UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------------------------
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 1997
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
For the transition period from ______ to ______ .
Commission File Number: 0-25880
ILM II LEASE CORPORATION
------------------------
(Exact name of registrant as specified in its charter)
Virginia 04-3248639
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
265 Franklin Street, Boston, MA 02110
- ------------------------------- --------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (800) 225-1174
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| . No |_|.
Shares on common stock outstanding as of May 31, 1997: 5,180,952. The
aggregate sales price of the shares sold was $500,000. This does not reflect
market value. There is no current market for these shares.
<PAGE>
ILM II LEASE CORPORATION
BALANCE SHEETS
May 31, 1997 and August 31, 1996 (Unaudited)
(In thousands)
ASSETS
May 31 August 31
------ ---------
Cash and cash equivalents $ 1,532 $ 1,591
Accounts receivable 327 5
Prepaid expenses and other assets 94 118
--------- --------
Total current assets 1,953 1,714
Furniture, fixtures and equipment 360 197
Less: accumulated depreciation (44) (14)
--------- --------
316 183
Deferred tax asset, net 17 38
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$ 2,286 $ 1,935
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Accounts payable and accrued expenses $ 650 $ 528
Real estate taxes payable 121 203
Accounts payable - affiliates 366 302
Security deposits 13 12
--------- --------
Total current liabilities 1,150 1,045
Deferred rent payable 108 131
--------- --------
Total liabilities 1,258 1,176
Shareholders' equity 1,028 759
--------- --------
$ 2,286 $ 1,935
========= ========
See accompanying notes.
<PAGE>
ILM II LEASE CORPORATION
STATEMENTS OF INCOME
For the three and nine months ended May 31, 1997 and 1996 (Unaudited)
(In thousands, except per share amounts)
Three Months Ended Nine Months Ended
May 31, May 31,
------------------ -----------------
1997 1996 1997 1996
---- ---- ---- ----
Revenues:
Rental and other income $ 3,587 $ 3,304 $ 10,745 $ 9,702
Interest income 9 10 28 24
------- -------- -------- ---------
3,596 3,314 10,773 9,726
Expenses:
Master lease rent expense 1,131 1,001 3,264 3,003
Dietary salaries, wages and
food service expenses 662 586 1,977 1,739
Administrative salaries, wages
and expenses 297 238 877 767
Marketing salaries, wages
and expenses 161 170 456 503
Utilities 240 239 763 722
Repairs and maintenance 127 136 371 395
Real estate taxes 129 143 383 391
Property management fees 169 181 549 534
Other property operating expenses 354 355 1,140 1,046
General and administrative 297 33 461 73
Advisory fees 18 16 54 48
Depreciation expense 12 - 30 -
------- -------- -------- --------
3,597 3,098 10,325 9,221
------- -------- -------- --------
Income (loss) before taxes (1) 216 448 505
Income tax expense (benefit):
Current - 79 158 246
Deferred - 7 21 (44)
------- -------- -------- --------
- 86 179 202
------- -------- -------- --------
Net income (loss) $ (1) $ 130 $ 269 $ 303
====== ======= ======== ========
Earnings (loss) per share
of common stock $(0.00) $0.02 $0.05 $0.06
====== ===== ===== =====
The above earnings (loss) per share of common stock is based upon the 5,180,952
shares outstanding for each period.
See accompanying notes.
<PAGE>
ILM II LEASE CORPORATION
STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
For the nine months ended May 31, 1997 and 1996 (Unaudited)
(In thousands)
Common Stock Additional
$.01 Par Value Paid-in Accumulated
Shares Amount Capital Earnings Total
------ ------ ------- -------- -----
Balance at August 31, 1995 15 $ - $ 1 $ (1) $ -
Issuance of common stock 5,166 52 447 - 499
Net income - - - 303 303
------ ----- ------ ------ ------
Balance at May 31, 1996 5,181 $ 52 $ 448 $ 302 $ 802
===== ===== ====== ====== ======
Balance at August 31, 1996 5,181 $ 52 $ 448 $ 259 $ 759
Net income - - - 269 269
----- ----- ------ ------ ------
Balance at May 31, 1997 5,181 $ 52 $ 448 $ 528 $1,028
===== ===== ====== ====== ======
See accompanying notes.
<PAGE>
ILM II LEASE CORPORATION
STATEMENTS OF CASH FLOWS
For the nine months ended May 31, 1997 and 1996 (Unaudited)
Increase (Decrease) in Cash and Cash Equivalents
(In thousands)
1997 1996
---- ----
Cash flows from operating activities:
Net income $ 269 $ 303
Adjustments to reconcile net income to
net cash provided by operating activities
Depreciation expense 30 -
Changes in assets and liabilities:
Accounts receivable (322) -
Prepaid expenses and other assets 24 (131)
Deferred tax asset, net 21 (44)
Accounts payable and accrued expenses 122 453
Accounts payable - affiliates 64 16
Real estate taxes payable (82) 147
Security deposits 1 13
Deferred rent payable (23) 139
Income taxes payable - 62
-------- -------
Total adjustments (165) 655
-------- -------
Net cash provided by operating activities 104 958
Cash flows from investing activities:
Additions to furniture, fixtures and equipment (163) -
-------- -------
Net cash used in investing activities (163) -
Cash flows from financing activities:
Proceeds from issuance of common stock - 499
-------- -------
Net cash provided by financing activities - 499
-------- -------
Net (decrease) increase in cash and cash equivalents (59) 1,457
Cash and cash equivalents, beginning of period 1,591 -
-------- -------
Cash and cash equivalents, end of period $ 1,532 $ 1,457
======== =======
Supplemental disclosure:
Cash paid during the period for income taxes $ 216 $ 173
======== =======
See accompanying notes.
