10-Q 1 a10-q.txt QUARTERLY REPORT ================================================================================ 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 QUARTERLY PERIOD ENDED MAY 31, 2000 ------------ 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: 0-18249 ILM SENIOR LIVING, INC. ----------------------- (Exact name of registrant as specified in its charter) VIRGINIA 04-3042283 ----------------------- -------------------- (State of organization) (I.R.S. Employer Identification No.) 1750 TYSONS BOULEVARD, SUITE 1200, TYSONS CORNER, VA 22102 -------------------------------------------------------------------------------- (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (888) 257-3550 ----------------------- Securities registered pursuant to Section 12(b) of the Act: Name of each exchange on Title of each class which registered ------------------- ----------------------- None None Securities registered pursuant to Section 12(g) of the Act: Shares of Common Stock $.01 Par Value ------------------------------------- (Title of Class) Indicate by check mark 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 of common stock outstanding as of May 31, 2000: 7,520,100. Current Report on Form 8-K of Registrant Dated June 2, 2000 ================================================================================ Page 1 of 21 ILM SENIOR LIVING, INC. INDEX Part I. Financial Information PAGE ---- Item 1. Financial Statements Consolidated Balance Sheets May 31, 2000 (Unaudited) and August 31, 1999.................4 Consolidated Statements of Income For the nine months and three months ended May 31, 2000 and 1999 (Unaudited)..........................5 Consolidated Statements of Changes in Shareholders' Equity For the nine months ended May 31, 2000 and 1999 (Unaudited).......................................6 Consolidated Statements of Cash Flows For the nine months ended May 31, 2000 and 1999 (Unaudited).......................................7 Notes to Consolidated Financial Statements (Unaudited).............................................8-12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............13-19 Part II. Other Information Item 5. Other Information...........................................20 Item 6. Exhibits and Reports on Form 8-K............................20 Signatures....................................................................21 -2- ILM SENIOR LIVING, INC PART I. FINANCIAL INFORMATION ------------------------------ Item I. Financial Statements (See next page) -3- ILM SENIOR LIVING, INC. CONSOLIDATED BALANCE SHEETS May 31, 2000 (Unaudited) and August 31, 1999 (Dollars in thousands, except per share data)

See accompanying notes. -4- ILM SENIOR LIVING, INC. CONSOLIDATED STATEMENTS OF INCOME For the nine months and three months ended May 31, 2000 and 1999 (Unaudited) (Dollars in thousands, except per share data)

The above earnings and cash dividends paid per share of common stock are based upon the 7,520,100 shares outstanding during each period. See accompanying notes. -5- ILM SENIOR LIVING, INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the nine months ended May 31, 2000 and 1999 (Unaudited) (Dollars in thousands, except per share data)

See accompanying notes. -6- ILM SENIOR LIVING, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS For the nine months ended May 31, 2000 and 1999 (Unaudited) (Dollars in thousands)

See accompanying notes. -7- ILM SENIOR LIVING, INC. Notes to Consolidated Financial Statements (Unaudited) 1. GENERAL The accompanying consolidated financial statements, footnotes and discussions should be read in conjunction with the consolidated financial statements and footnotes contained in ILM Senior Living, Inc.'s (the "Company") Annual Report on Form 10-K for the fiscal year ended August 31, 1999. In the opinion of management, the accompanying interim consolidated financial statements, which have not been audited, reflect all adjustments necessary to present fairly the results for the interim periods. All of the accounting adjustments reflected in the accompanying interim consolidated financial statements are of a normal recurring nature. The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in accordance with U.S. generally accepted accounting principles for interim financial information, 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, 2000 and revenues and expenses for each of the nine- and three-month periods ended May 31, 2000 and 1999. Actual results may differ from the estimates and assumptions used. Certain numbers in the prior period's financial statements have been reclassified to conform to the current period's presentation. The results of operations for the nine-month period ended May 31, 2000, are not necessarily indicative of the results that may be expected for the year ending August 31, 2000. The Company was incorporated on March 6, 1989 under the laws of the State of Virginia as a Virginia finite-life corporation, formerly PaineWebber Independent Mortgage Fund, Inc. On June 21, 1989, the Company sold to the public in a registered initial offering 7,520,100 shares of common stock, $.01 par value. The Company received capital contributions of $75,201,000, of which $201,000 represented the sale of 20,100 shares to an affiliate at that time, PaineWebber Group, Inc. ("PaineWebber"). For discussion purposes, the term "PaineWebber" will refer to PaineWebber Group, Inc. and all affiliates that provided services to the Company in the past. The Company elected to qualify and be taxed as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended, for each taxable year of