Edgar Filing: AMERICAN RETIREMENT CORP

American Retirement Corporation 10-Q

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 September 30, 2005
	or
___ ___	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

	For the transition period from _________ to _________

	Commission file number 01-13031

American Retirement Corporation

(Exact Name of Registrant as Specified in its Charter)

Tennessee	62-1674303
(State or Other Jurisdiction of	(I.R.S. Employer
Incorporation or Organization)	Identification No.)


111 Westwood Place, Suite 200, Brentwood, TN	37027
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s Telephone Number, Including Area Code: (615) 221-2250

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__

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X . No__

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ___ No X

As of November 2, 2005, 31,568,210 shares of the registrant’s common stock, par value $0.01 per share, were outstanding.

INDEX

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements	Page

	Condensed Consolidated Balance Sheets as of
	September 30, 2005 and December 31, 2004 (Unaudited)	3

	Condensed Consolidated Statements of Operations
	for the Three Months Ended September 30, 2005 (Unaudited)
	and 2004 (Unaudited; Restated)	4

	Condensed Consolidated Statements of Operations
	for the Nine Months Ended September 30, 2005 (Unaudited)
	and 2004 (Unaudited; Restated)	5

	Condensed Consolidated Statements of Cash Flows
	for the Nine Months Ended September 30, 2005 (Unaudited)
	and 2004 (Unaudited; Restated)	6

	Notes to Condensed Consolidated Financial Statements	9

Item 2.	Management’s Discussion and Analysis of
	Financial Condition and Results of Operations	25

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45

Item 4.	Controls and Procedures	45


PART II.	OTHER INFORMATION

Item 6.	Exhibits	46

Signatures		47

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands, except share data)	September 30,			December 31,
	2005			2004
ASSETS
Current assets:
Cash and cash equivalents	$	33,952		$	28,454
Restricted cash		19,168			25,270
Accounts receivable, net of allowance for doubtful accounts		19,516			16,175
Inventory		1,403			1,364
Prepaid expenses		4,059			2,667
Deferred income taxes		6,414			5,645
Other current assets		12,739			8,490
Total current assets		97,251			88,065

Restricted cash, excluding amounts classified as current		10,854			24,864
Notes receivable		27,537			18,563
Deferred income taxes		49,497			-
Leasehold acquisition costs, net of accumulated amortization		22,529			29,362
Land, buildings and equipment, net		552,242			496,297
Goodwill		36,463			36,463
Other assets		61,980			55,636
Total assets	$	858,353		$	749,250

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt	$	7,458		$	10,372
Current portion of capital lease and lease financing obligations		17,081			16,474
Accounts payable		3,973			5,937
Accrued payroll and benefits		9,711			10,125
Accrued property taxes		11,825			8,872
Other accrued expenses		9,421			9,023
Other current liabilities		8,789			8,505
Tenant deposits		5,301			4,804
Refundable portion of entrance fees		83,676			79,148
Deferred entrance fee income		35,848			33,800
Total current liabilities		193,083			187,060

Long-term debt, less current portion		128,213			125,584
Capital lease and lease financing obligations, less current portion		170,009			182,652
Deferred entrance fee income		122,222			111,386
Deferred gains on sale-leaseback transactions		90,009			98,876
Deferred income taxes		-			6,027
Other long-term liabilities		22,516			17,751
Total liabilities		726,052			729,336

Minority interest		7,505			14,213

Commitments and contingencies (See notes)

Shareholders' equity:
Preferred stock, no par value; 5,000,000 shares authorized, no
shares issued or outstanding		-			-
Common stock, $.01 par value; 200,000,000 shares authorized,
30,999,452 and 25,636,429 shares issued and outstanding, respectively		313			252
Additional paid-in capital		222,372			168,092
Accumulated deficit		(94,710	)		(160,425	)
Deferred compensation, restricted stock		(3,179	)		(2,218	)
Total shareholders' equity		124,796			5,701
Total liabilities and shareholders' equity	$	858,353		$	749,250

See accompanying notes to condensed consolidated financial statements.

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data)

	Three months ended September 30,
	2005			2004
				(restated)
Revenues:
Resident and health care	$	123,439		$	111,089
Management and development services		664			500
Reimbursed expenses		646			460
Total revenues		124,749			112,049

Operating expenses:
Community operating expenses		82,956			75,825
General and administrative		7,360			8,400
Lease expense		15,014			15,100
Depreciation and amortization		9,019			8,488
Amortization of leasehold acquisition costs		588			735
Loss on disposal or sale of assets		121			48
Reimbursed expenses		646			460
Total operating expenses		115,704			109,056

Operating income		9,045			2,993

Other income (expense):
Interest expense		(4,228	)		(8,400	)
Interest income		1,567			718
Other		340			257
Other expense, net		(2,321	)		(7,425	)

Income (loss) before income taxes and minority interest		6,724			(4,432	)

Income tax expense		2,151			2,501

Income (loss) before minority interest		4,573			(6,933	)

Minority interest in (earnings) losses of consolidated subsidiaries, net of tax		(483	)		270

Net income (loss)	$	4,090		$	(6,663	)

Basic earnings (loss) per share	$	0.13		$	(0.27	)
Dilutive earnings (loss) per share	$	0.13		$	(0.27	)




Weighted average shares used for basic earnings (loss) per share data		30,918			24,665
Effect of dilutive common stock options and non-vested shares		1,595			-
Weighted average shares used for dilutive earnings (loss) per share data		32,513			24,665

See accompanying notes to condensed consolidated financial statements.

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data)

	Nine months ended September 30,
	2005			2004
				(restated)
Revenues:
Resident and health care	$	361,769		$	328,150
Management and development services		1,680			1,439
Reimbursed expenses		1,990			1,752
Total revenues		365,439			331,341

Operating expenses:
Community operating expenses		242,189			223,742
General and administrative		20,716			21,102
Lease expense		45,969			44,793
Depreciation and amortization		27,063			21,948
Amortization of leasehold acquisition costs		1,976			2,181
Loss (gain) on disposal or sale of assets		477			(63	)
Reimbursed expenses		1,990			1,752
Total operating expenses		340,380			315,455

Operating income		25,059			15,886

Other income (expense):
Interest expense		(11,701	)		(27,033	)
Interest income		3,161			1,989
Other		484			4
Other expense, net		(8,056	)		(25,040	)

Income (loss) before income taxes and minority interest		17,003			(9,154	)

Income tax (benefit) expense		(49,866	)		2,721

Income (loss) before minority interest		66,869			(11,875	)

Minority interest in earnings of consolidated subsidiaries, net of tax		(1,154	)		(1,555	)

Net income (loss)	$	65,715		$	(13,430	)

Basic earnings (loss) per share	$	2.18		$	(0.57	)
Dilutive earnings (loss) per share	$	2.06		$	(0.57	)




Weighted average shares used for basic earnings (loss) per share data		30,147			23,404
Effect of dilutive common stock options and non-vested shares		1,701			-
Weighted average shares used for dilutive earnings (loss) per share data		31,848			23,404

See accompanying notes to condensed consolidated financial statements.

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)	Nine months ended September 30,
	2005			2004
				(restated)
Cash flows from operating activities:
Net income (loss)	$	65,715		$	(13,430	)
Adjustments to reconcile net income (loss) to cash and cash
equivalents provided by operating activities:
Tax benefit from release of tax valuation allowance		(55,697	)		-
Depreciation and amortization		29,039			24,129
Loss on extinguishment of debt		794			-
Amortization of deferred financing costs		533			4,597
Deferred entrance fee items:
Amortization of deferred entrance fee income		(13,418	)		(12,737	)
Proceeds from entrance fee sales - deferred income		26,463			24,906
Accrual of deferred interest		-			4,074
Amortization of deferred gain on sale-leaseback transactions		(8,867	)		(7,954	)
Amortization of deferred compensation		693			182
Minority interest in earnings of consolidated subsidiaries, net of tax		1,154			1,555
Tax benefit from exercise of stock options		817			-
(Gains) losses from unconsolidated joint ventures		(260	)		85
Loss (gain) on disposal or sale of assets		477			(63	)
Changes in assets and liabilities, exclusive of acquisitions
and sale-leaseback transactions:
Accounts receivable		(3,317	)		(618	)
Inventory		(31	)		39
Prepaid expenses		(1,560	)		218
Deferred income taxes		(1,226	)		(1,808	)
Other assets		(3,080	)		4,017
Accounts payable		(1,969	)		(1,204	)
Other accrued expenses and other current liabilities		3,748			6,382
Tenant deposits		407			(266	)
Deferred lease liability		2,764			(929	)
Other liabilities		(116	)		3,422
Net cash and cash equivalents provided by operating activities		43,063			34,597