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements
(Unaudited)
1. General
The accompanying financial statements, footnotes and discussions should be
read in conjunction with the financial statements and footnotes contained
in the Company's Annual Report for the year ended August 31, 1996. In the
opinion of management, the accompanying financial statements, which have
not been audited, reflect all adjustments necessary to present fairly the
results for the interim period. All of the accounting adjustments reflected
in the accompanying interim financial statements are of a normal recurring
nature.
The accompanying financial statements have been prepared on the accrual
basis of accounting in accordance with generally accepted accounting
principles which requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities as of May 31, 1997 and August 31, 1996
and revenues and expenses for each of the three- and nine-month periods
ended May 31, 1997 and 1996. Actual results could differ from the estimates
and assumptions used.
The Company was formed by PaineWebber Independent Living Mortgage Inc.
II (ILM) to operate nine rental housing projects for independent senior
citizens ("the Senior Housing Facilities") under a master lease
arrangement. ILM has elected to be taxed as a Real Estate Investment Trust
("REIT") under the Internal Revenue Code of 1986, as amended ("the Code"),
for each taxable year of operations. In order to maintain its status as a
REIT, 75% of ILM's annual gross income must be Qualified Rental Income as
defined by the Code. The rent paid by the residents of the Facilities
likely would not be deemed to be Qualified Rental Income because of the
extent of services provided to residents. Consequently, the operation of
the Facilities by ILM or its subsidiaries over an extended period of time
could adversely affect ILM's status as a REIT. Therefore, ILM formed the
Company to operate the Senior Housing Facilities, and by means of a
distribution, transferred the ownership of the common stock of the Company
to the holders of ILM common stock on September 1, 1995. Because the
Company, which is taxed as a regular C corporation, is no longer a
subsidiary of ILM, it can receive service-related income without
endangering the REIT status of ILM.
At a meeting of the ILM Board on January 10, 1997, the Advisor
recommended the immediate sale of the senior housing facilities held by ILM
and an affiliated entity, PaineWebber Independent Living Mortgage Fund,
Inc. ("ILM1"), by means of a controlled auction to be conducted by
PaineWebber, at no additional compensation, with PaineWebber offering to
purchase the properties for $127 million, thereby guaranteeing the
shareholders a "floor" price. The Advisor also stated that if PaineWebber
purchased the properties at the specified price and were then able to
resell the properties at a higher price, PaineWebber would pay any "excess
profits" to the shareholders. To assist the Company and ILM in evaluating
the Advisor's proposal, a disinterested, independent investment banker with
expertise in healthcare REITs and independent/assisted living financings
was engaged. Following a comprehensive analysis, the investment banker
recommended that ILM decline the Advisor's proposal and instead investigate
expansion and restructuring alternatives. After analyzing the Advisor's
proposal and the recommendations and other information provided by the
independent investment banker, the Boards of ILM and ILM1 voted unanimously
to decline the Advisor's proposal and to explore the alternatives
recommended by the independent investment banker. The Boards declined to
seek an immediate sale of the properties because, in the Boards' view, the
liquidation price would not reflect the "going concern" value of ILM and
ILM1 and, therefore, would not maximize shareholder value. In addition, the
Boards did not consider it advisable to liquidate ILM and ILM1 on the
suggested terms three years prior to their scheduled termination date.
The Advisor had indicated to the Board in its January 10, 1997 proposal
that it would not wish to continue to serve as advisor to ILM, ILM1 and
their affiliates if they declined to accept the Advisor's proposal. ILM and
ILM1 have accepted the resignation of the Advisor, effective as of June 18,
1997. The Advisor has agreed to continue to provide certain administrative
services to ILM, ILM1 and their affiliates through August 31, 1997,
pursuant to the terms of a transition services agreement to be entered into
with ILM, ILM1 and their affiliates. The Company, ILM, ILM1 and their
affiliates have also accepted, effective as of June 18, 1997, the
resignations of those officers and directors who are employees of or
otherwise affiliated with the Advisor or its affiliates. ILM and ILM1 are
currently evaluating various strategic alternatives, including the
possibility of becoming self-managed.
In addition, the Company and ILM continue to review various restructuring
alternatives. The Company and ILM are analyzing a merger of ILM with ILM
Holding and are also considering possibly merging ILM with ILM1 and the
Company with ILM I Lease Corporation. In addition, ILM is exploring listing
its shares on an exchange or, alternatively, having them trade through
NASDAQ. The independent investment banker is also in the process of
developing a new reorganization plan. The Company has not fully evaluated any
of these alternatives and is not in a position at this time to recommend any
action to its shareholders. There can be no assurance that the Company will
recommend taking any of such actions.