operations. The Company originally invested the net proceeds of the initial public offering in eight participating mortgage loans secured by senior housing facilities located in seven states ("Senior Housing Facilities"). All of the loans made by the Company were originally to Angeles Housing Concepts, Inc. ("AHC"), as mortgagor, a company specializing in the development, acquisition and operation of Senior Housing Facilities and guaranteed by AHC's corporate parent, Angeles Corporation ("Angeles"). ILM Holding, Inc. ("ILM Holding"), a majority-owned subsidiary of the Company, now holds title to the eight Senior Housing Facilities, which comprise the balance of the operating investment properties on the accompanying consolidated balance sheets, subject to certain mortgage loans payable to the Company. Such mortgage loans and the related interest expense are eliminated in the consolidation of the financial statements of the Company. The Company made charitable gifts of one share of the preferred stock in ILM Holding to each of 111 charitable organizations so that ILM Holding would meet the stock ownership requirements of a REIT as of January 30, 1997. The preferred stock has a liquidation preference of $1,000 per share plus any accrued and unpaid dividends. Dividends on the preferred stock accrue at a rate of 8% per annum on the original $1,000 liquidation preference and are cumulative from the date of issuance. Since ILM Holding is not expected to have sufficient cash flow in the foreseeable future to make the required dividend payments, it is anticipated that dividends will accrue and be paid at liquidation of ILM Holding. Cumulative dividends accrued as of May 31, 2000 on the preferred stock in ILM Holding totaled approximately $30,000. -8- ILM SENIOR LIVING, INC. Notes to Consolidated Financial Statements (Unaudited) (continued) 1. GENERAL (CONTINUED) As part of the fiscal 1994 settlement agreement with AHC, ILM Holding retained AHC as the property manager for all of the Senior Housing Facilities pursuant to the terms of a management agreement. The management agreement with AHC was terminated in July 1996. Subsequent to the effective date of the settlement agreement with AHC, in order to maximize the potential returns to the Company's existing Shareholders while maintaining its qualification as a REIT under the Internal Revenue Code, the Company formed a new corporation, ILM I Lease Corporation ("Lease I"), for the purpose of operating the Senior Housing Facilities under the terms of a facilities lease agreement (the "Facilities Lease Agreement"). All of the shares of capital stock in Lease I were distributed to the holders of record of the Company's common stock and the Senior Housing Facilities were leased to Lease I effective September 1, 1995 (see Note 2 for a description of the Facilities Lease Agreement). Lease I is a public company subject to the reporting obligations of the Securities and Exchange Commission. All responsibility for the day-to-day management of the Senior Housing Facilities, including administration of the property management agreement with AHC, was transferred to Lease I. On July 29, 1996, the management agreement with AHC was terminated and Lease I retained Capital Senior Management 2, Inc. ("Capital") to be the new property manager of its Senior Housing Facilities pursuant to a management agreement (the "Management Agreement"). Lawrence A. Cohen, who, through July 28, 1998, served as President, Chief Executive Officer and Director of the Company and a Director of Lease I, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer of Capital Senior Living Corporation. As a result, through July 28, 1998, Capital was considered a related party. AGREEMENT AND PLAN OF MERGER WITH CAPITAL SENIOR LIVING CORPORATION On February 7, 1999, the Company entered into an agreement and plan of merger, which was amended and restated on October 19, 1999, with Capital Senior Living Corporation ("CSLC"), the corporate parent of Capital, and certain affiliates of Capital. On April 18, 2000, the Company entered into a First Amendment to the Amended and Restated Agreement and Plan of Merger dated October 19, 1999. As stated in the April 18th amendment, if the merger is consummated, the Shareholders of the Company will receive all-cash merger consideration of approximately $11.63 per share compared to the previous merger consideration of $12.90 per share. The Company was advised by CSLC that, due to deteriorating conditions in the senior living industry and consequent decline in the loan value of the Company's properties, Capital was unable to raise sufficient financing to fund the original purchase price. CSLC has reported to the Company that it has obtained a signed financing commitment for substantially all of the merger consideration. In addition, the amended agreement requires CSLC to agree to pay the Company increased termination fees in certain circumstances. Further, the Company required CSLC to agree to reduce the amount of fees and expenses it would receive upon termination of the merger in certain circumstances. At a special meeting of Shareholders on June 22, 2000, holders of more than two-thirds of the outstanding shares of the Company's common stock voted in favor of approval of the proposed Amended and Restated Agreement and Plan of Merger dated October 19, 1999, as amended on April 18, 2000. Subject to the satisfaction of certain conditions, consummation of the merger is expected to occur on or about July 31, 2000. The agreement presently provides that it may be terminated if the merger is not consummated by September 30, 2000. Holders of