Cash flows from investing activities:
Additions to land, buildings and equipment		(23,820	)		(14,288	)
Acquisition of communities and property, net of cash acquired		(20,483	)		-
Acquisition of other assets		(6,000	)		-
Proceeds from the sale of assets		6,073			11,008
Investment in restricted cash		(10,985	)		(16,555	)
Proceeds from release of restricted cash		30,592			8,854
Net change in other restricted cash accounts		237			799
Issuance of notes receivable		(9,465	)		-
Receipts from notes receivable		258			269
Other investing activities		(275	)		346
Net cash and cash equivalents used by investing activities		(33,868	)		(9,567	)

Cash flows from financing activities:
Proceeds from the issuance of long-term debt		12,048			55,261
Proceeds from lease financing		-			120,500
Principal payments on long-term debt		(58,398	)		(179,992	)
Principal reductions in master trust liability		(817	)		(940	)
Refundable entrance fee items:
Proceeds from entrance fee sales - refundable portion		11,324			10,152
Refunds of entrance fee terminations		(15,935	)		(9,753	)
Expenditures for financing costs		(826	)		(428	)
Distributions to minority interest holders		(3,222	)		(3,243	)
Proceeds from the issuance of common stock		49,934			-
Proceeds from the issuance of stock under the associate stock purchase plan		796			142
Proceeds from the exercise of stock options		1,399			1,566
Net cash and cash equivalents used by financing activities		(3,697	)		(6,735	)

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
(UNAUDITED)
(in thousands)
	Nine months ended September 30,
	2005			2004
				(restated)

Net increase in cash and cash equivalents	$	5,498		$	18,295

Cash and cash equivalents at beginning of period		28,454			17,192
Cash and cash equivalents at end of period	$	33,952		$	35,487

Supplemental disclosure of cash flow information:
Cash paid during the period for interest (including capitalized interest)	$	11,474		$	21,504
Income taxes paid	$	5,030		$	526


During the nine months ended September 30, 2005, the Company acquired land, purchased the partner's minority interest in a community the Company operated via a joint venture, acquired the real assets of a retirement center and an assisted living community previously operated pursuant to operating leases, and the real assets of an entrance-fee continuing care retirement community for an aggregate consideration of approximately $20.5 million of cash plus the assumption of various liabilities, including existing entrance fee refund obligations. As a result of these transactions, assets and liabilities changed as follows:
	Nine months ended September 30,
		2005			2004

Land, buildings and equipment acquired	$	60,364		$	-
Long-term debt	$	(26,819	)		-
Refundable portion of entrance fees		(631	)		-
Deferred entrance fee income		(9,779	)		-
Other		(2,652	)		-
Cash paid for acquisition of communities and property, net of cash acquired	$	20,483		$	-


During the nine months ended September 30, 2004, the Company completed a sale-leaseback transaction in which the Company sold a substantial majority of its interest in the real property and improvements underlying two retirement centers and one free-standing assisted living community. Proceeds from the sale of these interests were:
	Nine months ended September 30,
		2005			2004
Land, buildings and equipment	$	-		$	16,165
Other assets		-			(9,037	)
Accrued interest		-			(1,951	)
Deferred gain on sale-leaseback transaction		-			16,568
Long-term debt		-			(5,673	)
Minority interest		-			(6,082	)
	$	-		$	9,990

Supplemental disclosure of non-cash transactions:
During the nine months ended September 30, 2005, the Company completed a transaction with a real estate investment trust ("REIT") pursuant to which the Company received $9.5 million in proceeds under its existing leases on two of its retirement center communities. This investment by the REIT is recorded by the Company as a refinancing of a previous $8.7 million note payable. In connection with this refinancing, the Company incurred a loss on debt extinguishment which is included as a non-cash charge in the Company's condensed consolidated statements of cash flows for the nine months ended September 30, 2005.

See accompanying notes to condensed consolidated financial statements.

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
(UNAUDITED)
(in thousands)
The Company granted 277,000 and 440,000 shares of restricted stock during the nine months ended September 30, 2005 and 2004, respectively. Current measured compensation related to these grants totaled $1.7 million and $2.6 million, respectively, which is being amortized as compensation expense over the period of vesting. See Note 5. As a result, equity changed as follows:
	Nine months ended September 30,
		2005			2004
Additional paid-in capital		1,738			2,618
Deferred compensation, restricted stock		(1,738	)		(2,618	)

During the nine months ended September 30, 2004, the Company issued 4,808,898 shares of common stock, par value $0.01 per share, to certain holders of the Company's 10% Series B Convertible Senior Subordinated Notes due 2008. The holders elected to convert $10.9 million of the Series B Notes to common stock at the conversion price of $2.25 per share. On April 1, 2004, the Company elected to redeem the balance of the Series B Notes on April 30, 2004. As a result, debt and equity were changed as follows:
	Nine months ended September 30,
		2005			2004
Long-term debt	$	-		$	(10,820	)
Common stock		-			48
Additional paid-in capital		-			10,772

See accompanying notes to condensed consolidated financial statements.

AMERICAN RETIREMENT CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of American Retirement Corporation (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. These financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals and other adjustments) considered necessary for a fair presentation have been included. In addition, certain prior period amounts have been reclassified to conform to current period presentation. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the entire year ending December 31, 2005.

The preparation of the consolidated financial statements requires management to make estimates and assumptions relating to the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.

2. Restatement

The Company filed an amendment on Form 10-K/A to its Annual Report on Form 10-K for the year ended December 31, 2004 to restate its consolidated statements of operations, statements of shareholders' equity and comprehensive loss and statements of cash flows for the years ended December 31, 2004, 2003 and 2002, and its balance sheets as of December 31, 2004 and 2003 and for the quarterly periods of the fiscal years ended December 31, 2004 and 2003. The information contained herein reflects such restatement.

The following is a summary of the impact of the restatement on the Company’s condensed consolidated statements of operations and cash flows for the three and nine months ended September 30, 2004 (in thousands, except per share data):

Condensed Consolidated Statements of Operations
	For the three months ended September 30, 2004									For the nine months ended September 30, 2004
	As previously filed			Adjustments			Restated			As previously filed			Adjustments			Restated

Total revenues	$	112,049		$	-		$	112,049		$	331,341		$	-		$	331,341

Lease expense		15,382			(282	)		15,100			45,654			(861	)		44,793
(Gain) loss on sale of assets		-			48			48			-			(63	)		(63	)
Total operating expenses		109,290			234			109,056			316,379			(924	)		315,455
Operating income		2,759			234			2,993			14,962			924			15,886

Loss (gain) on sale of assets		(48	)		48			-			63			(63	)		-
Other expense, net		(7,473	)		48			(7,425	)		(24,977	)		(63	)		(25,040	)
Loss before income taxes and minority interest		(4,714	)		282			(4,432	)		(10,015	)		861			(9,154	)
Income tax expense		2,501			-			2,501			2,721			-			2,721
Net loss		(6,945	)		282			(6,663	)		(14,291	)		861			(13,430	)

Basic and diluted loss per share		(0.28	)		0.01			(0.27	)		(0.58	)		0.01			(0.57	)


Condensed Consolidated Statement of Cash Flows
										For the nine months ended September 30, 2004
											As previously filed			Adjustments			Restated

Net loss											(14,291	)		861			(13,430	)
Entrance fee items:
Amortization of deferred entrance fee income											(12,737	)		-			(12,737	)
Proceeds from entrance fee sales - deferred income											35,058			(10,152	)		24,906
Refunds of entrance fee terminations											(9,753	)		9,753			-
Accrual of deferred interest											-			4,074			4,074
Other assets											3,949			68			4,017
Deferred lease liability											-			(929	)		(929	)
Net cash and cash equivalents provided by operating activities											30,922			3,675			34,597

Net cash and cash equivalents used by investing activities											(9,567	)		-			(9,567	)

Accrual of deferred interest											4,074			(4,074	)		-
Entrance fee items:
Proceeds from entrance fee sales - refundable portion											-			10,152			10,152
Refunds of entrance fee terminations											-			(9,753	)		(9,753	)
Net cash and cash equivalents used by financing activities											(3,060	)		(3,675	)		(6,735	)
Net increase in cash and cash equivalents											18,295			-			18,295

3. Principles of Consolidation

The accompanying condensed consolidated financial statements include the financial statements of American Retirement Corporation and its wholly owned and majority owned subsidiaries (each of which is a separate and distinct legal entity), that manage own and operate senior living communities. Certain subsidiaries may be restricted from being obligated for liabilities of the Company or other subsidiaries of the Company irregardless of their consolidation for financial reporting purposes. The accounts of limited liability companies, joint ventures and partnerships are consolidated when the Company maintains effective control over such entities' assets and operations, notwithstanding, in some cases, a lack of majority ownership. All significant intercompany balances and transactions are eliminated in consolidation.

