August 31, 1998: 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.

DOCUMENTS INCORPORATED BY REFERENCE

Documents Form 10-K Reference
- --------------------------------------------------- -------------------
Registration Statement on Form 10 of registrant Part III, Part IV
dated July 20, 1995, as supplemented [33 Act filing
#33-27653]

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

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<PAGE>

ILM I LEASE CORPORATION

1998 FORM 10-K/A

TABLE OF CONTENTS
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Part I Page
- ------ ----

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

Item 2 Properties.........................................................I-5

Item 3 Legal Proceedings..................................................I-6

Item 4 Submission of Matters to a Vote of Security Holders................I-7

Part II
- -------

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

Item 6 Selected Financial Data...........................................II-1

Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations.........................................II-2

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

Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure..........................................II-8

Part III
- --------

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

Item 11 Executive Compensation...........................................III-3

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

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

Part IV
- -------

Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K...IV-1

Signatures....................................................................IV-2

Index to Exhibits.............................................................IV-3

Financial Statements and Supplementary Data.................................F1-F17
</TABLE>

<PAGE>

PART I

ITEM 1. BUSINESS

ILM I Lease Corporation (the "Company") was formed in 1994 by ILM Senior
Living, Inc. ("ILM I"), formerly PaineWebber Independent Living Mortgage Fund,
Inc., a publicly-held, non-traded Real Estate Investment Trust ("REIT"), for the
purpose of operating eight rental housing projects that provide independent
living and assisted living services for senior citizens (the "Senior Housing
Facilities") under the terms of a master lease agreement. ILM I contributed
$700,000 to the Company in return for all of the issued and outstanding shares
of the Company's common stock. ILM I had originally made mortgage loans secured
by the Senior Housing Facilities to Angeles Housing Concepts, Inc. ("AHC")
between June 1989 and July 1992. In March 1993, AHC defaulted under the terms of
such mortgage loans and in connection with the settlement of such default, title
to the Senior Housing Facilities was transferred, effective April 1, 1994, to
certain majority-owned, indirect subsidiaries of ILM I, subject to the mortgage
loans. Subsequently, the indirect subsidiaries of ILM I were merged into ILM
Holding, Inc. ("ILM Holding"). As part of the fiscal 1994 settlement agreement
with AHC, AHC was retained as the property manager for all of the Senior Housing
Facilities pursuant to the terms of a management agreement which was assigned to
the Company as of September 1, 1995. As discussed further in Item 7, the
agreement with AHC was terminated in July 1996.

On September 1, 1995, after ILM I received the required regulatory
approval, it distributed all of the outstanding shares of capital stock of the
Company to the holders of record of ILM I's common stock. One share of common
stock of the Company was issued for each full share of ILM I's common stock
held. No fractional shares were issued. Holders of ILM I's common stock were not
required to pay any cash or other consideration or to exchange their common
stock of ILM I for the common stock of the Company. Prior to the distribution of
the Company's stock, ILM I's shareholders received an information statement
fully describing the Company and the distribution of its capital stock.

The Company's sole business is the operation of the Senior Housing
Facilities. The Company leases the Senior Housing Facilities from ILM Holding, a
majority-owned and consolidated affiliate of ILM I, which currently holds title
to the Senior Housing Facilities, pursuant to a master lease which commenced on
September 1, 1995 and expires on December 31, 1999; provided, however, that such
master lease may be terminated earlier by ILM Holding, in connection with a sale
of the Senior Housing Facilities to a non-affiliated third party, upon 30 days
notice to the Company.

In July 1996, the Company terminated the property management agreement
with AHC and entered into a property management agreement (the "Management
Agreement") with Capital Senior Management 2, Inc. ("Capital") to handle the
day-to-day operations of the Senior Housing Facilities. Since November 1996,
Lawrence A. Cohen, who, until July 28, 1998, served as a Director of the Company
and President, Chief Executive Officer and Director of ILM I, has also served as
Vice Chairman and Chief Financial Officer of Capital Senior Living Corporation,
an affiliate of Capital. As a result, through July 28, 1998, the management
agreement with Capital was considered a related party transaction.

I-1
<PAGE>

ITEM 1. BUSINESS (CONTINUED)

The master lease agreement, which commenced on September 1, 1995, is
between ILM Holding, as owner of the properties and lessor, and the Company, as
lessee. The master lease is a "triple-net" lease whereby the lessee pays all
operating expenses, governmental taxes and assessments, utility charges and
insurance premiums, as well as the costs of all required maintenance, personal
property and non-structural repairs in connection with the operation of the
Senior Housing Facilities. ILM Holding, as the lessor, is responsible for all
major capital improvements and structural repairs to the Senior Housing
Facilities. During the initial term of the master lease, which expires on
December 31, 1999, the Company is obligated to pay annual base rent for the use
of all of the Facilities in the aggregate amount of $6,364,800 per year.
Beginning in January 1997 and for the remainder of the lease term, the Company
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 $16,996,000. Variable rent expense related to fiscal years 1998 and
1997 was $894,000 and $315,000, respectively.

I-2
<PAGE>

ITEM 1. BUSINESS (CONTINUED)

The Senior Housing Facilities which the Company has leased from ILM
Holding as of August 31, 1998 are described below:
<TABLE>
<CAPTION>
Year
Facility Rentable Resident
Property Name and Location (1) Type of Property Built Units (3) Capacities (3)
- ------------------------------ ---------------- ----- ----------- --------------
<S> <C> <C> <C> <C> <C>
Independence Village of Winston-Salem Senior Housing Facility 1989 159 161
Winston-Salem, NC

Independence Village of East Lansing Senior Housing Facility 1989 161 162
East Lansing, MI

Independence Village of Raleigh Senior Housing Facility 1991 164 205
Raleigh, NC

Independence Village of Peoria Senior Housing Facility 1990 165 181
Peoria, IL

Crowne Point Apartments Senior Housing Facility 1984 135 163
Omaha, NE

Sedgwick Plaza Apartments Senior Housing Facility 1984 150 170
Wichita, KS

West Shores Senior Housing Facility 1986 136 166
Hot Springs, AR

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

(1) See Notes to the Financial Statements filed with this Annual Report for a
description of the agreements through which the Company has leased these
facilities.

(2) The Company operates Villa Santa Barbara under a co-tenancy arrangement
with an affiliated company, ILM II Lease Corporation ("Lease II"). The
Company has entered into an agreement with Lease II regarding such joint
tenancy. Lease II was formed for similar purposes as the Company by an
affiliated company, ILM II Senior Living, Inc. ("ILM II"), a subsidiary of
which owns a portion of the Villa Santa Barbara property. The portion of
the Senior Housing Facility leased by the Company represents 25% of the
total project. Villa Santa Barbara is 25% owned by ILM Holding and 75% by
ILM II Holding, Inc., a direct subsidiary of ILM II, as tenants in common.
Upon the sale of ILM I or ILM II, arrangements would be made to transfer
the Santa Barbara facility to the non-selling joint tenant (or one of its
subsidiaries). The property was extensively renovated in 1995.

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

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's sole
business is the operation of the Senior Housing Facilities. Therefore,
presentation of information about industry segments is not applicable.

I-3
<PAGE>

ITEM 1. BUSINESS (CONTINUED)

Through June 18, 1997, and subject to the supervision of and pursuant to
the general policies set by the Company's Board of Directors, assistance in
managing the business of the Company was provided by PaineWebber Lease Advisor,
L.P. ("PaineWebber"). For discussion purposes, PaineWebber will refer to
PaineWebber Lease Advisor, L.P. and all affiliates of PaineWebber that provided
services to the Company in the past. PaineWebber resigned from this position
effective as of June 18, 1997. PaineWebber agreed to perform certain
administrative services for the Company and its affiliates through August 31,
1997. Through the date of its resignation, PaineWebber performed the day-to-day
operations of the Company and acted as the investment advisor and consultant for
the Company. PaineWebber provided cash management, accounting, tax preparation,
financial reporting, investor communications and relations as well as asset
management services to the Company. These services are now being provided to the
Company, subject to the supervision of the Company's Board of Directors, by
various companies and consultants including Greenberg Traurig, Fleet Bank, Ernst
& Young LLP, and MAVRICC Management Systems, Inc. The resignation of PaineWebber
is discussed further below.