2. The Master Lease Agreement
The Company's sole business is the operation of the Senior Housing
Facilities. The Company has leased the Senior Housing Facilities from ILM II
Holding, Inc. ("ILM Holding"), a majority-owned and consolidated subsidiary
of ILM which currently holds title to the Facilities, pursuant to a master
lease which commenced on September 1, 1995 and expires on December 31, 2000
(December 31, 1999 with respect to the Santa Barbara Facility). The Company
has entered into a property management agreement with Capital Senior
Management 2, Inc. of Dallas, Texas ("Capital") to handle the day-to-day
operations of the Senior Housing Facilities. The management contract with
Capital was executed in July 1996. In November 1996, Lawrence A. Cohen, a
Director of the Company and President, Chief Executive Officer and Director
of ILM, also became Vice Chairman and Chief Financial Officer of Capital
Senior Living Corporation, an affiliate of Capital. As a result, the
management contract with Capital is considered a related party transaction
(see Note 3).
Descriptions of the properties covered by the master lease between the
Company and ILM Holding are summarized as follows:
Rentable Date of
Name Location Units (1) Construction (2)
The Palms Fort Myers, FL 205 October 1988
Crown Villa Omaha, NE 73 January 1992
Overland Park Place Overland Park, KS 139 June 1984
Rio Las Palmas Stockton, CA 164 June 1988
The Villa at Riverwood St. Louis County, MO 120 June 1985
Villa Santa Barbara (3) Santa Barbara, CA 125 June 1979
(1) The number of rentable units has been adjusted to account for the
new property management team's current program of placing
non-rental units back into service.
(2) Date initial construction was completed.
(3) The Company operates Villa Santa Barbara under a co-tenancy
arrangement with an affiliated company, ILM I Lease Corporation.
The Company has entered into an agreement with ILM I Lease
Corporation regarding such joint tenancy. ILM I Lease Corporation
was formed for similar purposes as the Company by an affiliated
REIT, PaineWebber Independent Living Mortgage Fund, Inc., a
subsidiary of which owns a portion of the Villa Santa Barbara
property. The portion of the Facility leased by the Company
represents 75% of the total project.
Terms of the Master Lease Agreement
During the term of the master lease, the Company is obligated to pay
annual base rent ("Base Rent") for the Facilities. For calendar year 1995,
the annual Base Rent was $3,548,700 (prorated according to the date of
commencement of the master lease), allocated as follows: $849,836 for the
Florida Facility, $541,010 for the Nebraska Facility, $720,252 for the Kansas
Facility, $591,429 for the Stockton, California Facility, $423,933 for the
Missouri Facility and $422,240 for the Santa Barbara, California Facility.
For calendar years 1996 through 1999, the annual Base Rent will be
$4,035,600, allocated as follows: $966,439 for the Florida Facility, $615,240
for the Nebraska Facility, $819,074 for the Kansas Facility, $672,576 for the
Stockton, California Facility, $482,098 for the Missouri Facility and
$480,173 for the Santa Barbara, California Facility. For calendar year 2000,
the annual Base Rent will be $3,555,427 (reflects rent reduction attributable
to termination of lease for Villa Santa Barbara on December 31, 1999). The
master lease is a "triple-net" lease whereby the Lessee pays all operating
expenses, governmental taxes and assessments, utility charges and insurance
premiums, as well as the costs of all required maintenance, personal property
and non-structural repairs in connection with the operation of the Senior
Housing Facilities ("Additional Rent"). ILM Holding, as the Lessor, is
responsible for major capital improvements and structural repairs to the
Senior Housing Facilities. In addition, beginning in the second quarter of
fiscal 1997 and for the remainder of the lease term, the Company is also
obligated to pay variable rent ("Variable Rent") for each Facility. Such
Variable Rent is payable quarterly and equals 40% of the excess, if any, of
the aggregate total revenues for the Facilities, on an annualized basis, over
$13,021,000. Variable rent amounted to $261,000 for the six months ended May
31, 1997.
Under the master lease, the Company's use of the Facilities is limited to
use as a Senior Housing Facility unless the Lessor's consent to some other
use is obtained. The Company has responsibility to obtain and maintain all
licenses, certificates and consents needed to use and operate each Facility,
and to use and maintain each Facility in compliance with all local board of
health and other applicable governmental and insurance regulations. The
Facilities located in California, Florida and Kansas are licensed by such
states to provide assisted living services. Also, various health and safety
regulations and standards which are enforced by state and local authorities
apply to the operation of all of the Facilities. Violations of such health
and safety standards could result in fines, penalties, closure of a Facility
or other sanctions.
3. Related Party Transactions
The Advisor receives a base fee in an amount equal to 0.5% of the Gross
Operating Revenues of the Facilities operated by the Company as compensation
for its services. This fee amounted to $54,000 and $48,000 for the nine-month
periods ended May 31, 1997 and 1996, respectively. In addition, an affiliate
of the Advisor is entitled to reimbursement for expenses incurred in
providing certain financial, accounting and investor communication services
to the Company. Included in general and administrative expenses for each of
the nine-month periods ended May 31, 1997 and 1996 is $44,000 and $23,000,
respectively, representing reimbursements to this affiliate of the Advisor
for providing such services to the Company.