4. Segment Information

The Company operates principally in three business segments: (1) retirement centers, (2) free-standing assisted living communities, and (3) management services. The Company currently operates 29 retirement centers, which provide a continuum of care services such as independent living, assisted living and skilled nursing care. Of the 29 retirement centers, the Company owns six, operates four pursuant to leases classified as lease financing obligations (which include purchase options), operates 18 pursuant to operating leases and consolidates one variable interest entity, a retirement center that the Company manages (Freedom Square). The Company operates seven retirement centers which are entrance fee communities for which the Company receives an upfront fee and provides housing and health care services under various types of entrance fee agreements with residents.

The Company currently operates 33 free-standing assisted living communities. Free-standing assisted living communities are generally comprised of stand-alone assisted living communities that are not located on a retirement center campus, most of which also provide some specialized care such as Alzheimer’s and memory enhancement programs. Free-standing assisted living communities are generally much smaller than retirement centers. Of the 33 free-standing assisted living communities operated by the Company, 12 are owned (one in a joint venture), six are operated pursuant to leases classified as lease financing obligations, and 15 are operated pursuant to operating leases.

The management services segment includes fees from management agreements for communities owned by others, and fees for other services including development services, and reimbursed expense revenues together with associated expenses. The management services segment does not include any managed communities that the Company consolidates. The Company has six management agreements for retirement centers with third parties. Of the managed communities, two are cooperatives that are owned by their residents and three are owned by not-for-profit sponsors. The remaining managed retirement center is owned by an unaffiliated third party.

The Company manages and evaluates the performance of its business segments principally based upon segment operating contributions, which the Company defines as revenue from the segment less operating expenses associated with the segment. The following is a summary of total revenues and operating contributions by segment for the three and nine months ended September 30, 2005 and 2004, and total assets by segment at September 30, 2005 and December 31, 2004 (in thousands).^(1)(2)(3)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004
			(restated)				(restated)
Revenues
Retirement centers	$	95,244	$	86,526	$	280,520	$	257,392
Free-standing assisted living communities		28,195		24,563		81,249		70,758
Management services⁽²⁾		1,310		960		3,670		3,191
Total revenues	$	124,749	$	112,049	$	365,439	$	331,341

Retirement centers
Resident and health care revenues	$	95,244	$	86,526	$	280,520	$	257,392
Community operating expense		63,482		58,168		186,241		171,505
Segment operating contribution (3)		31,762		28,358		94,279		85,887

Free-standing assisted living communities
Resident and health care revenues		28,195		24,563		81,249		70,758
Community operating expense		19,474		17,657		55,948		52,237
Segment operating contribution (3)		8,721		6,906		25,301		18,521

Management services operating contribution		664		500		1,680		1,439

General and administrative expense		7,360		8,400		20,716		21,102
Lease expense		15,014		15,100		45,969		44,793
Depreciation and amortization (4)		9,607		9,223		29,039		24,129
Loss (gain) on sale of assets		121		48		477		(63	)
Operating income	$	9,045	$	2,993	$	25,059	$	15,886

						September 30,		December 31,
						2005		2004
Total Assets
Retirement centers					$	520,520	$	498,132
Free-standing assisted living communities						194,731		182,353
Management services						143,102		68,765
Total					$	858,353	$	749,250

(1)

Segment financial and operating data does not include any inter-segment transactions or allocated costs.

(2)

Management Services represent the Company’s management fee revenue and reimbursed expense revenue.

(3)

Segment operating contribution is defined as segment revenues less segment operating expenses.

(4)

The Company’s depreciation expense for the nine months ended September 30, 2004 includes $0.5 million of depreciation expense which would have been recognized during 2003 while the assets were held-for-sale if the assets had been continuously classified as held-for-use.

5. Stock Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, Accounting for Share Based Payment, an amendment to SFAS No. 148, Stock-Based Compensation - Transition and Disclosure and a revision to SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R requires alternative methods of transition for the change to the fair value method of accounting for stock-based employee compensation and is effective as of the beginning of the first annual period that begins after June 15, 2005 (calendar 2006). The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123 established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. The following table illustrates the effect on net income (loss) if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands except per share data).

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
				(restated)						(restated)
Net income (loss), as reported	$	4,090		$	(6,663	)	$	65,715		$	(13,430	)
Add: Stock based compensation included in net income		280			182			692			182
Deduct: total stock-based employee compensation expense determined under fair-value-based method		(707	)		(447	)		(1,441	)		(856	)
Pro forma net income (loss)	$	3,663		$	(6,928	)	$	64,966		$	(14,104	)

Earnings (loss) per share:
Basic - as reported	$	0.13		$	(0.27	)	$	2.18		$	(0.57	)
Diluted - as reported	$	0.13		$	(0.27	)	$	2.06		$	(0.57	)
Basic - pro forma	$	0.12		$	(0.28	)	$	2.15		$	(0.60	)
Diluted - pro forma	$	0.11		$	(0.28	)	$	2.04		$	(0.60	)

As permitted by SFAS No. 123R, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of these statements. Beginning in calendar year 2006, the Company plans to expense stock options using the modified prospective transition method prescribed in SFAS 123R. The modified prospective transition method requires expense to be recognized for new grants or modifications issued in the period of adoption, plus the current period expense for non-vested awards issued prior to the adoption of this standard. No expense is recognized for awards vested in prior periods. The weighted average fair value of options granted during the three and nine months ended September 30, 2005 was $6.88 and $6.45, respectively, as compared to $2.85 and $2.37, for the three and nine months, respectively, ended September 30, 2004. Considering recent market trends, the Company expects this average fair value to continue to increase. At September 30, 2005, the Company had 0.8 million unvested options outstanding, of which 0.1 million vest during the remainder of 2005. The Company is currently evaluating the use of various models, as well as the necessary assumptions for calculating the impact from adoption of this standard. Based on current guidance, the Company intends to adopt SFAS 123R and begin expensing share payments January 1, 2006.

On September 22, 2005, the Company granted certain members of management a total of 277,000 shares of performance-based non-vested stock. The shares underlying the grant will vest in three tranches on March 31, 2006, March 31, 2007, and March 31, 2008, subject to continued employment and the Compnay’s achievement of certain performance targets. The first tranche is currently subject to “variable” accounting rules under APB 25. As a result, compensation expense related to these grants is recognized as the shares vest and varies with changes in the Company’s stock price. Compensation expense for the three and nine months ended September 30, 2005 is representative only of the first tranche vesting on March 31, 2006. Compensation expense will be recognized on the second and third tranches when performance measures are approved by the Compensation Committee of the Company’s Board of Directors and communicated to participants. Upon adoption of SFAS No. 123R, the Company will expense the remainder of the unvested shares over the vesting term based on grant-date fair values.

On July 19, 2004, the Company granted certain members of management a total of 440,000 shares of restricted stock. This stock had a $5.95 market value at the date of grant and vests ratably over a period of three years from the grant date, subject only to continued employment. Compensation expense under the grant is “fixed” under the provisions of APB Opinion No. 25 and will be treated similarly upon adoption of SFAS No. 123R. Measured compensation related to the grant totaled $2.6 million which is being amortized as compensation expense over the period of vesting.

For the three months and nine months ended September 30, 2005, the Company expensed $0.3 million and $0.7 million, respectively, as compensation expense related to the amortization of the 2004 and 2005 restricted stock grants. For the three months and nine months ended September 30, 2004, the Company expensed $0.2 million as compensation expense related to the amortization of the 2004 restricted stock grant.