There are currently three Directors of the Company, none of whom are
affiliates of PaineWebber or the property management company. The Directors are
subject to removal by the vote of the holders of a majority of the outstanding
shares of the Company's 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.

As discussed further in Item 7, on July 29, 1996, the Company terminated
the property management agreement with AHC and retained Capital to be the
property manager of the Senior Housing Facilities, and ILM I has guaranteed the
payment of all fees due to Capital under the terms of the Management Agreement.
Since November 1996, Lawrence A. Cohen, who, through July 28, 1998, served as a
Director of the Company and President, Chief Executive Officer and Director of
ILM I, has also served as Vice Chairman and Chief Financial Officer of Capital
Senior Living Corporation, an affiliate of Capital. As a result, through July
28, 1998, Capital was considered a related party (see Item 13). Capital earned
property management fees from the Company of $919,000 and $841,000 for the years
ended August 31, 1998 and 1997, respectively.

At a meeting of the Boards of Directors of ILM I and an affiliated
entity, ILM II Senior Living, Inc., ("ILM II"), formerly PaineWebber Independent
Living Mortgage, Inc., on January 10, 1997, PaineWebber recommended the
immediate sale of the Senior Housing Facilities operated by the Company and held
by ILM I as well as the Senior Housing Facilities held by ILM II, by means of a
controlled auction to be conducted by PaineWebber, at no additional
compensation, with PaineWebber offering to purchase the Senior Housing
Facilities held by ILM I and ILM II for $127 million, thereby guaranteeing the
shareholders a "floor" price. The Senior Housing Facilities operated by the
Company under its master lease with ILM Holding would represent approximately
$75 million of this amount. After taxes and closing costs, net proceeds to ILM I
would equal approximately $71 million or approximately $9.41 per share of ILM I
common stock. 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 and ILM I in evaluating PaineWebber's proposal, NatWest Securities, a
disinterested, independent investment banking firm with expertise in healthcare
REITs and independent/assisted living financings was engaged by the Company, ILM
I and ILM II and their affiliates. Following a comprehensive analysis, the
investment banking firm recommended that PaineWebber's proposal should be
declined and that instead investigation of expansion and restructuring
alternatives should be pursued. After analyzing PaineWebber's proposal and the
recommendations and other information provided by the

I-4
<PAGE>

ITEM 1. BUSINESS (CONTINUED)

independent investment banking firm, the Boards of ILM I and ILM II 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 Board's view, the
liquidation price would not reflect the "going concern" values of ILM I and ILM
II and, therefore, would not maximize shareholder value. In addition, the Boards
did not consider it advisable to liquidate ILM I and ILM II on the suggested
terms three years prior to their scheduled termination date.

PaineWebber indicated to the ILM I and ILM II Boards in its January 10,
1997 proposal that it would not wish to continue to serve as advisor to ILM I,
ILM II and their affiliates if they declined to accept PaineWebber's proposal.
The Company, Lease II, ILM I, and ILM II accepted the resignation of
PaineWebber, effective June 18, 1997. PaineWebber continued to provide certain
administrative services to the Company, Lease II, ILM I, and ILM II through
August 31, 1997, pursuant to the terms of a transition services agreement. 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 ILM I 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, ILM I 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 with third parties and the sale of ILM I 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. In
addition, because the master lease is due to terminate on December 31, 1999, but
could be terminated earlier by ILM Holding if the Senior Housing Facilities are
sold by ILM Holding, the Company's operations would not be expected to continue
beyond the date of any such transaction.

ITEM 2. PROPERTIES

As of August 31, 1998, the Company has leased the eight operating
properties referred to under Item 1 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
---------------------------------------------------------------------------
Fiscal1998
11/30/97 2/28/98 5/31/98 8/31/98 Average
-------- ------- ------- ------- ---------
<S> <C> <C> <C> <C> <C>
Independence Village
of Winston-Salem 96% 95% 94% 92% 94%

Independence Village
of East Lansing 93% 95% 94% 94% 94%

Independence Village of Raleigh 96% 97% 98% 96% 97%

Independence Village of Peoria 99% 99% 98% 99% 99%

Crown Pointe Apartments 98% 99% 98% 96% 98%

Sedgwick Plaza Apartments 91% 90% 89% 91% 90%

West Shores 95% 93% 98% 97% 96%

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

I-5
<PAGE>

ILM I LEASE CORPORATION

ITEM 3. LEGAL PROCEEDINGS

On July 29, 1996, Lease I and ILM Holding (collectively for this Item 3,
the "Companies") terminated a property management agreement with AHC, which
covered the eight Senior Housing Facilities leased by Lease I from ILM Holding
and engaged Capital as property manager. The management agreement with AHC 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
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 $1,250,000, 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. ILM I had guaranteed the payment of a
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 the Company 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 ILM I
and ILM II in the amount of $1,000,000 (the "Orders"). The Orders do not contain
any findings of fact or conclusions of law. On July 10, 1997, the Company, ILM
I, ILM II 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, the new property manager; Lawrence A.
Cohen, who, through July 28, 1998 was a Director of the Company and President,
Chief Executive Officer and Director of ILM I, 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 the Company 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 the Company 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 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. By August 31, 1998 Capital had
incurred $683,000 of legal expenses in the California litigation. 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 for Capital's California litigation
costs totaled approximately $519,000, although the final amount to be reimbursed
to Capital has not yet been determined.

I-6
<PAGE>

ILM I LEASE CORPORATION

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

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

At the Annual Meeting of Shareholders held on July 28, 1998, Julien G.
Redele', Jeffry R. Dwyer, and J. William Sharman, Jr., 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. Jeffry R. Dwyer has served as a Director since September 13, 1994, the
date of incorporation of the Company. J. William Sharman, Jr., has served as a
Director of the Company since September 18, 1997.

I-7
<PAGE>

ILM I LEASE CORPORATION

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S SHARES AND RELATED STOCKHOLDER MATTERS

Prior to September 1, 1995, the Company was a wholly-owned subsidiary of
ILM I. Pursuant to a reorganization and distribution agreement, ILM I
capitalized the Company with $700,000, an amount estimated to provide the
Company with necessary working capital. On September 1, 1995, Mavricc Management
Systems, Inc., as the distribution agent, caused to be issued on the stock
records of the Company the distributed common stock of the Company, in
uncertificated form, to the holders of record of ILM I common stock at the close
of business on July 14, 1995. One share of the Company's common stock was
distributed for each outstanding share of ILM I common stock. No certificates or
scrip representing fractional shares of the Company's common stock were issued
to holders of ILM I common stock as part of the distribution. In lieu of
receiving fractional shares, each holder of ILM I common stock who would
otherwise have been entitled to receive a fractional share of the Company's
common stock received a cash payment equivalent to $0.15 per share for such
fractional interest. At August 31, 1998, there were 5,103 record holders of the
Company's shares. The shares do not trade on an established exchange and the
only market that has developed is a secondary market. 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.

The Company did not pay cash dividends in fiscal years 1998, 1997 and
1996. The Company intends to review this policy during fiscal 1999, 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.

ITEM 6. SELECTED FINANCIAL DATA

ILM I LEASE CORPORATION
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
For the year For the year For the year
ended ended ended
August 31, 1998 August 31, 1997 August 31, 1996
------------------- -------------------- -------------------
<S> <C> <C> <C>
Revenues $ 19,294 $ 18,121 $ 17,285

Income (loss) before income taxes $ (435) $ (479) $ 603

Income tax expense (benefit) $ (54) $ (192) $ 241

Net income (loss) $ (381) $ (287) $ 362
=========== =========== ===========

Net income (loss) per share of
common stock $ (0.05) $ (0.04) $ 0.05
=========== =========== ===========

Total assets $ 3,198 $ 2,633 $ 2,797

Shares outstanding 7,519,430 7,519,430 7,519,430
</TABLE>

The above selected financial data should be read in conjunction with the
financial statements and related notes appearing in item 14 in this annual
report.