Company common stock will have no dissenters' rights in the merger. In connection with the merger, the Company has agreed to cause ILM Holding to cancel and terminate the Facilities Lease Agreement with Lease I on the date of consummation of the merger. The Facilities Lease Agreement was extended on a month-to-month basis as of December 31, 1999, beyond its original expiration date of December 31, 1999. If the merger is not consummated, it is anticipated that the Facilities Lease Agreement will remain in full force and effect pursuant to its terms. There can be no assurance as to whether the merger will be consummated or, if consummated, as to the timing thereof. -9- ILM SENIOR LIVING, INC. Notes to Consolidated Financial Statements (Unaudited) (continued) 2. OPERATING INVESTMENT PROPERTIES SUBJECT TO FACILITIES LEASE AGREEMENT At May 31, 2000, through its consolidated subsidiary, the Company owned eight Senior Housing Facilities. The name, location and size of the properties are as set forth below:

(1) The acquisition of Villa Santa Barbara was financed jointly by the Company and an affiliated entity, ILM II Senior Living, Inc ("ILM II"). All amounts generated from Villa Santa Barbara are equitably apportioned between the Company, together with its consolidated subsidiary, and ILM II, together with its consolidated subsidiary, generally 25% and 75%, respectively. Villa Santa Barbara is owned 25% by ILM Holding and 75% by ILM II Holding as tenants in common. Upon the sale of the Company or ILM II, arrangements would be made to transfer the Santa Barbara facility to the selling joint tenant (or one of its subsidiaries). The property was extensively renovated in 1995. (2) Rentable units represent the number of apartment units and is a measure commonly used in the real estate industry. Resident capacity equals the number of bedrooms contained within the apartment units and corresponds to measures commonly used in the healthcare industry. Subsequent to the effective date of the Settlement Agreement with AHC, in order to maximize the potential returns to the existing Shareholders while maintaining the Company's qualification as a REIT under the Internal Revenue Code, the Company formed a new corporation, Lease I, for the purpose of operating the Senior Housing Facilities under the terms of a Facilities Lease Agreement dated September 1, 1995 between the Company's consolidated affiliate, ILM Holding, as owner of the properties and lessor (the "Lessor"), and Lease I as lessee (the "Lessee"). The facilities lease is a "triple-net" lease whereby the Lessee pays all operating expenses, governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM Holding, as the Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. During the term of the Facilities Lease Agreement, which was extended on a month-to-month basis as of December 31, 1999, beyond its original expiration date of December 31, 1999, Lease I pays annual base rent for the use of all of the Senior Housing Facilities in the aggregate amount of $6,364,800 per year. Lease I also pays variable rent, on a quarterly basis, for each facility in an amount equal to 40% of the excess of aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $16,996,000. Variable rent was $929,000 and $313,000 for the nine- and three-month periods ended May 31, 2000, respectively, compared to $859,000 and $295,000 for the nine- and three-month periods ended May 31, 1999, respectively. -10- ILM SENIOR LIVING, INC. Notes to Consolidated Financial Statements (Unaudited) (continued) 3. RELATED PARTY TRANSACTIONS Lease I has retained Capital to be the property manager of the Senior Housing Facilities and the Company has guaranteed the payment of all fees due to Capital pursuant to the Management Agreement which commenced on July 29, 1996. Lawrence A. Cohen, who, through July 28, 1998, served as President, Chief Executive Officer and Director of the Company and a Director of Lease I, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer of Capital Senior Living Corporation. As a result, through July 28, 1998, Capital was considered a related party. For the nine-month periods ended May 31, 2000 and 1999, Capital earned property management fees from Lease I of $776,000, and $778,000, respectively. For the three-month periods ended May 31, 2000 and 1999, Capital earned property management fees from Lease I of $230,000 and $241,000, respectively. In connection with the Agreement and Plan of Merger discussed in Note 1, the Management Agreement with Capital will be terminated upon consummation of the merger. On September 18, 1997, Lease I entered into an agreement with Capital Senior Development, Inc., an affiliate of Capital, to manage the development process for the potential expansion of several of the Senior Housing Facilities. Capital Senior Development, Inc. will receive a fee equal to 7% of the total development costs of these expansions if they are pursued. The Company will reimburse Lease I for all costs related to these potential expansions, including fees to Capital Senior Development, Inc. During fiscal 2000 and 1999, Capital Senior Development, Inc. earned no fees from Lease I for managing pre-construction development activities for potential expansions of the Senior Housing Facilities. Jeffry R. Dwyer, Secretary and Director of the Company, is a shareholder of Greenberg Traurig, Counsel to the Company and its affiliates since 1997. For the nine-month periods ended May 31, 2000 and 1999, Greenberg Traurig earned fees from the Company of $902,000 and $1,027,000, respectively. For the three-month periods ended May 31, 2000 and 1999, Greenberg