6. Earnings (Loss) per Share

Basic and diluted earnings per share for the three and nine months ended September 30, 2005 have been computed on the basis of the weighted average number of shares outstanding. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. During the three and nine months ended September 30, 2005, there were approximately 2.1 million options to purchase shares of common stock outstanding which had an exercise price below the average market price of the common shares for the corresponding periods, respectively. During the three and nine months ended September 30, 2004, there were approximately 2.4 million and 2.2 million options to purchase shares of common stock outstanding which had an exercise price below the average market price of the common shares for the corresponding periods, respectively.

A computation of diluted earnings (loss) per share is as follows (in thousands):

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2005		2004			2005			2004
			(restated)						(restated)
Net income (loss)	$	4,090	$	(6,663	)	$	65,715		$	(13,430	)

Weighted average shares used for basic earnings per share data		30,918		24,665			30,147			23,404
Effect of dilutive common securities:
Employee stock options and non-vested stock		1,595		-			1,701			-
Weighted average shares used for diluted earnings per share data		32,513		24,665			31,848			23,404

Basic income (loss) per share	$	0.13	$	(0.27	)	$	2.18		$	(0.57	)
Effect of dilutive securities		-		-			(0.12	)		-
Diluted income (loss) per share	$	0.13	$	(0.27	)	$	2.06		$	(0.57	)

The following options outstanding during the three and nine months ended September 30, 2005 and 2004 were excluded from the computation of diluted earnings per share for the respective period because the options’ exercise price was greater than the average market price of the common shares and, therefore, the effect would be anti-dilutive. All options outstanding during the three and nine months ended September 30, 2004 were excluded from the computation of diluted earnings per share for such periods because of net losses during these periods.

	Three Months				Nine Months
	Ended September 30,				Ended September 30,
	2005		2004		2005		2004
Number of options (in thousands)		21		162		36		206
Weighted-average exercise price	$	17.55	$	10.80	$	16.35	$	9.69

On April 1, 2004, the Company elected to redeem the balance of its 10% Series B Convertible Senior Subordinated Notes due 2008 (Series B Notes). The notes were not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2004 as the effect would be anti-dilutive.

7. Notes Receivable

On September 14, 2005, the Company entered into a 15-year management agreement with American Senior’s Foundation of Edmond, LLC (“ASF”), to manage a not-for-profit community in Edmund, Oklahoma ASF recently acquired.

The Company facilitated ASF's $9 million acquisition by providing a $6.0 million, 4.5 year senior mortgage loan bearing interest at one month LIBOR plus 4%, and a $4.5 million, 15-year junior mortgage loan bearing interest at 12.5%, both of which are fully collateralized by the assets of the facility. It is ASF's intention to replace the interim financing with permanent tax-exempt financing at the appropriate time. At September 30, 2005, the Company has $9.5 million outstanding under these notes, which approximates current fair value.

At September 30, 2005, the Company also held a note resulting from a loan to a lessor of a retirement community that is being leased by the Company. This note generally earns interest at fixed rate of approximately 6%. Interest and principal are due monthly based on a 35 year amortization. The note receivable matures June 2038 and is secured by the related community. At September 30, 2005, the Company has $18.0 million outstanding under this note, which approximates current fair value.

8. Long-term Debt and Other Transactions

A summary of long-term debt is as follows (in thousands):

	September 30,			December 31,
	2005			2004
Various mortgage notes, interest at variable and fixed rates, generally payable monthly with any unpaid principal and interest due between 2006 and 2037. Interest rates at September 30, 2005 range from 5.9% to 9.5%. The loans are secured by certain land, buildings and equipment.	$	115,506		$	109,401
Other long-term debt, interest generally payable monthly with any unpaid principal due between 2005 and 2018. Fixed and variable interest rates at September 30, 2005 range from 4.7% to 9.0%.		20,165			26,555
Subtotal debt		135,671			135,956
Capital lease and lease financing obligations with principal and interest payable monthly bearing interest at fixed rates ranging from 0.41% to 10.9%, with final payments due between 2006 and 2017. The obligations are secured by certain land, buildings and equipment.		187,090			199,126
Total debt including capital lease and lease financing obligations		322,761			335,082
Less current portion:
Debt		(7,458	)		(10,372	)
Capital lease and lease financing obligations		(17,081	)		(16,474	)
Total long-term debt, excluding current portion:
Debt		128,213			125,584
Capital lease and lease financing obligations		170,009			182,652
Total	$	298,222		$	308,236

At September 30, 2005, the aggregate scheduled maturities of long-term debt were as follows (in thousands):

	Long-term Debt		Capital Lease and Lease Financing Obligations		Total Debt at September 30, 2005
For the twelve months ended September 30, 2006	$	7,458	$	17,081	$	24,539
For the twelve months ended September 30, 2007		16,164		17,504		33,668
For the twelve months ended September 30, 2008		18,225		18,280		36,505
For the twelve months ended September 30, 2009		3,112		19,092		22,204
For the twelve months ended September 30, 2010		24,907		16,901		41,808
Thereafter		65,805		98,232		164,037
	$	135,671	$	187,090	$	322,761

2005 Activity

The Company used the proceeds of its January 26, 2005 secondary offering to make certain debt repayments. During January 2005, the Company repaid in full the balance on a mortgage loan from Health Care Property Investors (HCPI) in the amount of $5.7 million, bearing interest at 9%. In addition, during January 2005, the Company repaid in full the $17.2 million of 9.625% fixed interest-only mortgage notes, issued in 2001, due October 1, 2008.

During May 2005, the Company repaid in full the balance on a 5.5%, $7.1 million floating rate mortgage loan, due April 2011, related to a free-standing assisted living community.

During the second quarter of 2005, the Company completed four transactions as part of its strategy to release portions of its restricted cash, and to increase capacity in its portfolio through certain community expansions and new development. These transactions in the aggregate released approximately $13 million of restricted cash and facilitated the Company’s expansion plans at certain communities.

On June 29, 2005, the Company obtained a letter of credit facility from a commercial bank. The facility provides for the issuance of up to $10.7 million of standby letters of credit and is collateralized by a mortgage on two of the Company’s free-standing assisted living communities. The Company presently has $8.4 million of letters of credit outstanding under this facility, which has an initial term of one year, and can be renewed for two additional one year periods in accordance with its terms. A fee of 1% per annum is payable for any letters of credit issued under the facility. In the event a standby letter of credit is drawn upon, the amount so drawn will bear interest at the prime rate. The letter of credit facility contains certain financial convenants and other restrictions related to certain communities. As a result of this letter of credit facility, the Company released approximately $8.4 million from its restricted cash balance, which was used to repay debt.

On June 29, 2005, the Company completed a transaction with a real estate investment trust (“REIT”) from whom the Company leases two of its Alabama retirement center communities. Pursuant to this transaction, the Company received $9.5 million in proceeds which were then used to repay the balance of a $9.5 million loan related to its leasehold in the communities. The additional investment by the REIT is recorded by the Company as a refinancing and is included as debt in the Company’s condensed consolidated balance sheet at September 30, 2005. In connection with this refinancing, the Company incurred a loss on debt extinguishment. This loss is included as interest expense in the Company’s condensed consolidated statement of operations for the nine months ended September 30, 2005.

The Company had a master lease with another REIT for nine of its communities. On June 30, 2005, the Company amended the master lease as part of a transaction that involved the sale to the REIT of two of the Company’s owned free-standing assisted living communities for inclusion in the master lease, and the contemporaneous removal of two other free-standing assisted living communities from the master lease. In connection with this exchange, the Company also received $1.5 million of cash from the REIT, which correspondingly increased the Company’s lease basis under the master lease. The operating results of all four of these communities are included in the Company’s condensed consolidated financial statements before and after the exchange. This exchange will facilitate planned expansions for both of the communities that were repurchased and removed from the master lease. Additionally, as part of this transaction, the REIT established a program to reduce up to $7.0 million of security deposit requirements under the master lease based on the satisfaction of certain financial performance tests for the master lease portfolio. The Company currently has $7.0 million of restricted cash underlying these security deposits that will be released incrementally as these tests are met. The master lease was also amended to extend the timing of a purchase option for one community under the master lease. The option was initially exercisable in 2010, which date may be deferred for up to three years at the option of the REIT.