II-1
<PAGE>
ILM I LEASE CORPORATION

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

LIQUIDITY AND CAPITAL RESOURCES

The Company was formed in 1995 by ILM I, a publicly-held, non-traded
REIT, for the purpose of operating eight Senior Housing Facilities under the
terms of a master lease agreement. ILM I contributed $700,000 in return for all
of the issued and outstanding shares of the Company's common stock. ILM I had
originally made mortgage loans secured by the Senior Housing Facilities to AHC
between June 1989 and July 1992. In March 1993, AHC defaulted under the terms of
such mortgage loans and in connection with the settlement of such default, title
to the Senior Housing Facilities was transferred, effective April 1, 1994, to
certain majority-owned, indirect subsidiaries of ILM I, subject to the mortgage
loans. Subsequently, these indirect subsidiaries were merged into ILM Holding,
which is also a majority-owned subsidiary of ILM I. As part of the fiscal 1994
settlement agreement with AHC, AHC was retained as the property manager for the
Senior Housing Facilities pursuant to the terms of an agreement which was
assigned to the Company as of September 1, 1995. As discussed further below, the
agreement with AHC was terminated in July 1996.

ILM I 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 I's annual gross income must be
Qualified Rental Income as defined by the Code. The rent paid by the residents
of the Senior Housing 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 Senior Housing Facilities by ILM I or its
subsidiaries over an extended period of time could adversely affect ILM I's
status as a REIT. Therefore, ILM I 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 I common stock. Because
the Company, which is taxed as a regular C corporation, is no longer a
subsidiary of ILM I, it can receive service-related income without endangering
the REIT status of ILM I. On September 1, 1995, after ILM I received the
required regulatory approval, it distributed all of the outstanding shares of
capital stock of the Company to the holders of record of ILM I's common stock.
One share of common stock of the Company was issued for each full share of ILM
I's common stock held. No fractional shares were issued. Holders of ILM I's
common stock were not required to pay any cash or other consideration or to
exchange their common stock of ILM I for the common stock of the Company. Prior
to the distribution of the Company's stock, ILM I's shareholders received an
information statement fully describing the Company and the distribution of its
capital stock.

The master lease agreement, which commenced on September 1, 1995, is
between ILM Holding, as owner of the properties and lessor, and the Company, as
lessee. The master lease is a "triple-net" lease whereby the Company, as the
lessee, pays all operating expenses, governmental taxes and assessments, utility
charges and insurance premiums, as well as the costs of all required
maintenance, personal property and non-structural repairs in connection with the
operation of the Senior Housing Facilities. ILM Holding, as the lessor, is
responsible for all major capital improvements and structural repairs to the
Senior Housing Facilities. If the Company and ILM Holding decide that any of the
Senior Housing Facilities should be expanded, the master lease agreement between
the Company and ILM Holding would be amended to include such expansion. During
the initial term of the master lease, which expires on December 31, 1999, the
Company is obligated to pay annual base rent for the use of all of the Senior
Housing Facilities in the aggregate amount of $6,364,800 each year. Beginning in
January 1997 and for the remainder of the lease term, the Company 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
$16,996,000. Variable rent expense related to the years ended August 31, 1998
and 1997, respectively, was $894,000 and $315,000.

II-2
<PAGE>
ILM I LEASE CORPORATION

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

As noted above, the Company's master lease is scheduled to expire on
December 31, 1999. Accordingly, since the Company does not have any current
plans to operate or own any other facilities or engage in any other business
outside of its relationship with ILM I, there is no assurance that the Company's
operations will continue beyond December 1999. The master lease may be
terminated earlier, however, by ILM Holding upon 30 days notice to the Company
in connection with a sale to a non-affiliated third party of the Senior Housing
Facilities.

On July 29, 1996, the Company terminated the agreement with AHC covering
eight Senior Housing Facilities leased by the Company (see "Item 3, Legal
Proceedings") and retained Capital to be the manager of the Senior Housing
Facilities. Lawrence A. Cohen, who, through July 28, 1998 served as a Director
of the Company and President, Chief Executive Officer and Director of ILM 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,
until 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, as well
as 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. ILM I has guaranteed the payment of all fees due to
Capital under the terms of the management agreement.

By August 31, 1998 Capital had incurred $683,000 of legal expenses in the
California litigation. 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 for Capital's California litigation costs totaled approximately $519,000,
although the final amount to be reimbursed to Capital has not yet been
determined.

Occupancy levels for the eight properties which the Company leases from
ILM Holding averaged 96% for the year ended August 31, 1998. The Senior Housing
Facilities have generated sufficient net cash flow to cover the base master
lease payments at their current level of $6,364,800 per year since the inception
of the Company's operations. As noted above, the master lease also provides for
the payment of variable rent beginning in January 1997. 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. Accordingly, the Company had variable rental expense in fiscal years 1998
and 1997 in the amount of $894,000 and $315,000, respectively.

II-3
<PAGE>

ILM I LEASE CORPORATION

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
$1,897,000. 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 any major capital improvements or 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 years
1998, 1997 and 1996. The Company intends to review this policy during fiscal
1999, 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.

YEAR 2000

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

Based on ongoing assessments, the Company, through Capital, its property
manager, has developed a program to modify or replace portions of its software
and certain hardware, which are generally PC-based systems, so that those
systems will properly recognize and utilize dates beyond December 31, 1999.
While there can be no assurance, as of August 31, 1998, the Company believes
that it will substantially complete all software and hardware upgrades as of
December 31, 1998. The Company believes that these modifications and
replacements of existing software and certain hardware will mitigate the Year
2000 issue. However, if such modifications and replacements are not completed
timely, the Year 2000 issue could have a material impact on the operations of
the Company. The costs of Year 2000 remediation are not expected to be material
based on the Company's operations.

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

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

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

II-4
<PAGE>

ILM I LEASE CORPORATION

RESULTS OF OPERATIONS

1998 COMPARED TO 1997

REVENUES. Total revenues were $19,294,000 for the year ended August 31,
1998 compared to $18,121,000 for the year ended August 31, 1997, representing an
increase of $1,173,000 or 6.5%. Rental and other income from the Company's
senior housing operations was $19,232,000 at August 31, 1998, representing an
increase of $1,183,000 or 6.6%, primarily as a result of improved occupancies
and increases in rental rates at certain of the facilities located in strong
markets.

EXPENSES. Total expenses were $19,729,000 in fiscal 1998 compared to
$18,600,000 in fiscal 1997, representing an increase of $1,129,000 or 6.1%. This
increase was principally comprised of increases in master lease rent expense of
$579,000 or 8.7%, dietary and food service salaries, wages and expenses of
$135,000 or 3.9%, general and administrative expenses of $593,000 or 67%,
property management fees of $78,000 or 9.3%, and additional termination fee
expense incurred in fiscal 1998 of $375,000 (see "Item 3, Legal Proceedings")
representing a decrease of 37.5% from fiscal year 1997. In addition, total
charges to depreciation expense in 1998 include additional depreciation expense
of $136,000 in recognition of changes in remaining useful life for certain
assets purchased in 1997 and prior to conform to the lease termination date, as
such assets are not subject to repurchase by ILM Holding. As a result, total
depreciation expense increased $223,000 or 301.4%. These increases were offset,
in part, by a decrease in administrative salaries, wages and expenses of $59,000
or 4.6%, marketing salaries, wages and expenses of $27,000 or 3.1%, other
property operating expenses of $88,000 or 5.6% and advisory fees of $70,000 or
100%. The increase in master lease rent expense is the result of variable rents
due under the Master Lease Agreement in 1998. General and administrative expense
increased as a result of higher AHC litigation expenses in 1998 coupled with the
analysis of restructuring alternatives performed by an independent investment
banking firm. The increases in other operating costs cited above were the result
of higher operating levels associated with improved occupancies.

