Edgar Filing: FIVE STAR QUALITY CARE INC

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) of THE
SECURITIES EXCHANGE ACT OF 1934

(mark one)

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

For the fiscal year ended December 31, 2001

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-16817

FIVE STAR QUALITY CARE, INC.
(Exact name of the Registrant as specified in its Charter)

Maryland 04-3516029
(State or Other Jurisdiction of Incorporation or (IRS Employer
Organization) Identification No.)

400 Centre Street, Newton, Massachusetts 02458
(Address of Principal Executive Office) (Zip Code)

617-796-8387
(Registrant's Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) ofthe Act:

Title of Each Class Name of Each Exchange on Which Registered

Common Stock American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

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

The aggregate market value of the voting stock of the registrant held by
non-affiliates was $31.9 million based on $7.40 per share, the last reported
sale price of the shares of the registrant's common stock, $0.01 par value per
share (the "Common Shares"), on the American Stock Exchange on March 25, 2002.
For purposes of determining the aggregate market value of the registrant's
voting stock, 310,732.6 Common Shares held by the Directors and officers of the
registrant have been included in the number of shares held by affiliates. 35,000
Common Shares held by Senior Housing Properties Trust are included in the
aggregate total of 310,732.6 Common Shares.

Number of the registrant's Common Shares outstanding as of March 25, 2002:
4,624,334

DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Annual Report on Form 10-K is to be incorporated herein by
reference from the definitive Proxy Statement of Five Star Quality Care, Inc.
(referred to as "us", "we", "our" or the "Company") for its annual meeting of
shareholders currently scheduled to be held on May 7, 2002.

---------------

CERTAIN IMPORTANT FACTORS

We have made statements that are not historical facts in this Form 10-K
that constitute "forward-looking statements" as that term is defined in the
Private Securities Litigation Reform Act of 1995. These forward-looking
statements concern: our ability to successfully close our pending acquisition on
negotiated terms or at all; our ability to manage effectively the 56 facilities
we lease from Senior Housing Properties Trust and the communities we intend to
acquire; Marriott Senior Living Services, Inc.'s ability to manage effectively
the 31 retirement communities we lease from Senior Housing; our ability to
generate revenues in excess of our operating expenses and the sufficiency of
these and other resources to provide capital for our growth or to pay our
liabilities, including rent, as they come due; our ability to close our pending
$20 million line of credit; our ability to access additional capital to fund our
operations and growth; our ability to acquire and operate successfully
additional senior living businesses; our tax status as a "United States real
property holding corporation" assuming completion of our pending acquisition;
and our ability to operate successfully as a separate public company. Also,
whenever we use words such as "believe", "expect", "anticipate", "estimate" or
similar expressions, we are making forward-looking statements. Forward-looking
statements are not guaranteed to occur and involve risks and uncertainties. Our
expected results may not be achieved, and actual results may differ materially
from our expectations. Investors should not rely upon forward-looking statements
except as statements of our present intentions and of our present expectations
which may or may not occur. The accompanying information contained in this Form
10-K, including the information under the headings "Business and Properties" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", identifies other important factors that could cause such
differences.

FIVE STAR QUALITY CARE, INC.
2001 FORM 10-K ANNUAL REPORT

Table of Contents

Page

PART I

Items 1 & 2 Business and Properties....................................................................1
Item 3 Legal Proceedings.........................................................................19
Item 4 Submission of Matters to a Vote of Security Holders.......................................19

PART II

Item 5 Market for the Registrant's Common Equity and Related Shareholder Matters.................20
Item 6 Selected Financial Data...................................................................20
Item 7 Management's Discussion and Analysis of Financial Condition and Results of
Operations..............................................................................22
Item 7A Quantitative and Qualitative Disclosures About Market Risk................................27
Item 8 Financial Statements and Supplementary Data...............................................27
Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure......27

PART III

To be incorporated by reference from our definitive Proxy Statement for the
annual meeting of shareholders currently scheduled to be held on May 7, 2002,
which is expected to be filed not later than 120 days after the end of the our
fiscal year.

PART IV

Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K...........................28

Items 1 and 2. Business and Properties

GENERAL

We are in the business of operating senior living facilities, including
independent living and congregate care communities, assisted living facilities
and nursing homes. We lease and operate 56 senior living facilities. We lease 31
communities managed by Marriott Senior Living Services, Inc. ("Marriott"), a
subsidiary of Marriott International, Inc. Combined, these 87 facilities, which
we lease from Senior Housing Properties Trust ("Senior Housing"), include 4,060
independent living apartments, 1,766 assisted living suites, 294 special care
beds and 6,578 nursing beds; 59% of their revenues in 2001 was paid from
residents' private resources and 41% was paid by Medicare and Medicaid.

We have recently agreed to purchase five senior living communities from
ILM II Senior Living, Inc. and its subsidiary, ILM II Holding, Inc., which we
will own and operate. In combination with our existing facilities, these 92
facilities include 4,591 independent living apartments, 1,939 assisted living
suites, 294 special care beds and 6,578 nursing beds. Sixty percent of our pro
forma revenues from these 92 facilities in 2001 was paid from residents' private
resources and 40% was paid by Medicare and Medicaid:

FIVE STAR UNITS AFTER FIVE STAR REVENUES AFTER
COMPLETION OF PENDING ACQUISITION COMPLETION OF PENDING ACQUISITION

[Pie Chart [Pie Chart
6,578 nursing beds 49% Revenues from
4,591 indep. liv. apts. 35% private resources:
1,939 asst. liv. suites 14% $313 million 60%
294 spec. care beds 2%] Revenues from
Medicare/Medicaid
Programs:
$206 million 40%]

OUR BUSINESS AND GROWTH STRATEGY

Our growth strategy is to acquire facilities that provide high quality
services to residents who pay with private resources. In January 2002, we leased
31 senior living communities from Senior Housing. Approximately 88% of the
revenues from these communities is paid by residents from their private
resources. At the five communities we have agreed to acquire, all of the
revenues are paid by residents from private resources. Our nursing homes derive
a majority of their revenues from Medicare and Medicaid. In the future we may
decide to expand our nursing home operations; however, if we do so, we expect to
price such acquisitions at levels which take account of the increased risks
associated with Medicare and Medicaid revenues.

Our senior management team has significant experience in the senior
living industry. Although we have substantial lease obligations, we currently
have zero debt. We believe our relationship with our former parent company,
Senior Housing, may provide us with capital to finance some acquisitions. We
believe that this combination of our experienced management, our financial
position and our

relationship with Senior Housing will enable us to expand our operations and
compete successfully in the senior living industry.

OUR HISTORY

In July 2000, Senior Housing repossessed or acquired senior living
facilities from two former tenants. We were created by Senior Housing in 2000 as
a 100% subsidiary to conduct the businesses of operating these facilities. Under
the amended Internal Revenue Code, or IRC, Senior Housing was required to engage
an independent operating company to manage the healthcare businesses which we
owned. Barry M. Portnoy and Gerard M. Martin, our Managing Directors, formed
FSQ, Inc. to manage these facilities. During the past year, we believe the
combined operations at these 56 facilities have stabilized and improved.

In August 2001, Senior Housing agreed to acquire 31 Marriott senior
living facilities. The operations at these 31 communities are managed by
Marriott under long term management contracts. The operating income generated by
these facilities is not REIT qualified income under applicable IRC rules. To
complete this acquisition and remain a REIT, Senior Housing was required to
identify a taxable entity to lease these facilities.

On December 31, 2001, Senior Housing distributed substantially all of
our outstanding shares to its shareholders and we became a separate publicly
owned company listed on the American Stock Exchange. Pursuant to the transaction
agreement governing this spin-off: Senior Housing capitalized us with $50
million of equity, consisting of cash and working capital, primarily operating
receivables net of operating payables; we leased 56 facilities from Senior
Housing; we agreed to merge with FSQ, Inc. in order to acquire the personnel,
systems and assets necessary to operate these 56 facilities; and we agreed to
lease the 31 Marriott communities from Senior Housing when they were acquired by
Senior Housing.

Effective January 2, 2002, we completed our merger with FSQ, Inc. As
consideration for this merger Messrs. Portnoy and Martin each received 125,000
of our Common Shares.

On January 10, 2002, we entered a non-binding letter of intent for a
new, three year, $20 million credit line which will be secured by our accounts
receivable. Although the closing of this transaction is subject to customary
conditions, we expect it to occur on or before April 30, 2002.

On January 11, 2002, Senior Housing completed its acquisition of the 31
Marriott communities, and we leased these facilities from Senior Housing.

On January 23, 2002, we agreed to acquire five senior living
communities for $45.5 million. The closing of this acquisition is subject to
completion of various state licensing matters and other customary closing
conditions, and although we expect it to be completed during April 2002, we can
give no assurances that it will close.

TYPES OF FACILITIES

Our present business plan contemplates the leasing and management of
senior apartments, independent living apartments or congregate care communities,
assisted living facilities and nursing homes. Some facilities combine more than
one type of service in a single building or campus.

Senior Apartments. Senior apartments are marketed to residents who are
generally capable of caring for themselves. Residence is usually restricted on
the basis of age. Purpose built facilities may have special function rooms,
concierge services, high levels of security and assistance call systems for
emergency use. Tenants at these facilities who need healthcare or assistance
with the activities of daily living are expected to contract independently for
these services with home healthcare companies.

Independent Living Apartments. Independent living apartments, or
congregate care communities as they are sometimes called, also provide high
levels of privacy to residents and require residents to be capable of relatively
high degrees of independence. Unlike a senior apartment facility, an independent
living apartment usually bundles several services as part of a regular monthly
charge-for example, one or two meals per day in a central dining room, weekly
maid service and a social director. Additional services are generally available
from staff employees on a fee-for-service basis. In some congregate care
communities, separate parts of the facility are dedicated to assisted living or
nursing services.

Assisted Living Facilities. Assisted living facilities are typically
comprised of one bedroom suites which include private bathrooms and efficiency
kitchens. Services bundled within one charge usually include three meals per day
in a central dining room, daily housekeeping, laundry, medical reminders and 24
hour availability of assistance with the activities of daily living such as
dressing and bathing. Professional nursing and healthcare services are usually
available at the facility on call or at regularly scheduled times.

Nursing Homes. Nursing homes generally provide extensive nursing and
healthcare services similar to those available in hospitals, without the high
costs associated with operating theaters, emergency rooms or intensive care
units. A typical purpose built nursing home includes mostly two-bed units with a
separate bathroom in each unit and shared dining and bathing facilities. Some
private rooms are often available for those residents who can afford to pay
higher rates or for patients whose medical conditions require segregation.
Nursing homes are generally staffed by licensed nursing professionals 24 hours
per day.

During the past few years, nursing home operators have faced two
significant business challenges. First, the rapid expansion of the assisted
living industry which started in the early 1990s has attracted a number of
residents away from nursing homes. This was especially significant because the
residents who chose assisted living facilities often previously had been the
most profitable residents in the nursing homes. These residents required a
lesser amount of care and were able to pay higher private rates rather than
government rates.

The second major challenge arose as a result of Medicare and Medicaid
cost containment laws, particularly 1997 federal legislation that required the
Medicare program to implement a prospective payment program for various subacute
services provided in nursing homes. Implementation of this Medicare prospective
payment program began on July 1, 1998. Prior to the prospective payment program,
Medicare generally paid nursing home operators based upon audited costs for
services provided. The new prospective payment system sets Medicare rates based
upon government estimated costs of treating specified medical conditions.
Although it is possible that a nursing home may increase its profit if it is
able to provide services at below average costs, we believe that the effect of
the Medicare prospective payment system has been and will be to reduce the
profitability of Medicare services in nursing homes. This belief is based upon
our observation of the impact of similar Medicare changes that were implemented
for hospitals during the 1980s and the large number of bankruptcies which have
occurred in the nursing home industry since the implementation of the Medicare
prospective payment system began.

OUR SENIOR LIVING FACILITIES

Assuming we close our pending acquisition of five communities, we will
lease or operate 92 senior living facilities: five facilities which we expect to
own and operate directly; 56 facilities included in one lease which we operate
directly; and 31 communities included in a second lease which are managed by
Marriott:

No. of Units Year ended December 31, 2001
-------------------------------------------------- ----------------------------
Independent Assisted Specialty
Living Living Care Nursing
Ownership Apartments Suites Beds Beds Total Rent Revenues
--------- ---------- ------ ---- ---- ----- ---- --------
($ in thousands)

Pending acquisition (5 facilities
owned and operated by us) .... 531 173 -- -- 704 N/A $ 14,194(2)
Senior Housing Lease No. 1 (56
facilities operated by us).... 79 153 -- 4,979 5,211 $ 7,000 227,044
Senior Housing Lease No. 2 (31
facilities managed by
Marriott) .................... 3,981 1,613 294 1,599 7,487 63,000(1) 277,461
----- ----- --- ----- ------
Total units: .................... 4,591 1,939 294 6,578 13,402

(1) In addition to the $63 million of rent, we are required to pay a percentage of our gross revenue as an escrowed reserve for
recurring capital expenditures. In 2001 this pro forma amount was $7.4 million.

(2) For the twelve months ended November 30, 2001.

PENDING ACQUISITION

In January 2002, we agreed to purchase five senior living communities
from ILM II Senior Living, Inc. and its subsidiary ILM II Holding, Inc. Our
acquisition of these five communities is subject to completion of various state
licensing matters and other customary closing conditions. At this time we expect
to own and operate these communities directly. In the future we may decide to
finance these properties with Senior Housing or another third party. These five
communities contain 704 living units and are located in five states. The
following table provides additional information about these five communities and
their current operations:

Percent of
revenues from
No. private pay
Location of units Type of units Occupancy (1) Revenues (2) sources
--------------------------------------------------------------------------------------------------------------------------
($ in thousands)

1. Stockton, CA......................... 84 ind. liv. apts.
80 asst. liv. suites
---
164 total units 94% $3,406 100%

2. Ft. Myers, FL........................ 186 ind. liv. apts.
20 asst. liv. suites
---
206 total units 90% 4,107 100%

3. Overland Park, KS.................... 141 ind. liv. apts. 91% 2,887 100%

4. Florissant, MO....................... 120 ind. liv. apts. 81% 1,974 100%

5. Omaha, NE............................ 73 asst. liv. suites 82% 1,820 100%
---

Totals: 5 communities in 5 states....... 531 ind. liv. apts.
173 asst. liv. suites
--- ---------
704 units 88% $14,194 100%
-----------

(1) As of November 30, 2001.

(2) For the twelve months ended November 30, 2001.

SENIOR HOUSING LEASE NO. 1 FACILITIES

We lease and operate 56 senior living facilities which are owned by
Senior Housing. These 56 facilities include 54 nursing homes and two assisted
living facilities; four of the nursing homes also contain some assisted living
units or independent living apartments. These 56 facilities have 5,211 beds or
living units and they are located in 12 states. The following table provides
additional information about these facilities and their current operations as of
and for the year ended December 31, 2001:

Percent of Percent of
revenues from revenues from
Revenues Medicare/ Revenues Medicare/
Location/Units Occpy. ($ in 000s) Medicaid Location/Units Occpy. ($ in 000s) Medicaid
--------------------------------------------------------------- ------------------------------------------------------------

1. Phoenix, AZ 80% $4,367 80% 24. Des Moines, IA 88% $3,862 80%
119 nursing beds 85 nursing beds
25. Glenwood, IA 100% 6,754 99%
2. Yuma, AZ 92% 6,080 80% 116 nursing beds
125 nursing beds 26. Mediapolis, IA 89% 2,299 66%
3. Yuma, AZ 84% 576 0% 62 nursing beds
52 asst. liv. suites 27. Pacific Junction, IA 100% 733 96%
4. Arleta, CA 87% 1,473 0% 12 nursing beds
85 asst. liv. suites 28. Winterset, IA 70% 2,637 50%
5. Lancaster, CA 94% 4,860 67% 98 nursing beds
99 nursing beds 19 ind. liv. apts.
6. Stockton, CA 97% 6,620 72% 29. Ellinwood, KS 93% 1,821 56%
116 nursing beds 55 nursing beds
7. Thousand Oaks, CA 94% 7,142 72% 4 ind. liv. apts.
124 nursing beds 30. Farmington, MI 76% 9,985 78%
8. Van Nuys, CA 97% 2,835 83% 149 nursing beds
58 nursing beds 31. Howell, MI 88% 9,999 86%
9. Canon City, CO 91% 3,576 62% 149 nursing beds
85 nursing beds 32. Tarkio, MO 69% 1,936 70%
48 ind. liv. apts. 75 nursing beds
10. Cherrelyn, CO 90% 9,272 83% 33. Ainsworth, NE 87% 1,652 71%
198 nursing beds 48 nursing beds
11. Colorado Springs, CO 100% 3,833 75% 34. Ashland, NE 94% 4,423 69%
75 nursing beds 101 nursing beds
12. Delta, CO 78% 3,572 83% 35. Blue Hill, NE 85% 2,136 69%
76 nursing beds 63 nursing beds
16 asst. liv. suites 36. Campbell, NE 85% 1,538 76%
13. Grand Junction, CO 87% 4,152 62% 45 nursing beds
95 nursing beds 37. Central City, NE 95% 2,310 73%
14. Grand Junction, CO 93% 4,221 71% 65 nursing beds
82 nursing beds
15. Lakewood, CO 86% 5,677 82% 38. Columbus, NE 98% 2,087 63%
125 nursing beds 48 nursing beds
16. New Haven, CT 98% 10,101 95% 39. Edgar, NE 86% 1,680 66%
150 nursing beds 52 nursing beds
17. Waterbury, CT 95% 10,109 93% 40. Exeter, NE 87% 1,489 58%
150 nursing beds 48 nursing beds
18. College Park, GA 91% 3,163 98%
99 nursing beds 41. Grand Island, NE 98% 3,091 66%
19. Dublin, GA 85% 3,798 97% 74 nursing beds
130 nursing beds 42. Gretna, NE 93% 2,459 67%
20. Glenwood, GA 81% 1,694 95% 63 nursing beds
61 nursing beds 43. Lyons, NE 81% 1,822 57%
21. Marietta, GA 87% 3,745 88% 63 nursing beds
109 nursing beds 44. Milford, NE 90% 1,950 69%
22. Clarinda, IA 60% 2,366 70% 54 nursing beds
96 nursing beds 45. Sutherland, NE 92% 2,354 80%
23. Council Bluffs, IA 95% 2,428 87% 62 nursing beds
62 nursing beds 46. Utica, NE 96% 1,715 75%
40 nursing beds

47. Waverly, NE 86% $2,003 49% 53. Pewaukee, WI 84% $7,275 71%
50 nursing beds 175 nursing beds
48. Brookfield, WI 95% 11,612 73% 54. Waukesha, WI 96% 5,327 56%
226 nursing beds 105 nursing beds
49. Clintonville, WI 87% 3,634 74% 55. Laramie, WY 92% 4,416 70%
101 nursing beds 98 nursing beds
50. Clintonville, WI 94% 3,264 67% 56. Worland, WY 84% 3,414 71%
61 nursing beds 85 nursing beds
51. Madison, WI 74% 2,891 59% 8 ind. liv. apts.
63 nursing beds -------------------------------------------------------
52. Milwaukee, WI 80% 6,816 76% Totals: 56 facilities 88% $227,044 76%
154 nursing beds in 12 states,
5,211 units

After it repossessed or acquired the foregoing facilities from former
tenants, Senior Housing undertook to correct deferred maintenance which had been
allowed to occur by former operators. Between July 2000 and December 2001, $8.3
million was spent by Senior Housing under this program. At the time of our
spin-off from Senior Housing, Senior Housing provided us cash of $1.6 million to
fund the estimated costs of these projects which remained unfinished. During the
course of these projects, parts of these facilities are sometimes closed and
these closings can adversely impact occupancy; however, we believe these
projects are necessary for continuing operations at these facilities and may
make the facilities more attractive to residents. We expect this correction of
deferred maintenance projects to be completed in 2002.