On June 30, 2005, the Company completed a transaction with a third REIT to repurchase the REIT’s minority interest in the lessor of two of its entrance fee communities. As a result of the repurchase of these two minority ownership positions, the Company now owns 100% of both entrance fee communities. In exchange for these minority interests, the Company issued to the REIT a $6.2 million note, due July 1, 2010, bearing interest at 9%. The transaction simplifies the ownership structure of the two communities and facilitates the current expansion of one of them. In a related transaction, the REIT amended a separate lease with the Company to eliminate a $5 million security deposit requirement. As a result, $5 million of the Company’s restricted cash was released to unrestricted cash.

On July 7, 2005, the Company acquired all of the real property interests underlying Freedom Plaza Care Center (FPCC), a 128-bed skilled nursing and 44-unit assisted living center in Peoria, Arizona for $20.3 million. The Company previously operated FPCC pursuant to a long-term operating lease with Maybrook Realty, which was 50% owned by W.E. Sheriff, the Company’s chairman, chief executive officer and president. The Company consummated the acquisition pursuant to an option under the lease, which provided for a fixed purchase price of $20.3 million. The Company also contemporaneously acquired the third-party ground lessor’s interest in the property, including an adjacent parcel of land, for a purchase price of $3.1 million. The total purchase price for these two transactions was $23.4 million, which was supported by a fair market value appraisal. The purchase price was paid with $4.7 million of cash and with the proceeds of an $18.7 million mortgage loan obtained from a commercial bank. The loan is evidenced by a loan agreement and two promissory notes and is secured by the community. The $18.7 million mortgage loan matures on July 1, 2010, and requires principal payments to be made on an 18-year amortization schedule. Half of the outstanding principal balance of the loan bears interest at a fixed rate of 6.61% and the other half of the outstanding principal balance bears interest at a variable rate calculated, at the Company’s election, at either the prime rate plus 1% or the eurodollar fixed rate plus 2.375% (or a combination thereof).

As a result of these July 7, 2005 transactions, the Company simultaneously acquired the real estate interests of both Maybrook and the ground lessor in FPCC and, consequently, owns 100% of the community. On July 7, 2005, the Company also entered into a $4.5 million construction loan administration agreement (and related promissory note) with a commercial bank in order to finance a 21-unit assisted living and a 20-bed dementia expansion of the community. The $4.5 million loan matures on July 1, 2010, requires quarterly principal payments beginning April 1, 2008, and bears interest at a variable rate calculated, at the Company’s election, at either the prime rate plus 1% or the eurodollar fixed rate plus 2.375% (or a combination thereof).

On September 22, 2005, the Company entered into a $21 million construction loan with a commercial lender in order to finance the expansion of one of its assisted living communities in Austin, Texas. The expansion involves the development of a 99-bed skilled nursing facility that will be integrated into the community. The loan is evidenced by a loan agreement and a promissory note, and is secured by a deed of trust on the community, each of which contains customary terms and provisions. The loan matures in September 2008, and includes two one-year extension options. The outstanding principal balance of the loan will bear interest at a variable rate equal to LIBOR plus 2.75%. The Company will be required to make monthly payments of interest only through the scheduled maturity date. If the Company exercises its extension options, it will also be required to make monthly principal payments (based upon a 25 year amortization schedule) during the extension period(s).

Other Activity

Approximately $62.7 million of the Company’s $187.1 million in lease financing obligations include contingent earnout provisions under certain leases which expire between December 2005 and October 2006. The contingent earnout provisions relate to a retirement center and six free-standing assisted living communities. When these provisions expire, the Company’s continuing involvement related to the initial sale-leaseback transactions will be relieved and the subject leases will no longer be accounted for as lease financing obligations, but will be accounted for as operating leases. As a result, lease financing obligations, depreciation expense and interest expense will decrease and operating lease obligations and lease expense will increase. The expected reduction of lease financing obligations as a result of these expirations, unless further extended and assuming no modifications in payment terms, is:

During the three months ended December 31, 2005	$	5.5 million
During the three months ended March 31, 2006		7.2 million
During the three months ended December 31, 2006		46.7 million
	$	59.4 million

The Company guarantees approximately $18.1 million of mortgage debt that is not reflected on the Company’s balance sheet, of which $9.7 million relates to a retirement center which the Company leases and $8.4 million relates to a joint venture which the Company manages. These guarantees require that the Company pay or perform the borrower’s obligation. Accordingly, the Company would be required to make any payments, and perform any obligations, if the relevant borrower fails to do so. To date, the Company has not been required to fund any debt guarantees, and at September 30, 2005, the Company does not believe that it will be required to make payments under its currently outstanding guarantees. If it were required to fund a debt guarantee, the Company would be entitled to seek indemnity or contribution payments from the borrower and, if applicable, any co-guarantor.

Liquidity

The Company believes that its current cash and cash equivalents and expected cash flow from operations will be sufficient to fund its operating requirements, ongoing capital expenditure requirements, periodic debt service requirements, lease and tax obligations during the next twelve months.

The Company has substantial debt and lease obligations. During the past twelve months, total debt decreased $29.7 million from $352.5 million at September 30, 2004 to $322.8 million at September 30, 2005. Approximately $249.1 million or 77.2% of the Company’s debt and lease financing obligations have fixed interest rates, which on a weighted average basis approximated 4.1% at September 30, 2005. The remaining $73.6 million, or 22.8%, of debt has variable interest rates, which on a weighted average basis approximated 6.3% at September 30, 2005. The Company has scheduled current debt and lease principal payments of $24.5 million and minimum rental obligations of $67.2 million under long-term operating leases due during the twelve months ended September 30, 2006.

As of September 30, 2005, the Company had approximately $34.0 million in unrestricted cash and cash equivalents and $30.0 million in restricted cash. For the nine months ended September 30, 2005, the Company’s cash provided by operations was $43.1 million. At September 30, 2005, the Company had $95.8 million of negative working capital, which includes the classification of $119.5 million of entrance fees and $5.3 million of tenant deposits as current liabilities as required by applicable accounting pronouncements. During 2002, 2003 and 2004, the Company experienced that only 12%, 11%, and 9%, respectively, of these entrance fee liabilities actually became payable and were required to be settled in cash. During this same period, entrance fee liabilities paid were offset by proceeds generated by subsequent entrance fee sales. Entrance fee sales, net of refunds paid, provided $21.5 million, $26.7 million, and $31.2 million of cash during 2002, 2003, and 2004, respectively.

On January 26, 2005, the Company completed a public offering of 5,175,000 shares of common stock, including the underwriter’s over-allotment of 675,000 shares. The shares were priced at $10.25. The net proceeds of the offering, after deducting underwriting discounts, commissions and expenses, were approximately $49.9 million.

Substantially all of the Company's assets are pledged (including first priority mortgages) to secure its indebtedness. Certain of the Company’s indebtedness and lease agreements are cross-collateralized or cross-defaulted. Any default with respect to such obligations could cause the Company’s lenders or lessors to declare defaults, accelerate payment obligations or foreclose upon the communities securing such indebtedness or exercise their remedies with respect to such communities, which could have a material adverse effect on the Company. Certain of the Company’s debt instruments and leases contain financial and other covenants, typically related to the specific communities financed or leased.

9. Operating Leases

As of September 30, 2005, the Company operated 43 of its senior living communities under long-term leases (33 operating leases and ten capital lease or lease financing obligations). Of the 33 operating lease communities, 25 are operated under four master lease agreements, with the remaining communities leased under individual lease agreements. The Company also leases its corporate offices and is obligated under several ground leases for senior living communities. The base lease terms vary from three to 19 years. Many of the leases provide for renewal, extension and purchase options. Many of the leases also provide for graduated lease payments, either based upon fixed rate increases or a specified formula. In addition, several leases have provisions for contingent lease payments based on revenue, occupancy levels or other measures. Contingent rent that depends on factors directly related to the future use of leased property is accrued when it is deemed probable such amounts will be due. In addition, a majority of the Company’s lease agreements impose certain restrictions or require pre-approval for certain changes such as expansions or significant modifications to the leased property.