Traurig earned fees from the Company of $309,000 and $651,000, respectively. Accounts receivable - related party at May 31, 2000 and August 31, 1999, represent amounts due from an affiliated company, Lease I, principally for variable rent. Accounts payable - related party at May 31, 2000 and August 31, 1999, represent accrued legal fees due to Greenberg Traurig, Counsel to the Company and its affiliates and a related party, as described above. -11- ILM SENIOR LIVING, INC. Notes to Consolidated Financial Statements (Unaudited) (continued) 4. LEGAL PROCEEDINGS AND CONTINGENCIES FELDMAN LITIGATION On May 8, 1998 Andrew A. Feldman and Jeri Feldman, as Trustees for the Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990, commenced a purported class action on behalf of that trust and all other shareholders of the Company and ILM II in the Supreme Court of the State of New York, County of New York naming the Company, ILM II and their Directors as defendants. The class action complaint alleged that the Directors engaged in wasteful and oppressive conduct and breached fiduciary duties in preventing the sale or liquidation of the assets of the Company and ILM II, diverting certain of their assets. The complaint sought compensatory damages in an unspecified amount, punitive damages, the judicial dissolution of the Company and ILM II, an order requiring the Directors to take all steps to maximize Shareholder value, including either an auction or liquidation, and rescinding certain agreements, and attorney's fees. On October 15, 1999, the parties entered into a Stipulation of Settlement and filed it with the Court, which approved the settlement, by order dated October 21, 1999. In issuing that order the Court entered a final judgment dismissing the action and all non-derivative claims of the settlement class against the defendants with prejudice. This litigation was settled at no cost to the Company and ILM II. As part of the settlement, Capital Senior Living Corporation increased its proposed merger consideration payable to the Company and ILM II shareholders and is also responsible for a total of approximately $1.1 million in plaintiffs' attorneys fees and expenses if the proposed merger is consummated. If the proposed merger is not consummated and if the Company and ILM II were to consummate an extraordinary transaction with a third party, then the Company and ILM II would be responsible for the plaintiffs' attorneys fees and expenses. 5. CONSTRUCTION LOAN FINANCING During 1999, the Company secured a construction loan facility with a major bank that provides the Company with up to $24.5 million to fund the capital costs of potential expansion programs. The construction loan facility is secured by a first mortgage of the Senior Housing Facilities and collateral assignment of the Company's leases of such properties. The loan expires on December 31, 2000, with possible extensions through September 29, 2003. Principal is due at expiration. Interest is payable monthly at a rate equal to LIBOR plus 1.10% or Prime plus 0.5%. Amounts outstanding under the loan at May 31, 2000, were approximately $2.1 million. Loan origination fees of $272,000 were paid in connection with this loan facility and are being amortized over the term of the loan. Capitalized interest at May 31, 2000, and August 31, 1999, was $123,093 and $31,233. 6. SUBSEQUENT EVENTS On June 2, 2000, the Company's Board of Directors unanimously agreed not to declare any dividends on shares of the Company's common stock for the remainder of Fiscal Year 2000. The Board cited transaction costs previously incurred and to be incurred through closing of the pending merger with Capital and the establishment of a reserve to fund the short-term operations of the Company's senior living communities if the proposed merger with Capital is not consummated. The Company also announced that, should the merger not be consummated, its Board of Directors would reevaluate its dividend policy. On June 2, 2000, the Company caused Holding I to notify Lease I that the Facilities Lease Agreement would terminate on the date of consummation of the pending merger of the Company with CSLC. Subject to the satisfaction of certain conditions and the receipt of requisite approvals, consummation of the merger is expected to occur on or about July 31, 2000. If the merger is not consummated, it is anticipated that the Facilities Lease Agreement will remain in full force and effect pursuant to its terms. On June 22, 2000, at a special meeting of Shareholders, holders of more than two-thirds of the outstanding shares of the Company's common stock voted in favor of approval of the proposed Amended and Restated Agreement and Plan of Merger dated October 19, 1999, as amended on April 18, 2000. -12- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Company offered shares of its common stock to the public from June 21, 1989 to July 21, 1989 pursuant to a Registration Statement filed under the Securities Act of 1933. Capital contributions of $75,201,000 were received by the Company (including $201,000 contributed by PaineWebber) and, after deducting selling expenses and offering costs and allowing for adequate cash reserves, approximately $62.8 million was available to be invested in participating first mortgage loans secured by Senior Housing Facilities. The Company originally invested the net proceeds of the initial public offering in eight participation mortgage loans secured by Senior Housing Facilities located in seven different states. All of the loans made by the Company were originally with AHC. As previously reported, AHC defaulted on the