As discussed in Note 1, ILM and ILM1 have accepted the resignation of the
Advisor effective as of June 18, 1997. The Company, ILM and ILM1 and their
affiliates and the Advisor intend to enter into a transition services
agreement pursuant to which the Advisor would continue to provide certain
administrative services to the Company, ILM, ILM1 and their affiliates
through August 31, 1997.
The Company has retained Capital Senior Management 2, Inc. ("Capital") of
Dallas, Texas to be the property manager of the Senior Housing Facilities
pursuant to a Management Agreement which commenced on July 29, 1996. The
initial term of the Management Agreement expires on December 31, 2000, which
coincides with the expiration of the master lease agreement between the
Company and ILM Holding described in Note 2. Under the terms of the
Management Agreement, in the event that the master lease agreement is
extended beyond December 31, 2000, the Management Agreement will be extended
as well, but not beyond July 29, 2001. Effective in November 1996, Lawrence
A. Cohen, a Director of the Company and President, Chief Executive Officer
and Director of ILM, was also named Vice Chairman and Chief Financial Officer
of Capital Senior Living Corporation, an affiliate of Capital. Under the
terms of the Management Agreement, Capital earns a Base Management Fee equal
to 4% of the Gross Operating Revenues of the Senior Housing Facilities, as
defined. Capital is also eligible to earn an Incentive Management Fee equal
to 25% of the amount by which the average monthly Net Cash Flow of the Senior
Housing Facilities, as defined, for the twelve month period ending on the
last day of each calendar month exceeds a specified Base Amount. Each August
31, beginning on August 31, 1997, the Base Amount will be increased based on
the percentage increase in the Consumer Price Index. ILM has guaranteed the
payment of all fees due to Capital under the terms of the Management
Agreement. Capital earned total management fees of $549,000 for the nine
months ended May 31, 1997.
Accounts payable - affiliates at May 31, 1997 and August 31, 1996 includes
advances of $294,000 and $225,000, respectively, received from ILM Holding,
primarily for the purchase of personal property to operate the Senior Housing
Facilities. The remaining balance of accounts payable - affiliates at May 31,
1997 includes management fees payable to Capital of $54,000 and advisory fees
payable to the Advisor of $18,000. The remaining balance of accounts payable
- affiliates at August 31, 1996 includes management fees of $60,000 payable
to Capital and advisory fees payable to the Advisor of $17,000.
4. Contingencies
A management agreement between ILM Holding and Angeles Housing Concepts,
Inc. ("AHC") which covered the management of all six Senior Housing
Facilities was assigned to the Company effective September 1, 1995. On July
29, 1996, the Company and ILM Holding ("the Companies") terminated the
property management agreement with AHC. The management agreement was
terminated for cause pursuant to the terms of the contract. Simultaneously
with the termination of the management agreement, the Companies, together
with certain affiliated entities, filed suit against AHC in the United States
District Court for the Eastern District of Virginia for breach of contract,
breach of fiduciary duty and fraud. The Company and ILM Holding allege, among
other things, that AHC willfully performed actions specifically in violation
of the management agreement and that such actions caused damages to the
Companies. Due to the termination of the agreement for cause, no termination
fee was paid to AHC. Subsequent to the termination of the management
agreement, AHC filed for protection under Chapter 11 of the U.S. Bankruptcy
Code in its domestic state of California. The filing was challenged by the
Companies, and the Bankruptcy Court dismissed AHC's case effective October
15, 1996. In November 1996, AHC filed an Answer with the Virginia District
Court in response to the litigation initiated by the Companies and a
Counterclaim against ILM Holding. The Counterclaim alleges that the
management agreement was wrongfully terminated for cause and requests damages
which include the payment of a termination fee in the amount of $750,000,
payment of management fees pursuant to the contract from August 1, 1996
through October 15, 1996, and recovery of attorney's fees and expenses. The
aggregate amount of damages against all parties as requested in AHC's
Counterclaim exceeds $2,000,000. ILM has guaranteed the payment of the
termination fee at issue in these proceedings to the extent that any
termination fee is deemed payable by the court and in the event that the
Company fails to perform pursuant to its contractual obligations. The court
initially set a trial date of April 28, 1997 but, at AHC's request, recently
rescheduled the trial for June 23, 1997. On June 13, 1997 and July 8, 1997,
the court issued Orders purporting to enter judgment against ILM and ILM1 in
the amount of $1,000,000. In so doing, the court effectively canceled the
June 23, 1997 trial date. The Orders do not contain any findings of fact or
conclusions of law. On July 10, 1997, the Company, ILM, ILMI and ILM I Lease
Corporation filed a notice of appeal to the United State Court of Appeals for
the Fourth Circuit from the Orders. The Company intends to diligently
prosecute the appeal. The eventual outcome of this litigation cannot
presently be determined. No provision for any liability which might result
from the outcome of this matter has been recorded in the accompanying
financial statements.