OUR LEASE FOR THE 56 FACILITIES

One of our subsidiaries leases the 56 facilities described above; and
we have guaranteed our subsidiary's obligations under the lease. The lease has
been filed as an exhibit to this Annual Report on Form 10-K. If you want more
information about the lease terms, you should read the entire lease. The
following is a summary of material terms of this lease:

Operating Costs. The lease is a so-called "triple-net" lease which
requires us to pay all costs incurred in the operation of the facilities,
including the costs of personnel, service to residents, insurance and real
estate and personal property taxes.

Minimum Rent. Our minimum rent is $7 million per year.

Percentage Rent. Starting in 2004, we are required to pay additional
rent with respect to each lease year in an amount equal to three percent (3%) of
net patient revenues at each leased facility in excess of net patient revenues
at the facility during 2003.

Term. The initial term expires on December 31, 2018.

Renewal Option. We have the option to renew the lease for all but not
less than all the 56 facilities for one renewal term ending on December 31,
2033, by notice on or before December 31, 2015. We may not exercise this renewal
option unless we also exercise our renewal option under our lease for the
Marriott facilities.

Rent During Renewal Term. Rent during the renewal term is a
continuation of minimum rent and percentage rent payable during the initial
term.

Maintenance and Alterations. We are required to operate continuously
and maintain, at our expense, the leased facilities in good order and repair,
including structural and nonstructural components. We may request Senior Housing
to fund amounts needed for repairs and renovations in return for rent
adjustments to provide Senior Housing a return on its investment according to a
formula set forth in the lease. At the end of the lease term, we are required to
surrender the leased facilities in substantially the same condition as existed
on the commencement date of the lease, subject to any permitted alterations and
subject to ordinary wear and tear.

Assignment and Subletting. Senior Housing's consent is generally
required for any direct or indirect assignment or sublease of any of the
facilities. In the event of any assignment or subletting, we will remain liable
under the lease.

Environmental Matters. We are required, at our expense, to remove and
dispose of any hazardous substance at the leased facilities in compliance with
all applicable environmental laws and regulations. We have indemnified Senior
Housing for any liability which may arise as a result of the presence of
hazardous substances at any leased facilities and from any violation or alleged
violation of any applicable environmental law or regulation.

Indemnification and Insurance. With limited exceptions, we are required
to indemnify Senior Housing from all liabilities which may arise from the
ownership or operation of the facilities. We generally are required to maintain
commercially reasonable insurance, including:

o "all-risk" property insurance, in an amount equal to 100% of the full
replacement cost of the facilities;

o business interruption insurance;

o comprehensive general liability insurance, including bodily injury and
property damage, in amounts as are generally maintained by companies
providing senior living services;

o flood insurance if any facility is located in whole or in part in a
flood plain;

o worker's compensation insurance if required by law; and

o such additional insurance as may be generally maintained by companies
providing senior living services.

The lease requires that Senior Housing be named as an additional
insured under these policies.

Damage, Destruction or Condemnation. If any of the leased facilities is
damaged by fire or other casualty or taken for a public use, we are generally
obligated to rebuild unless the facility cannot be restored. If the facility
cannot be restored, Senior Housing will generally receive all insurance or
taking proceeds and we are liable to Senior Housing for the amount of any
deductible or deficiency between the replacement cost and the insurance
proceeds.

Events of Default. Events of default under the lease include the
following:

o our failure to pay rent or any other sum when due;

o our failure to maintain the insurance required under the lease;

o the occurrence of certain events with respect to our insolvency;

o the institution of a proceeding for our dissolution;

o any person or group of affiliated persons acquiring ownership of more
than 9.8% of us without Senior Housing's consent;

o any change in our control or sale of a material portion of our assets
without Senior Housing's consent;

o our default under the lease for the Marriott facilities;

o our default under any indebtedness which gives the holder the right to
accelerate;

o our being declared ineligible to receive reimbursement under Medicare
or Medicaid programs for any of the leased facilities; and

o our failure to perform any terms, covenants or agreements of the lease
and the continuance thereof for a specified period of time after
written notice.

Remedies. Upon the occurrence of any event of default, the lease
provides that, among other things, Senior Housing may, to the extent legally
permitted:

o accelerate the rent;

o terminate the lease;

o terminate the other lease which we have with Senior Housing;

o enter the property and take possession of any and all our personal
property and retain or sell the same at a public or private sale; and

o make any payment or perform any act required to be performed by us
under the lease.

We are obligated to reimburse Senior Housing for all costs and expenses
incurred in connection with any exercise of the foregoing remedies.

Management. We may not enter into, amend or modify any management
agreement affecting any leased property without the prior written consent of
Senior Housing.

Lease Subordination. Our lease may be subordinated to any mortgages of
the leased properties by Senior Housing.

Financing Limitations; Security. We may not incur debt secured by our
investments in our tenant subsidiary. Further, our tenant subsidiary is
prohibited from incurring liabilities other than operating liabilities incurred
in the ordinary course of business, those liabilities secured by accounts
receivables or purchase money debt. We are required to pledge 100% of the equity
interests of our tenant subsidiary to Senior Housing or its lenders.

SENIOR HOUSING LEASE NO. 2 FACILITIES

We lease 31 senior living facilities from Senior Housing which are
managed by Marriott. These facilities contain 7,487 living units and are located
in 13 states. The following table provides additional information about these
facilities and their current operations as of and for Marriott's fiscal year
ended December 28, 2001:

Year ended December 28, 2001
---------------------------------------
Percent
Ind. Asst. Spec. of revenues
liv. liv. care Nursing Revenues from private
Location apts. suites beds beds Totals Occupancy ($ in 000s) pay resources
------------------------------------------------------------------------------------------------------------------

1. Peoria, AZ.............. 155 79 -- 57 291 90% $9,119 93%
2. Scottsdale, AZ.......... 167 33 -- 96 296 91% 10,675 90%
3. Tucson, AZ.............. 202 30 27 67 326 96% 11,835 92%
4.,5. San Diego, CA........... 246 100 -- 59 405 93% 18,380 98%
6. Newark, DE.............. 62 26 -- 110 198 97% 9,865 66%
7. Wilmington, DE.......... 140 37 -- 66 243 97% 11,495 82%
8. Wilmington, DE.......... 71 44 _ 46 161 94% 6,070 93%
9. Wilmington, DE.......... 62 15 _ 82 159 93% 7,664 66%
10. Wilmington, DE.......... -- 51 26 31 108 72% 3,259 100%
11. Coral Springs, FL....... 184 62 -- 35 281 91% 9,317 84%
12. Deerfield Beach, FL..... 198 33 -- 60 291 88% 10,339 69%
13. Ft. Lauderdale, FL...... -- 109 -- -- 109 90% 2,096 100%
14. Ft. Myers, FL........... -- 85 -- -- 85 90% 2,234 100%
15. Palm Harbor, FL......... 230 87 -- -- 317 82% 7,184 100%
16. West Palm Beach, FL..... 276 64 -- -- 340 84% 7,220 100%
17. Indianapolis, IN........ 117 -- 30 74 221 93% 10,623 82%
18. Overland Park, KS....... 117 30 -- 60 207 94% 8,087 90%
19. Lexington, KY........... 140 9 -- -- 149 94% 4,128 100%
20. Lexington, KY........... -- 22 -- 111 133 95% 6,952 66%
21. Louisville, KY.......... 240 44 -- 40 324 97% 10,465 91%
22. Winchester, MA.......... -- 125 -- -- 125 99% 5,669 100%
23. Lakewood, NJ............ 217 108 -- 60 416 80% 15,039 88%
24. Albuquerque, NM......... 114 34 -- 60 208 99% 9,235 95%
25. Columbus, OH............ 143 87 25 60 315 93% 13,396 93%
26. Myrtle Beach, SC........ -- 60 36 68 164 84% 5,740 66%
27. Dallas, TX.............. 190 38 -- 90 318 92% 13,067 83%
28. El Paso, TX............. 123 -- 15 120 258 86% 9,501 71%
29. Houston, TX............. 197 71 60 87 415 96% 17,500 93%
30. San Antonio, TX......... 151 30 28 60 269 96% 10,802 95%
31. Woodlands, TX........... 239 100 16 -- 355 93% 10,505 100%
----------------------------------------------------------------------------------
Totals: 31 facilities in
13 states......... 3,981 1,613 294 1,599 7,487 91% $277,461 88%

OUR LEASE FOR THE MARRIOTT FACILITIES

The lease for the Marriott facilities has been filed as an exhibit to
this Annual Report on Form 10-K. If you want more information about lease terms,
you should read the entire lease. The material terms of our lease for the
Marriott facilities are substantially the same as those of our lease for the 56
facilities, except as follows:

Minimum Rent. Our minimum rent is $63 million per year.

Percentage Rent. Starting in 2003, we are required to pay additional
rent with respect to each lease year in an amount equal to five percent (5%) of
net patient revenues at each leased facility in excess of net patient revenues
at the facility during 2002.

FF&E Reserves. We are required to maintain accounts for replacements
and improvements as described below in "-Marriott Management-FF&E Reserves and
Capital Improvements."

Term. The initial term expires on December 31, 2017.

Renewal Options. We have two options to renew the lease for all but not
less than all the facilities: the first for 10 years ending on December 31,
2027, and the second for five years ending on December 31, 2032. We may not
exercise these renewal options unless we have exercised our renewal option under
the lease for the 56 facilities. The first renewal option must be exercised by
notice two years prior to the expiration of the initial term. The second renewal
option must be exercised by notice at least 11 months before the then current
term expires.

Events of Default. In addition to the events of default described under
our lease for the 56 facilities, the lease for the Marriott facilities includes
the following events of default:

o our default under any Marriott management agreement; and

o our default under the lease for the 56 facilities owned by Senior
Housing.

MARRIOTT MANAGEMENT

The 31 Marriott facilities are each subject to a management agreement
with Marriott. The following is a description of the material terms of the
management agreements. If you want more information about these agreements, you
should read the representative form of management agreement which has been filed
as an exhibit to this Annual Report on Form 10-K.

Term. Generally each of the management agreements has an initial term
expiring in 2027, with one five-year renewal term at Marriott's option.

Facility Services. Marriott has responsibility and authority for all
day-to-day operations of the managed facilities, including obtaining and
maintaining all licenses necessary for operations, insurance, establishing
resident care policies and procedures, carrying out and supervising all
necessary repairs and maintenance, procuring food, supplies, equipment,
furniture and fixtures, and establishing prices, rates and charges for services
provided. Marriott also recruits, employs and directs all facility based
employees, including managerial employees.

Central Services. Marriott also furnishes certain central
administrative services, which are provided on a central or regional basis to
all senior living facilities managed by Marriott. Such services include: (i)
marketing and public relations; (ii) human resources program development; (iii)
information systems development and support; and (iv) centralized computer
payroll and accounting.

Working Capital. We are required to maintain working capital at each of
the managed facilities at levels consistent with the Marriott senior living
system standard.

FF&E Reserves and Capital Improvements. Marriott has established a
reserve account under each management agreement, referred to as an FF&E Reserve,
to cover the expected recurring cost of replacements and renewals to the
furniture, furnishings, fixtures, soft goods, case goods, vehicles and
equipment, and for building repairs and maintenance which are normally
capitalized. The FF&E Reserve accounts are funded from the operating revenues of
the managed facilities. The amount of this funding varies somewhat among the
managed facilities; however, for most facilities it is currently set at 2.65% of
gross revenues and is expected to gradually increase to 3.5%. In the event major
capital improvements are required, or if the amounts set aside in the FF&E
Reserve accounts are inadequate for required repairs, we may be required to fund
such repairs and improvements. Any such funding which we provide increases the
amount of our owner's priority, described below. Also, under our lease we have
the option to request Senior Housing to provide such required funding in return
for rent adjustments to provide Senior Housing a return on its investment
according to a formula set forth in the lease.

Fees. For its facility services, Marriott receives a base fee generally
equal to 5% of the managed facilities' gross revenues, plus an incentive fee
generally equal to 20% of operating profits in excess of owner's priority
amounts, as defined in the agreements. For its central services, Marriott
receives a fee generally equal to 2% of gross revenues. Generally, through the
earlier of (i) the end of June 2004 or (ii) the date on which certain
performance criteria have been met, payment of up to one half of this central
services fee (i.e., 1% of gross revenues) is conditional, and is waived if
specified annual profit targets are not achieved. During 2001 management fees
paid to Marriott totaled $18.1 million.

Owner's Priority. We receive the profits of the Marriott managed
facilities on a priority basis before Marriott receives any incentive fees for
facility services or any conditional central services fees. The amount of the
owner's priority for each managed facility is established based upon a specified
rate of return on historical capital investments in these facilities, including
capital investments funded in addition to the FF&E Reserve. For fiscal year
2001, the aggregate amount of owner's priority for all 31 properties was $69.4
million.

Pooling. Twenty-nine of the facilities are subject to pooling
arrangements whereby the calculation and payment of FF&E Reserves, fees payable
to Marriott and owner's priority for several groups of these 29 facilities are
combined.

Events of Default. Events of default under the management agreements
include, among others, certain events relating to the insolvency or bankruptcy
of either party.

Termination. The Marriott management agreements may be terminated as
follows:

o Upon material default, by the non-defaulting party after applicable
cure periods lapse.

o Starting in 2006 by us, if a specific facility, or a pooled combination
of facilities, fails to achieve specified financial performance;
provided, however, Marriott has the option to avoid financial
performance terminations by making specified payments to us or by
temporarily reducing certain of its fees.

o By us, upon 120 days notice, provided we make a termination payment to
Marriott calculated according to a formula set forth in the agreements.

Our right to exercise termination options under the Marriott management
agreements is subject to approval by Senior Housing under the terms of the lease
for these 31 Marriott facilities.

GOVERNMENT REGULATION AND RATE SETTING

Senior Apartments. Generally, government programs do not pay for
housing in senior apartments. Rents are paid from the residents' private
resources. Accordingly, the government regulations that apply to these types of
properties are generally limited to zoning, building and fire codes, Americans
with Disabilities Act requirements and other life safety type regulations
applicable to residential real estate. Government rent subsidies and government
assisted development financing for low income senior housing are exceptions to
these general statements. The development and operation of subsidized senior
housing properties are subject to numerous governmental regulations. While it is
possible that we may lease some subsidized senior apartment facilities, we do
not expect these facilities to be a major part of our future business, and we do
not own senior apartments where rent subsidies are applicable.

Independent Living Apartments. Government benefits generally are not
available for services at independent living apartments and the resident charges
in these facilities are paid from private resources. However, a number of
Federal Supplemental Security Income program benefits pay housing costs for
elderly or disabled residents to live in these types of residential facilities.
The Social Security Act requires states to certify that they will establish and
enforce standards for any category of group living arrangement in which a
significant number of supplemental security income residents reside or are
likely to reside. Categories of living arrangements which may be subject to
these state standards include independent living apartments and assisted living
facilities. Because independent living apartments usually offer common dining
facilities, in many locations they are required to obtain licenses applicable to
food service establishments in addition to complying with land use and life
safety requirements. In many states, independent living apartments are licensed
by state health departments, social service agencies, or offices on aging with
jurisdiction over group residential facilities for seniors. To the extent that
independent living apartments include units in which assisted living or nursing
services are provided, these units are subject to applicable state licensing
regulations, and if the facilities receive Medicaid or Medicare funds, to
certification standards. In some states, insurance or consumer protection
agencies regulate independent living apartments in which residents pay entrance
fees or prepay other costs.

Assisted Living Facilities. According to the National Academy for State
Health Policy, 39 states provide or are approved to provide Medicaid payments
for residents in some assisted living facilities under waivers granted by the
Federal Centers for Medicare and Medicaid Services, known as CMS, or under
Medicaid state plans, and eight other states are planning some Medicaid funding
by requesting waivers implementing assisted living pilot programs or
demonstration projects. Because rates paid to assisted living facility operators
are lower than rates paid to nursing home operators, some states use Medicaid
funding of assisted living as a means of lowering the cost of services for
residents who may not need the higher intensity of health-related services
provided in nursing homes. States that administer Medicaid programs for assisted
living facilities are responsible for monitoring the services at, and physical
conditions of, the participating facilities. Different states apply different
standards in these matters, but generally we believe these monitoring processes
are similar to the concerned states' inspection processes for nursing homes.

In light of the large number of states using Medicaid to purchase
services at assisted living facilities and the growth of assisted living in the
1990s, a majority of states have adopted licensing standards applicable to
assisted living facilities. According to the National Academy for State Health
Policy, 29 states have licensing statutes or standards specifically using the
term "assisted living". The majority of states have revised their licensing
regulations recently or are reviewing their policies or drafting or revising
their regulations. State regulatory models vary; there is no national consensus
on a definition of assisted living, and no uniform approach by the states to
regulating assisted living facilities. Most state licensing standards apply to
assisted living facilities whether or not they accept Medicaid funding. Also,
according to the National Academy for State Health Policy, seven states require

certificates of need from state health planning authorities before new assisted
living facilities may be developed and two states have exempted assisted living
facilities from certificate of need laws. Based on our analysis of current
economic and regulatory trends, we believe that assisted living facilities that
become dependent upon Medicaid payments for a majority of their revenues may
decline in value because Medicaid rates may fail to keep up with increasing
costs. We also believe that assisted living facilities located in states that
adopt certificate of need requirements or otherwise restrict the development of
new assisted living facilities may increase in value because these limitations
upon development may help ensure higher occupancy and higher non-governmental
rates.