Net lease expense for the three months ended September 30, 2005 was $15.0 million, which includes lease payments of $16.9 million, plus accruals for future lease escalators (straight-line lease expense) of $1.1 million, net of the amortization of the deferred gain from prior sale-leasebacks of $3.0 million. Net lease expense for the three months ended September 30, 2004 was $15.1 million, which includes lease payments of $16.5 million, plus accruals for future lease escalators of $1.5 million, net of the amortization of the deferred gain from prior sale-leasebacks of $2.9 million.

Net lease expense for the nine months ended September 30, 2005 was $46.0 million, which includes lease payments of $51.0 million, plus accruals for future lease escalators (straight-line lease expense) of $3.9 million, net of the amortization of the deferred gain from prior sale-leasebacks of $8.9 million. Net lease expense for the nine months ended September 30, 2004 was $44.8 million, which includes lease payments of $48.2 million, plus accruals for future lease escalators of $4.5 million, net of the amortization of the deferred gain from prior sale-leasebacks of $7.9 million.

Future minimum lease payments at September 30, 2005 are as follows (in thousands):

Twelve months ended September 30, 2006	$	67,159
Twelve months ended September 30, 2007		68,251
Twelve months ended September 30, 2008		67,471
Twelve months ended September 30, 2009		67,983
Twelve months ended September 30, 2010		68,928
Thereafter		367,351
	$	707,143

The following table provides a summary of operating lease obligations at September 30, 2005 by lessor:

	Future Minimum Lease Payments
	Twelve Months Ending		Remaining
	September 30, 2006		Lease Term
Master lease agreements for ten communities. Initial term ranging from 10 to 15 years, with renewal options for two additional ten year terms.	$	24,176	$	221,194
Operating lease agreements for three communities with an initial term of 15 years and renewal options for two additional five year terms or two additional ten year terms.		9,243		130,900
Master lease agreement for nine communities. Initial 12 year term, with renewal options for two additional five year terms.		11,054		89,488
Operating lease agreement for a community which has a 23 year term, with a seven year renewal option. The Company also has an option to purchase the community at the expiration of the lease term at fair market value.		4,345		46,854
Operating lease agreement for a community with an initial term of 15 years with two five year renewal options and a right of first refusal to repurchase the community. The Company recorded a deferred gain of $11.7 million on the sale, which is being amortized over the base term of the lease.		3,893		41,319
Master lease agreement for six communities with an initial ten year term, with renewal options for four additional ten year terms.		6,103		38,096
Other lease agreements for three communities, as well as a lease for the home office. Initial terms ranging from eight to 17 years, with various renewal options.		8,345		72,133
Total operating lease obligations	$	67,159	$	639,984

10. Income Taxes

As a result of reported losses and other factors, the Company had previously established a valuation allowance against certain deferred tax assets. The Company has determined it is more likely than not that it will realize the benefit of certain of these deferred tax assets, and therefore has reduced its valuation allowance by approximately $55.7 million during the nine months ended September 30, 2005, resulting in a significant tax benefit during the period.

11. Commitments and Contingencies

The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. In the opinion of management, the ultimate liability with respect to those proceedings and claims will not materially affect the financial position, operations, or liquidity of the Company. The Company maintains commercial insurance on a claims-made basis for medical malpractice and professional liabilities.

Insurance

The delivery of personal and health care services entails an inherent risk of liability. Participants in the senior living and health care services industry have become subject to an increasing number of lawsuits alleging negligence or related legal theories, many of which involve large claims and result in the incurrence of significant exposure and defense costs. The Company currently maintains general and professional medical malpractice insurance policies for the Company's owned, leased and certain of its managed communities under a master insurance program. Premiums and deductibles for this insurance coverage have risen dramatically in recent years, particularly during 2002 and 2003. In response to these conditions, the Company has significantly increased the staff and resources involved in quality assurance, compliance and risk management during the past several years, and has also modified its insurance programs.

The Company currently maintains single incident and aggregate liability protection in the amount of $25.0 million for general liability and $15.0 million for professional liability, with self-insured retentions of $1.0 million and $5.0 million, respectively. The Company believes it has adequately accrued amounts to cover open claims not yet settled and incurred but not reported claims as of September 30, 2005.

The Company operates under a self-insured workers’ compensation program, with excess loss coverage provided by third party carriers. As of September 30, 2005, the Company’s coverage for workers’ compensation and related programs, excluding Texas, included excess loss coverage of $350,000 per individual claim and approximately $6.3 million in the aggregate. As of September 30, 2005, the Company provided cash collateralized letters of credit in the aggregate amount of $7.7 million related to this program, which are reflected as restricted cash on the Company’s consolidated balance sheet. For work-related injuries in Texas, the Company is a non-subscriber under Texas state law, meaning that work-related losses are covered under a defined benefit program outside of the Texas Workers' Compensation system. The Company carries excess loss coverage of $250,000 per individual under its non-subscriber program. Losses are paid as incurred and estimated losses are accrued on a monthly basis. The Company utilizes a third party administrator to process and pay filed claims.

The Company maintains a self-insurance program for employee medical coverage, with stop-loss insurance coverage of approximately $250,000 per associate. Estimated costs related to this self-insurance program are accrued based on known claims and projected settlements of unasserted claims incurred but not yet reported to the Company. Subsequent changes in actual experience (including claim costs, claim frequency, and other factors) could result in additional costs to the Company.

During the three and nine months ended September 30, 2005, the Company expensed $4.4 million and $12.9 million, respectively, as compared to $4.6 million and $13.0 million for the three and nine months ended September 30, 2004, respectively, related to premiums, claims and costs for general liability and professional medical malpractice, workers’ compensation, and employee medical insurance related to multiple insurance years.

Management Agreements

The Company’s management agreements are generally for terms of three to 20 years, but certain of the agreements may be canceled by the owner of the community, without cause, on three to nine months’ notice. One management agreement provides the Company with two ten year renewal options. Pursuant to the management agreements, the Company is generally responsible for providing management personnel, marketing, nursing, resident care and dietary services, accounting and data processing services, and other services for these communities in exchange for a monthly fee for its services based on either a contractually fixed amount, a percentage of revenues or income, or cash flows in excess of operating expenses and certain cash flows of the community. The Company’s existing management agreements expire at various times through June 2020.

In connection with these management agreements, the Company has guaranteed mortgage debt of $8.4 million related to a joint venture which the Company manages.

Regulatory Requirements

Federal and state governments regulate various aspects of the Company's business. The development and operation of health care facilities and the provision of health care services are subject to federal, state, and local licensure, certification, and inspection laws that regulate, among other matters, the number of licensed beds, the provision of services, the distribution of pharmaceuticals, billing practices and policies, equipment, staffing (including professional licens-ing), operating policies and procedures, fire prevention measures, environmental matters, and compliance with building and safety codes. Failure to comply with these laws and regulations could result in the denial of reimbursement, the imposition of fines, temporary suspension of admission of new patients, suspension or decertification from the Medicare programs, restrictions on the ability to acquire new communities or expand existing communities, and, in extreme cases, the revocation of a community's license or closure of a community. Management believes the Company was in compliance with such federal and state regulations at September 30, 2005.

Other

A portion of the Company’s skilled nursing and therapy service revenue is attributable to reimbursements under Medicare. Certain per person annual limits on therapy services, which were effective September through December 2003, have been placed on moratorium for two years. These caps will become effective for the first quarter of 2006, unless revised or extended, which will have an adverse impact on the earnings from the Company’s therapy services.

12. Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29.” The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. SFAS No. 153 amends APB No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005, while early application was permitted for nonmonetary asset exchanges occurring in fiscal periods beginning after December 2004. The Company adopted the provisions of SFAS No. 153 on April 1, 2005.

In March 2005, the FASB issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143 (“FIN No. 47”). FIN No. 47 clarifies that the term, conditional asset retirement obligation as used in SFAS No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional upon a future event that may or may not be within the control of the entity. Even though uncertainty about the timing and/or method of settlement exists and may be conditional upon a future event, the obligation to perform the asset retirement activity is unconditional. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. Uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred generally upon acquisition, construction, or development or through the normal operation of the asset. SFAS No. 143 acknowledges that in some cases, sufficient information may not be available to reasonably estimate the fair value of an asset retirement obligation. FIN No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN No. 47 is effective no later than the end of reporting periods ending after December 15, 2005, and early adoption of FIN No. 47 is encouraged. The Company will adopt FIN No. 47 in the fourth quarter of 2005. The Company does not believe that the adoption of FIN No. 47 will have a material effect on its financial position, results of operations or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”, a replacement to APB Opinion No. 20, “Accounting Changes” and Financial Accounting Standards No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. Additionally, SFAS No. 154 carries forward the guidance in APB Opinion No. 20 for reporting the correction of an error, a change in accounting estimate and requires justification of a change in accounting principle. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, and accordingly, the Company will adopt SFAS No. 154 in the first quarter of 2006.