scheduled mortgage loan payments due to the Company on March 1, 1993. Its parent company, Angeles, subsequently filed for bankruptcy. In fiscal 1994, a Settlement Agreement was executed whereby ownership of the properties was transferred from AHC to certain designated affiliates of the Company which were majority owned by the Company. Subsequently, these affiliates were merged into ILM Holding, which is majority owned by the Company. ILM Holding holds title to the eight Senior Housing Facilities which comprise the balance of operating investment properties in the accompanying consolidated balance sheets, subject to certain mortgage loans payable to the Company. As part of the fiscal 1994 Settlement Agreement with AHC, ILM Holding retained AHC as the property manager for all of the Senior Housing Facilities pursuant to the terms of the Agreement. As discussed further below, the Agreement with AHC was terminated in July 1996. Subsequent to the effective date of the Settlement Agreement with AHC, in order to maximize the potential returns to the Company's existing Shareholders while maintaining its qualification as a REIT under the Internal Revenue Code, the Company formed a new corporation, Lease I, for the purpose of operating the Senior Housing Facilities under the terms of a Facilities Lease Agreement. As of August 31, 1995, Lease I, which is taxable as a so-called "C" corporation and not as a REIT, was a wholly-owned subsidiary of the Company. On September 1, 1995 the Company, after receiving the required regulatory approval, distributed all of the shares of capital stock of Lease I to the holders of record of the Company's common stock. One share of common stock of Lease I was issued for each full share of the Company's common stock held. Prior to the distribution, the Company capitalized Lease I with $700,000 from existing cash reserves, which was an amount estimated to provide Lease I with necessary working capital. The Facilities Lease Agreement is between the Company's consolidated affiliate, ILM Holding, as owner of the Senior Housing Facilities and Lessor, and Lease I as Lessee. The facilities lease is a "triple-net" lease whereby the Lessee pays all operating expenses, governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM Holding, as the Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. Pursuant to the Facilities Lease Agreement, which expired on December 31, 1999, but has been extended on a month-to-month basis, Lease I pays annual base rent for the use of all of the Senior Housing Facilities in the aggregate amount of $6,364,800. Lease I also pays variable rent, on a quarterly basis, for each Senior Housing Facility in an amount equal to 40% of the excess, if any, of the aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $16,996,000. Variable rental income for the nine- and three-month periods ended May 31, 2000 was $929,000 and $313,000, respectively, compared to variable rental income of $859,000 and $295,000 for the nine- and three-month periods ended May 31, 1999, respectively. The Company completed its restructuring plans by qualifying ILM Holding as a REIT for Federal tax purposes. In connection with these plans, on November 21, 1996, the Company requested that PaineWebber sell all of its stock in ILM Holding to the Company for a price equal to the fair market value of the 1% economic interest in ILM Holding represented by the common stock. On January 10, 1997, this transfer of the common stock of ILM Holding was completed at an agreed upon fair value of $46,000, representing a $39,000 increase in fair value. This increase in fair value is based on the increase in values of the Senior Housing Facilities which occurred between April 1994 and January 1996, as supported by independent appraisals. With this transfer completed, effective January 23, 1997, ILM -13- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL (CONTINUED) Holding recapitalized its common stock and preferred stock by replacing the outstanding shares with 50,000 shares of new common stock and 275 shares of non-voting, 8% cumulative preferred stock issued to the Company (the "Preferred Stock"). The number of authorized shares of preferred stock and common stock in ILM Holding were also increased as part of the recapitalization. Following the recapitalization, the Company made charitable gifts of one share of the Preferred Stock in ILM Holding to each of 111 charitable organizations so that ILM Holding would meet the stock ownership requirements of a REIT as of January 30, 1997. The Preferred Stock has a liquidation preference of $1,000 per share plus any accrued and unpaid dividends. Dividends on the Preferred Stock accrue at a rate of 8% per annum on the original $1,000 liquidation preference and are cumulative from the date of issuance. It is anticipated that dividends will accrue and be paid at liquidation. Cumulative dividends accrued as of May 31, 2000 on the Preferred Stock in ILM Holding totaled approximately $30,000. The assumption of ownership of the Senior Housing Facilities through ILM Holding, which was organized as a so-called "C" corporation for tax purposes at the time of assumption, has resulted in a possible future tax liability which would be payable upon the ultimate sale of the Senior Housing Facilities (the "built-in gain tax"). The amount of such tax would be calculated based on the lesser of the total net gain realized from the sale transaction or the portion of the net gain realized upon a final sale which is attributable to the period during which the properties were held in a "C" corporation. Any future appreciation in the value of