On February 4, 1997, AHC filed a Complaint in the Superior Court of the
State of California against Capital, Lawrence Cohen, and others alleging that
the defendants intentionally interfered with AHC's property management
agreement with ILM Holding by inducing ILM Holding to terminate the agreement
(the "California litigation"). The complaint seeks damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to federal
district court in the Central District of California. Trial in the action has
been set for January 13, 1998 and discovery has just begun. At a Board
meeting on February 26, 1997, the Company's Board of Directors concluded that
since all of Mr. Cohen's actions relating to the California litigation were
taken either on behalf of the Company under the direction of the Board or as
a PaineWebber Properties employee, the Company or its affiliates should
indemnify Mr. Cohen with respect to any expenses arising from the California
litigation, subject to any insurance recoveries for those expenses. The
Company's Board also concluded that, subject to certain conditions, the
Company or its affiliates should advance up to $20,000 to pay reasonable
legal fees and expenses incurred by Capital in the California litigation.
Subsequently the Boards of the Company and ILM I Lease Corporation voted to
increase the maximum amount of the advance to $100,000. The defendants intend
to vigorously defend the claims made against them in the California
litigation. The eventual outcome of this litigation cannot presently be
determined and, accordingly, no provision for any liability has been recorded
in the accompanying financial statements.
5. Federal Income Taxes
The Company is taxable as a regular C corporation and, therefore, its
income is subject to tax at the federal and state levels. The Company reports
on a calendar year for tax purposes. Income taxes at the appropriate
statutory rates have been provided for in the accompanying financial
statements.
Deferred income tax expense (benefit) reflects the net tax effects of
temporary differences between the carrying amounts of assets and liabilities
for financial reporting purposes and the amounts used for income tax
purposes. The Company's deferred tax assets and liabilities as of May 31,
1997 and August 31, 1996 are comprised of the following amounts (in
thousands):
May 31 August 31
------ ---------
Deferred tax asset - straight-line
rent expense $ 43 $ 53
Deferred tax liability - tax over
book amortization 26 15
------- -----
Net deferred tax asset $ 17 $ 38
======= =====
<PAGE>
The components of income tax expense (benefit) for the three and nine
months ended May 31, 1997 and 1996 are as follows (in thousands):
Three Months Ended Nine Months Ended
May 31, May 31,
------------------ ------------------
1997 1996 1997 1996
---- ---- ---- ----
Current:
Federal $ - $ 67 $ 134 $ 209
State - 12 24 37
------ ------- ------- ------
Total current - 79 158 246
------ ------- ------- ------
Deferred:
Federal - 6 18 (37)
State - 1 3 (7)
------ ------- ------- ------
Total deferred - 7 21 (44)
------ ------- ------- ------
$ - $ 86 $ 179 $ 202
====== ======= ======= ======
The reconciliation of income tax computed at U.S. federal statutory rates
to income tax expense for the nine months ended May 31, 1997 and 1996 is as
follows (in thousands):
1997 1996
------------- -------------
Tax at U.S. statutory rate $ 15 34% $ 172 34%
State income taxes, net
of federal tax benefit 27 6% 30 6%
------ --- ------ ----
$ 179 40% $ 202 40%
====== === ====== ====
<PAGE>
ILM II LEASE CORPORATION
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Liquidity and Capital Resources
- -------------------------------
ILM II Lease Corporation (the "Company") was formed by PaineWebber
Independent Living Mortgage Inc. II ("ILM"), a publicly-held, non-traded Real
Estate Investment Trust ("REIT"), for the purpose of operating six Senior
Housing Facilities under the terms of a master lease agreement. ILM contributed
$500,000 in return for all of the issued and outstanding shares of the Company's
common stock. ILM has elected to be taxed as a REIT under the Internal Revenue
Code of 1986, as amended ("the Code"), for each taxable year of operations. In
order to maintain its status as a REIT, 75% of ILM's annual gross income must be
Qualified Rental Income as defined by the Code. The rent paid by the residents
of the Facilities likely would not be deemed to be Qualified Rental Income
because of the extent of services provided to residents. Consequently, the
operation of the Facilities by ILM or its subsidiaries over an extended period
of time could adversely affect ILM's status as a REIT. Therefore, ILM formed the
Company to operate the Facilities, and by means of a distribution, transferred
the ownership of the common stock of the Company to the holders of ILM common
stock on September 1, 1995. Because the Company, which is taxed as a regular C
corporation, is no longer a subsidiary of ILM, it can receive service-related
income without endangering the REIT status of ILM.
The Company's sole business is the operation of the Senior Housing
Facilities. The Company has leased the Senior Housing Facilities from ILM II
Holding, Inc. ("ILM Holding"), a majority-owned and consolidated subsidiary of
ILM which currently holds title to the Facilities, pursuant to a master lease
which commenced on September 1, 1995 and expires on December 31, 2000 (December
31, 1999 with respect to the Santa Barbara Facility). The master lease is a
"triple-net" lease whereby the Lessee pays all operating expenses, governmental
taxes and assessments, utility charges and insurance premiums, as well as the
costs of all required maintenance, personal property and non-structural repairs
in connection with the operation of the Senior Housing Facilities. ILM Holding,
as the Lessor, is responsible for major capital improvements and structural
repairs to the Senior Housing Facilities. During the initial term of the master
lease, the Company is obligated to pay annual base rent for the use of all of
the Facilities in the aggregate amount of $3,548,700 for calendar year 1995
(prorated based on the commencement date of the lease), $4,035,600 for calendar
years 1996 through 1999 and $3,555,427 for calendar year 2000 (reflects rent
reduction attributable to termination of lease for Villa Santa Barbara on
December 31, 1999). Beginning in the second quarter of fiscal 1997 and for the
remainder of the lease term, the Company is also obligated to pay variable rent
for each Facility. Such variable rent is payable quarterly and equals 40% of the
excess, if any, of the aggregate total revenues for the Facilities, on an
annualized basis, over $13,021,000. Variable rent amounted to $261,000 for the
six months ended May 31, 1997.