In June 2005, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 05-06, Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination (“EITF 05-06”). EITF 05-06 concludes that the amortization period for leasehold improvements acquired in a business combination and leasehold improvements that are in service significantly after and not contemplated at the beginning of the lease term should be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are deemed to be reasonably assured at the date of inception. As of September 30, 2005 this pronouncement had no impact on the consolidated financial statements.

In June 2005, the EITF reached consensus in EITF 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights, to provide guidance on how general partners in a limited partnership should determine whether they control a limited partnership and therefore should consolidate it. The EITF agreed that the presumption of general partner control would be overcome only when the limited partners have either of two types of rights. The first type, referred to as kick-out rights, is the right to dissolve or liquidate the partnership or otherwise remove the general partner without cause. The second type, referred to as participating rights, is the right to effectively participate in significant decisions made in the ordinary course of the partnership’s business. The kick-out rights and the participating rights must be substantive in order to overcome the presumption of general partner control. The consensus is effective for general partners of all new limited partnerships formed and for existing limited partnerships for which the partnership agreements are modified subsequent to the date of FASB ratification (June 29, 2005). For existing limited partnerships that have not been modified, the guidance in EITF 04-5 is effective no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005. The Company is currently evaluating what impact, if any, EITF 04-5 will have on its financial statements, but at this time the Company does not believe that the adoption of EITF 04-5 will have a material effect on its financial position, results of operations or cash flows.

Other recent accounting pronouncements issued by the FASB (including its EITF and FIN), the AICPA, and the SEC did not or are not believed by management to have a material impact on the Company’s present or future consolidated financial statements.

13. Subsequent Events

On November 2, 2005, the Company completed the acquisition, through a newly formed joint venture, to acquire eight senior assisted living communities from Epoch SL VI, Inc., an affiliate of Epoch Senior Living, Inc. (“Epoch”). The communities are located in Arizona (2), Colorado, Georgia, Kansas, Minnesota, Nevada and Texas.

In order to consummate the transaction, the Company assigned its rights in its previously executed purchase agreement to the joint venture. The Company owns 20% of the joint venture, with its sole partner, an affiliate of Prudential Real Estate Investors (collectively, “Investors”), owning the remaining 80% interest.

The joint venture acquired the communities for a purchase price of $138.0 million plus the assumption of certain operating obligations and customary transaction expenses (subject to customary closing adjustments). Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services, Inc., provided a 5-year, $85.0 million term loan to the joint venture to fund a portion of the purchase price. The interest-only loan bears interest at one-month LIBOR plus 2%. The remainder of the purchase price was funded with proportional capital contributions by the Investors.

The Company simultaneously entered into a long-term management agreement to manage these eight communities.

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

Overview

The senior living industry is experiencing growth as a result of demographic changes and various other factors. According to census data, the over age 75 population in the United States is growing much faster than the general population. We have seen increasing demand for services at both our retirement centers and our free-standing assisted living communities during the past year, and expect that this demand will continue over the next several years. As a general rule, economic factors that affect seniors will have a corresponding impact on the senior living industry. For example, general concerns regarding lower interest rates on savings and uncertainty of investment returns have impacted seniors during the past several years, as well as uncertainties related to world events such as the Iraqi war. On the other hand, the continuing strength of the home resale market in most areas of the country has been beneficial to seniors, since the equity from the sale of a home is a significant source of funding for senior living care in many cases. In addition, overall economic conditions and general consumer confidence can impact the senior living industry, since many adult children subsidize the cost for care of elderly parents, and share in decisions regarding their care.

The assisted living industry is maturing and rapidly evolving. The demand for assisted living services increased significantly beginning with the emergence of the industry segment in the mid-1990s. However, the development of new assisted living communities across the country outstripped demand during that period, resulting in oversupply of unit capacity, longer fill up times, price pressures and deep discounting. The steadily increasing demand for assisted living services, coupled with minimal new development activity, reduced much of the oversupply in many of our markets in 2002 and 2003. As a result, we were able to increase occupancy, increase rates and reduce promotional discounting for our free-standing assisted living communities during 2003, 2004 and the first nine months of 2005. Based on available industry data, we believe that new assisted living development in the near term will remain at sustainable levels and, accordingly, expect this trend to continue. The average length of stay in our free-standing assisted living community segment is approximately two years, which represents a challenge and an opportunity for us. We must find a number of new residents to maintain and build occupancy. However, we also have the opportunity to “mark-to-market” if we are able to attract new residents at higher current market rates, replacing prior residents with lower or discounted rates.

Our retirement center segment is a more mature segment of the industry, and has seen demand and price increases in recent years, with new unit capacity entering the market at sustainable levels. Management expects this growth in demand and selling rate increases to continue over the next several years. The average length of stay is much longer in our retirement centers, approximately five to seven years in the rental communities, and approximately ten to twelve years in the entrance fee communities. In addition, we believe that many of our retirement centers benefit from significant barriers to entry from competitors, including the significant cost and length of time to develop competitive communities, certificate of need requirements for nursing beds in certain states, the difficulty in finding acceptable development sites in the geographical areas in which our retirement centers are located, and the length of time and difficulty in developing strong competitive reputations.

We earn our revenues primarily by providing housing and services to our residents. Approximately 84% of our revenues come from private pay sources, meaning that residents or their families pay from their own funds (or from the proceeds of their privately funded long-term care policies). All private pay residents are billed in advance for the next month’s housing and care. In addition, we receive private pay revenues from the sale of entrance fee contracts at our entrance fee communities. While this cash is received at the time the resident moves in, the non-refundable portion of the entrance fee is primarily recognized as income for financial reporting purposes over the actuarial life of the resident.

Our most significant expenses are:

·	Community operating expenses - Labor and labor related expenses for community associates represent approximately 60% to 65% of this line item. Other significant items in this category are food costs, property taxes, utility costs, marketing costs and insurance.

General and administrative - Labor costs also represent the largest component of this category, comprising the home office and regional staff supporting community operations. Other significant items are travel and legal and professional service costs. In response to higher liability insurance costs and deductibles in recent years, and the inherent liability risk in providing personal and health-related services to seniors, we have significantly increased our staff and resources involved in quality assurance, compliance and risk management.

Lease expense - Our lease expense has grown significantly over the past several years, as a result of the large number of sale-leaseback transactions completed in connection with various financing transactions. Our lease expense includes the rent expense for all operating leases, including an accrual for known lease escalators in future years (the impact of these future escalators is spread evenly over the lease term for financial reporting purposes), and is reduced by the amortization of deferred gains on previous sale-leaseback transactions.

·	Depreciation and amortization expense - We incur significant depreciation expense on our fixed assets (primarily community buildings and equipment) and amortization expense related primarily to leasehold acquisition costs.

·	Interest expense - Our interest expense is comprised of interest on our outstanding debt, capital lease and lease financing obligations.

Results of Operations

We filed an amendment on Form 10-K/A to our Annual Report on Form 10-K for the year ended December 31, 2004 to restate our consolidated statements of operations, statements of shareholders' equity and comprehensive loss and statements of cash flows for the years ended December 31, 2004, 2003 and 2002, and our balance sheets as of December 31, 2004 and 2003 and for the quarterly periods of the fiscal years ended December 31, 2004 and 2003. The information herein reflects such restatement.

Recent Events

During January 2005, we completed a secondary equity offering of 5,175,000 common shares, resulting in approximately $49.9 million of net proceeds to us. We used $37.1 million of these proceeds to further reduce certain high cost debt, to acquire a retirement center, and to acquire the real assets of an assisted living community we previously operated pursuant to an operating lease. We used the remaining proceeds to acquire certain leased real estate at our communities, and for certain expansion and development activity at our communities or for working capital.

During the second quarter of 2005, we completed four transactions as part of our strategy to release portions of our restricted cash, and to increase the capacity level of our portfolio through certain community expansions and new development. These transactions in the aggregate released approximately $13 million of restricted cash and facilitated our expansion plans for certain communities. See Note 8 to the condensed consolidated financial statements.