Two federal government studies provide background information and make
recommendations regarding the regulation of, and the possibility of increased
governmental funding for, the assisted living industry. The first study, an
April 1999 report by the General Accounting Office to the Senate Special
Committee on Aging on assisted living facilities in four states, found a variety
of residential settings serving a wide range of resident health and care needs.
The General Accounting Office found that consumers often receive insufficient
information to determine whether a particular facility can meet their needs and
that state licensing and oversight approaches vary widely. The General
Accounting Office anticipates that as the states increase the use of Medicaid to
pay for assisted living, federal financing will likewise grow, and these trends
will focus more public attention on the place of assisted living in the
continuum of long-term care and upon state standards and compliance approaches.
The second study, a National Study of Assisted Living for the Frail Elderly, was
funded by the U.S. Department of Health and Human Services Assistant Secretary
for Planning and Evaluation and is expected to result in a report on the effects
of different service and privacy arrangements on resident satisfaction, aging in
place and affordability. In 2001, the Senate Special Committee on Aging held
hearings on assisted living and its role in the continuum of care and on
community-based alternatives to nursing homes. We cannot predict whether these
studies will result in governmental policy changes or new legislation, or what
impact any changes may have. Based upon our analysis of current economic and
regulatory trends, we do not believe that the federal government is likely to
have a material impact upon the current regulatory environment in which the
assisted living industry operates unless it also undertakes expanded funding
obligations, and we do not believe a materially increased financial commitment
from the federal government is presently likely. However, we do anticipate that
assisted living facilities will increasingly be licensed and regulated by the
various states, and that in absence of federal standards, the states' policies
will continue to vary widely.

Nursing Homes-Reimbursement. About 58% of all nursing home revenues in
the U.S. in 2000 came from government Medicare and Medicaid programs, including
about 48% from Medicaid programs. Nursing homes are among the most highly
regulated businesses in the country. The federal and state governments regularly
monitor the quality of care provided at nursing homes. State health departments
conduct surveys of resident care and inspect the physical condition of nursing
home properties. These periodic inspections and occasional changes in life
safety and physical plant requirements sometimes require nursing home operators
to make significant capital improvements. These mandated capital improvements
have in the past usually resulted in Medicare and Medicaid rate adjustments,
albeit on the basis of amortization of expenditures over expected useful lives
of the improvements. A new Medicare prospective payment system, often referred
to as PPS, began being phased in over three years beginning with cost reporting
years starting on or after July 1, 1998. Under this new Medicare payment system,
capital costs are part of the prospective rate and are not facility specific.
This new Medicare payment system and other recent legislative and regulatory
actions with respect to state Medicaid rates are limiting the reimbursement
levels for some nursing home and other eldercare services. At the same time
federal and state enforcement and oversight of nursing homes are increasing,
making licensing and certification of these facilities more rigorous. These
actions have adversely affected the revenues and increased the expenses of many
nursing home operators, including us. The new Medicare payment system was
established by the Balanced Budget Act of 1997, and was intended to reduce the
rate of growth in Medicare payments for skilled nursing facilities. Before the

new Medicare payment system, Medicare rates were facility-specific and
cost-based. Under the new Medicare payment system, facilities receive a fixed
payment for each day of care provided to Medicare patients. Each patient is
assigned to one of 44 care groups depending on that patient's medical
characteristics and service needs. Per diem payment rates are based on these
care groups. Medicare payments cover substantially all services provided to
Medicare patients in skilled nursing facilities, including ancillary services
such as rehabilitation therapies. The new Medicare payment system is intended to
provide incentives to providers to furnish only necessary services and to
deliver those services efficiently. During the three year phase in period,
Medicare rates for skilled nursing facilities were based on a blend of facility
specific costs and rates established by the new Medicare payment system.
According to the General Accounting Office, between fiscal year 1998 and fiscal
year 1999, the first full year of the new Medicare payment system phase-in, the
average Medicare payment per day declined by about nine percent. As of September
30, 2001, all of the facilities that we currently lease from Senior Housing and
that participate in the Medicare program have derived their Medicare revenues
under the new payment system rates for at least six months. The new Medicare
payment system rates have been applied to 34 of our 87 leased facilities since
January 1, 2001.

Since November 1999, Congress has provided some relief from the impact
of the Balanced Budget Act of 1997. Effective April 1, 2000, the Medicare,
Medicaid and SCHIP Balanced Budget Refinement Act of 1999 temporarily boosted
payments for certain skilled nursing cases by 20% and allowed nursing facilities
to transition more rapidly to the federal payment system. This Act also
increased the new Medicare payment rates by four percent for fiscal years 2001
and 2002 and imposed a two-year moratorium on some therapy limitations for
skilled nursing patients covered under Medicare Part B.

In December 2000, the Medicare, Medicaid and SCHIP Benefits Improvement
and Protection Act of 2000 was approved. Effective April 1, 2001 to October 1,
2002, this Act increases the nursing component of the payment rate for each care
group by 16.6%. This Act also increased annual inflation adjustments for fiscal
year 2001, increased rehabilitation care group rates by 6.7%, and maintained the
previously temporary 20% increase in the other care group rates established in
1999.

Effective October 1, 2002, the 4% across-the-board increase in Medicare
payment rates, the 16.66% increase in the nursing component of the rates, and
the 6.7% increase in rehabilitation care group rates, are scheduled to expire.
The 20% increase for the skilled nursing care groups will expire when the
current resource utilization groups are refined. The Bush administration's
fiscal year 2003 budget proposal assumes that the add-ons to the Medicare rates
will expire as scheduled and does not provide for additional Medicaid funding
for nursing homes. The Medicare Payment Advisory Commission has recommended that
Congress incorporate the 20% increases into the base rate for fiscal year 2003
and that the other add-ons expire as scheduled.

Nursing Homes-Survey and Enforcement. CMS has begun to implement an
initiative to increase the effectiveness of Medicare and Medicaid nursing
facility survey and enforcement activities. CMS' initiative follows a July 1998
General Accounting Office investigation which found inadequate care in a
significant proportion of California nursing homes and CMS' July 1998 report to
Congress on the effectiveness of the survey and enforcement system. In 1999, the
U.S. Department of Health and Human Services Office of Inspector General issued
several reports concerning quality of care in nursing homes, and the General
Accounting Office issued reports in 1999 and 2000 which recommended that CMS and
the states strengthen their compliance and enforcement practices to better
ensure that nursing homes provide adequate care. Since 1998, the Senate Special
Committee on Aging has been holding hearings on these issues. CMS is taking
steps to focus more survey and enforcement efforts on nursing homes with
findings of substandard care or repeat violations of Medicare and Medicaid
standards and to identify chain operated facilities with patterns of
noncompliance. CMS is increasing their oversight of state survey agencies and
requiring state agencies to use enforcement sanctions and remedies more promptly
when substandard care or repeat violations are identified, to investigate
complaints more promptly, and to survey facilities more consistently. In
addition, CMS has

adopted regulations expanding federal and state authority to impose civil money
penalties in instances of noncompliance. Medicare survey results for each
nursing home are posted on the internet at http://www.medicare.gov. When
deficiencies are identified under state licensing and Medicare and Medicaid
laws, sanctions and remedies such as denials of payment for new Medicare and
Medicaid admissions, civil money penalties, state oversight and loss of Medicare
and Medicaid participation may be imposed. We and Marriott receive notices of
potential sanctions and remedies from time to time, and such sanctions have been
imposed on some of our nursing homes and assisted living facilities from time to
time. Sanctions imposed on us or Marriott for deficiencies that have been
identified or that are identified in the future may have adverse financial
consequences to us. In 2000, CMS issued a report on their study linking nursing
staffing levels with quality of care, and CMS is assessing the impact that
minimum staffing requirements would have on facility costs and operations. In a
report to be presented to Congress in 2002, the Department of Health and Human
Services has found that 90% of nursing homes lack the nurse and nurse aide
staffing necessary to provide adequate care to residents. The Bush
administration has indicated that it does not intend to impose minimum staffing
levels or to increase Medicare or Medicaid rates to cover the costs of increased
staff at this time, but is considering publishing the staffing level at each
nursing home to increase market demand.

Federal efforts to target fraud and abuse and violations of
anti-kickback laws and physician referral laws by Medicare and Medicaid
providers have also increased. In March 2000, the U.S. Department of Health and
Human Services Office of Inspector General issued compliance guidelines for
nursing facilities, to assist them in developing voluntary compliance programs
to prevent fraud and abuse. Also, new rules governing the privacy, use and
disclosure of individually identified health information became final in 2001
and will require compliance by 2003, with civil and criminal sanctions for
noncompliance. An adverse determination concerning any of our licenses or
eligibility for Medicare or Medicaid reimbursement or compliance with applicable
federal or state regulations could negatively affect our financial condition and
results of operations.

Certificates of Need. Most states also limit the number of nursing
homes by requiring developers to obtain certificates of need before new
facilities may be built. Even states such as California and Texas that have
eliminated certificate of need laws often have retained other means of limiting
new nursing home development, such as the use of moratoria, licensing laws or
limitations upon participation in the state Medicaid program. We believe that
these governmental limitations generally make nursing homes more valuable by
limiting competition.

A number of legislative proposals that would affect major reforms of
the healthcare system have been introduced in Congress, such as additional
Medicare and Medicaid reforms and cost containment measures. We cannot predict
whether any of these legislative proposals will be adopted or, if adopted, what
effect, if any, these proposals would have on our business.

LIABILITY INSURANCE

Litigation against senior living operators has been increasing during
the past few years. Several cases by nursing home patients or their families who
have won large monetary awards for mistreatment have been widely publicized. The
amount of such litigation in Florida and Texas has been particularly
significant. As a result, liability insurance costs are rising and, in some
cases, such insurance is not available to senior living operators.

We have liability insurance for the 56 properties which we now operate.
None of these facilities are located in Florida or Texas. One of the five
facilities we intend to purchase and operate is located in Florida; this Florida
property has 186 independent living apartments and 20 assisted living suites,
but it has no nursing beds. Based upon preliminary inquires which we have made,
we believe that our planned operations at the five facilities we intend to
acquire may be included within our existing insurance. Our current liability
insurance expires in June 2002; we expect our insurance costs to

increase, and we do not know the amount of any such increase. If such increased
cost is not acceptable to us, we intend to explore alternatives, including
possibly higher deductible or retention amounts and self insurance.

Marriott is responsible for obtaining insurance for the 31 senior
living communities which we lease and Marriott manages. These 31 communities
include six in Florida (888 independent living apartments, 440 assisted living
suites and 95 nursing beds), and five in Texas (900 independent living
apartments, 239 assisted living suites, 119 special care beds and 357 nursing
beds). Liability insurance for these facilities' operations is currently
provided in part by an insurance company subsidiary of Marriott International,
Inc. The cost of this insurance increased on October 1, 2001, and we are
currently exploring with Marriott whether it may be possible to reduce this
cost, but we can provide no assurance that these insurance costs can be reduced
or that they will not increase further in the future.

COMPETITION

The senior living services business is highly competitive. We compete
with service providers offering different types of services, such as home
healthcare services, as well as other companies providing real estate facility
based services. We believe we can compete successfully for the following
reasons:

o Our acquisition of FSQ, Inc. and our shared services agreement with
Reit Management & Research LLC ("Reit Management") provide us a depth
and quality of management which we believe is equal to or stronger than
most other senior living facility operators.

o Our historical and continuing relationship with Senior Housing may
provide us opportunities to expand our business by acquiring new
leaseholds from Senior Housing.

o The senior living services industry has experienced severe financial
distress during the past few years.

o Many operators of nursing homes and assisted living facilities have
been forced into bankruptcy. As a new company without any material
debt, we are not burdened with financial difficulties of the types
which currently burden some of our competitors.

Our management team has been recently assembled within the past two
years, and, although we believe it is experienced and highly talented, it does
not have extensive experience working together. We expect we may expand our
business with Senior Housing; however, Senior Housing is not obligated to
provide us with opportunities to lease additional properties. We have no debt,
but we do have large lease obligations and limited financeable assets; and many
of our competitors have greater financial resources than us. For all of these
reasons and others, we cannot provide you any assurance that we will be able to
compete successfully for business in the senior living industry.

TECHNOLOGY SYSTEMS

When we began operating senior living facilities for Senior Housing in
July 2000 we created new internet based data processing and management
information systems for our clinical, operational and financial information.
These systems currently support over 1,000 widely distributed computers in a
secure and stable working environment. Because they were built in 2000 and 2001
and are internet based, we believe our technology systems are among the most
up-to-date and efficient systems currently in use in the senior living industry.
Moreover, these systems were designed to be readily scalable to support our
growth strategy.

ENVIRONMENTAL MATTERS

Under various federal, state and local laws, ordinances and
regulations, owners as well as tenants and operators of real estate may be
required to investigate and clean up hazardous substances released at a
property, and may be held liable to a governmental entity or to third parties
for property damage or personal injuries and for investigation and clean-up
costs incurred in connection with any contamination. Under our leases, we have
also agreed to indemnify Senior Housing for any such liabilities related to the
leased facilities. In addition, some environmental laws create a lien on a
contaminated site in favor of the government for damages and costs it incurs in
connection with the contamination, which lien may be senior in priority to our
leases. We have reviewed some preliminary environmental surveys of the
facilities we lease and the properties we expect to acquire in the pending
acquisition. Based upon that review we do not believe that any of these
properties are subject to any material environmental contamination. However, no
assurances can be given that:

o a prior owner, operator or occupant of our leased facilities or the
properties we intend to acquire did not create a material environmental
condition not known to us which might have been revealed by more in-depth
study of the properties; and

o future uses or conditions (including, without limitation, changes in
applicable environmental laws and regulations) will not result in the
imposition of environmental liability upon us.

EMPLOYEES

As of March 20, 2002, we had approximately 6,000 employees, including
5,500 full time equivalents. Approximately 690 employees, including 570 full
time equivalents, are represented under seven collective bargaining agreements,
all of which have remaining terms of two to three years. We have no other
employment agreements. We believe relations with our union and non-union
employees to be good. The five facilities which we expect to acquire in the
pending acquisition are staffed by approximately 250 employees, some of whom are
represented by a union; we expect to offer to employ these people when this
acquisition closes.

FEDERAL INCOME TAX CONSIDERATIONS FOR NON-U.S. PERSONS

The following summary of federal income tax considerations for non-U.S.
persons is based on existing law, and is limited to investors who own our Common
Shares as investment assets rather than as inventory or as property used in a
trade or business. The summary does not discuss the particular tax consequences
that might be relevant to you if you are subject to special rules under the
federal income tax law.

This summary is based on applicable Internal Revenue Code, or IRC,
provisions, related rules and regulations and administrative and judicial
interpretations, all of which are subject to change, possibly with retroactive
effect. Future legislative, judicial, or administrative actions or decisions
could affect the accuracy of statements made in this summary. We can not assure
you that the IRS or a court will agree with the statements made in this summary.
In addition, the following summary is not exhaustive of all possible tax
consequences, and does not discuss any state, local or foreign tax consequences.
For all these reasons, we urge you to consult with a tax advisor about the
federal, state, local and non-U.S. income tax and other tax consequences of your
acquisition, ownership and disposition of our Common Shares.

For purposes of this summary, a non-U.S. person for federal income tax
purposes is a person other than:

o a citizen or resident of the United States, including an alien
individual who is a lawful permanent resident of the United States or
meets the substantial presence residency test under the federal income
tax laws,

o a corporation, partnership or other entity treated as a corporation or
partnership for federal income tax purposes, that is created or
organized in or under the laws of the United States, any state thereof
or the District of Columbia, unless otherwise provided by Treasury
regulations,

o an estate the income of which is subject to federal income taxation
regardless of its source, or

o a trust if a court within the United States is able to exercise primary
supervision over the administration of the trust and one or more United
States persons have the authority to control all substantial decisions
of the trust, or electing trusts in existence on August 20, 1996 to the
extent provided in Treasury regulations, whose status as a non-U.S.
person is not overridden by an applicable tax treaty.

DISTRIBUTIONS AND DISPOSITIONS

Distributions on Our Common Shares. At the present time, we do not
expect to pay any dividends on our Common Shares. However, if we do later decide
to do so, your tax consequences would generally be as follows.

Dividends paid to you will be subject to withholding of federal income
tax at a 30% rate or a lower rate as may be specified by an applicable income
tax treaty. If you are eligible for a reduced rate of withholding tax pursuant
to a tax treaty, you may obtain a refund of any excess amounts previously
withheld by filing an appropriate claim for refund with the IRS. To claim the
benefits of an income tax treaty, you are required to satisfy the applicable
certification requirements, generally by executing an applicable IRS Form W-8 or
substantially similar form.

If the dividends paid to you are effectively connected with the conduct
of a trade or business within the United States or, if a treaty so provides,
attributable to a permanent establishment of a non-U.S. person within the United
States, you will be exempt from withholding tax, provided you provide us or our
paying agent with an applicable IRS Form W-8 or a substantially similar form
containing your taxpayer identification number. Effectively connected dividend
income will be subject to U.S. federal income tax on a net basis at applicable
graduated rates. If you are a corporation with effectively connected dividend
income you may be subject to an additional branch profits tax at a rate of 30%
or a lower rate specified by an applicable income tax treaty.

Dispositions of our Common Shares. You will generally not be subject to
United States federal income tax in respect of gain you recognize on your
disposition of our Common Shares unless:

o the gain is effectively connected with a trade or business carried on
within the United States (in which case the branch profits tax
discussed above may also apply if you are a corporation) or the gain is
attributable to a permanent establishment maintained in the United
States if that is required by an applicable income tax treaty as a
condition to subjecting you to United States income tax on a net basis;

o you are an individual and are present in the United States for 183 days
or more in the taxable year of disposition and certain other tests are
met;

o you are subject to tax pursuant to the provisions of the Code regarding
the taxation of U.S. expatriates; or

o we are or have been a "United States real property holding corporation"
for U.S. federal income tax purposes at any time within the shorter of
the five-year period preceding such disposition or your holding period
(in which case the branch profits tax discussed above may also apply if
you are a corporation). However, your gain on a disposition of our
Common Shares will not be subject to tax under this rule, if our Common
Shares are "regularly traded" as defined by applicable Treasury
regulations on an established securities market like the American Stock
Exchange, and if you have at all times during the preceding five years
owned 5% or less by

value of our Common Shares. At this time, we believe that upon
completion of our pending acquisition, we will likely become a "United
States real property holding corporation" for federal income tax
purposes, but can provide no assurance in this regard.