On July 29, 1996, the Company and ILM Holding ("the Companies") terminated
the property management agreement with AHC covering the six Senior Housing
Facilities leased by the Company. The management agreement was terminated for
cause pursuant to the terms of the contract. Simultaneously with the termination
of the management agreement, the Companies, together with certain affiliated
entities, filed suit against AHC in the United States District Court for the
Eastern District of Virginia for breach of contract, breach of fiduciary duty
and fraud. The Company and ILM Holding allege, among other things, that AHC
willfully performed actions specifically in violation of the management
agreement and that such actions caused damages to the Companies. Due to the
termination of the agreement for cause, no termination fee was paid to AHC.
Subsequent to the termination of the management agreement, AHC filed for
protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic state of
California. The filing was challenged by the Companies, and the Bankruptcy Court
dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed an
Answer with the Virginia District Court in response to the litigation initiated
by the Companies and a Counterclaim against ILM Holding. The Counterclaim
alleges that the management agreement was wrongfully terminated for cause and
requests damages which include the payment of a termination fee in the amount of
$750,000, payment of management fees pursuant to the contract from August 1,
1996 through October 15, 1996, and recovery of attorney's fees and expenses. The
aggregate amount of damages against all parties as requested in AHC's
Counterclaim exceeds $2,000,000. ILM has guaranteed the payment of the
termination fee at issue in these proceedings to the extent that any termination
fee is deemed payable by the court and in the event that the Company fails to
perform pursuant to its contractual obligations. The court initially set a trial
date of April 28, 1997 but, at AHC's request, recently rescheduled the trial for
June 23, 1997. On June 13, 1997 and July 8, 1997, the court issued Orders
purporting to enter judgment against ILM and ILM1 in the amount of $1,000,000.
In so doing, the court effectively canceled the June 23, 1997 trial date. The
Orders do not contain any findings of fact or conclusions of law. On July 10,
1997, the Company, ILM, ILM1 and ILM I Lease Corporation filed a notice of
appeal to the United State Court of Appeals for the Fourth Circuit from the
Orders. The Company intends to diligently prosecute the appeal. The eventual
outcome of this litigation cannot presently be determined. No provision for any
liability which might result from the outcome of this matter has been recorded
in the accompanying financial statements.
Subsequent to terminating the management agreement with AHC, the
Company retained Capital Senior Management 2, Inc. ("Capital") of Dallas, Texas
to be the new manager of the Senior Housing Facilities pursuant to a Management
Agreement which commenced on July 29, 1996. The initial term of the Management
Agreement expires on December 31, 2000, which coincides with the expiration of
the master lease agreement between the Company and ILM Holding described above.
Under the terms of the Management Agreement, in the event that the master lease
agreement is extended beyond December 31, 2000, the Management Agreement will be
extended as well, but not beyond July 29, 2001. Effective in November 1996,
Lawrence A. Cohen, a Director of the Company and President, Chief Executive
Officer and Director of ILM, was also named Vice Chairman and Chief Financial
Officer of Capital Senior Living Corporation, an affiliate of Capital. Under the
terms of the Agreement, Capital earns a Base Management Fee equal to 4% of the
Gross Operating Revenues of the Senior Housing Facilities, as defined. Capital
is also eligible to earn an Incentive Management Fee equal to 25% of the amount
by which the average monthly Net Cash Flow of the Senior Housing Facilities, as
defined, for the twelve month period ending on the last day of each calendar
month exceeds a specified Base Amount. Each August 31, beginning on August 31,
1997, the Base Amount will be increased based on the percentage increase in the
Consumer Price Index. ILM has guaranteed the payment of all fees due to Capital
under the terms of the Management Agreement.
On February 4, 1997, AHC filed a Complaint in the Superior Court of
the State of California against Capital, Lawrence Cohen, and others alleging
that the defendants intentionally interfered with AHC's property management
agreement with ILM Holding by inducing ILM Holding to terminate the agreement
(the "California litigation"). The complaint seeks damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to federal
district court in the Central District of California. Trial in the action has
been set for January 13, 1998 and discovery has just begun. At a Board meeting
on February 26, 1997, the Company's Board of Directors concluded that since all
of Mr. Cohen's actions relating to the California litigation were taken either
on behalf of the Company under the direction of the Board or as a PaineWebber
Properties employee, the Company or its affiliates should indemnify Mr. Cohen
with respect to any expenses arising from the California litigation, subject to
any insurance recoveries for those expenses. The Company's Board also concluded
that, subject to certain conditions, the Company or its affiliates should
advance up to $20,000 to pay reasonable legal fees and expenses incurred by
Capital in the California litigation. Subsequently, the Boards of the Company
and ILM I Lease Corporation voted to increase the maximum amount of the advance
to $100,000. The defendants intend to vigorously defend the claims made against
them in the California litigation. The eventual outcome of this litigation
cannot presently be determined and, accordingly, no provision for any liability
has been recorded in the accompanying financial statements.