During the third quarter of 2005, we acquired all of the real property interests underlying Freedom Plaza Care Center (FPCC), a 128-bed skilled nursing and 44-unit assisted living center in Peoria, Arizona for $20.3 million. We previously operated FPCC pursuant to a long-term operating lease with Maybrook Realty, which was 50% owned by W.E. Sheriff, our chairman, chief executive officer and president. We consummated the acquisition pursuant to an option under the lease, which provided for a fixed purchase price of $20.3 million. We also contemporaneously acquired the third-party ground lessor’s interest in the property, including an adjacent parcel of land, for a purchase price of $3.1 million. The purchase price was paid with $4.7 million of cash and with the proceeds of an $18.7 million mortgage loan obtained from a commercial bank.

As a result of these transactions, we simultaneously acquired the real estate interests of both Maybrook and the ground lessor in FPCC and, consequently, own 100% of the community. On July 7, 2005, we also entered into a $4.5 million construction loan administration agreement (and related promissory note) with a commercial bank in order to finance a 21 assisted living unit and 20 dementia bed expansion of the community. See Note 8 to the condensed consolidated financial statements.

On September 14, 2005, we entered into a 15-year management agreement with American Senior’s Foundation of Edmond, LLC (“ASF”), to manage the Bradford Village community ASF recently acquired. Bradford Village, formerly known as Oklahoma Christian Retirement Community, is an entry-fee community that serves middle income seniors in Edmond, Oklahoma. The campus consists of 78 cottage homes, 44 assisted living units, 10 memory care units and 102 skilled nursing beds, for a total of 234 units/beds. See Note 7 to the condensed consolidated financial statements.

On September 22, 2005, we entered into a $21 million construction loan with a commercial bank in order to finance the expansion of one of our assisted living communities in Austin, Texas. The expansion involves the development of a 99-bed skilled nursing facility that will be integrated into the community. See Note 8 to the condensed consolidated financial statements.

Highlights of Operating Results

Our statements of operations in recent years should be considered in light of the following factors, some of which are likely to influence our future operating results and financial outlook:

During the three months ended September 30, 2005, we experienced temporary disruption at eight of our Texas communities as a result of Hurricane Rita. All residents and associates weathered the storm safely, but we did incur additional costs of preparation and some temporary evacuations, as well as some minor storm damage. The total impact of this storm was approximately $350,000 during the three months ended September 30, 2005, including approximately $150,000 of lost revenue.

Our statements of operations for the three and nine months ended September 30, 2005 show significant improvement versus the respective prior year periods. Net income for the three months ended September 30, 2005 was $4.1 million versus a net loss for the three months ended September 30, 2004 of $6.7 million. Net income for the nine months ended September 30, 2005 was $65.7 million, including the $55.7 million impact of the reduction of our deferred tax valuation allowance, versus a net loss for the nine months ended September 30, 2004 of $13.4 million. Cash provided by operating activities has increased $8.5 million, to $43.1 million from $34.6 million for the nine months ended September 30, 2005 and 2004, respectively.

In order to continue to increase net income, we are focusing on improving results in our retirement centers and free-standing assisted living segments, while controlling our general and administrative costs and reducing our debt service costs. We are also focused on the growth of our ancillary service revenues, as well as the expansion of capacity at several communities.

We are focused on increasing the revenues and operating contribution of our retirement centers. Revenue per unit increases at our retirement centers resulted primarily from increases in selling rates, increased therapy and ancillary service revenues, as well as annual billing rate increases to existing residents. In addition, a significant component of the average revenue per unit increase stems from the “mark-to-market” effect of resident turnover. Since monthly rates for new residents (current market selling rates) are generally higher than billing rates for current residents (since annual increases to billing rates are typically capped in resident agreements), turnover typically results in significantly increased monthly fees for the new resident. This “mark-to-market” increase is generally more significant in entrance fee communities due to much longer average length of stay (ten or more years).

For the three months ended September 30, 2005, retirement center revenues were up 10.1% versus prior year, and segment operating contribution was up 12.0% versus the same period last year. Operating contribution per unit per month increased 9.6% for the same period, from $1,124 to $1,232. For the nine months ended September 30, 2005, retirement center revenues were up 9.0% and segment operating contribution was up 9.8% versus the nine months ended September 30, 2004. Operating contribution per unit per month increased 7.5% from $1,138 to $1,223.

We are also focusing on increasing our free-standing assisted living segment operating contribution further primarily by increasing occupancy above the current 91% level, and by increasing revenue per unit through price increases, ancillary services, and the “mark-to-market” effect of turnover of units that are at lower rates, while maintaining control of our operating costs. Since monthly rates for new residents (current market selling rates) are generally higher than billing rates for current residents, turnover typically results in significantly increased monthly fees for the new resident. We believe that, absent unforeseen market or pricing pressures, occupancy increases above 90% should produce high incremental community operating contribution margins for this segment. The risks to improving occupancy in our free-standing assisted living community portfolio are unexpected increases in move outs in any period (due to health or other reasons) and the development of new unit capacity or renewed price discounting by competitors in our markets, which could make it more difficult to fill vacant units and which could result in lower revenue per unit.

Our free-standing assisted living communities have continued to increase revenue and segment operating contribution during 2005, primarily as a result of a 9.7% year over year increase in revenue per unit as of September 30, 2005, as well as an increase in ending occupancy from 88% as of September 30, 2004, to 91% as of September 30, 2005. The increased revenue per unit in our free-standing assisted living communities resulted primarily from selling rate increases, reduced discounting, and turnover of units resulting in new residents paying higher current market rates. In addition, our residency agreements provide for annual rate increases. The increased amount of ancillary services, including therapy services, also contributed to the increased revenue per unit.

Our free-standing assisted living community incremental increase in operating contribution as a percentage of revenue increase was 50% and 65% for the three and nine months ended September 30, 2005, respectively, versus 65% and 79% for the three and nine months ended September 30, 2004. Our free-standing assisted living community operating contribution per unit per month increased 20.8% during the three months ended September 30, 2005, versus the same period last year, to $1,122 per unit per month. For the nine months ended September 30, 2005, our free-standing assisted living community operating contribution per unit per month increased 29.7% versus the same period last year to $1,097 per unit per month.

Segment Results

We operate in three business segments: retirement centers, free-standing assisted living communities, and management services.

The following table presents the number, total unit capacity and total ending and average occupancy percentages of our communities by operating segment at September 30, 2005 and 2004.

	Number of Communities /				Ending Occupancy % /				Average Occupancy % /
	Total Ending Capacity				Ending Occupied Units				Average Occupied Units
	September 30,				September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004		2005		2004

Retirement Centers		29		28		95%		95%		95%		95%
		9,059		8,870		8,635		8,436		8,564		8,387

Free-standing ALs		33		33		91%		88%		89%		85%
		3,011		2,999		2,736		2,642		2,688		2,560

Management Services		6		5		94%		95%		95%		93%
		1,423		1,187		1,339		1,125		1,146		1,086

Total		68		66		94%		93%		94%		92%
		13,493		13,056		12,710		12,203		12,398		12,033

We measure the performance of our three business segments, in part, based upon the operating contribution produced by these business segments. We compute operating contribution by deducting the operating expenses associated with a segment from the revenues produced by that segment. The following table sets forth certain selected financial and operating data on an operating segment basis⁽¹⁾(dollars in thousands, except for per unit amounts).

	Three Months Ended September 30,				2005 vs. 2004					Nine Months Ended September 30,				2005 vs. 2004
	2005		2004		Change		%			2005		2004		Change		%
			(restated)									(restated)
Revenues:
Retirement Centers	$	95,244	$	86,526	$	8,718		10.1	%	$	280,520	$	257,392	$	23,128		9.0	%
Free-standing Assisted Living Communities		28,195		24,563		3,632		14.8	%		81,249		70,758		10,491		14.8	%
Management Services		1,310		960		350		36.5	%		3,670		3,191		479		15.0	%
Total revenue	$	124,749	$	112,049	$	12,700		11.3	%	$	365,439	$	331,341	$	34,098		10.3	%

Retirement Centers
Ending occupied units		8,635		8,436		199		2.4%			8,635		8,436		199		2.4%
Ending occupancy %		95%		95%		0%					95%		95%		0%