INCOME TAX EXPENSE. Income tax benefit decreased $138,000 or 71.9%, from
$192,000 in fiscal 1997 to a benefit of $54,000 in fiscal 1998, after giving
effect to the $120,000 valuation allowance in 1998 on the Company's deferred tax
asset. The effective income tax rate was 7% in fiscal 1998 and 40% in fiscal
1997. The 1997 deferred tax provision reflects a reclassification of $240,000 of
current tax expense in 1997, which was ultimately determined to be deductible in
1998.

NET INCOME (LOSS). Primarily as a result of the factors discussed
above, net loss increased $94,000 or 32.8%, from a net loss of $287,000 in
fiscal 1997 to a net loss of $381,000 in fiscal 1998.

1997 COMPARED TO 1996

REVENUES. Total revenues were $18,121,000 for the year ended August 31,
1997, compared to $17,285,000 for the year ended August 31, 1996, representing
an increase of $836,000, or 4.8%. Rental and other income from the Company's
senior housing operations was $18,049,000 as of August 31, 1998, representing an
increase of $822,000 or 4.8%, primarily as a result of improved occupancies and
increases in rental rates at certain of the facilities located in strong
markets.

EXPENSES. Total expenses were $18,600,000 in 1997 compared to
$16,682,000 in 1996, representing an increase of $1,918,000 or 11.5%. This
increase was principally comprised of increases in master lease rent expense of
$315,000 or 5%, dietary and food service salaries, wages and expenses of
$262,000 or 8.3%, administrative salaries, wages and expenses of $171,000 or
15.5%, general and administrative expenses of $545,000 or 165.2% and other
property operating expenses of $136,000 or 9.5%, and termination fee expense
incurred in fiscal 1997 of $600,000 (see "Item 3, Legal Proceedings")
representing an increase of 100% from fiscal year 1996. These increases were
offset, in part, by a decrease in property management fees of $103,000 or 10.9%,
as a result of the July Master Lease Agreement taking effect for the first time
in 1997. General and administrative expense increased

II-5
<PAGE>
ILM I LEASE CORPORATION

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

$545,000 or 165.2% as a result of higher AHC litigation expenses in 1997 coupled
with the analysis of restructuring alternatives performed by an independent
investment banking firm. The increases in other operating costs cited above were
the result of higher operating levels associated with improved occupancies and
the implementation of a health insurance program for property-level staff.

INCOME TAX EXPENSE. Income tax expense decreased $433,000 or
179.7%, from $241,000 in 1996 to a benefit of $192,000 in 1997 as a result of a
net loss before taxes of $479,000 as the effective income tax rate was 40% in
both years.

NET INCOME. Primarily as a result of the factors discussed above, net
income decreased $649,000 or 179.3%, from $362,000 in 1996 to a net loss of
$287,000 in 1997.

INFLATION

The Company completed its third 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 tenant
leases at the Senior Housing Facilities. Rental 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.
As noted above, under the terms of the master lease agreement between the
Company and ILM Holding, the Company is obligated to pay variable rent, in
addition to the base rent owed, in an amount equal to 40% of the excess of total
revenues from the Senior Housing Facilities over a specified base amount.
Accordingly, to the extent that the total revenues are in excess of this
threshold, a portion of the increase in revenues would be payable to the Lessor.

II-6
<PAGE>
ILM I LEASE CORPORATION

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

FORWARD-LOOKING INFORMATION

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

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

II-7
<PAGE>
ILM I LEASE CORPORATION

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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

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

None.

II-8
<PAGE>
ILM I LEASE CORPORATION

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

There currently are three Directors of the Company. The Directors are
subject to removal by the vote of the holders of a majority of the outstanding
shares of the Company's common stock. 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>
Dates
Name Office Age of Office
---- ------ --- ----------
<S> <C> <C> <C>
Julien G. Redele President and Director 63 7/28/98-present
Jeffry R. Dwyer Secretary and Director 52 9/13/94*-present
J. William Sharman, Jr. Director 58 9/18/97-present

Lawrence A. Cohen Director 45 9/13/94*-9/28/98
John B. Watts III Director 45 9/13/94*-9/28/98
</TABLE>

* The date of incorporation of the Company.

(c) There is no family relationship among any of the current Directors
or Officers. All of the current 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:

JULIEN G. 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 also presently serves as
President and Director of Lease II.

JEFFRY R. DWYER is Secretary and Director of the Company. Mr. Dwyer
has been a shareholder of Greenberg Traurig, which has provided legal services
to the Company and its affiliates since June 1997. 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, ILM II and
Lease II. Mr. Dwyer has written several law review articles and a major treatise
on real estate financing and taught Real Estate Planning as an Adjunct Professor
at the Georgetown University law Center. Mr. Dwyer graduated from Georgetown
University and received his law degree from the Georgetown University Law
Center.

J. WILLIAM SHARMAN, JR. was President and Director of the Company
until July 28, 1998, when Julien G. Redele succeeded him as President.. Mr.
Sharman is also a Director of Lease II. Mr. Sharman is the Chairman of the Board
and CEO 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 President and Director of ILM I and ILM II. He has a
Bachelor of Science degree from the University of Notre Dame.

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ILM I LEASE CORPORATION

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

LAWRENCE A. COHEN served as Director of the Company from inception
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 was contracted by the Company in July 1996 to perform property management
services for the Senior Housing Facilities. 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 II
and President, Chief Executive Officer and Director of ILM I and ILM II 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.

JOHN B. WATTS III was a Director of the Company and of Lease II until
July 28, 1998. Mr. Watts currently directs institutional real estate
acquisitions for the PNL Companies in New York. Mr. Watts was Senior Vice
President and Director of Real Estate Advisory and Portfolio Management at
PaineWebber, where he was employed from June 1988 to August 1996. Mr. Watts has
over 19 years of experience in acquisitions, dispositions and finance of real
estate and has directed the portfolios of real estate partnerships and REITS. He
received degrees of Bachelor of Architecture, Bachelor of Arts and Master of
Business Administration from the University of Arkansas.

(e) Except for the Feldman litigation as discussed below, 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. 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 ILM I and ILM II (affiliates of the Company, as previously
described) in the Supreme Court of the State of New York, County of New York
against ILM I, ILM II and Lawrence A. Cohen, Jeffry R. Dwyer, Julien G.
Redele, Carl J. Schramm and J. William Sharman, Jr. as 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 ILM I and ILM II,
diverting certain of their assets and changing the nature of ILM I and ILM
II. The complaint seeks damages in an unspecified amount, punitive damages,
the judicial dissolution of ILM I and ILM II, 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 defendants moved to dismiss the complaint on all
counts.

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 defendant'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 ILM I as a whole. The defendants doubt that such a
cause of action could be alleged and continue to believe that this lawsuit is
meritless. The defendants have directed outside counsel to continue vigorously
contesting the action.

(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.

III-2
<PAGE>
ILM I LEASE CORPORATION

ITEM 11. EXECUTIVE COMPENSATION

The Company's Directors each receive annual compensation of $12,000
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.

Lawrence A. Cohen, who was a Director of the Company until July 28,
1998, received compensation from and was an employee of Capital Senior Living
Corporation, an affiliate of Capital, a related party.

Jeffry R. Dwyer receives compensation from and is a shareholder of
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 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
Company, the former officers resigned effective the same date; therefore no
services were provided by such persons subsequent to June 18, 1997.

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 hereof.