The six properties which the Company leases from ILM Holding averaged 92%
occupancy for the quarter ended May 31, 1997. Current annualized operating
income levels are sufficient to cover the base master lease payments at their
current annual level of $4,035,600, which will remain in effect throughout the
remaining term of the lease. As noted above, the master lease also provides for
the payment of variable rent beginning in December 1996. The Senior Housing
Facilities are currently generating gross revenues which are in excess of the
specified threshold in the variable rent calculation, as discussed further
above. Variable rent amounted to $261,000 for the six months ended May 31, 1997.
Further improvements in operating income levels are expected upon the successful
implementation of several new programs by the new property management company.
At many properties, the management company has increased the number of rentable
units by asking the facility managers to move off site. The increased rental
revenue is expected to more than offset any additional costs of housing the
managers and providing 24-hour coverage at the front desk. The live-in assistant
manager positions at several properties are also being eliminated, which will
increase the number of rentable units. In addition, the management company is in
the process of implementing new marketing plans at several of the properties and
increasing rental rates at properties that have maintained high occupancy levels
and are located in strong markets. Property improvements to be paid for the
Company during fiscal 1997 include new dining room carpeting at The Palms, and a
new on-site vehicle for The Villa at Riverwood. Fiscal 1997 capital expenditure
plans to be funded by ILM include an ongoing program to replace air-conditioning
units at the Santa Barbara facility, landscaping upgrades at Rio Las Palmas, as
well as planned roof repairs at Overland Park Place and The Palms. ILM is also
investigating the potential for future expansions of several of the facilities
which are located in areas that have particularly strong markets for senior
housing.
At a meeting of the ILM Board on January 10, 1997, the Advisor recommended
the immediate sale of the senior housing facilities held by ILM and an
affiliated entity, PaineWebber Independent Living Mortgage Fund, Inc. ("ILM1"),
by means of a controlled auction to be conducted by PaineWebber, at no
additional compensation, with PaineWebber offering to purchase the properties
for $127 million, thereby guaranteeing the shareholders a "floor" price. The
Advisor also stated that if PaineWebber purchased the properties at the
specified price and were then able to resell the properties at a higher price,
PaineWebber would pay any "excess profits" to the shareholders. To assist the
Company and ILM in evaluating the Advisor's proposal, a disinterested,
independent investment banker with expertise in healthcare REITs and
independent/assisted living financings was engaged. Following a comprehensive
analysis, the investment banker recommended that ILM decline the Advisor's
proposal and instead investigate expansion and restructuring alternatives. After
analyzing the Advisor's proposal and the recommendations and other information
provided by the independent investment banker, the Boards of ILM and ILM1 voted
unanimously to decline the Advisor's proposal and to explore the alternatives
recommended by the independent investment banker. The Boards declined to seek an
immediate sale of the properties because, in the Boards' view, the liquidation
price would not reflect the "going concern" value of ILM and ILM1 and,
therefore, would not maximize shareholder value. In addition, the Boards did not
consider it advisable to liquidate ILM and ILM1 on the suggested terms three
years prior to their scheduled termination date.
The Advisor had indicated to the Board in its January 10, 1997 proposal
that it would not wish to continue to serve as advisor to ILM, ILM1 and their
affiliates if they declined to accept the Advisor's proposal. ILM and ILM1 have
accepted the resignation of the Advisor, effective as of June 18, 1997. The
Advisor has agreed to continue to provide certain administrative services to
ILM, ILM1 and their affiliates through August 31, 1997, pursuant to the terms of
a transition services agreement to be entered into with ILM, ILM1 and their
affiliates. The Company, ILM, ILM1 and their affiliates have also accepted,
effective as of June 18, 1997, the resignations of those officers and directors
who are employees of or otherwise affiliated with the Advisor or its affiliates.
ILM and ILM1 are currently evaluating various strategic alternatives, including
the possibility of becoming self-managed.
In addition, the Company and ILM are continuing to review various
restructuring alternatives. The Company and ILM are analyzing a merger of ILM
with ILM Holding and are also considering possibly merging ILM with ILM1 and the
Company with ILM I Lease Corporation. In addition, ILM is exploring listing its
shares on an exchange or, alternatively, having them trade through NASDAQ. The
independent investment banker is also in the process of developing a new
reorganization proposal. The Company has not fully evaluated any of these
alternatives and is not in a position at this time to recommend any action to
its shareholders. There can be no assurance that the Company will recommend
taking any of such actions.
At May 31, 1997, the Company had cash and cash equivalents of $1,532,000.
Such amounts will be used for the Company's working capital requirements. As
noted above, under the terms of the master lease, the Lessor is responsible for
major capital improvements and structural repairs to the Senior Housing
Facilities. Consequently, the Company does not have any material commitments for
capital expenditures. Furthermore, the Company does not currently anticipate the
need to engage in any borrowing activities. As a result, substantially all of
the Company's cash flow will be generated from operating activities. The Company
did not pay cash dividends in fiscal 1996. The Company intends to review this
policy during the second half of fiscal 1997 and may or may not determine to pay
cash dividends in the future. Payment of dividends, if any, will be at the
discretion of the Company's Board of Directors and will depend upon such factors
as the Company's financial condition, earnings, anticipated investments and
other relevant factors. The source of future liquidity is expected to be from
operating cash flow from the Senior Housing Facilities, net of the master lease
payments to ILM Holding, and interest income earned on invested cash reserves.