the Senior Housing Facilities subsequent to the conversion of ILM Holding to a REIT would not be subject to the built-in gain tax. The built-in gain tax would most likely not be incurred if the properties were to be held for a period of at least ten years from the date of the conversion of ILM Holding to a REIT. Although the Company originally anticipated holding the properties through December 31, 1999, pursuant to the Articles of Incorporation, the Board of Directors may defer the Company's scheduled liquidation date if in the opinion of a majority of the Directors the disposition of the Company's assets at such time would result in a material under-realization of the value of such assets; provided, however, that no such deferral may extend beyond December 31, 2014 absent amendment of the Company's Articles of Incorporation. The Company's Board of Directors voted to extend the term of the Company and the Facilities Lease Agreement with Lease I on a month-to-month basis commencing December 31, 1999. Based on management's estimate of the increase in values of the Senior Housing Facilities which occurred between April 1994 and January 1996, as supported by independent appraisals, ILM Holding would incur a sizeable tax if the Senior Housing Facilities were sold. Based on this increase of values during the time that ILM Holding was operated as a regular "C" corporation, a sale within ten years of the date of the conversion of ILM Holding to a REIT could result in a built-in gain tax of as much as $2.9 million, which could be reduced by $2.45 million using available net operating loss carryforwards of ILM Holding of approximately $7.2 million. Because the ownership of the assets of ILM Holding was expected to be transferred to the Company or its wholly-owned subsidiary, ILM Holding was capitalized with funds to provide it with working capital only for a limited period of time. At the present time, ILM Holding is not expected to have sufficient cash flow during fiscal year 2000 to (i) meet its obligations to make the debt service payments due under the loans and (ii) pay for capital improvements and structural repairs in accordance with the terms of the Facilities Lease Agreement. Although ILM Holding is not expected to fully fund its scheduled debt service payments to the Company, the current values of the Senior Housing Facilities are well in excess of the mortgage principal amounts plus accrued interest at May 31, 2000. As a result, the Company is expected to receive the full amount that would be due under the loans upon sale of the Senior Housing Facilities. -14- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL (CONTINUED) AGREEMENT AND PLAN OF MERGER WITH CAPITAL SENIOR LIVING CORPORATION On February 7, 1999, the Company entered into an agreement and plan of merger, which was amended and restated on October 19, 1999, with Capital Senior Living Corporation ("CSLC"), the corporate parent of Capital, and certain affiliates of Capital. On April 18, 2000, the Company entered into a First Amendment to the Amended and Restated Agreement and Plan of Merger dated October 19, 1999. As stated in the April 18th amendment, if the merger is consummated, the Shareholders of the Company will receive all-cash merger consideration of approximately $11.63 per share compared to the previous merger consideration of $12.90 per share. The Company was advised by CSLC that, due to deteriorating conditions in the senior living industry and consequent decline in the loan value of the Company's properties, Capital was unable to raise sufficient financing to fund the original purchase price. CSLC has reported to the Company that it has obtained a signed financing commitment for substantially all of the merger consideration. In addition, the amended agreement requires CSLC to agree to pay the Company increased termination fees in certain circumstances. Further, the Company required CSLC to agree to reduce the amount of fees and expenses it would receive upon termination of the merger in certain circumstances. At a special meeting of Shareholders on June 22, 2000, holders of more than two-thirds of the outstanding shares of the Company's common stock voted in favor of approval of the proposed Amended and Restated Agreement and Plan of Merger dated October 19, 1999, as amended on April 18, 2000. Subject to the satisfaction of certain conditions, consummation of the merger is expected to occur on or about July 31, 2000. The agreement presently provides that it may be terminated if the merger is not consummated by September 30, 2000. Holders of Company common stock will have no dissenters' rights in the merger. In connection with the merger, the Company has agreed to cause ILM Holding to cancel and terminate the Facilities Lease Agreement with Lease I on the date of consummation of the merger. The Facilities Lease Agreement was extended on a month-to-month basis as of December 31, 1999, beyond its original expiration date of December 31, 1999. If the merger is not consummated, it is anticipated that the Facilities Lease Agreement will remain in full force and effect pursuant to its terms. There can be no assurance as to whether the merger will be consummated or, if consummated, as to the timing thereof. -15- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES Occupancy levels for the eight properties in which the Company has invested averaged 90% for the three-month period ended May 31, 2000, compared to 95% for the three-month period ended May 31, 1999. The Company's net operating cash flow is expected to be relatively stable and predictable due to the structure of the Facilities