(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 in managing the business of the Company was provided by PaineWebber.
Under the 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 a fee in an amount equal
to 0.5% of the gross operating revenue of the facilities. PaineWebber earned
management fees totaling $0, $70,000 and $88,000 for the years ended August 31,
1998, 1997 and 1996, respectively. PaineWebber was reimbursed for direct
expenses relating to the administration of the Company. Paine Webber performed
certain accounting, tax preparation, securities law compliance and investor
communication and relations services for the Company. Included in general and
administrative expenses on the accompanying statements of income for the years
ended August 31, 1998, 1997 and 1996 is $0, $80,000 and $73,000, respectively,
representing reimbursements to PaineWebber for providing such services to the
Company. As discussed in Items 1 and 7, the Company, ILM I, ILM II and their
affiliates accepted the resignation of Paine Webber effective as of June 18,
1997. The Company, ILM I, ILM II and their affiliates and Paine Webber entered
into a transition services agreement pursuant to which PaineWebber would
continue to provide certain administrative services to the Company, ILM I, ILM
II and their affiliates through August 31, 1997.

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.

III-3
<PAGE>
ILM I LEASE CORPORATION

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)

The Company retained Capital to be the property manager of the Senior
Housing Facilities pursuant to a Management Agreement which commenced on July
29, 1996. As discussed in Note 1, Lawrence A. Cohen, who served as a Director of
the Company as well as President, Chief Executive Officer and Director of ILM I
through July 28, 1998, has also served as Vice Chairman and Chief Financial
Officer of Capital Senior Living Corporation, an affiliate of Capital, since
November 1996. Under the Management Agreement, Capital generally is required to
perform all operational functions necessary to operate the Senior Housing
Facilities other than certain administrative functions. The functions performed
by Capital include periodic reporting to and coordination with the Company,
leasing the individual units in the Senior Housing Facilities, maintaining bank
accounts, maintaining books and records, advertising and marketing the Senior
Housing Facilities, hiring and supervising on-site personnel, and performing
maintenance. 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 the 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. ILM I has
guaranteed the payment of all fees due to the terms of the Management Agreement.
Capital earned property management fees from the Company of $919,000, $841,000
and $75,000 for the years ended August 31, 1998, 1997, and 1996, respectively.

On September 18, 1997, the Company 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. ILM Holding
will reimburse the Company 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 $212,000 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 $168,000 and $0 for the years ended August 31, 1998 and 1997,
respectively.

III-4
<PAGE>
ILM I LEASE CORPORATION

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) Exhibits:

See (a)(3) above.

The Company filed a Current Report on Form 8-K dated
August 21, 1998, reporting the Company's settlement
of the AHC litigation.

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 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.

ILM I LEASE CORPORATION

By: /s/ Jeffry Dwyer
--------------------------------
Jeffry R. Dwyer
Chief Operating Officer
(Principal Accounting Officer)

Dated: November 12, 1999
--------------------

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

By: /s/ Jeffry R. Dwyer Date: November 12, 1999
------------------------------------ -----------------------------
Jeffry R. Dwyer
Director

By: /s/ Julien G. Redele Date: November 16, 1999
------------------------------------ -----------------------------
Julien G. Redele
Director

By: /s/ J. William Sharman, Jr. Date: November 16, 1999
----------------------------------- ---------------------------------
J. William Sharman, Jr.
Director

IV-2
<PAGE>

ILM I LEASE CORPORATION

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

ILM I LEASE CORPORATION

INDEX TO EXHIBITS

<TABLE>
<CAPTION>
PAGE NUMBER IN THE REPORT
EXHIBIT NO. DESCRIPTION OF DOCUMENT OR OTHER REFERENCE
- -------------- ------------------------ -----------------------------------
<S> <C> <C>
(3) and (4) Registration Statement on Form 10 of Filed with the Commission pursuant
the Registrant dated July 20, 1995, as to Rule 424(c) and incorporated
supplemented. herein by reference.

(13) Annual Reports to Shareholders No Annual Report for the year ended
August 31, 1998 has been sent to
the Shareholders. An Annual Report
will be sent to the Shareholders
subsequent to this filing.

(27) Financial Data Schedule Filed as last page of EDGAR
submission following the Financial
Statements and Financial Statement
Schedule required by Item 14.
</TABLE>

IV-3
<PAGE>

ILM I LEASE CORPORATION

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

ILM I LEASE CORPORATION

INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
<TABLE>
<CAPTION>

REFERENCE

ILM I LEASE CORPORATION:
<S> <C>
Report of Ernst & Young LLP, Independent Auditors F-2

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

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

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

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

Notes to Financial Statements F-7
</TABLE>

Financial statements 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 financial statements, including the notes thereto.

F-1

<PAGE>

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Shareholders of
ILM I Lease Corporation:

We have audited the accompanying balance sheets of ILM I Lease
Corporation as of August 31, 1998 and 1997, and the related statements of
operations, changes in shareholders' equity, and cash flows for each of the
three years in the period ended August 31, 1998. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements 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 financial statements referred to above present
fairly, in all material respects, the financial position of ILM I Lease
Corporation at August 31, 1998 and 1997, and the results of its operations and
its cash flows for each of the three years in the period ended August 31, 1998,
in conformity with generally accepted accounting principles.

ERNST & YOUNG LLP

Dallas, Texas
October 13, 1998

F-2
<PAGE>

ILM I LEASE CORPORATION

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

ASSETS
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Cash and cash equivalents $ 1,897 $ 1,473
Accounts receivable--related party -- 93
Accounts receivable, net 56 --
Tax refunds receivable 145 --
Prepaid expenses and other assets 127 259
------- -------
Total current assets 2,225 1,825

Furniture, fixtures and equipment 999 591
Less: accumulated depreciation (390) (93)
------- -------
609 498

Deferred tax asset, net 364 310
$ 3,198 $ 2,633
======= =======
</TABLE>

LIABILITIES AND SHAREHOLDERS'EQUITY
<S> <C> <C>
Accounts payable and accrued expenses $ 1,123 $ 882
Termination fee payable 975 600
Real estate taxes payable 213 170
Accounts payable - related party 438 116
Security deposits 7 5
------- -------
Total current liabilities 2,756 1,773

Deferred rent payable 49 86
------- -------
Total liabilities 2,805 1,859

Commitments and contingencies

Shareholders' equity:

Common stock, $0.01 par value, 20,000,000 shares authorized,
7,519,430 shares issued and outstanding 75 75
Additional paid-in capital 625 625
Retained earnings (deficit) (307) 74
------- -------
Total shareholders' equity 393 774
------- -------
$ 3,198 $ 2,633
======= =======
</TABLE>

See accompanying notes.

F-3
<PAGE>
ILM I LEASE CORPORATION

STATEMENTS OF OPERATIONS
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 $ 19,232 $ 18,049 $ 17,227
Interest income 62 72 58
-------- -------- --------
19,294 18,121 17,285

EXPENSES:

Master lease rent expense 7,222 6,643 6,328
Dietary and food service salaries, wages and expenses 3,566 3,431 3,169
Administrative salaries, wages and expenses 1,218 1,277 1,106
Marketing salaries, wages and expenses 856 883 915
Utilities 834 850 868
Repairs and maintenance 661 666 668
Real estate taxes 827 816 811
Property management fees 919 841 944
Other property operating expenses 1,486 1,574 1,438
General and administrative 1,468 875 330
Termination fee expense 375 600 --
Advisory fees -- 70 86
Depreciation expense 297 74 19
-------- -------- --------
19,729 18,600 16,682
-------- -------- --------

Income (loss) before income taxes (435) (479) 603

Income tax expense (benefit):
Current -- 92 267
Deferred (54) (284) (26)
-------- -------- --------
(54) (192) 241
-------- -------- --------

NET INCOME (LOSS) $ (381) $ (287) $ 362
======== ======== ========
NET INCOME (LOSS) PER SHARE OF COMMON STOCK $ (0.05) $ (0.04) $ 0.05
======== ======== ========
</TABLE>

The above net income (loss) per share of common stock is based upon the weighted
average number of shares outstanding for the years ended August 31, 1998, 1997
and 1996 of 7,519,430.