Such sources of liquidity are expected to be adequate to meet the Company's
operating requirements on both a short-term and long-term basis.
Results of Operations
Three Months Ended May 31, 1997
- -------------------------------
The Company had a net loss of $1,000 for the three months ended May 31,
1997, as compared to net income of $216,000 for the same period in the prior
year. The decrease in net income is the result of an increase in operating
expenses of $499,000. The increase in operating expenses was mainly due to
increases dietary expenses, general and administrative expenses and master lease
rent expense of $76,000, $264,000 and $130,000, respectively. The increase in
dietary expenses primarily reflects an increase in the portfolio occupancy level
as compared to the same period in the prior year. General and administrative
expenses increased largely due to an increase in legal fees attributable to the
ongoing AHC litigation and the analysis of restructuring alternatives referred
to above. In addition, during the current three-month period the Company
incurred professional fees related to the advisory services of the independent
investment banker referred to above and for the preliminary evaluation of the
feasibility of completing expansions at certain of the facilities. Master lease
rent expense increased due to additional variable rent accrued effective for the
second quarter of fiscal 1997 in accordance with the Master Lease Agreement. The
increases in operating expenses were partially offset by an increase in rental
income from the senior housing facilities of $283,000. The increase in rental
income is mainly due increases in rental rates at certain of the facilities
located in strong markets. Due to the unfavorable change in the Company's net
operating results, income tax expense improved by $86,000 for the current
three-month period.
Nine Months Ended May 31, 1997
- ------------------------------
The Company reported net income of $269,000 for the nine months ended May
31, 1997, as compared to net income of $303,000 for the same period in the prior
year. The decrease in net income is the result of an increase in operating
expenses of $1,104,000. The increase in operating expenses was mainly due to
increases in dietary expenses, general and administrative expenses and master
lease rent expense of $238,000, $388,000 and $261,000, respectively. The
increase in dietary expenses primarily reflects an increase in the portfolio
occupancy level as compared to the same period in the prior year. General and
administrative expenses increased largely due to an increase in legal fees
attributable to the ongoing AHC litigation and the analysis of restructuring
alternatives referred to above. In addition, during the current nine-month
period the Company incurred professional fees related to the advisory services
of the independent investment banker referred to above and for the preliminary
evaluation of the feasibility of completing expansions at certain of the
facilities. Master lease rent expense increased due to additional variable rent
accrued effective for the second quarter of fiscal 1997 in accordance with the
Master Lease Agreement. The increases in operating expenses were partially
offset by an increase in rental income from the senior housing facilities of
$1,043,000. The increase in rental income is due to an increase in the
portfolio's average occupancy level, mainly due to the leasing activity at Villa
Santa Barbara, as well as increases in rental rates at certain of the facilities
located in strong markets. Due to the decline in net income, income tax expense
declined by $23,000 for the current nine-month period.
<PAGE>
PART II
Other Information
Item 1. Legal Proceedings
In the litigation involving the Company, ILM II Holding, Inc. and Angeles
Housing Concepts, Inc. that was reported in the Company's Annual Report on Form
10-K for the year ended August 31, 1996 and the Company's Quarterly Report on
Form 10-Q for the quarter ended February 28, 1997, the court, on June 13, 1997
and July 8, 1997, issued Orders purporting to enter judgment against ILM and
ILM1 in the amount of $1,000,000. In doing so, the court effectively canceled
the June 23, 1997 trial date. The Orders do not contain any findings of fact or
conclusions of law. On July 10, 1997, the Company, ILM, ILM1 and ILM I Lease
Corporation filed a notice of appeal to the United States Court of Appeals for
the Fourth Circuit from the Orders. The Company intends to diligently prosecute
the appeal. The eventual outcome of this litigation cannot presently be
determined. No provision for any liability which might result from the outcome
of this matter has been recorded in the accompanying financial statements.
Item 2. through 5. NONE
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits: NONE
(b) Reports on Form 8-K: NONE
<PAGE>
ILM II LEASE CORPORATION
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
By: ILM II LEASE CORPORATION
By: /s/ John B. Watts III
---------------------
John B. Watts III
President
Dated: July 18, 1997
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Partnership's audited financial statements for the nine months ended May 31,
1997 and is qualified in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> AUG-31-1997
<PERIOD-END> MAY-31-1997
<CASH> 1,532
<SECURITIES> 0
<RECEIVABLES> 327
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 1,953
<PP&E> 360
<DEPRECIATION> 44
<TOTAL-ASSETS> 2,286
<CURRENT-LIABILITIES> 1,150
<BONDS> 0
0
0
<COMMON> 500
<OTHER-SE> 528
<TOTAL-LIABILITY-AND-EQUITY> 2,286
<SALES> 0
<TOTAL-REVENUES> 10,773
<CGS> 0
<TOTAL-COSTS> 10,325
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 448
<INCOME-TAX> 179
<INCOME-CONTINUING> 269
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 269
<EPS-PRIMARY> 0.05
<EPS-DILUTED> 0.05
</TABLE>