INFORMATION REPORTING AND BACKUP WITHHOLDING

Information reporting and backup withholding may apply to distributions
or proceeds paid to our shareholders in the circumstances discussed below.
Amounts withheld under backup withholding are generally not an additional tax
and may be refunded or credited against your federal income tax liability,
provided that you furnish the required information to the IRS. The current
backup withholding rate is 30% for the calendar years 2002 and 2003, and is
scheduled to gradually decrease to 28% by calendar year 2006.

Distributions on our Common Shares paid to you during each calendar
year, and the amount of tax withheld if any, will generally be reported to you
and to the IRS. This information reporting requirement applies regardless of
whether you were subject to withholding, or whether the withholding was reduced
or eliminated by an applicable tax treaty. Also, distributions and other
payments to you on our Common Shares may be subject to backup withholding,
unless you have properly certified your non-U.S. person status on an IRS Form
W-8 or substantially similar form. Similarly, information reporting and backup
withholding will not apply to proceeds you receive upon the sale, exchange,
redemption, retirement or other disposition of our Common Shares if you have
properly certified your non-U.S. person status on an IRS Form W-8 or
substantially similar form.

Item 3. Legal Proceedings

From time to time, we are subject to legal actions and regulatory
investigations arising in the normal course of our business. We are not aware of
any currently pending material legal proceeding affecting our facilities for
which we may become liable. We cannot assure you that such actions or
investigations would not have a material adverse effect on our business or
financial results.

Item 4. Submission of Matters to a Vote of Security Holders

Prior to our spin-off from Senior Housing, the following matters were
submitted to a vote of security holders during the fourth quarter of the fiscal
year covered by this Annual Report Form 10-K: on December 5, 2001, Senior
Housing, our then sole shareholder, unanimously voted by written consent to (i)
amend and restate our Articles of Incorporation, (ii) approve our 2001 Stock
Option and Stock Incentive Plan and (iii) approve the Agreement of Merger among
us, our subsidiary FSQ Acquisition, Inc. and FSQ, Inc. effecting our acquisition
of FSQ, Inc.

PART II

Item 5. Market for the Registrant's Common Equity and Related Shareholder
Matters

Our Common Shares are traded on the American Stock Exchange under the
symbol "FVE." The following table presents the high and low closing price for
our Common Shares as reported on the American Stock Exchange for each calendar
quarter since they began to trade:

Period Low High
------ ----- -----
December 17 to 31, 2001.................................. $6.12 $7.50
January 1 to March 25, 2002.............................. 6.97 8.75

The closing price of the Common Shares on the American Stock Exchange
on March 25, 2002, was $7.40 per share.

As of March 25, 2002, there were 4,843 shareholders of record of our
Common Shares, and we estimate that as of such date there was approximately
100,000 beneficial owners of our Common Shares. We do not expect to pay
dividends in the foreseeable future.

On September 17, 2001, we sold 1,000 Common Shares to Senior Housing
Properties Trust for $1,000 in connection with our organization under Maryland
law. No underwriter was used in this transaction, and the sale of these
securities was made in reliance upon the exemption from registration provided by
Section 4(2) of the Securities Act of 1933 for transactions by an issuer not
involving a public offering.

On December 6, 2001, our registration statement on Form S-1, File No.
333-69846 (the "Registration Statement"), was declared effective by the
Securities and Exchange Commission in connection with our spin-off from Senior
Housing through distribution of 4,342,170 of our Common Shares to Senior Housing
shareholders on December 31, 2001. The offering or distribution of the Common
Shares registered was not underwritten by an investment bank or otherwise. We
incurred aggregate fees and expenses reasonably estimated to be $1,750,000,
which were paid by Senior Housing. We did not receive any proceeds or other
consideration from this offering or distribution.

On March 26, 2002 we sold 3,700,000 Common Shares in an underwritten
public offering, raising gross proceeds of $25,911,100. We incurred aggregate
fees and expenses reasonably estimated to be $500,000. We intend to use the
estimated net proceeds of $25,400,000 to partially fund our pending acquisition.
The public offering price of the shares was $7.45 per share.

Item 6. Selected Financial Data

The following table presents selected financial data which has been
derived from our historical financial statements for the period from April 27,
2000 (the date we commenced operations) through December 31, 2001. The following
data should be read in conjunction with, and is qualified in its entirety by
reference to, our financial statements and the notes thereto included in this
Annual Report on Form 10-K. As discussed under "Management's Discussion and
Analysis of Financial Condition and Results of Operations", we are a relatively
new company and our historical financial information is not

reflective of our current operations. Accordingly, you should not place
undue reliance on our historical financial information.

Period from
April 27, 2000
Year ended through
December 31, 2001 December 31, 2000
----------------- ------------------
($ in thousands, except per share amounts)

Five Star Quality Care, Inc.
Operating data
Total revenues.......................................... $229,235 $2,520
Net income (loss)....................................... $527 $(1,316)
Earnings (loss) per share............................... $0.12 $(0.30)
Balance sheet data
Total assets............................................ $68,043 $54,788

The following table presents selected financial data of our two
predecessors and has been derived from historical financial statements of those
predecessors included elsewhere in this Annual Report on Form 10-K. The
following data should be read in conjunction with the financial statements and
notes thereto entitled Combined Financial Statements of the Forty-two Facilities
Acquired by Senior Housing Properties Trust from Integrated Health Services,
Inc. and Combined Financial Statements of Certain Mariner Post-Acute Network
Facilities (Operated by subsidiaries of Mariner Post-Acute Network) included in
this Annual Report on Form 10-K, and "Management's Discussion and Analysis of
Financial Condition and Results of Operations-Historical Results of
Operations-Mariner Predecessor" and "Historical Results of Operations-Integrated
Predecessor". The following table presents the information from 1997 to 2000.

Year ended December 31,
---------------------------------------------------
2000 1999 1998 1997
---------- --------- --------- ----------
($ in thousands)

Integrated Predecessor
Operating data
Operating revenues.................................... $135,378 $130,333 $140,116 $104,727
Net loss.............................................. (25,252) (126,939) (17,183) (10,432)
Balance sheet data
Total assets.......................................... $34,942 $61,274 $190,553 $174,954
Long term liabilities................................. -- 17,500 17,751 18,006
Mariner Predecessor
Operating data
Operating revenues.................................... $85,325 $86,945 $105,486 $107,829
Net loss.............................................. (7,421) (43,804) (7,710) (9,453)
Balance sheet data
Total assets.......................................... $23,052 $17,433 $62,502 $84,119
Long term liabilities................................. 32,091 28,603 33,195 15,498

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

OVERVIEW

We were incorporated in April 2000 as a Delaware corporation and
reincorporated in Maryland in September 2001. We were formed as a 100% owned
subsidiary of Senior Housing. Effective July 1, 2000, we assumed the operations
of healthcare facilities from two bankrupt former tenants of Senior Housing. At
the time we assumed operations of these facilities, we had not received
substantially all of the required licenses for these facilities. As a result,
for the period from July 1, 2000, through December 31, 2000, we accounted for
the operations of these facilities using the equity method of accounting and we
only recorded the net income from these operations. Since that time, we have
obtained all necessary licenses to operate these facilities, and on January 1,
2001, we began to consolidate the results of operations of these facilities. On
December 31, 2001, Senior Housing distributed substantially all of our shares to
its shareholders in a spin-off transaction and we became an independent public
company.

Since we succeeded to substantially all of the business formerly
conducted by subsidiaries or units of two former tenants of Senior Housing,
these subsidiaries and units are considered to be our predecessors. We have
included the financial statements of these predecessors in this Annual Report on
Form 10-K and discuss their results of operations. Our predecessors' financial
statements are entitled: Certain Mariner Post-Acute Network Facilities (Operated
by subsidiaries of Mariner Post-Acute Network) (referred to herein as Mariner
Predecessor); and Forty-two Facilities Acquired by Senior Housing Properties
Trust from Integrated Health Services, Inc. (referred to herein as Integrated
Predecessor).

Our revenues consist primarily of payments for services provided to
residents at our facilities. The payments are either paid for by the residents,
their families or insurers, or by the Medicare and Medicaid programs. The
substantial majority of our historical revenues have been paid by the Medicare
and Medicaid programs. The substantial majority of the revenues associated with
the 31 Marriott facilities are paid by the patients, or private pay.

On a pro forma basis, after giving effect to the new lease which we
entered for the 31 Marriott facilities in January 2002 and the pending
acquisition of five facilities, for the year ended December 31, 2001, private
pay revenues would have represented 60% of our total revenues, or 59% if our
pending acquisition does not close. Our expenses consist primarily of wages and
benefits of personnel, food, supplies and other resident care costs, as well as
taxes, insurance and other property related costs.

We were a subsidiary of Senior Housing until December 31, 2001. The
2001 results presented in this Annual Report on Form 10-K are for a period
during which we were a subsidiary of Senior Housing and they are not necessarily
indicative of what our results would have been as a separate public company.
Similarly these results are not indicative of future financial performance. Our
future results of operations are expected to differ materially from the
historical results presented in this Annual Report on Form 10-K. Material
differences are expected because our future operations will include, among other
factors, rent expense on leases to Senior Housing, general and administrative
costs incurred by us as a separate company, revenues and expenses related to our
lease entered in January 2002 for 31 retirement communities operated by Marriott
and from the pending acquisition, if it closes.

We accounted for our merger with FSQ, Inc. as the termination of a
management contract rather than as a business combination. As a result, at the
closing of the merger, because the FSQ, Inc. liabilities assumed plus the value
of our Common Shares issued in connection with the FSQ, Inc. acquisition
exceeded the fair value of FSQ's, Inc. assets acquired, we recognized an expense
of $2.8 million. For this purpose, the fair value of our Common Shares was based
on the average of the high and low price of our shares on the day of the merger,
or $7.50 per share.

OUR HISTORICAL RESULTS OF OPERATIONS

As described above, we operated, until completion of the spin-off, as a
subsidiary of Senior Housing. Our past operations as Senior Housing's subsidiary
differ from our current operations as an independent public company as follows:

o our historical operating business included certain facilities, assets
and activities which we do not own or conduct and did not include such
other factors discussed above; and

o the principal source of financing for these operating businesses was
intercompany advances from Senior Housing, an entity with financial
resources substantially in excess of ours.

We believe that because of these differences, the historical results of
operations described below are not comparable to our current operations or our
expected future operations. Specifically, in the historical periods discussed we
operated only 56 properties for Senior Housing, which owned the real estate as
well as the operations. Effective December 31, 2001, we leased these 56
facilities from Senior Housing which continued to own the real estate. On
January 11, 2002, we began to lease an additional 31 facilities from Senior
Housing. Moreover, we now conduct our own affairs and incur costs as a separate
public company some of which are more and some of which are less than the costs
incurred by Senior Housing and allocated to us in the historical periods.

Years ended December 31, 2001 and 2000

We did not begin to operate the senior living facilities of our
predecessors or generate revenue until July 1, 2000. Therefore, our results for
the year ended December 31, 2001, are not comparable to the year ended December
31, 2000.

Revenues for the year ended December 31, 2001, were $229.2 million. On
a combined basis, the two predecessor entities had revenues of $220.7 million
for the year ended December 31, 2000. This increase was due mainly to an
increase in the average daily rate received during these periods.

Expenses for the year ended December 31, 2001, were $228.8 million. On
a combined basis, the predecessor entities had expenses of $253.4 million for
the year ended December 31, 2000. The decrease is due primarily to rent and
interest expenses which were included in the 2000 expenses of our predecessors
but were zero in 2001 because, after Senior Housing's repossessions and
foreclosures, rent and interest payments on the leases and mortgages ceased.
Period from April 27, 2000 (date operations commenced) through December 31, 2000

This period was our first period of operations and, therefore, there is
no comparable period.

During 2000 we accounted for our investment in these operating
businesses using the equity method of accounting. As a result, the reported
revenues included our equity in earnings of these investees. Revenues for 2000
were $2.5 million and represent the net amount of net patient revenues in excess
of expenses of these operations for the 2000 period. Net patient revenues at the
operating businesses for the six months ended December 31, 2000, were $114.5
million and expenses incurred for the period were $112.0 million.

LIQUIDITY AND CAPITAL RESOURCES

On a historical basis our expenditures, including capital expenditures
and for working capital, were provided by Senior Housing. We maintained no
financing sources apart from Senior Housing.

At the time of our spin-off from Senior Housing on December 31, 2001,
we had cash of $24.9 million, operating accounts receivable of $36.4 million and
accrued operating expenses and other liabilities totaling $17.8 million.

We lease all of our current facilities from Senior Housing. Our leases
with Senior Housing require us to pay a total of $70 million of base rent
annually. Percentage rent on our current leases does not begin until 2003 and
2004. We expect these increases to be modest relative to our overall liquidity.
Payments required of us under our lease for 31 Marriott facilities also include
a percentage of revenues for a capital expenditure reserve. If events of default
under the leases occur, Senior Housing has the ability to accelerate our rent
payments. Our leases with Senior Housing are cross-defaulted with one another,
and events of default include: our failure to pay rent when due; our default
under any indebtedness which gives the holder the right to accelerate; our
default under the Marriott management agreements; and our being declared
ineligible to receive reimbursement under Medicare and Medicaid programs for any
of the leased facilities.

On January 10, 2002, we accepted a non-binding letter of intent from a
lender for a new, three year $20 million line of credit to be secured by our
accounts receivable. This financing is subject to lender diligence, final
documentation and other customary conditions. We expect this financing to close
on or before April 30, 2002, but it may not close before that date or at all.

On January 23, 2002, we agreed to acquire five communities for $45.5
million. We expect to fund this acquisition with our cash and the proceeds of
our common share offering discussed below.

In March 2002, we issued 3,700,000 million common shares, raising gross
proceeds of $25.9 million. Net proceeds, after underwriting costs and other
estimated offering expenses, were $25.4 million and are expected to be used
together with cash on hand, to acquire the communities discussed above.

Other than our leases with Senior Housing and our agreement to acquire
five communities, we have no individually material contractual or commercial
obligations or commitments.

Our primary source of cash to fund operating expenses, including rent
and routine capital expenditures, is the resident revenues we generate at our
facilities. Changes in laws and regulations which impact Medicare or Medicaid
rates, on which many of our properties rely for substantial amounts of revenues,
or changes in insurance costs caused by recent, material litigation awards in
some states may materially affect our future results. We believe that our
revenues will be sufficient to allow us to meet our ongoing operating expenses,
working capital needs and rent payments to Senior Housing in the short term, or
next 12 months, and long term, whether or not we arrange for a line of credit
secured by our receivables, as described above. Despite this belief, our
operating cash flow as a percentage of our revenues is small; a small percentage
decline in revenue or increase in our operating expenses could eliminate or
reduce our operating cash flow. If our other resources, such as our cash on
hand, or our pending $20 million line of credit, are not available or
insufficient, the decline in operating cash flow may cause lease defaults or
other material consequences.

Our shared services agreement with Reit Management allows us to defer
payments to Reit Management under the shared services agreement if necessary to
make rent payments to Senior Housing. On a pro forma basis, assuming completion
of our January 2002 lease for 31 Marriott facilities and our pending
acquisition, payments to Reit Management for shared services would have totaled
$3.1 million during the year ended December 31, 2001.

SEASONALITY

Our business is subject to modest effects of seasonality. During the
calendar fourth quarter holiday periods nursing home and assisted living
residents are sometimes discharged to join family celebrations and admission
decisions are often deferred. The first quarter of each calendar year usually
coincides with increased illness among nursing home and assisted living
residents which can result in increased costs or discharges to hospitals. As a
result of these factors, nursing home and assisted living operations sometimes
produce greater earnings in the second and third quarters of a calendar year and
lesser earnings in the first and fourth quarters. We do not believe that this
seasonality will cause fluctuations

in our revenues or operating cash flow to such an extent that we will have
difficulty paying our expenses, including rent, which do not fluctuate
seasonally.

INFLATION AND DEFLATION

Inflation in the past several years in the United States has been
modest. Future inflation might have both positive or negative impacts on our
business. Rising price levels may allow us to increase occupancy charges to
residents, but may also cause our operating costs, including our percentage
rent, to increase.

Deflation would likely have a negative impact upon us. A large
component of our expenses consist of minimum rental obligations to Senior
Housing. Accordingly we believe that a general decline in price levels which
could cause our charges to residents to decline would likely not be fully offset
by a decline in our expenses.

CRITICAL ACCOUNTING POLICIES

Our most critical accounting policies regard revenue recognition and
our assessment of the net realizable value of our accounts receivable. These
policies involve significant judgments based upon our experience, including
judgments about changes in payment methodology, contract modifications and
economic conditions that may affect the collectibility of our accounts
receivable. In the future we may need to revise our assessment to incorporate
information which is not yet known and such revisions could increase or decrease
our net revenues or cause us to adjust the net carrying value of our accounts
receivable.

HISTORICAL RESULTS OF OPERATIONS-MARINER PREDECESSOR

The Mariner Predecessor conducted operations of 17 facilities leased
from Senior Housing. The operations of the Mariner Predecessor during the period
prior to its acquisition by Senior Housing differ from our operations as
follows:

o The business of the Mariner Predecessor was conducted by its then
parent, Mariner Post-Acute Network, Inc., an entity with a capital
structure, corporate overhead costs, and operating systems
substantially different than ours.

o During the period of Mariner's operation of this business, significant
write-offs of goodwill and other long lived assets of the Mariner
Predecessor occurred and Mariner filed for bankruptcy.

We believe that because of these differences, the historical results of
operations described below are not comparable to our operations. Specifically,
the historical operations described below include: revenues and operating
expenses for only 17 facilities, one of which has since been closed, while
currently we generate revenues and incur operating expenses at 87 facilities;
revenues prior to 1999 which were based in part upon Medicare rates established
prior to the completion of the phase-in of the new Medicare prospective payment
system; depreciation expenses which relate to real estate and amortization
expenses which relate to goodwill, while we do not have substantial depreciable
assets; expenses related to allocation of corporate overhead by the parent of
these operations, while we incur different corporate expenses; rent expense
under a lease which has been cancelled; charges for impairments of long lived
assets of substantial amounts, while we do not have substantial long lived
assets and have not incurred similar changes; and interest expense incurred on
debt, while we have no debt at this time.