See accompanying notes.

F-4
<PAGE>
ILM I LEASE CORPORATION

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 Retained
--------------------------- Paid-in Earnings
Shares Amount Capital (Deficit) Total
------------ ----------- ----------- ------------- -------------
<S> <C> <C> <C> <C> <C>
BALANCE AT AUGUST 31, 1995 15,000 $ -- $ 1 $ (1) $ --

Issuance of common stock 7,504,430 75 624 -- 699

Net income -- -- -- 362 362
---------- ---------- ---------- ---------- ----------

BALANCE AT AUGUST 31, 1996 7,519,430 75 625 361 1,061

Net loss -- -- -- (287) (287)
---------- ---------- ---------- ---------- ----------

BALANCE AT AUGUST 31, 1997 7,519,430 75 625 74 774

Net loss -- -- -- (381) (381)
---------- ---------- ---------- ---------- ----------

BALANCE AT AUGUST 31, 1998 7,519,430 $ 75 $ 625 $ (307) $ 393
========== ========== ========== ========== ==========
</TABLE>

See accompanying notes.

F-5
<PAGE>

ILM I LEASE CORPORATION

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 (loss) $ (381) $ (287) $ 362
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating activities:

Depreciation expense 297 74 19
Deferred taxes (54) (284) (26)
Changes in assets and liabilities:
Accounts receivable - related party 93 -- --
Accounts receivable, net (56) 77 (77)
Tax refunds receivable (145) -- --
Prepaid expenses and other assets 132 8 (267)
Accounts payable and accrued expenses 241 19 863
Accounts payable - related party 322 (422) 445
Termination fee payable 375 600 --
Real estate taxes payable 43 (130) 300
Security deposits 2 -- 5
Deferred rent payable (37) (37) 123
------- ------- -------
Net cash provided by (used in) operating activities 832 (382) 1,747
------- ------- -------

Cash flows from investing activities:

Additions to furniture, fixtures and equipment (408) (330) (261)
------- ------- -------
Net cash used in investing activities (408) (330) (261)
------- ------- -------

Cash flows from financing activities:

Proceeds from issuance of common stock -- -- 699
------- ------- -------
Net cash provided by financing activities -- -- 699
------- ------- -------

Net increase (decrease) in cash and cash equivalents 424 (712) 2,185

Cash and cash equivalents, beginning of period 1,473 2,185 --
------- ------- -------

Cash and cash equivalents, end of period $ 1,897 $ 1,473 $ 2,185
======= ======= =======

SUPPLEMENTAL DISCLOSURE:

Cash paid during the period for income taxes $ 201 $ 181 $ 317
======= ======= =======

See accompanying notes.
</TABLE>

F-6
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements

1. ORGANIZATION, RESTRUCTURING, AND NATURE OF OPERATIONS

ILM I Lease Corporation ("the Company") was organized as a corporation
on September 12, 1994 under the laws of the state of Virginia. Through
August 31, 1995, the Company had no significant operations. The Company was
formed by ILM Senior Living, Inc. ("ILM I"), formerly PaineWebber
Independent Mortgage Fund, Inc., to operate eight rental housing projects
that provide independent living and assisted living services for
independent senior citizens ("the Senior Housing Facilities") under a
master lease agreement. ILM I initially made mortgage loans to Angeles
Housing Concepts, Inc. ("AHC") secured by the Senior Housing Facilities
between June 1989 and July 1992. In March 1993, AHC defaulted under the
terms of such mortgage loans and in connection with the settlement of such
default, title to the Senior Housing Facilities was transferred, effective
April 1, 1994, to certain majority-owned, indirect subsidiaries of ILM I,
subject to the mortgage loans. Subsequently, the indirect subsidiaries of
ILM I were merged into ILM Holding, Inc. ("ILM Holding"). As part of the
fiscal 1994 settlement agreement with AHC, AHC was retained as the property
manager for all of the Senior Housing Facilities pursuant to the terms of a
management agreement which was assigned to the Company as of September 1,
1995. As discussed further in Note 6, the agreement with AHC was terminated
in July 1996.

ILM I 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 I's annual gross income must be Qualified Rental Income as
defined by the Code. The rent paid by the residents of the Senior Housing
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 Senior Housing Facilities by ILM I or its subsidiaries
over an extended period of time could adversely affect ILM I's status as a
REIT. Therefore, ILM I 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 I common stock on
September 1, 1995 (see Note 4). Because the Company, which is taxed as a
regular C corporation, is no longer a subsidiary of ILM I, it can receive
service-related income without endangering the REIT status of ILM I.

The Company's sole business is the operations of the Senior Housing
Facilities. The Company leases the Senior Housing Facilities from ILM
Holding, a majority-owned and consolidated affiliate of ILM I which
currently holds title to the Senior Housing Facilities, pursuant to a
master lease which commenced on September 1, 1995 and expires on December
31, 1999 (see Note 5). In July 1996, the Company terminated the property
management agreement with AHC and entered into a property management
agreement (the "Management Agreement") with Capital Senior Management 2,
Inc. ("Capital") to handle the day-to-day operations of the Senior Housing
Facilities. Since November 1996, Lawrence A. Cohen, who served as a
Director of the Company and President, Chief Executive Officer and Director
of ILM I until July 28, 1998, has also served as Vice Chairman and Chief
Financial Officer of Capital Senior Living Corporation, an affiliate of
Capital. As a result, through July 28, 1998, the Management Agreement with
Capital was considered a related party transaction (see Note 3).

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 require 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 the years ended August 31, 1998, 1997
and 1996. Actual results could differ from the estimates and assumptions
used.

Furniture, fixtures and equipment are carried at the lower of cost,
reduced by accumulated depreciation, or fair value in accordance with FAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets To Be Disposed Of." Depreciation expense was provided on
a straight-line basis using an estimated useful life of 3 to 5 years. In
1998, the Company changed the estimated useful lives of its assets

F-7
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

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

the lease termination date of December 31, 1999, as such assets are not
subject to repurchase by ILM Holding. This increased depreciation expense by
$136,000 in 1998.

Units at the Senior Housing Facilities are generally rented for terms
of twelve months or less. The base rent charged varies depending on the
unit size, with added fees collected for more than one occupant per unit
and for assisted living services. Included in the amount of base rent
charged are certain meals, housekeeping, medical and social services
provided to the residents of each Facility.

The Company rents the Senior Housing Facilities from ILM Holding
pursuant to a multi-year operating lease. Rent expense is recognized on a
straight-line basis over the term of the lease agreement. Deferred rent
payable represents the difference between rent expense recognized on a
straight-line basis and cash paid for rent pursuant to the terms of the
lease agreement.

The Company's policy is to expense all advertising costs as incurred.
Advertising expenses were $857,000, $883,000 and $915,000 for the years
ended August 31, 1998, 1997 and 1996, respectively.

The cash and cash equivalents, receivables, accounts payable and
accrued liabilities appearing on the accompanying balance sheets represent
financial instruments for purposes of Statement of Financial Accounting
Standards No. 107, "Disclosures about Fair Value of Financial Instruments."
The carrying amount of these assets and liabilities approximates their fair
value as of August 31, 1998 due to the short-term nature of these
instruments.

Income tax expense is provided for using the liability method as
prescribed by Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes." The Company has provided a valuation
allowance in fiscal 1998 to recognize the effect that the lease termination
date may have on the estimated net realizable value of the deferred tax
asset as explained more fully in Note 7 to the accompanying financial
statements. At August 31, 1998, a valuation allowance for deferred taxes of
$120,000 is included in deferred taxes, net, on the accompanying balance
sheet.

For purposes of reporting cash flows, cash and cash equivalents
include all highly liquid investments with original maturities of 90 days or
less.

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.