Lease Agreement. The annual base rental payments owed to ILM Holding are $6,364,800 and will remain at that level for the remainder of the lease term. In addition, the Senior Housing Facilities are currently generating gross revenues which are in excess of the specified threshold in the variable rent calculation, as discussed further above, which became effective in January 1997. The Company and Lease I have been pursuing the potential for future expansion of several of the Senior Housing Facilities which are located in areas that have particularly strong markets for senior housing to increase cash flow and shareholder value. Potential expansion candidates include the facilities located in Raleigh, North Carolina, East Lansing, Michigan, Omaha, Nebraska, Peoria, Illinois and Hot Springs, Arkansas. Approximately two acres of land located adjacent to the East Lansing facility and approximately two-and-one-half acres of land located adjacent to the Omaha facility were acquired by ILM Holding during the quarter ended November 30, 1997. In addition, an agreement has been obtained by ILM Holding to purchase approximately five acres of land located adjacent to the Peoria facility. The Hot Springs facility already includes a vacant land parcel of approximately two acres which could accommodate an expansion of the existing facility or the construction of a new free-standing facility. Preliminary feasibility evaluations have been completed for all of these potential expansions and pre-construction design and construction-cost evaluations are underway for expansions of the facilities located in Raleigh and Omaha. The Company secured a construction loan facility with a major bank that provides the Company with up to $24.5 million to fund the capital costs of the potential expansion programs. The construction loan facility is secured by a first mortgage of the Senior Housing Facilities and collateral assignment of the Company's leases of such Senior Housing Facilities. The loan expires December 31, 2000, with possible extensions through September 29, 2003. Principal is due at expiration. Interest is payable monthly at a rate equal to LIBOR plus 1.10% or Prime plus 0.5%. Loan origination costs in connection with this loan facility are being amortized over the life of the loan. On June 7, 1999, the Company borrowed approximately $2.1 million under the construction loan facility to fund the pre-construction capital costs, incurred through April 1999, of the potential expansions of the Senior Housing Facilities. As of May 31, 2000, approximately $22.4 million of the construction loan facility is unused and available. At May 31, 2000, the Company had cash and cash equivalents of $1,097,000 compared to $2,615,000 at August 31, 1999. Remaining cash will be used for the working capital requirements of the Company, along with the investment in the properties owned by ILM Holding for certain capital improvements and transaction costs associated with the merger. If the merger is not consummated, future capital improvements could be financed from operations or through borrowings, depending on the magnitude of the improvements, the availability of financing and the Company's incremental borrowing rate. The source of future liquidity and dividends to the Shareholders is expected to be through facilities lease payments from Lease I, interest income earned on invested cash reserves and proceeds from the future sales of the underlying operating investment properties. Such sources of liquidity are expected to be adequate to meet the Company's operating requirements on both a short-term and long-term basis. The Company generally will be obligated to distribute annually at least 95% of its taxable income to its shareholders in order to continue to qualify as a REIT under the Internal Revenue Code. While the Company has potential liabilities pending due to ongoing litigation against the Company, the eventual outcome of this litigation cannot presently be determined. The Company will vigorously defend against all claims made against it and, at this time, it is not certain that the Company will have ultimate responsibility for any such claims. -16- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MARKET RISK The Company believes its market risk is immaterial. -17- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS NINE MONTHS ENDED MAY 31, 2000 VERSUS NINE MONTHS ENDED MAY 31, 1999 Net income increased $573,000 or 26.1% to $2,766,000 for the nine-month period ended May 31, 2000 compared to $2,193,000 for the nine-month period ended May 31, 1999. Total revenue was $5,745,000 representing an increase of $59,000 or 1.0%, compared to $5,686,000 for the same period of the prior year. Rental and other income increased $55,000, or 1.0%, to $5,693,000 from $5,638,000, due to increased rental income earned pursuant to the terms of the Facilities Lease Agreement. Total expenses decreased $514,000 or 14.7%, to $2,979,000 for the nine-month period ended May 31, 2000, compared to $3,493,000 for the nine-month period ended May 31, 1999. This overall decrease in expenses is primarily attributable to a $375,000 or 20.0% decrease in professional fees as the result of decreased use of legal, financial and advisory professionals who were engaged to assist the Company with the agreement and plan of merger with Capital Senior Living Corporation (as discussed in Note 1 to the financial statements). In addition, legal fees associated with the construction loan facility, also an expense of the prior year, were not repeated this year contributing to the overall decrease in professional fees when compared to 