Years ended December 31, 2000 and 1999-Mariner Predecessor

Revenues for the year ended December 31, 2000, were $85.3 million.
These revenues represent a decrease of $1.6 million from the revenues in the
1999 period. This decrease is attributable primarily to

a slight decrease in occupancy at the facilities in operation during both
periods and to the closing of one facility.

Expenses for the year ended December 31, 2000, were $92.6 million, a
decrease of $1.6 million over the 1999 period, excluding non-recurring or
unusual charges and write-offs incurred in 1999. This decrease is attributable
primarily to decreases in general and administrative costs and provision for bad
debts and rent, offset by an increase in salary, wages and benefits.

Net loss for the year ended December 31, 2000, was $7.4 million, a
decrease in loss of $36.4 million over the 1999 period. This decrease in loss is
principally attributable to the impact of unusual charges related to the
impairment of long lived assets in 1999.

HISTORICAL RESULTS OF OPERATIONS-INTEGRATED PREDECESSOR

The Integrated Predecessor conducted operations of 42 facilities leased
from or mortgaged to Senior Housing. The operations of the Integrated
Predecessor during the period prior to its acquisition by Senior Housing differ
from our operations as follows:

o The business of the Integrated Predecessor was conducted by its then
parent, Integrated Health Services, Inc., an entity with a capital
structure, corporate overhead costs, and operating ms
systesubstantially different than ours.

o During the period of Integrated Health Services' operation of this
business, significant write-offs of goodwill and other long lived
assets of the Integrated Predecessor occurred and Integrated Health
Services filed for bankruptcy.

We believe that because of these differences, the historical results of
operations described below are not comparable to our operations. Specifically,
the historical operations described below include: revenues and operating
expenses for only 42 facilities, one of which has since been closed, while we
currently generate revenues and incur operating expenses at 87 facilities;
revenues prior to 1999 which were based in part upon Medicare rates established
prior to the completion of the phase in of the new Medicare prospective payment
system; depreciation expenses which relate to real estate and amortization
expenses which relate to intangible assets, while we do not have substantial
depreciable assets; expenses related to corporate overhead and management fees
charged by the parent of the Integrated Predecessor, while we incur different
corporate expenses; rent expense under a lease which has been cancelled; charges
for impairments of long lived assets of substantial amounts, while we do not
have substantial long lived assets and have not incurred similar charges; and
interest expense incurred on debt, while we currently have no debt.

Years ended December 31, 2000 and 1999-Integrated Predecessor

Revenues for the year ended December 31, 2000, were $135.4 million.
These revenues represent an increase of $5.0 million over the revenues in the
1999 period. This increase resulted primarily from an increase in Medicaid rates
and an increase in occupancy at the Integrated Predecessor facilities.

Expenses for the year ended December 31, 2000, excluding non-recurring
or unusual charges and write-offs of $16.7 million as discussed in the next
paragraph, were $144.0 million, a decrease of $2.1 million from the 1999 period.
This decrease is attributable primarily to a decrease in rent, depreciation and
amortization at the Integrated Predecessor facilities offset by increased
operating expenses.

During the 2000 period, the Integrated Predecessor incurred unusual
charges related to a loss on settlement of lease and mortgage obligations of
$16.7 million. These charges were a result of the bankruptcy settlement between
Integrated and Senior Housing and represent the carrying value of the tangible
and intangible assets of the facilities conveyed to Senior Housing, less the
debts due Senior

Housing which were not paid. During the 1999 period, the Integrated Predecessor
incurred write-offs and unusual charges related to a loss on impairment of long
lived assets of $120.0 million.

Net loss for the year ended December 31, 2000, was $25.3 million, a
decrease of $101.7 million from the net loss of $126.9 million in 1999. This
decrease in loss is attributable to the decreases in rent, depreciation and
amortization and the impact of unusual charges discussed above.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We have no obligations for funded debt and as such are not directly
affected by changes in market interest rates. However, as discussed above, we
expect to enter a $20 million revolving credit facility secured by our accounts
receivable. We expect that this loan facility will require interest on drawn
amounts at floating rates based upon a spread above LIBOR. Accordingly, whenever
borrowings are outstanding under such a credit facility we may be exposed to
market changes in interest rates, especially market changes in short term LIBOR
rates. For example, if the full amount of a $20 million line of credit were
drawn and interest rates rose by 1% per annum, our interest expense would
increase by $200,000 per year, or $0.02 per share.

We may from time to time consider our exposure to interest rate risks
if we have or expect to have material amounts of floating rate obligations. As a
result of these considerations we may decide to purchase interest rate caps or
other hedging instruments.

Item 8. Financial Statements and Supplementary Data

The information required by this Item is included elsewhere in this
Annual Report on Form 10-K. Our financial statements and financial statement
schedules begin on Page F-1 (see index in Item 14(a)).

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

Not applicable.

PART III

The information in Part III (Items, 10, 11, 12 and 13) is incorporated
by reference to our definitive Proxy Statement, which is expected to be filed
not later than 120 days after the end of our fiscal year.

PART IV

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

(a) Index to Financial Statements and Financial Statement Schedules

Page

Five Star Quality Care, Inc. Historical Financial Statements

Report of Independent Auditors.................................................................................. F-1

Consolidated Balance Sheets at December 31, 2001 and 2000....................................................... F-2

Consolidated Statements of Operations for the year ended December 31, 2001 and the period from April 27,
2000 (Inception) through December 31, 2000...................................................................... F-3

Consolidated Statement of Shareholders' Equity for the year ended December 31, 2001 and the period April 27,
2000 (Inception) through December 31, 2000...................................................................... F-4

Consolidated Statements of Cash Flows for the year ended December 31, 2001 and the period from April 27,
2000 (Inception) through December 31, 2000...................................................................... F-5

Notes to Consolidated Financial Statements...................................................................... F-6

Combined Financial Statements of the Forty-two Facilities Acquired by Senior Housing Properties Trust from
Integrated Health Services, Inc. (Integrated Predecessor)

Independent Auditors' Report.................................................................................... F-13

Combined Balance Sheets at December 31, 2000 and 1999........................................................... F-14

Combined Statements of Operations for the years ended December 31, 2000 and 1999................................ F-15

Combined Statements of Changes in Net Equity (Deficit) of Parent Company for the years ended December 31,
2000 and 1999................................................................................................... F-16

Combined Statements of Cash Flows for the years ended December 31, 2000 and 1999................................ F-17

Notes to Combined Financial Statements.......................................................................... F-18

Schedule II-Valuation and Qualifying Accounts for the years ended December 31, 2000 and 1999.................... F-29

Combined Financial Statements of Certain Mariner Post-Acute Network Facilities (Operated by subsidiaries of
Mariner Post-Acute Network) (Mariner Predecessor)

Report of Independent Auditors.................................................................................. F-30

Combined Balance Sheets at December 31, 2000 and 1999........................................................... F-31

Combined Statements of Operations for each of the two years ended December 31, 2000 and 1999.................... F-32

Combined Statements of Divisional Equity (Deficit) for each of the two years ended December 31, 2000 and 1999... F-33

Combined Statements of Cash Flows for each of the two years ended December 31, 2000 and 1999.................... F-34

Notes to Combined Financial Statements.......................................................................... F-35

Schedule II-Valuation and Qualifying Accounts for each of the two years ended December 31, 2000 and 1999........ F-45

(b) Reports on Form 8-K

During the fourth quarter of 2001, the Company did not file any Current
Reports on Form 8-K.

Exhibit No. Description

2.1* Transaction Agreement, dated December 7, 2001, by and among
Senior Housing Properties Trust, certain subsidiaries of Senior
Housing Properties Trust party thereto, the Registrant, certain
subsidiaries of the Registrant party thereto, FSQ, Inc.,
Hospitality Properties Trust, HRPT Properties Trust and Reit
Management & Research LLC

2.2* Agreement of Merger, dated December 5, 2001, among the
Registrant, FSQ Acquisition, Inc. and FSQ, Inc.

2.3** Sale-Purchase Agreement between ILM II Senior Living, Inc. and
ILM II Holding, Inc. and the Registrant, dated January 23, 2002

2.4** First Amendment to Sale-Purchase Agreement among ILM II Senior
Living, Inc., ILM II Holding, Inc. and Five Star Quality Care,
Inc., dated February 22, 2002

2.5** Second Amendment to Sale-Purchase Agreement among ILM II Senior
Living, Inc., ILM II Holding, Inc., and Five Star Quality Care,
Inc., dated March 1, 2002

3.1*** Articles of Amendment and Restatement of the Registrant

3.2*** Amended and Restated Bylaws of the Registrant

4.1*** Specimen Certificate for shares of common stock of the
Registrant

4.2 Description of Capital Stock of the Registrant (contained in
Exhibits 3.1 and 3.2)

10.1*** Stock Purchase Agreement, dated August 9, 2001, among Senior
Housing Properties Trust, SNH/CSL Properties Trust, Crestline
Capital Corporation and CSL Group, Inc.

10.2**** Amendment to Stock Purchase Agreement, dated November 5, 2001,
among Senior Housing Properties Trust, SNH/CSL Properties Trust,
Crestline Capital Corporation and CSL Group, Inc.

10.3** Shared Services Agreement, dated January 2, 2002, between the
Registrant and Reit Management & Research LLC

10.4** Amendment No. 1 to Shared Services Agreement between the
Registrant and Reit Management & Research LLC, dated January 14,
2002

10.5+*** 2001 Stock Option and Stock Incentive Plan of the Registrant

10.6***** Master Lease Agreement, dated December 31, 2001, by and among
certain affiliates of Senior Housing Properties Trust, as
Landlord, and Five Star Quality Care Trust, as Tenant

10.7***** Guaranty Agreement, dated December 31, 2001, made by the
Registrant, as Guarantor, for the benefit of the Landlord under
the Master Lease Agreement, dated December 31, 2001, by and
among certain affiliates of Senior Housing Properties Trust, as
Landlord, and Five Star Quality Care Trust, as Tenant

10.8** Pledge of Shares of Beneficial Interest Agreement, dated
December 31, 2001, made by the Registrant for the benefit of the
Landlord under the Master Lease Agreement, dated December 31,
2001, by and among certain affiliates of Senior Housing
Properties Trust, as Landlord, and Five Star Quality Care Trust,
as Tenant

10.9** Security Agreement, dated December 31, 2001, by and among Five
Star Quality Care Trust and the Landlord under the Master Lease
Agreement by and among certain affiliates of Senior Housing
Properties Trust, as Landlord, and Five Star Quality Care Trust,
as Tenant, dated December 31, 2001

10.10***** Amended Master Lease Agreement, dated January 11, 2002, by and
among certain affiliates of Senior Housing Properties Trust, as
Landlord, and FS Tenant Holding Company Trust and FS Tenant Pool
III Trust, as Tenant

10.11***** Guaranty Agreement, dated January 11, 2002, made by the
Registrant, as Guarantor, for the benefit of the Landlord under
the Amended Master Lease Agreement, dated January 11, 2002, by
and among certain affiliates of Senior Housing Properties Trust,
as Landlord, and FS Tenant Holding Company Trust and FS Tenant
Pool III Trust, as Tenant

10.12** Pledge of Shares of Beneficial Interest Agreement, dated January
11, 2002, made by FSQ, Inc. for the benefit of the Landlord
under the Amended Master Lease Agreement, dated January 11,
2002, by and among certain affiliates of Senior Housing
Properties Trust, as Landlord, and FS Tenant Holding Company
Trust and FS Tenant Pool III Trust, as Tenant

10.13** Security Agreement, dated January 11, 2002, by and among FS
Tenant Holding Company Trust and the Landlord under the Amended
Master Lease Agreement, dated January 11, 2002, by and among
certain affiliates of Senior Housing Properties Trust, as
Landlord, and FS Tenant Holding Company Trust and FS Tenant Pool
III Trust, as Tenant

#10.14** Representative Form of Composite Copy of Operating Agreement, as
amended through December 13, 2001 between certain subsidiaries
of the Registrant and Marriott Senior Living Services, Inc.

#10.15*** Representative Form of Pooling Agreement by and between certain
subsidiaries of the Registrant and Marriott Senior Living
Services, Inc.

21.1** Subsidiaries of the Registrant

-----------
* Incorporated by reference to Senior Housing Properties Trust's Current
Report on Form 8-K, dated December 13, 2001.

** Incorporated by reference to the Registrant's Registration Statement
on Form S-1, File No. 333-83648.

*** Incorporated by reference to the Registrant's Registration Statement
on Form S-1, File No. 333-69846.

**** Incorporated by reference to Senior Housing Properties Trust's Current
Report on Form 8-K, dated November 5, 2001.

***** Incorporated by reference to Senior Housing Properties Trust's Current
Report on Form 8-K, dated December 31, 2001.

+ Indicates a management contract or a compensatory plan, contract or
arrangement.

# Agreement filed is illustrative of numerous other agreements to which
the Registrant is a party.

(d) Financial Statement Schedules

1. Schedule II-Valuation and Qualifying Accounts of Forty-two Facilities
Acquired by Senior Housing Properties Trust from Integrated Health
Services, Inc.

2. Schedule II-Valuation and Qualifying Accounts of Certain Mariner
Post-Acute Network Facilities (Operated by subsidiaries of Mariner
Post-Acute Network, Inc.)

All other schedules have been ommitted because the required information is
included in the consolidated financial statements or notes thereto or they are
not required submissions.

REPORT OF INDEPENDENT AUDITORS

To the Directors and Shareholders of
Five Star Quality Care, Inc.

We have audited the accompanying consolidated balance sheets of Five Star
Quality Care, Inc. as of December 31, 2001 and 2000, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
the year ended December 31, 2001 and the period April 27, 2000 (inception)
through December 31, 2000. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Five Star Quality
Care, Inc. at December 31, 2001 and 2000, and the consolidated results of its
operations and its cash flows for the year ended December 31, 2001 and the
period April 27, 2000 (inception) through December 31, 2000 in conformity with
accounting principles generally accepted in the United States.

/s/ Ernst & Young LLP
Boston, Massachusetts
February 22, 2002

F-1

FIVE STAR QUALITY CARE, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share and per share amounts)

December 31,
-------------------------------------------
2001 2000
-------------------- ---------------------

Assets
Current assets:
Cash and cash equivalents.............................. $24,943 $--
Accounts receivable, net of allowance of $3,787 at
December 31, 2001.................................... 36,436 --
Prepaid expenses and other current assets ............. 3,750 --
--------------------- ---------------------
Total current assets................................... 65,129 --
Net investment in facilities' operations.................. -- 29,046

Property and equipment, net............................... 2,914 25,742
--------------------- ---------------------
$68,043 $54,788
===================== =====================

Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable and accrued expenses.................. $7,141 $--
Accrued compensation and benefits...................... 5,288 --
Due to affiliates, net................................. 2,232 --
Accrued real estate taxes.............................. 1,485 --
Note payable........................................... -- 100
Other current liabilities.............................. 1,664 --
--------------------- ---------------------
Total current liabilities.............................. 17,810 100

Commitments and contingencies

Shareholders' equity:
Preferred stock, par value $0.01:1,000,000 shares
authorized, none issued -- --
Common stock, par value $0.01: 10,000,000 shares
authorized, 4,374,334 shares issued and outstanding
as of December 31, 2001 and 3,000 shares authorized,
1,000 shares issued and outstanding as of December 31,
2000 44 --
Additional paid-in-capital 50,978 56,004
Accumulated deficit (789) (1,316)
--------------------- ---------------------
Total shareholders' equity 50,233 54,688
--------------------- ---------------------
$68,043 $54,788
===================== =====================

See accompanying notes.

F-2

FIVE STAR QUALITY CARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except per share amounts)

Period
April 27, 2000
(Inception)
through
Year Ended December 31,
December 31, 2001 2000
------------------- ----------------

Revenues:
Net patient revenues.......................................... $229,235 $--
Income from facilities' operations............................ -- 2,520
------------------- ----------------
Total revenues..................................................... 229,235 2,520

Expenses:
Wages and benefits............................................ 138,883 --
Other operating expenses...................................... 72,967 --
General and administrative.................................... 15,627 3,519
Depreciation ................................................. 1,274 317
------------------- ----------------
Total expenses..................................................... 228,751 3,836
------------------- ----------------

Operating income (loss) ........................................... 484 (1,316)

Interest income, net............................................... 43 --
------------------- ----------------

Net income (loss) before income taxes.............................. 527 (1,316)

Provision for income taxes......................................... -- --
------------------- ----------------

Net income (loss) ................................................. $527 $(1,316)
=================== ================

Weighted average shares outstanding ............................... 4,374 4,374
=================== ================

Earnings (loss) per share ........................................ $0.12 $(0.30)
=================== ================

See accompanying notes.

F-3

FIVE STAR QUALITY CARE, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(amounts in thousands, except share amounts)

For the year ended December 31, 2001 and the period April 27, 2000
(Inception) through December 31, 2000

Additional
Number of Common Paid-in Accumulated
Shares Stock Capital Deficit Total
------ ----- ------- ------- -----

Balance at April 27, 2000............. 1,000 $-- $ 1 $- $1

Contribution from Senior Housing,
net................................... -- -- 56,003 -- 56,003

Net loss.............................. -- -- -- (1,316) (1,316)
---------- -------- ----------- ----------- -----------

Balance at December 31, 2000.......... 1,000 -- 56,004 (1,316) 54,688

Issuance of shares, pursuant to
spin-off.............................. 4,373,334 44 189 -- 233

Distribution to Senior Housing, net... -- -- (5,215) -- (5,215)

Net income............................ -- -- -- 527 527
---------- -------- ----------- ----------- -----------

Balance at December 31, 2001.......... 4,374,334 $44 $50,978 $(789) $50,233
========== ======== =========== =========== ===========

See accompanying notes.