3. RELATED PARTY TRANSACTIONS

The Company entered into an advisory agreement (the "Advisory
Agreement") with PaineWebber Lease Advisor, L.P. For discussion purposes,
PaineWebber Lease Advisor, L.P. and all affiliates of PaineWebber will be
collectively referred to as ("PaineWebber"). Subject to the supervision of
and pursuant to the general policies set by the Company's Board of
Directors, assistance in the managing of the business of the Company was
provided by PaineWebber. Under the Advisory Agreement, the Company engaged
PaineWebber and PaineWebber agreed to use its best efforts to manage the
day-to-day affairs and operations of the Company and to provide
administrative services and facilities appropriate for such management. The
specific duties of

F-8
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

3. RELATED PARTY TRANSACTIONS (CONTINUED)

PaineWebber under the Advisory Agreement included recommending selections
of providers of professional and specialized services and handling other
managerial functions with respect to the Senior Housing Facilities.
PaineWebber was also obligated to provide office and clerical facilities
adequate for the Company's operations and to provide, or obtain others to
provide, accounting, custodial, funds collection and payment, stockholder
communications, legal and other services necessary in connection with the
Company's operations. The Advisory Agreement also obligated PaineWebber to
handle or arrange for the handling of the Company's financial and other
records.

PaineWebber received a base fee in an amount equal to 0.5% of the
gross operating revenues of the Senior Housing Facilities operated by the
Company as compensation for its services. This fee amounted to $0, $70,000
and $88,000 for the years ended August 31, 1998, 1997 and 1996. In
addition, PaineWebber was 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 year ended August 31, 1998, 1997 and 1996 was $0, $80,000 and
$73,000, representing reimbursements to PaineWebber for providing such
services to the Company. In performing its services under the Advisory
Agreement, PaineWebber was required to pay certain employment expenses of
its personnel, certain expenses of employees and agents of PaineWebber and
of Directors, officers and employees of the Company who are also employees
of PaineWebber, and certain of its overhead and miscellaneous
administrative expenses relating to performance of its functions under the
Advisory Agreement. The Company was responsible for reimbursing
out-of-pocket expenses of Directors, Officers and employees of the Company
incurred by them exclusively in such capacity and for all other costs of
its operations.

At a meeting of the Boards of Directors of ILM I and an affiliated
entity, ILM II Senior Living, Inc. ("ILM II"), on January 10, 1997,
PaineWebber recommended the immediate sale of the Senior Housing Facilities
operated by the Company and held by ILM I as well as the Senior Housing
Facilities held by ILM II, by means of a controlled auction to be conducted
by PaineWebber, at no additional compensation, with PaineWebber offering to
purchase the Senior Housing Facilities held by ILM I and ILM II for $127
million, thereby guaranteeing the shareholders a "floor" price. The Senior
Housing Facilities operated by the Company under its master lease with ILM
Holding would represent approximately $75 million of this amount. After
taxes and closing costs, net proceeds to ILM I would equal approximately
$71 million or approximately $9.41 per share of ILM I common stock.
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 and ILM I in evaluating PaineWebber's proposal, NatWest
Securities, a disinterested, independent investment banking firm with
expertise in healthcare REITs and independent/assisted living financings
was engaged by the Company, ILM I and ILM II and their affiliates.
Following a comprehensive analysis, the investment banking firm recommended
that PaineWebber's proposal should be declined and that instead,
investigation 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 ILM I and ILM II 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 Board's view, the liquidation price would
not reflect the "going concern" values of ILM I and ILM II and, therefore,
would not maximize shareholder value. In addition, the Boards did not
consider it advisable to liquidate ILM I and ILM II on the suggested terms
several years prior to their scheduled termination dates.

F-9
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

3. RELATED PARTY TRANSACTIONS (CONTINUED)

PaineWebber indicated to the Board in its January 10, 1997, proposal
that it would not wish to continue to serve as advisor to ILM I, ILM II and
their affiliates if they declined to accept PaineWebber's proposal. The
Company, ILM Lease II Corporation ("Lease II"), ILM I and ILM II accepted
the resignation of PaineWebber effective June 18, 1997. PaineWebber agreed
to continue to provide certain administrative services to the Company,
Lease II, ILM I, ILM II and their affiliates through August 31, 1997,
pursuant to the terms of a transition services agreement entered into with
ILM I, ILM II and their affiliates. The Company, Lease II, ILM I, ILM II
and their affiliates also accepted, effective June 18, 1997, the
resignations of those Officers and Directors who were employees or
otherwise affiliated with PaineWebber.

The Company and ILM I 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, ILM I 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 with third parties and the sale
of ILM I 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 retained Capital to be the property manager of the Senior
Housing Facilities pursuant to a Management Agreement which commenced on
July 29, 1996. As discussed in Note 1, since November 1996, Lawrence A.
Cohen, who was a Director of the Company as well as President, Chief
Executive Officer and Director of ILM I through July 28, 1998, has also
served as Vice Chairman and Chief Financial Officer of Capital Senior
Living Corporation, an affiliate of Capital. Under the Management
Agreement, Capital generally is required to perform all operational
functions necessary to operate the Senior Housing Facilities other than
certain administrative functions. The functions performed by Capital
include periodic reporting to and coordinating with the Company, leasing
the individual units in the Senior Housing Facilities, hiring and
supervising on-site personnel, and performing maintenance. 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 the 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. ILM I has guaranteed the payment of all fees due to Capital under
the terms of the Management Agreement. Capital earned property management
fees from the Company of $919,000, $841,000 and $75,000 for the years ended
August 31, 1998, 1997 and 1996, respectively.

F-10
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

3. RELATED PARTY TRANSACTIONS (CONTINUED)

$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. By August 31, 1998 Capital had
incurred $683,000 of legal expenses in the California litigation. 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 for Capital's California
litigation costs totaled approximately $519,000, although the final amount
to be reimbursed to Capital has not yet been determined.

On September 18, 1997, the Company entered into an agreement with
Capital Senior Development, Inc., an affiliate of Capital, to manage the
development process for the potential expansions of several of the Senior
Housing Facilities. Capital Senior Development, Inc. will receive a fee
equal to 7% of the total development costs of these expansions if they are
pursued. ILM Holding will reimburse the Company 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 $212,000 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 1997. For the years ended August
31, 1998 and 1997, Greenberg Traurig earned fees from the Company of
$168,000 and $0, respectively.

Accounts receivable - related party at August 31, 1998 and August 31,
1997 includes advances of $0 and $93,000, respectively, to ILM Holding,
primarily to fund facility expansion costs. Accounts payable - related
party at August 31, 1998 and 1997 consists principally of variable rent
payable to ILM Holding of $243,000 and $116,000, respectively, and expense
reimbursements payable to ILM Holding in the amounts of $93,000 and $0,
respectively, and to Lease II in the amounts of $102,000 and $0,
respectively.

4. CAPITAL STOCK

Prior to September 1, 1995, the Company was a wholly-owned subsidiary
of ILM I. Pursuant to a reorganization and distribution agreement, ILM I
capitalized the Company with $700,000, an amount estimated to provide the
Company with necessary working capital. On September 1, 1995, Mavricc
Management Systems, Inc., as the distribution agent, caused to be issued on
the stock records of the Company the distributed Common Stock of the
Company, in uncertificated form, to the holders of record of ILM I Common
Stock at the close of business on July 14, 1995. One share of the Company's
Common Stock was distributed for each outstanding share of ILM I Common
Stock. No certificates or scrip representing fractional shares of the
Company's Common Stock were issued to holders of ILM I Common Stock as part
of the distribution. In lieu of receiving fractional shares, each holder of
ILM I Common Stock who would otherwise have been entitled to receive a
fractional share of the Company's Common Stock received a cash payment
equivalent to $0.15 per share for such fractional interest.

5. THE MASTER LEASE AGREEMENT

ILM Holding (the "Lessor") has leased the Senior Housing Facilities to
the Company (the "Lessee") pursuant to a master lease which commenced on
September 1, 1995. Under the terms of the master lease, which has a
scheduled expiration date of December 31, 1999, the Lessor has the right to
terminate the master lease as to any Senior Housing Facility sold as of the
date of such sale. The master lease is accounted for as an operating lease
in the Company's financial statements.