1999. Other decreases include an $87,000 or 24.1% decrease in general and administrative costs due to decreased insurance costs of $61,000 or 33.2%; an $11,000 or 43.1% decrease in investor servicing costs; and decreased state tax expense of $14,000 or 35.3%. Amortization expense decreased $57,000 or 25.9% as the amortization of mortgage placement fees was completed as of January 2000. THREE MONTHS ENDED MAY 31, 2000 VERSUS THREE MONTHS ENDED MAY 31, 1999 Net income increased $413,000 or 77.6%, to $945,000 for the third quarter ended May 31, 2000 compared to $532,000 for the third quarter ended May 31, 1999. Total revenue was $1,917,000 representing an increase of $31,000 or 1.6%, compared to $1,886,000 for the same period of the prior year. Rental and other income increased $28,000 or 1.5%, to $1,905,000 from $1,877,000, due to increased rental income earned pursuant to the terms of the Facilities Lease Agreement. Total expenses decreased $382,000, or 28.2%, to $972,000 for the quarter ended May 31, 2000 compared to $1,354,000 for the quarter ended May 31, 1999. This decrease in expenses is primarily attributable to a decrease of $345,000 or 41.4% in professional fees due to decreased use of legal, financial and advisory professionals who were engaged to assist the Company with the agreement and plan of merger with Capital Senior Living Corporation (as discussed in Note 1 to the financial statements). In addition, legal fees associated with the construction loan facility, an expense of the prior year, were not repeated this year, contributing to the overall decrease in professional fees when compared to 1999. A $50,000 or 68.5% decrease in amortization expense is the result of mortgage placement fees becoming fully amortized as of January 2000. -18- ILM SENIOR LIVING, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING INFORMATION CERTAIN STATEMENTS INCLUDED IN THIS QUARTERLY REPORT ON FORM 10-Q ("QUARTERLY REPORT") CONSTITUTE "FORWARD-LOOKING STATEMENTS" INTENDED TO QUALIFY FOR THE SAFE HARBORS FROM LIABILITY ESTABLISHED BY SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES ACT OF 1934, AS AMENDED (THE "EXCHANGE ACT"). THESE FORWARD-LOOKING STATEMENTS GENERALLY CAN BE IDENTIFIED AS SUCH BECAUSE THE CONTEXT OF THE STATEMENT WILL INCLUDE WORDS SUCH AS "BELIEVES," "COULD," "MAY," "SHOULD," "ENABLE," "LIKELY," "PROSPECTS," "SEEK," "PREDICTS," "POSSIBLE," "FORECASTS," "PROJECTS," "ANTICIPATES," "EXPECTS" AND WORDS OF ANALOGOUS IMPORT AND CORRELATIVE EXPRESSIONS THEREOF, AS WELL AS STATEMENTS PRECEDED OR OTHERWISE QUALIFIED BY: "THERE CAN BE NO ASSURANCE" OR "NO ASSURANCE CAN BE GIVEN." SIMILARLY, STATEMENTS THAT DESCRIBE THE COMPANY'S FUTURE PLANS, OBJECTIVES, STRATEGIES OR GOALS ALSO ARE FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS MAY ADDRESS FUTURE EVENTS AND CONDITIONS CONCERNING, AMONG OTHER THINGS, THE COMPANY'S CASH FLOWS, RESULTS OF OPERATIONS AND FINANCIAL CONDITION; THE CONSUMMATION OF ACQUISITION AND FINANCING TRANSACTIONS AND THE EFFECT THEREOF ON THE COMPANY'S BUSINESS, ANTICIPATED CAPITAL EXPENDITURES, PROPOSED OPERATING BUDGETS AND ACCOUNTING RESERVES; LITIGATION; PROPERTY EXPANSION AND DEVELOPMENT PROGRAMS OR PLANS; REGULATORY MATTERS; AND THE COMPANY'S PLANS, GOALS, STRATEGIES AND OBJECTIVES FOR FUTURE OPERATIONS AND PERFORMANCE. ANY SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN SUCH FORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO A NUMBER OF ASSUMPTIONS REGARDING, AMONG OTHER THINGS, GENERAL ECONOMIC, COMPETITIVE AND MARKET CONDITIONS. SUCH ASSUMPTIONS NECESSARILY ARE BASED ON FACTS AND CONDITIONS AS THEY EXIST AT THE TIME SUCH STATEMENTS ARE MADE, THE PREDICTION OR ASSESSMENT OF WHICH MAY BE DIFFICULT OR IMPOSSIBLE AND, IN ANY CASE, BEYOND THE COMPANY'S CONTROL. FURTHER, THE COMPANY'S BUSINESS IS SUBJECT TO A NUMBER OF RISKS THAT MAY AFFECT ANY SUCH FORWARD-LOOKING STATEMENTS AND ALSO COULD CAUSE ACTUAL RESULTS OF THE COMPANY TO DIFFER MATERIALLY FROM THOSE PROJECTED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. ALL FORWARD-LOOKING STATEMENTS CONTAINED IN THIS QUARTERLY REPORT ARE EXPRESSLY QUALIFIED IN THEIR ENTIRETY BY THE CAUTIONARY STATEMENTS IN THIS PARAGRAPH. MOREOVER, THE COMPANY DOES NOT INTEND TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS TO REFLECT ANY CHANGES IN GENERAL ECONOMIC, COMPETITIVE OR MARKET CONDITIONS AND DEVELOPMENTS BEYOND ITS CONTROL. READERS OF THIS QUARTERLY REPORT ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON ANY OF THE FORWARD-LOOKING STATEMENTS SET FORTH HEREIN AND THAT ACTUAL FUTURE RESULTS MAY DIFFER. -19- ILM SENIOR LIVING, INC. PART II-OTHER INFORMATION ITEM 1 THROUGH 5. NONE ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 27. Financial Data Schedule (b) Reports on Form 8-K: The Company filed a Current Report on Form 8-K dated June 2, 2000, reporting (1) the impending termination of the Facilities Lease Agreement between the Company and ILM I Lease Corporation; and (2) the Board of Director's decision regarding the declaration of dividends for the remainder of fiscal year 2000. The Company filed a Current Report on Form 8-K dated April 18, 2000, reporting that the Company had entered into the First Amendment to the Amended and Restated Agreement and Plan of Merger dated October 19, 1999, with Capital Senior Living Corporation. -20- ILM SENIOR LIVING, INC. SIGNATURES Pursuant to the requirements 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 SENIOR LIVING, INC. By: /s/ J. WILLIAM SHARMAN, JR. ---------------------------------- J. William Sharman, Jr. President and Director Dated: July 14, 2000 -21-

ILM SENIOR LIVING INC /VA 10-Q