F-4

FIVE STAR QUALITY CARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)

Period
April 27, 2000
(Inception)
Year Ended through December
December 31, 2001 31, 2000
-------------------- ------------------

Cash flows from operating activities:
Net income (loss)................................................... $ 527 $(1,316)
Adjustments to reconcile net income (loss) to cash used in operating
activities:
Depreciation................................................... 1,274 317
Amortization................................................... 47 --
Provision for bad debt......................................... 1,587 --
Income from facilities' operations............................. -- (2,520)
Changes in assets and liabilities:
Accounts receivable......................................... 9,571 --
Prepaid expenses and other current assets................... (2,685) --
Accounts payable and accrued expenses....................... (4,905) --
Accrued compensation and benefits........................... (492) --
Due to affiliates, net...................................... 2,232 --
Other current liabilities................................... (8,316) --
----------------- ---------------
Cash used in operating activities.............................. (1,160) (3,519)
----------------- ---------------

Cash flows from investing activities:
Real estate acquisitions............................................ -- (2,300)
Investment in facilities' operations................................ -- (38,530)
Equipment purchases................................................. (2,176) --
----------------- ---------------
Cash used in investing activities.............................. (2,176) (40,830)
----------------- ---------------

Cash flows from financing activities:
Payment of deferred financing costs................................. (1,016) --
Proceeds from note payable.......................................... -- 100
Proceeds from mortgage payable...................................... 9,100 --
Proceeds from issuance of common stock.............................. 233 1
Owners contribution, net............................................ 12,783 44,248
----------------- ---------------
Cash provided by financing activities.......................... 21,100 44,349
----------------- ---------------

Increase in cash and cash equivalents.................................. 17,764 --
Cash and cash equivalents at beginning of period....................... -- --
Cash and cash equivalents at facilities' operations, beginning of
period............................................................... 7,179 --
----------------- ---------------
Cash and cash equivalents at end of period............................. $ 24,943 $--
----------------- ---------------

Non-cash investing and financing activities:
Contribution of real estate and related property from Senior
Housing........................................................... $(2,232) $(23,759)
Distribution of real estate and other assets to Senior Housing...... 29,330 --
Liabilities assumed by facilities' operations....................... -- 12,004
Assumption of mortgage payable by Senior Housing.................... (9,100) --

See accompanying notes.

F-5

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

1. Organization

Five Star Quality Care, Inc. (the "Company") was organized on April 27,
2000, as a wholly owned subsidiary of Senior Housing Properties Trust ("Senior
Housing"). The Company was formed under Delaware law in 2000 and reincorporated
under Maryland law on September 20, 2001. Effective July 1, 2000, the Company
assumed the operations of healthcare facilities from two former tenants of
Senior Housing.

On December 31, 2001, Senior Housing distributed 4,342 of the Company's
Common Shares to its shareholders (the "Spin-Off"). Additionally, the Company
sold 32 Common Shares to Senior Housing and HRPT Properties Trust ("HRPT").
Concurrent with the Spin-Off, the Company entered into a lease agreement with
Senior Housing for 56 healthcare facilities. The Company also entered into a
transaction agreement to govern the initial capitalization and other events
related to the Spin-Off. Pursuant to the transaction agreement, the Company's
initial capitalization of $50,000 was provided by Senior Housing. In connection
with the Spin-Off, the Company (i) transferred title to seven properties and
other assets with a net book value at December 31, 2001 of $29,330 to Senior
Housing, (ii) conveyed a mortgage of $9,100 at December 31, 2001 to Senior
Housing and (iii) obtained title to two properties with a net book value of
$2,232 at December 31, 2001 from Senior Housing.

2. Summary of Significant Accounting Policies

Basis of presentation. The accompanying consolidated financial
statements include the accounts of the Company and all of its subsidiaries. All
intercompany transactions have been eliminated.

The Company was owned by Senior Housing until December 31, 2001 and
transactions are presented on Senior Housing's historical basis. Prior to
December 31, 2001, substantially all of the income from the facilities'
operations received by the Company was deposited in and commingled with Senior
Housing's general funds, and Senior Housing provided funds for working capital
and other cash required by the Company. General and administrative expenses are
comprised of costs incurred by Senior Housing and charged to the Company
primarily based on a specific identification basis, which in the opinion of
management is reasonable. It is not practicable to estimate additional costs
that would have been incurred by the Company as a separate entity.

The facilities operations commenced by the Company on July 1, 2000 were
initially subject to completion of state and Federal regulatory processes, which
were substantially completed on December 31, 2000. As a result, for the period
July 1, 2000 through December 31, 2000, the facilities were accounted for using
the equity method. Net income from these operations for the period prior to
December 31, 2000, is reported as income from facilities' operations in the
Consolidated Statements of Operations and the capital invested in these
operations as of December 31, 2000, is included in net investment in facilities'
operations on the Consolidated Balance Sheets.

Cash and cash equivalents. Highly liquid investments with original
maturities of three months or less at the date of purchase are considered to be
cash equivalents.

Property and equipment. Fixed assets are stated at cost. Depreciation
of property and equipment is expensed on a straight-line basis over the
estimated useful lives of up to 40 years for buildings and improvements and up
to 12 years for personal property.

F-6

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

2. Summary of Significant Accounting Policies (Continued)

Impairment of long lived assets. Impairment losses are recognized when
indicators of impairment are present and the undiscounted cash flow estimated to
be generated by the Company's investments is less than the carrying amount of
such investments. The amount of impairment loss, if any, is determined by
comparing the carrying amount of the Company's investment to its estimated fair
value.

Income taxes. Prior to December 31, 2001, substantially all of the
Company's taxable income was included in the taxable income of Senior Housing
for federal income tax purposes. Senior Housing qualifies as a real estate
investment trust ("REIT") under the Internal Revenue Code of 1986, as amended
("IRC"), and, prior to December 31, 2001, the Company was a subsidiary of Senior
Housing. A portion of the Company's income generated by subsidiaries is subject
to federal income taxes. These subsidiaries generated tax losses in both 2001
and 2000.

Use of estimates. Preparation of these financial statements in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that may affect the
amounts reported in these financial statements. Actual results could differ from
these estimates.

Per common share amounts. Earnings per share has been presented as if
the shares outstanding at December 31, 2001 were outstanding as of April 27,
2000. The Company has no common share equivalents, instruments convertible into
Common Shares or other dilutive instruments.

Revenues. The Company's revenues are derived primarily from providing
healthcare services to residents. Approximately 76% of 2001 revenues was derived
from payments under Federal and state medical assistance programs. The Company
accrues for revenues when services are provided at standard charges adjusted to
amounts estimated to be received under governmental programs and other
third-party contractual arrangements. Revenues are reported at their estimated
net realizable amounts and are subject to audit and retroactive adjustment. As
of December 31, 2001 the Company had an allowance for doubtful accounts which
totaled $3,787. During 2001, the Company increased its allowance for doubtful
accounts by $3,283 and wrote off $1,696 of accounts receivable as uncollectable.

Amounts due from the Federal government Medicare program were $14,020
at December 31, 2001. Amounts due from various state Medicaid programs were
$17,979 at December 31, 2001. Of these balances approximately $1,800 is expected
to be paid to Integrated Health Services Inc. ("IHS") for the Company's account.
The Company believes IHS will pay these funds pursuant to its contractual
obligation approved by the Bankruptcy Court. However, IHS remains in bankruptcy
proceedings and its record keeping and payment processing has not been timely.

New accounting pronouncements. In 2001 the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards ("SFAS") No.
141 "Business Combinations", SFAS No. 142 "Goodwill and Other Intangible Assets"
and SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets". The Company will adopt these pronouncements as of January 1, 2002. The
Company expects the adoption of these standards will not have a material effect
on the Company's financial position or results of operations.

F-7

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

3. Net Investment in Facilities' Operations

The Company assumed operating responsibility for the healthcare
facilities effective July 1, 2000, pending final regulatory approvals required
in the healthcare industry. Former tenants of Senior Housing performed these
licensed services until January 1, 2001. Because all approvals had not been
received by December 31, 2000, net income from these facilities is reflected as
income from facilities' operations in the Consolidated Statements of Operations
for the period April 27, 2000 (Inception) through December 31, 2000. The capital
invested in these operations as of December 31, 2000, is included in net
investment in facilities' operations in the Consolidated Balance Sheets.

Summary financial data for these facilities' operations is as follows:

July 1 through
December 31, 2000 December 31, 2000
----------------- -----------------

Current assets.............................. $55,938 Revenues............................. $114,483
Property and equipment, net................. 2,399 Expenses............................. 111,963
------- -------
$58,337 Income from facilities' operations... $2,520
======= ======
Current liabilities......................... $29,291
Net investment in facilities' operations.... 29,046
------
$58,337
=======

4. Property and Equipment

Property and equipment, at cost, consists of the following as of
December 31, 2001 and 2000:

2001 2000
--------------- ---------------

Land......................................................... $237 $2,949
Building and improvements.................................... 1,999 20,584
Furniture, fixtures and equipment............................ 885 2,526
------ -------
3,121 26,059
Accumulated depreciation..................................... (207) (317)
------ -------
$2,914 $25,742
====== =======

F-8

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

5. Income Taxes

Significant components of the Company's deferred tax assets and
liabilities as of December 31, 2001, and 2000 are:

2001 2000
------------ ------------

Deferred tax assets (liabilities)
Allowance for doubtful accounts................................................... $1,325 $65
Net operating loss carryforward................................................... 168 66
Property and equipment............................................................ 1,977 (37)
------ ----
Net deferred tax assets before valuation allowance................................ 3,470 94
Valuation allowance............................................................... (3,470) (94)
------- ----
Net deferred tax assets........................................................... $ - $ -
=== ===

During 2001 and 2000, some of the Company's subsidiaries were taxable
entities separate from Senior Housing and generated net operating loss
carryforwards for tax purposes. These subsidiary net operating loss
carryforwards totaled $479 and $189 at December 31, 2001 and 2000 respectively,
and may be used under certain conditions to reduce future taxable income of the
Company. These net operating loss carryforwards will expire beginning in 2015,
if unused.

During 2001 and 2000, the Company and certain of its subsidiaries were
part of Senior Housing for federal tax purposes. These subsidiaries contributed
expenses in excess of revenues for tax purposes to Senior Housing during 2001
and 2000. Some of the temporary differences between such excess and the
Company's book income in 2001 and 2000 are expected to reverse in future periods
when the Company is a separate consolidated group (i.e., after the Spin-Off).
Such temporary differences totaled approximately $1,400 as of December 31, 2001,
and relate primarily to the allowance for doubtful accounts.

In connection with the Spin-Off, Senior Housing contributed assets to
the Company with tax basis in excess of book basis; the tax effect of this
temporary difference was approximately $1,900 as of December 31, 2001.

A full valuation allowance has been recorded in the accompanying
financial statements to offset the net deferred tax asset because its future
realizability is uncertain.

The blended statutory federal and state income tax rates applicable to
the Company of 35% in 2001 and 2000 was fully offset by the change in valuation
allowances for those periods.

6. Transactions with Affiliates

On October 1, 2000, the Company entered into third party management
agreements with FSQ, Inc. to manage the operations of its facilities. Messrs.
Martin and Portnoy, the Company's Managing Directors, own FSQ, Inc. During 2001
and 2000, management fees paid to FSQ, Inc. by the Company totaled approximately
$11,500 and $5,100, respectively. As of December 31, 2001, the Company was owed
approximately $1,000 from FSQ, Inc. for amounts advanced by the Company on its

F-9

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

6. Transactions with Affiliates (Continued)

behalf. This amount was satisfied as part of the merger of FSQ, Inc. into the
Company which occurred on January 2, 2002.

During 2000, HRPT, an affiliate of Senior Housing, foreclosed on a
mortgage with a principal balance outstanding of $2,400 that had been in
default. The collateral security for this mortgage was an assisted living
facility in the vicinity of a nursing home operated by the Company. In November
2000, a subsidiary of the Company purchased the former collateral from HRPT for
$2,300, its appraised value.

Pursuant to the Spin-Off transaction agreement, Senior Housing agreed
to contribute $50,000 of net working capital to the Company on December 31,
2001. Amounts were estimated on December 31, 2001 and the transaction agreement
provided that a true up of amounts contributed would be completed subsequent to
the year end. The amount owed to Senior Housing by the Company is approximately
$3,300 as of December 31, 2001.

Pursuant to the Spin-Off transaction agreement, the Company entered
into a shared service agreement with Reit Management and Research, LLC ("RMR").
Messrs. Martin and Portnoy, the Company's Managing Directors, own RMR. This
agreement provides that RMR will perform services for the Company that RMR has
historically performed for FSQ, Inc. and that the Company will pay RMR a fee
equal to 0.6% of the Company's revenues starting in 2002.

As part of the Spin-Off transaction, and in order that HRPT could make
a round lot distribution to its shareholders of one for 100 of Company shares
which HRPT received as a shareholder of Senior Housing, HRPT acquired 7 shares
of the Company from the Company for $7.26 per share. This purchase price per
share was determined as the average trading price of the Company's shares on the
date of the Spin-Off as reported by the American Stock Exchange.

The Company leases its headquarters from an entity owned by Messrs.
Martin and Portnoy. The lease expires in 2011 and requires rent of $531 per
year, subject to annual increases of $16 per year.

7. Leases

The Company has entered into a noncancelable lease with Senior Housing
for 56 facilities. The lease is a "triple-net" lease and requires that the
Company pay for all costs incurred in the operation of the facilities, including
the cost of personnel, service to residents, insurance, and real estate and
personal property taxes. The lease also requires the Company to maintain the
facilities during the lease term and to indemnify Senior Housing for any
liability which may arise during the lease term. The lease requires minimum rent
payments of $7,000 per year and percentage rent starting in 2004. The percentage
rent is an amount equal to three percent (3%) of net patient revenues at each
facility in excess of net patient revenues at such facility during 2003. The
lease expires on December 31, 2018, and the Company has one renewal option for
an additional 15 years.

F-10

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

7. Leases (Continued)

The future minimum rent required by this lease as of December 31, 2001,
is as follows:

2002........................................................... $7,000
2003........................................................... 7,000
2004........................................................... 7,000
2005........................................................... 7,000
2006........................................................... 7,000
Thereafter..................................................... 84,000
---------
$119,000
=========

8. Employee Benefit Plan

During 2001, the Company established an employee savings plan under the
provisions of the Internal Revenue Code section 401(k). All employees are
eligible to participate in the plan and are entitled, upon termination, or
retirement, to receive their portion of the plan assets. The Company does not
contribute to this plan, but does pay certain expenses of the plan. The
Company's plan expenses were $30 for the year ended December 31, 2001.

9. Fair Value of Financial Instruments

The Company's financial instruments are limited to cash and cash
equivalents, accounts receivables and payables. The fair value of these
financial instruments was not materially different from their carrying values at
December 31, 2001 and 2000.

10. Commitments and Contingencies

In conjunction with certain Medicaid rate adjustments that the Company
obtained from the State of Connecticut, the Company is obligated to fund certain
tenant improvements at the Company's Connecticut facilities. The Company expects
these improvements will be completed in 2002.

Applicable provisions of Federal and some state laws allow paying
agents for the Medicare and Medicaid programs to recoup amounts owed by Mariner
Post Acute Network, Inc. ("Mariner") and IHS to these programs for historical
overpayments from current payments to facilities now operated by the Company,
despite the bankruptcy filings by Mariner and IHS. Also, some state nursing home
licensing agencies have in the past required that a successor nursing home
licensee, such as the Company, agree to assume financial responsibility for a
predecessor licensee's obligations due to those state Medicaid programs. The
Company has negotiated agreements with the U.S. Department of Justice and
understandings with several state Medicaid agencies to limit the Company's
liabilities for obligations of Mariner and IHS to the Federal Medicare and state
Medicaid programs.

11. Subsequent Events

On January 2, 2002, the Company acquired FSQ, Inc. in order to acquire
the personnel, systems and assets necessary to manage the facilities the Company
leases from Senior Housing. The acquisition

F-11

FIVE STAR QUALITY CARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001
(amounts in thousands, except per share amounts)

11. Subsequent Events (Continued)

was a stock for stock transaction, and Messrs. Martin and Portnoy, the owners of
FSQ, Inc., each received 125 of the Company's Common Shares valued at $7.50 per
share.

On January 11, 2002, the Company entered into a lease with Senior
Housing for 31 retirement communities. These communities are managed by Marriott
Senior Living Services, Inc. ("Marriott"). The 31 retirement communities are
leased from Senior Housing through 2017, with renewal options for an additional
15 years. The minimum rent payable by the Company for these facilities is
$63,000 per year, plus a varying percentage of gross revenue each year which is
paid as additional rent to Senior Housing but will be escrowed for future
capital expenditures at the leased facilities. In addition, percentage rent will
be payable, starting in 2003, in amounts equal to five percent (5%) of net
patient revenues at each facility in excess of net patient revenues at such
facility in 2002.

12. Pro Forma Information (Unaudited)

If the Company had obtained all required healthcare licenses and began
operating the facilities as of January 1, 2000, its pro forma 2000 revenues,
expense and net loss would have been $220,703, $223,015 and $2,312,
respectively. This unaudited pro forma information is not indicative of the
operating results that would have occurred had the Company obtained all required
healthcare licenses and began operating the facilities as of January 1, 2000,
nor is it indicative of future results of operations.

13. Selected Quarterly Financial Data (Unaudited)

Summary unaudited quarterly results of operations of the Company for
the year ended December 31, 2001 and the period April 27, 2000 (Inception)
through December 31, 2000:

2001
--------------------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
----------------- ----------------- ------------------- ---------------

Revenues................................... $57,354 $55,906 $57,421 $58,554
Net (loss) income.......................... (839) (1,063) 1,238 1,191
(Loss) earnings per common share........... $(0.19) $(0.24) $0.28 $0.27

2000
------------------------------------------------------
Second Quarter Third Quarter Fourth Quarter
----------------- ------------------ ---------------

Revenues..................................................... $-- $1,228 $1,292
Net income (loss) ........................................... (870) 1,070 (1,516)
Earnings (loss) per common share............................. $(0.20) $0.24 $(0.34)

F-12

INDEPENDENT AUDITORS' REPORT

The Board of Directors
Senior Housing Properties Trust:

We have audited the accompanying combined balance sheets of the Forty-two
facilities acquired by Senior Housing Properties Trust from Integrated Health
Services, Inc. (Acquired Facilities) as described in note 1 as of December 31,
2000 and 1999 and the related statements of operations, changes in net equity
(deficit) of parent company and cash flows for each of the years in the two-year
period ended December 31, 2000. In connection with our audits of the combined
financial statements, we also have audited the financial statement schedule of
valuation and qualifying accounts. These financial statements and the financial
statement schedule are the responsibility of the Acquired facilities'
management. Our responsibility is to express an opinion on these financial
statements and the financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the combined financial position of the Acquired
facilities as of December 31, 2000 and 1999 and the results of their operations
and their cash flows for each of the years in the two-year period ended December
31, 2000 in conformity with accounting principles generally accepted in the
United States of America. Also in our opinion, the related financial statement
schedule, when considered in relation to the basic combined financial statements
taken as a whole, presents fairly, in all material respects, the information set
forth therein.