F-11
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

5. THE MASTER LEASE AGREEMENT (CONTINUED)

Descriptions of the properties covered by the master lease between the
Company and ILM Holding are summarized as follows:

<TABLE>
<CAPTION>
Year
Facility Rentable Resident
Name Location Built Units (2) Capacity (2)
---- -------- ----- --------- ------------
<S> <C> <C> <C> <C>
Independence Village of East Lansing, MI 1989 161 162
East Lansing

Independence Village of Winston-Salem, NC 1989 159 161
Winston-Salem

Independence Village of Raleigh, NC 1991 164 205
Raleigh

Independence Village of Peoria, IL 1990 165 181
Peoria

Crown Pointe Apartments Omaha, NE 1984 135 163

Sedgwick Plaza Apartments Wichita, KS 1984 150 170

West Shores Hot Springs, AR 1986 136 166

Villa Santa Barbara (1) Santa Barbara, CA 1979 125 125
</TABLE>

(1) The Company operates Villa Santa Barbara under a co-tenancy arrangement
with an affiliated company, ILM II Lease Corporation ("Lease II"). The
Company has entered into an agreement with Lease II regarding such
joint tenancy. Lease II was formed for similar purposes as the Company
by an affiliated company, ILM II Senior Living, Inc. ("ILM II"), a
subsidiary of which owns a portion of the Villa Santa Barbara property.
The portion of the Senior Housing Facility leased by the Company
represents 25% of the total project. Villa Santa Barbara is 25% owned
by ILM Holding and 75% by ILM II Holding, Inc., a direct subsidiary of
ILM II, as tenants in common. Upon the sale of ILM I or ILM II,
arrangements would be made to transfer the Santa Barbara facility to
the non-selling joint tenant (or one of its subsidiaries). The property
was extensively renovated in 1995.

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

During the term of the master lease, the Company is obligated to pay
annual base rent for the Senior Housing Facilities. For calendar year 1996
and subsequent years, the annual base rent is $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

F-12
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

5. THE MASTER LEASE AGREEMENT (CONTINUED)

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. In addition, beginning in January
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 rental expense related to fiscal year 1998 and 1997 was $894,000
and $315,000, respectively.

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 Senior Housing Facility, and to use and maintain each Senior Housing
Facility in compliance with all local board of health and other applicable
governmental and insurance regulations. The Senior Housing 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 Senior Housing Facilities. Violations
of such health and safety standards could result in fines, penalties,
closure of a Senior Housing Facility or other sanctions.

6. LEGAL PROCEEDINGS AND CONTINGENCIES

A management agreement between ILM Holding and 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 alleged among other
things, 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 agreement, AHC filed
for protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic
state of California. The filing was challenged by the Companies, and the
Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
November 1996, AHC filed with the Virginia District Court an Answer in
response to the litigation initiated by the Companies and a counterclaim
against ILM Holding. The counterclaim alleged that the agreement was
wrongfully terminated for cause and requested damages which include the
payment of the 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, which is the earliest date that the management 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. ILM I had guaranteed
the payment of the termination fee at issue in these proceedings to the
extent that any termination fee would be deemed payable by the court and in
the event that the Company fails to perform pursuant to its contractual
obligations. On June 13, 1997 and July 8, 1997, the court issued orders to
enter judgment against ILM I and ILM II 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, ILM II and Lease II filed a
notice of appeal to the United States Court of Appeals for the Fourth
Circuit from the Orders.

F-13
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

6. LEGAL PROCEEDINGS AND CONTINGENCIES (CONTINUED)

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 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
the Company 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 the Company 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 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. By August 31, 1998, Capital had
incurred $683,000 of legal expenses in the California litigation. At August
31, 1998, $311,000 of legal fees have been either advanced or accrued in
the Company's financial statements and $208,000 of legal fees have been
either advanced or accred in Lease II's financial statements 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. The
Company 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 feels 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 the
Company and Lease II at the end of fiscal year 1997. At August 31, 1997, a
provision of $600,000 for the liability which might have resulted to the
Company had been recorded on the financial statements as "termination fee
payable", with the remaining $400,000 provision recorded on the financial
statements of Lease II. 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 the Company 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.

F-14
<PAGE>

ILM I LEASE CORPORATION
Notes to Financial Statements (continued)

7. 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 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 August 31, 1998 and
1997, are comprised of the following amounts (in thousands):
<TABLE>
<CAPTION>
1998 1997
----------- --------
<S> <C> <C>
Deferred tax asset - straight-line rent expense $ 19 $ 34
Deferred tax asset (liability) - book over tax
(tax over book) depreciation 54 (32)
Deferred tax asset - book over tax amortization 45 68
Deferred tax asset - termination fee payable -- 240
Net operating loss carryforward 366 --
----- -----
Gross deferred tax asset 484 310
Valuation allowance for deferred tax asset (120) --
----- -----
Net deferred tax asset $ 364 $ 310
===== =====
</TABLE>

The 1997 deferred tax provision reflects a reclassification of
$240,000 of current tax expense in 1997 which was ultimately determined to be
deductible in 1998.

The Company has provided a valuation allowance in fiscal 1998 to
consider the effects that the lease termination date (December 31, 1999)
might have on historical taxable income after giving effect to the
non-recurring termination fee, related legal expenses and the fact that the
net operating loss carryforward might not be utilized by the lease
termination date. The net operating loss carryforward will expire in 2013.

F-15
<PAGE>

7. FEDERAL INCOME TAXES (CONTINUED)

The components of income tax expense (benefit) for fiscal 1998 and 1997
are as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Current:

Federal $-- $ 78 $ 227
State -- 14 40
----- ----- -----
Total current -- 92 267
----- ----- -----

Deferred:

Federal (47) (241) (22)
State (7) (43) (4)
----- ----- -----
Total deferred (54) (284) (26)
----- ----- -----
$ (54) $(192) $ 241
===== ===== =====
</TABLE>

The reconciliation of income tax computed for fiscal 1998 and 1997, at
U.S. federal statutory rates to income tax expense (benefit) is as follows (in
thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------------------ -------------------- ---------------------
<S> <C> <C> <C> <C> <C> <C>
Tax at U.S. statutory $(148) (34%) $(163) (34%) $ 205 34%
rates
State income taxes, net
of federal tax benefit (26) (6) (29) (6) 36 6
Valuation allowance 120 33 -- -- -- --
----- ----- ----- ----- ----- -----
$ (54) (7%) $(192) (40%) $ 241 40%
===== ===== ===== ===== ===== =====
</TABLE>

8. SUBSEQUENT EVENTS

On February 11, 1999, the Company's Board of Directors elected Jeffry
R. Dwyer to the office of Chief Operating Officer.

F-16

<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE BALANCE
SHEET AS OF AUGUST 31, 1998 AND THE STATEMENT OF INCOME FOR THE PERIOD ENDED
AUGUST 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1998
<PERIOD-END> AUG-31-1998
<CASH> 1,897
<SECURITIES> 0
<RECEIVABLES> 61
<ALLOWANCES> 5
<INVENTORY> 0
<CURRENT-ASSETS> 2,225
<PP&E> 999
<DEPRECIATION> 390
<TOTAL-ASSETS> 3,198
<CURRENT-LIABILITIES> 2,756
<BONDS> 0
0
0
<COMMON> 75
<OTHER-SE> 393
<TOTAL-LIABILITY-AND-EQUITY> 3,198
<SALES> 19,232
<TOTAL-REVENUES> 19,294
<CGS> 0
<TOTAL-COSTS> 19,729
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (435)
<INCOME-TAX> (54)
<INCOME-CONTINUING> (381)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (381)
<EPS-BASIC> (.05)
<EPS-DILUTED> (.05)

</TABLE>