/s/ KPMG LLP

Baltimore, Maryland
September 13, 2001

F-13

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

COMBINED BALANCE SHEETS (Note 1)
December 31, 2000 and 1999
(Dollars in thousands)

2000 1999
------- ------

Assets
Current assets:
Cash and cash equivalents.................................................................. $4,514 1,684
Patient accounts and third-party payor settlements receivable (note 3)..................... 29,266 22,624
Other current assets....................................................................... 576 2,657
------- ------

Total current assets.................................................................... 34,356 26,965
Property, plant and equipment (note 4)........................................................ 586 16,199
Intangible assets, net (note 5)............................................................... -- 18,110
------- ------
$34,942 61,274
======= ======
Liabilities and Net Equity (Deficit) of Parent Company
Current liabilities:
Accounts payable and accrued expenses (note 6)............................................. $9,499 12,891
Current maturities of long-term debt (note 7).............................................. -- 273
Due to Senior Housing Properties Trust (note 8)............................................ 27,323 --
------ -----

Total current liabilities............................................................... 36,822 13,164
Long-term debt, less current maturities (note 7).............................................. -- 17,500
Commitments and contingencies (notes 11 and 13)...............................................
Net equity (deficit) of Parent Company........................................................ (1,880) 30,610
------- ------
$34,942 61,274
======= ======

See accompanying notes to financial statements.

F-14

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

COMBINED STATEMENTS OF OPERATIONS (Note 1)
Years ended December 31, 2000 and 1999
(Dollars in thousands)

2000 1999
-------------- ------------

Total patient service revenues................................................... $135,378 130,333
-------------- ------------

Costs and expenses:
Operating expenses............................................................ 131,916 124,732
Depreciation and amortization................................................. 889 4,265
Rent (note 9)................................................................. 9,102 13,191
Interest, net................................................................. 2,053 3,899
Loss on impairment of long-lived assets (note 12)............................. -- 120,007
Loss on settlement of lease and mortgage obligations (note 1)................. 16,670 --
-------------- ------------

Total costs and expenses................................................... 160,630 266,094
-------------- ------------

Loss before income taxes................................................... (25,252) (135,761)
Federal and state income taxes (benefit) (note 10)............................... -- (8,822)
-------------- ------------

Net loss................................................................... $(25,252) (126,939)
============== ============

See accompanying notes to financial statements.

F-15

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

COMBINED STATEMENTS OF CHANGES IN NET EQUITY (DEFICIT)
OF PARENT COMPANY (Note 1)
Years ended December 31, 2000 and 1999
(Dollars in thousands)

Balance at December 31, 1998................................... $147,025
Net contributions from Parent............................... 10,524
Net loss.................................................... (126,939)
---------

Balance at December 31, 1999................................... 30,610
Net contributions from (distributions to) Parent............ (7,238)
Net loss.................................................... (25,252)
---------

Balance at December 31, 2000................................... $ (1,880)
=========

See accompanying notes to financial statements.

F-16

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

COMBINED STATEMENTS OF CASH FLOWS (Note 1)
Years ended December 31, 2000 and 1999
(Dollars in thousands)

2000 1999
------------- ------------

Cash flows from operating activities:
Net loss......................................................................... $(25,252) (126,939)
Adjustments to reconcile net loss to net cash used by operating activities:
Loss on impairment of long-lived assets....................................... -- 120,007
Loss on settlement............................................................ 16,670 --
Deferred income taxes......................................................... -- (8,822)
Depreciation and amortization................................................. 889 4,265
Decrease (increase) in patient accounts and third-party payor settlements (6,642) 7,540
receivable..................................................................
Increase (decrease) in other current assets................................... 2,081 (60)
Increase (decrease) in accounts payable....................................... (3,392) (3,822)
------------- ------------

Net cash used by operating activities....................................... (15,646) (7,831)
------------- ------------

Cash flows from investing activities:
Purchases of property, plant and equipment....................................... (1,472) (3,108)
------------- ------------

Net cash used by investing activities....................................... (1,472) (3,108)
------------- ------------

Cash flows from financing activities:
Repayments of long-term debt..................................................... (137) (220)
Net contributions from (distributions to) parent company......................... (7,238) 10,524
Advances from Senior Housing Properties Trust.................................... 27,323 --

Net cash provided by financing activities................................... 19,948 10,304
------------- ------------

Increase (decrease) in cash and cash equivalents............................ 2,830 (635)
Cash and cash equivalents, beginning of period...................................... 1,684 2,319
------------- ------------

Cash and cash equivalents, end of period............................................ $4,514 1,684
============= ============

See accompanying notes to financial statements.

F-17

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS
December 31, 2000 and 1999
(Dollars in thousands)

1. Background and Basis of Presentation

Prior to July 7, 2000, Integrated Health Services, Inc. (IHS or the
Parent Company), through its wholly owned subsidiaries, operated various skilled
nursing facilities with respect to which Senior Housing Properties Trust (SNH)
was owner/lessor or first mortgage lender. In January 2000, IHS ceased making
rent and interest payments on these obligations and subsequently filed for
bankruptcy in February 2000.

On July 7, 2000, effective as of July 1, 2000, the Bankruptcy Court
approved a settlement agreement whereby IHS' lease and mortgage obligations to a
subsidiary of SNH were cancelled and IHS conveyed nine nursing homes and one
parcel of non-operating real property to SNH. As a result, SNH has obtained the
operations of 42 facilities previously operated by IHS (the Acquired
Facilities). IHS managed the Acquired Facilities under a management agreement
with SNH for the period from July 1, 2000 to September 30, 2000. An affiliate of
SNH has managed the Acquired Facilities subsequent to September 30, 2000.

The Acquired Facilities' financial statements are presented for the
purposes of complying with the Securities and Exchange Commission's rules and
regulations regarding acquired businesses.

The combined financial statements of the Acquired Facilities reflect
the historical accounts of the skilled nursing facilities, including allocations
of general and administrative expenses from the IHS corporate office to the
individual facilities. Such corporate office allocations, calculated as a
percentage of revenue, are based on determinations that management believes to
be reasonable. However, IHS has operated certain other businesses and has
provided certain services to the Acquired Facilities, including financial,
legal, accounting, human resources and information systems services.
Accordingly, expense allocations to the Company may not be representative of
costs of such services to be incurred in the future (see note 11).

The financial statements for periods prior to July 1, 2000 represent
the financial position and results of operations of the Acquired Facilities as
reflected in the accounts of IHS' subsidiaries. Such subsidiaries leased 19
facilities from SNH, owned 11 facilities with respect to which SNH was
mortgagee, and owned, leased or managed 12 other facilities not previously
affiliated with SNH.

The financial statements for the period subsequent to July 1, 2000
represent the financial position and results of operations of the Acquired
Facilities as described above and give effect to the terms of the aforementioned
settlement agreement. Accordingly, as of July 1, 2000, the accounts of the
Acquired Facilities no longer include the property, plant and equipment and
intangible assets of the facilities conveyed to SNH, related mortgage debt,
mortgage interest, and depreciation and amortization of such facilities. The
loss on settlement represents the carrying value of the tangible and intangible
assets of the facilities conveyed to SNH, less the related mortgage debt.

F-18

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

1. Background and Basis of Presentation (Continued)

The operating results of the Acquired Facilities for the six-month
period ended June 30, 2000 (prior to the settlement agreement) and the six-month
period ended December 31, 2000 are summarized below:

Six Months
Six Months ended Year ended
ended December 31, December 31,
June 30, 2000 2000 2000
--------------- -------------- --------------

Total patient service revenues................... $65,195 70,183 135,378
--------------- -------------- --------------

Costs and expenses:
Operating expenses............................ 63,865 68,051 131,916
Depreciation and amortization................. 876 13 889
Rent (note 9)................................. 6,323 2,779 9,102
Interest, net................................. 2,053 - 2,053
Loss on settlement............................ - 16,670 16,670
--------------- -------------- --------------

Total costs and expenses.................... 73,117 87,513 160,630
--------------- -------------- --------------

Loss before income taxes.................... $(7,922) (17,330) (25,252)
=============== ============== ==============

2. Summary of Significant Accounting Policies

(a) Revenues

Revenues, primarily patient services revenues related to room and board
charges, ancillary charges and revenues of pharmacy, rehabilitation and similar
service operations, are recorded at established rates and adjusted for
differences between such rates and estimated amounts reimbursable by third-party
payors. As of January 1, 1999, Medicare revenue is recognized pursuant to the
Prospective Payment System (PPS). Under PPS, per diem federal rates were
established for urban and rural areas. Rates are case-mix adjusted using
Resource Utilization Groups. PPS is implemented over a three-year transition
period that blends a facility-specific payment rate with the federal case-mix
adjusted rate.

Estimated settlements under third-party payor retrospective rate
setting programs (primarily Medicare for periods prior to January 1, 1999 and
Medicaid) are accrued in the period that related services are rendered.
Settlements receivable and related revenues under such programs are based on
annual cost reports prepared in accordance with federal and state regulations,
which reports are subject to audit and retroactive adjustment. In the opinion of
management, adequate provision has been made therefore, and such adjustments in
determining final settlements will not have a material effect on financial
position or results of operations.

(b) Cash and Cash Equivalents

Cash equivalents consist of highly liquid debt instruments with
original maturities of three months or less.

F-19

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

2. Summary of Significant Accounting Policies (Continued)

Property, plant and equipment are recorded at cost. Depreciation and
amortization are provided using the straight-line method over the estimated
useful lives of the related assets, generally 25 years for land improvements, 10
years for equipment, 40 years for buildings and the term of the lease for costs
of leasehold interests and improvements.

(d) Intangible Assets

Prior to the fourth quarter of 1999, intangible assets of businesses
acquired (primarily goodwill) were amortized by the straight-line method
primarily over 40 years, the period over which such costs were estimated to be
recoverable through operating cash flows. As discussed in note 12, management of
IHS continued to evaluate the impact of the 1997 Balanced Budget Act (BBA),
particularly the impact of the prospective payment system (PPS), upon future
operating results of the facilities. Utilizing IHS' experience with PPS since
January 1, 1999, management performed a preliminary analysis of such impact in
the third quarter of 1999 and a more comprehensive analysis at December 31,
1999. PPS has had a dramatic negative impact on the operating results and
financial condition of the Acquired Facilities. The PPS system has significantly
reduced the revenues, cash flow and liquidity of the Acquired Facilities and the
long-term care industry in 1999. As a result of the negative impact of the
provisions of PPS, management changed the estimated life of its goodwill to 20
years. This change has been treated as a change in accounting estimate and is
being recognized prospectively beginning October 1, 1999.

(e) Impairment of Long-lived Assets

Management regularly evaluates whether events or changes in
circumstances have occurred that could indicate an impairment in the value of
long-lived assets. If there is an indication that the carrying value of an asset
is not recoverable, management estimates the projected undiscounted cash flows
of the related individual facilities (the lowest level for which there are
identifiable cash flows independent of other groups of assets) to determine if
an impairment loss should be recognized. The amount of impairment loss is
determined by comparing the historical carrying value of the asset to its
estimated fair value. Estimated fair value is determined through an evaluation
of recent financial performance and projected discounted cash flows of
facilities using standard industry valuation techniques. In addition to
consideration of impairment upon the events or changes in circumstances
described above, management regularly evaluates the remaining lives of its
long-lived assets. If estimates are changed, the carrying value of affected
assets is allocated over the remaining lives. Management performed such an
analysis at December 31, 1999 (see notes 1 (d) and 12).

(f) Income Taxes

The Acquired Facilities are included in the Parent Company's
consolidated federal income tax return. The income taxes reported in the
Acquired Facilities financial statements are an allocation of

F-20

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

2. Summary of Significant Accounting Policies (Continued)

income taxes calculated as if the Acquired Facilities were a separate taxpayer,
in accordance with Statement of Financial Accounting Standards No. 109 (SFAS No.
109), Accounting for Income Taxes.

Deferred income taxes are recognized for the tax consequences of
temporary differences between financial statement carrying amounts and the
related tax bases of assets and liabilities as required by SFAS No. 109. Such
tax effects are measured by applying enacted statutory tax rates applicable to
future years in which the differences are expected to reverse, and any change in
tax rates will be recognized in the period that includes the date of enactment.

(g) Net Equity (Deficit) of Parent Company

The Parent Company transfers excess cash from and makes working capital
advances and corporate allocations to the Acquired Facilities. These advances
include amounts to fund cash shortfalls, capital expenditures, advances for
accounts payable and amounts paid for employee benefits and other programs
administered by the Parent Company. The resulting net balance of the
aforementioned transactions, the Parent Company's initial investment in the
Acquired Facilities and the cumulative deficit of the Acquired Facilities is
classified as Net Equity (Deficit) of Parent Company in the accompanying balance
sheet.

(h) Business and Credit Concentrations

The Acquired Facilities' patient services are provided through 42
facilities located in 10 states throughout the United States. The Acquired
Facilities generally do not require collateral or other security in extending
credit to patients; however, the Acquired Facilities routinely obtain
assignments of (or are otherwise entitled to receive) benefits receivable under
the health insurance programs, plans or policies of patients (e.g., Medicare,
Medicaid, commercial insurance and managed care organizations) (see note 3).

(i) Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.

(j) Reclassification

Certain amounts presented in 1999 have been reclassified to conform
with the presentation for 2000.

F-21

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

3. Patient Accounts and Third-Party Payor Settlements Receivable

Patient accounts and third-party payor settlements receivable consist
of the following at December 31:

2000 1999
---- ----

Patient accounts....................................................... $28,996 19,396
Third-Party payor settlements.......................................... 13,147 12,194
----------- -----------

42,143 31,590
Allowance for doubtful accounts and contractual adjustments............ (12,877) (8,966)
----------- -----------
$29,266 22,624
=========== ===========

Patient accounts receivable and third party payor settlements
receivable from the Federal government (Medicare) were approximately $14,246 and
$10,757 at December 31, 2000 and 1999, respectively. Amounts receivable from
various states (Medicaid) were approximately $17,161 and $16,189 at December 31,
2000 and 1999, respectively.

4. Property, Plant and Equipment

Property, plant and equipment are summarized as follows at December 31:

2000 1999
---- ----

Land and improvements.................................................. $-- 6,306
Buildings and improvements............................................. -- 3,104
Leasehold interests and improvements................................... -- 2,637
Equipment.............................................................. 598 7,134
----------- -----------

598 19,181
Less accumulated depreciation and amortization......................... 12 2,982
----------- -----------

Net property, plant and equipment................................. 586 16,199
=========== ===========

5. Intangible Assets

Intangible assets are summarized as follows at December 31, 1999:

Intangible assets of business acquired, primarily goodwill....... $23,287
Less accumulated amortization.................................... (5,177)
----------

Net intangible assets....................................... $18,110
==========

Management regularly evaluates whether events or circumstances have
occurred that would indicate an impairment in the carrying value or the life of
goodwill. In accordance with SFAS No. 121, if there is an indication that the
carrying value of an asset, including goodwill, is not recoverable, Management
estimates the projected undiscounted cash flows, excluding interest, of the
related

F-22

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

5. Intangible Assets (Continued)

business unit to determine if an impairment loss should be recognized. Such
impairment loss is determined by comparing the carrying amount of the asset,
including goodwill, to its estimated fair value. Management performs the
impairment analysis at the individual facility level. See note 12 for
information regarding impairment of assets in the year ended December 31, 1999.

6. Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses are summarized as follows at December 31:

2000 1999
---- ----
Accounts payable........................................ $5,105 8,294
Accrued salaries and wages.............................. 3,015 3,468
Other accrued expenses.................................. 1,379 1,129
-------- --------

9,499 12,891
======== ========

7. Long-Term Debt

Long-term debt is summarized as follows at December 31, 1999:

Mortgages payable in monthly installments of $87, including interest at rates ranging from
10.3% to 10.86%, due December 2016.................................................. $8,687
Mortgages payable in monthly installments of $95, including interest at 11.5%, due January
2006................................................................................ 9,086
-----------
17,773
Less current maturities................................................................. 273
-----------
Total long-term debt, less current portion $17,500
===========

At December 31, 1999 the aggregate maturities of long-term debt for the five
years ending December 31, 2004 are as follows:

2000........................................................... $273
2001........................................................... 304
2002........................................................... 339
2003........................................................... 378
2004........................................................... 421
Thereafter..................................................... 16,058
---------
$17,773
=========
F-23

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

8. Due to Senior Housing Properties Trust (SNH)

Subsequent to July 1, 2000, SNH advanced funds for operating expenses
and working capital of the Acquired Facilities and allocated facility rents.
Such advances bear no interest (see notes 9 and 11).

9. Leases

The Acquired Facilities leased equipment under short-term operating
leases having rental costs of approximately $1,146 in 2000 and $1,800 in 1999.
Leases of facilities were terminated in 2000 as discussed in note 1; however, in
accordance with Staff Accounting Bulletin No. 55, Allocation of Expenses and
Related Disclosure in Financial Statements of Subsidiaries, Divisions or Lesser
Business Components of Another Entity, $2,159 is included in rent expense for
the period subsequent to July 1, 2000, representing an allocation of the total
estimated fair market rental value of facilities. The annual fair market rental
value has been estimated for a combined group of facilities, including the
Acquired Facilities, and has been allocated based on the respective total
revenues of the facilities.

10. Income Taxes

The Acquired Facilities have been included in the Parent Company's
consolidated federal income tax return. The allocated provision (benefit) for
income taxes on loss before income taxes is summarized as follows at December
31:

2000 1999
---------- -----------

Current......................................................................... $-- --
Deferred........................................................................ -- (8,822)
----------- ------------
$-- (8,822)
----------- ===========

The amount computed by applying the Federal corporate tax rate of 35%
in 2000 and 1999 to loss before income taxes is summarized as follows at
December 31:

2000 1999
---------- -----------

Income tax computed at statutory rates.......................................... $(7,648) (47,516)
State income taxes, net of Federal tax benefit and nondeductible items.......... (1,044) (6,724)
Jobs tax credit................................................................. (70) (94)
Valuation allowance adjustment.................................................. 8,762 45,512
---------- -----------
$-- (8,822)
---------- -----------

F-24

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

10. Income Taxes (Continued)

Deferred income tax liabilities (assets) at December 31, 2000 and 1999, are
summarized as follows:

2000 1999
---------- -----------

Difference in book and tax bases of intangible assets........................... $-- (28,002)
Difference in book and tax bases of fixed assets................................ -- (9,327)
Allowance for doubtful accounts................................................. (5,018) (3,586)
Net operating loss carryforwards................................................ (57,627) (13,038)
Job tax credit carryovers....................................................... (254) (184)
---------- -----------

Total before valuation allowance........................................... (62,899) (54,137)
---------- -----------
Valuation allowance............................................................. 62,899 54,137
---------- -----------
Net deferred tax liabilities............................................... -- --
========== ===========

11. Other Related Party Transactions

Corporate administrative and general expenses (included in operating
expenses) represent management fees for certain services, including financial,
legal, accounting, human resources and information systems services provided by
the Parent Company. Management fees have been provided at approximately 6% of
total revenues of each facility.

Management fees charged by the Parent Company were $4,311 for the nine
months ended September 30, 2000 and $6,254 in 1999, and have been determined
based on an allocation of the Parent Company's corporate general and
administrative expenses. Such allocation has been made because specific
identification of expenses is not practicable. Management believes that this
allocation method is reasonable. However, management believes that the Acquired
Facilities' corporate administrative and general expenses on a stand-alone basis
may have been different had the Acquired Facilities operated as an unaffiliated
entity. Management fees charged by an SNH affiliate were $1,773 for the three
months ended December 31, 2000.

12. Loss on Impairment of Long-Lived Assets

During the year ended December 31, 1999, the Parent Company continued
to evaluate the impact of the 1997 Balanced Budget Act (BBA), particularly the
impact of the Prospective Payment System (PPS), upon the future operating
results on its facilities. Utilizing the Parent Company's (including the
Acquired Facilities) experience with PPS since January 1, 1999, the Parent
Company performed a preliminary analysis of such impact as of September 30, 1999
and a more comprehensive analysis at December 31, 1999. PPS has had a dramatic
impact on the operating results and financial condition of the Acquired
Facilities. PPS has significantly reduced the revenues, cash flow and liquidity
of the Acquired Facilities and others in the industry in 1999. As a result of
the negative impact of the provisions of PPS, the Acquired Facilities assessed
the impairment of its long-lived assets in accordance with the provisions of
Statement of Financial Accounting Standards (SFAS) No. 121 in 1999.

F-25

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

12. Loss on Impairment of Long-Lived Assets (Continued)

In accordance with SFAS No. 121, the Acquired Facilities estimated the future
cash flows expected to result from those assets to be held and used.

In estimating the future cash flows for determining whether an asset is
impaired, and if expected future cash flows used in measuring assets are
impaired, the Acquired Facilities grouped the assets at the lowest level for
which there are identifiable cash flows independent of other groups of assets,
which is at the facility level.

After determining the facilities eligible for an impairment charge,
Management determined the estimated fair value of such facilities and compared
such fair value to the carrying values of the related assets. The carrying value
of buildings and improvements, leasehold improvements, equipment and goodwill
exceeded the fair value by $120,007; accordingly, the Acquired Facilities
recognized such amount as a loss on impairment of long-lived assets during the
year ended December 31, 1999.

13. Certain Significant Risks and Uncertainties

The following information is provided in accordance with the AICPA
Statement of Position No. 94-6, Disclosure of Certain Significant Risks and
Uncertainties.

The Acquired Facilities and others in the healthcare business are
subject to certain inherent risks, including the following:

o Substantial dependence on revenues derived from reimbursement by the
Federal Medicare and state Medicaid programs which have been
drastically cut in recent years and which entail exposure to various
healthcare fraud statutes;

o Government regulations, government budgetary constraints and proposed
legislative and regulatory changes; and

o Lawsuits alleging malpractice and related claims.

Such inherent risks require the use of certain management estimates in
the preparation of the Acquired Facilities financial statements and it is
reasonably possible that a change in such estimates may occur.

The Acquired Facilities receives payment for a significant portion of
services rendered to patients from the Federal government under Medicare and
from the states in which its facilities and/or services are located under
Medicaid. The Acquired Facilities operations are subject to a variety of
Federal, state and local legal and regulatory risks, including without
limitation the federal Anti-Kickback statute and the federal Ethics in Patient
Referral Act (so-called "Stark Law"), many of which apply to virtually all
companies engaged in the health care services industry. The Anti-Kickback
statute prohibits, among other things, the offer, payment, solicitation or
receipt of any form of remuneration in return for the referral of Medicare and
Medicaid patients. The Stark Law prohibits, with limited exceptions, financial
relationships between ancillary service providers and referring physicians.
Other regulatory risks

F-26

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

13. Certain Significant Risks and Uncertainties (Continued)

assumed by the Acquired Facilities and other companies engaged in the health
care industry are as follows:

o False Claims -- "Operation Restore Trust" is a major anti-fraud
demonstration project of the Office of the Inspector General. The
primary purpose for the project is to scrutinize the activities of
healthcare providers which are reimbursed under the Medicare and
Medicaid programs. False claims are prohibited pursuant to criminal and
civil statutes and are punishable by imprisonment and monetary
penalties.

o Regulatory Requirement Deficiencies -- In the ordinary course of
business health care facilities receive notices of deficiencies for
failure to comply with various regulatory requirements. In some cases,
the reviewing agency may take adverse actions against a facility,
including the imposition of fines, temporary suspension of admission of
new patients, suspension or decertification from participation in the
Medicare and Medicaid programs and, in extreme cases, revocation of a
facility's license.

o Changes in laws and regulations -- Changes in laws and regulations
could have a material adverse effect on licensure, eligibility for
participation in government programs, permissible activities, operating
costs and the levels of reimbursement from governmental and other
sources.

In response to the aforementioned regulatory risks, the Parent Company
formed a Corporate Compliance Department in 1996 to help identify, prevent and
deter instances of Medicare and Medicaid noncompliance. Although the Parent
Company and the Acquired Facilities strive to manage these regulatory risks,
there can be no assurance that federal and/or state regulatory agencies that
currently have jurisdiction over matters including, without limitation,
Medicare, Medicaid and other government reimbursement programs, will take the
position that the Acquired Facilities business and operations are in compliance
with applicable law or with the standards of such regulatory agencies.

In some cases, violation of such applicable law or regulatory standards
by the Acquired Facilities can carry significant civil and criminal penalties
and can give rise to qui tam litigation. In this connection, the Acquired
Facilities are a defendant in certain actions or the subject of investigations
concerning alleged violations of the False Claims Act or of Medicare
regulations. As a result of the Parent Company's and the Acquired Facilities'
financial position, various agencies of the federal government accelerated
efforts to reach a resolution of all outstanding claims and issues related to
the Parent Company's and the Acquired Facilities' alleged violations of
healthcare statutes and related causes of action. The Parent Company has
commenced global settlement negotiations with the government; however, the
Parent Company is unable to assess fully the merits of the government's monetary
claims at this time. In addition, the Parent Company is unable to determine the
amount, if any, that might relate to the Acquired Facilities.

The BBA, enacted in August 1997, made numerous changes to the Medicare
and Medicaid programs that are significantly affecting the Acquired Facilities.
With respect to Medicare, the BBA provides, among other things, for a
prospective payment system for skilled nursing facilities. As a result, in 1999
the Acquired Facilities bore the cost risk of providing care inasmuch as they
receive specified

F-27

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)
December 31, 2000 and 1999
(Dollars in thousands)

13. Certain Significant Risks and Uncertainties (Continued)

reimbursement for each treatment regardless of actual cost. With respect to
Medicaid, the BBA repeals the so-called Boren Amendment, which required state
Medicaid programs to reimburse nursing facilities for the costs that are
incurred by efficiently and economically operated providers in order to meet
quality and safety standards. As a result, states now have considerable
flexibility in establishing payment rates and the Management believes many
states are moving toward a prospective payment type system for skilled nursing
facilities.

The BBA mandates the establishment of a PPS for Medicare skilled
nursing facility services, under which facilities are paid a fixed fee for
virtually all covered services. PPS is being phased in over a four-year period,
effective January 1, 1999 for the Acquired Facilities. During the first three
years, payments will be based on a blend of the facility's historical costs and
a pre-determined federal rate. Thereafter, the per diem rates will be based 100%
on the federal cost rate. Under PPS, each patient's clinical status is evaluated
and placed into a payment category. The patient's payment category dictates the
amount that the provider will receive to care for the patient on a daily basis.
The per diem rate covers (i) all routine inpatient costs currently paid under
Medicare Part A, (ii) certain ancillary and other items and services currently
covered separately under Medicare Part B on a "pass-through" basis, and (iii)
certain capital costs. The Acquired Facilities ability to offer the ancillary
services required by higher acuity patients, such as those in its subacute care
programs to Medicare beneficiaries, in a cost-effective manner will continue to
be critical to the Acquired Facilities services and will affect the
profitability. To date the per diem reimbursement rates have generally been
significantly less than the amount the Acquired Facilities received on a daily
basis under cost based reimbursement, particularly in the case of higher acuity
patients. As a result, PPS has had a material adverse impact on the Acquired
Facilities' results of operations and financial condition (see note 12).

The Acquired Facilities are also subject to malpractice and related
claims, which arise in the normal course of business and which could have a
significant effect on the Acquired Facilities. As a result, the Acquired
Facilities maintain occurrence basis professional and general liability
insurance with coverage and deductibles which management believes to be
appropriate.

F-28

FORTY-TWO FACILITIES ACQUIRED BY SENIOR HOUSING PROPERTIES TRUST
FROM INTEGRATED HEALTH SERVICES, INC.

SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31, 2000 and 1999
(Dollars in thousands)

Column A Column B Column C Column D Column E
-------- -------- -------- -------- --------
Additions
Balance at charged to Balance at
beginning of operating end of
Description year accounts Deductions (1) year
---------------------------------------------------------------------------------------------------------------------

Allowance for doubtful accounts:
Year ended December 31, 2000................. $8,966 5,001 (1,090) 12,877
====== ===== ======= ======
Year ended December 31, 1999................. $7,016 2,598 (648) 8,966
====== ===== ===== =====

(1) Amounts represent bad debt write-offs

F-29

REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Shareholders of
Five Star Quality Care, Inc.:

We have audited the accompanying combined balance sheets of Certain Mariner
Post-Acute Network Facilities (Operated by subsidiaries of Mariner Post-Acute
Network, Inc.) (the "Facilities"), as defined in Note 1, as of December 31, 2000
and 1999, and the related combined statements of operations, divisional equity
(deficit), and cash flows for the years then ended. Our audits also included the
financial statement schedule listed in the Index on page F-45. These financial
statements and schedule are the responsibility of the Facilities' management.
Our responsibility is to express an opinion on these financial statements and
schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the
audits to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the combined financial position of Certain Mariner
Post-Acute Network Facilities (Operated by subsidiaries of Mariner Post-Acute
Network, Inc.), as defined in Note 1, at December 31, 2000 and 1999, and the
combined results of their operations and their cash flows for the years then
ended, in conformity with accounting principles generally accepted in the United
States. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP

September 19, 2001
Boston, Massachusetts

F-30

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

COMBINED BALANCE SHEETS
(Dollars in thousands)

December 31,
---------------------
2000 1999
-------- --------

Assets
Current assets:
Cash and cash equivalents...................................................... $2,508 $--
Patient receivables, less allowance for doubtful accounts of $1,834 in 2000
and $1,534 in 1999.......................................................... 7,501 6,888
Other receivables.............................................................. 3,489 321
Other current assets........................................................... 477 226
-------- --------
Total current assets.............................................................. 13,975 7,435
Property and equipment:
Building improvements.......................................................... 4,128 3,563
Furniture, fixtures and equipment.............................................. 635 371
-------- --------
4,763 3,934
Less accumulated depreciation.................................................. (3,725) (2,425)
-------- --------
1,038 1,509
Goodwill, net..................................................................... 8,012 8,471
Other assets...................................................................... 27 18
-------- --------

Total assets...................................................................... $23,052 $17,433
======== ========

Liabilities and divisional deficit
Current liabilities:
Accounts payable and accrued expenses.......................................... $12,645 $9,638
Accrued wages and related liabilities.......................................... 3,570 3,584
Due to Senior Housing Properties Trust......................................... 5,760 --
Current portion of long-term debt.............................................. -- 919
Current portion of unfavorable lease obligations and other non-current
liabilities................................................................. 3,673 3,719
-------- --------

Total current liabilities......................................................... 25,648 17,860
Liabilities subject to compromise................................................. 7,111 -

Unfavorable lease obligations and other non-current liabilities................... 24,980 28,603
-------- --------
Total liabilities................................................................. 57,739 46,463
Commitments and contingencies
Divisional deficit................................................................ (34,687) (29,030)
-------- --------

Total liabilities and divisional deficit.......................................... $23,052 $17,433
======== ========

See accompanying notes.

F-31

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

COMBINED STATEMENTS OF OPERATIONS
(Dollars in thousands)

Year ended December 31,
--------------------------
2000 1999
------------ ------------

Revenues:
Net patient revenues..................................................... $85,128 $86,643
Other.................................................................... 197 302
--------- ---------
Total revenues.............................................................. 85,325 86,945
Expenses:
Salaries, wages and benefits............................................. 55,033 50,619
Nursing, dietary and other supplies...................................... 5,445 5,592
Ancillary services....................................................... 4,077 3,848
Facility general and administrative costs................................ 7,205 9,394
Allocation of corporate overhead......................................... 4,101 4,347
Insurance................................................................ 4,496 4,876
Rent..................................................................... 8,748 9,315
Depreciation and amortization............................................ 1,766 2,027
Impairment of long-lived assets.......................................... - 36,322
Provision for bad debts.................................................. 1,758 4,233
--------- ---------
Total expenses.............................................................. 92,629 130,573
--------- ---------
Loss from operations........................................................ (7,304) (43,628)
Interest expense............................................................ (121) (181)
Interest income............................................................. 4 5
Loss before income taxes.................................................... (7,421) (43,804)
Provision for income taxes.................................................. - -
--------- ---------
Net Loss.................................................................... $(7,421) $(43,804)
========= =========

See accompanying notes.

F-32

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

COMBINED STATEMENTS OF DIVISIONAL EQUITY (DEFICIT)
(Dollars in thousands)
Years ended December 31, 2000 and 1999

Balance at January 1, 1999..................................... $14,464
Contributions from Parent, net.............................. 310
Net loss.................................................... (43,804)
------------
Balance at December 31, 1999................................... (29,030)
Contributions from Parent, net.............................. 1,764
Net loss.................................................... (7,421)
------------
Balance at December 31, 2000................................... $(34,687)
============

See accompanying notes.

F-33

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

COMBINED STATEMENTS OF CASH FLOWS
(Dollars in thousands)

Year ended December 31,
----------------------------
2000 1999
---------- ---------

Operating activities
Net loss......................................................................... $(7,421) $(43,804)
Adjustments to reconcile net loss to net cash provided by operating
activities:
Depreciation and amortization................................................. 1,766 2,027
Amortization of unfavorable lease obligations and other non-current
liabilities................................................................ (3,673) (3,691)
Provision for bad debts....................................................... 1,758 4,233
Impairment of long-lived assets............................................... -- 36,322
Increase (decrease) in cash arising from changes in operating assets and
liabilities:
Patient receivables.............................................................. 3,567 2,915
Other receivables................................................................ (3,168) 987
Other assets..................................................................... (9) (35)
Accounts payable and accrued expenses............................................ 3,007 1,527
Accrued wages and related liabilities............................................ (14) 621
Due to Senior Housing Properties Trust........................................... 5,760 --
---------- ---------

Net cash provided by operating activities........................................... 1,573 1,102
---------- ---------

Investing activities
Purchases of property and equipment................................................. (829) (1,362)
Disposals of property, equipment and other assets................................... -- --
---------- ---------

Net cash used in investing activities............................................... (829) (1,362)
---------- ---------

Financing activities
Capital contributions, net.......................................................... 1,764 310
Repayment of debt................................................................... -- --
Repayment of capital lease.......................................................... -- (50)
---------- ---------

Net cash provided by financing activities........................................... 1,764 260
---------- ---------

Net increase in cash................................................................ 2,508 --
Cash at beginning of year........................................................... -- --
---------- ---------

Cash at end of year................................................................. $2,508 $--
========== =========

See accompanying notes.

F-34

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS

1. Organization

The combined financial statements of Certain Mariner Post-Acute Network
Facilities (the "Facilities") include the accounts of 17 nursing home facilities
and certain related assets and liabilities owned and controlled by Mariner
Post-Acute Network, Inc. ("Mariner" or the "Parent"). The Facilities are owned
by wholly owned subsidiaries of GranCare, Inc. ("GranCare"), a wholly owned
subsidiary of Mariner. The Facilities constitute a division of Mariner and are
not separate legal entities.

Mariner, formerly known as Paragon Health Network, Inc., was formed in
November 1997 through the recapitalization by merger of Living Centers of
America, Inc. ("LCA") with a newly-formed entity owned by certain affiliates of
Apollo Management, L.P. and the subsequent merger of GranCare (the "GranCare
Merger").

Mariner and certain of its respective subsidiaries, including those
subsidiaries operating the Facilities, filed separate voluntary petitions
(collectively, the "Chapter 11 Filings") for relief under Chapter 11 of Title 11
of the United States Code (the "Bankruptcy Code") with the United States
Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") on
January 18, 2000 (the "Petition Date"). Mariner is presently operating its
business as a debtor-in-possession and is subject to the jurisdiction of the
Bankruptcy Court while a plan of reorganization is formulated. Mariner's and its
subsidiaries' need to seek relief afforded by the Bankruptcy Code is due, in
part, to the significant financial pressure created by the implementation of the
Balanced Budget Act of 1997.

Mariner, through its GranCare subsidiaries, leased the Facilities from
a wholly owned subsidiary of Senior Housing Properties Trust ("SNH"), which
succeeded to the interests of Health and Retirement Properties Trust ("HRPT
Properties"). On May 10, 2000, the Bankruptcy Court approved a settlement
agreement (the "Settlement Agreement") between Mariner, certain of its GranCare
subsidiaries, and subsidiaries of SNH. The Settlement Agreement is effective at
the close of business on June 30, 2000 and is subject to obtaining regulatory
approvals in the states where the Facilities are located. Based upon the terms
of the Settlement Agreement: (a) the Facilities leased by the GranCare
subsidiaries and the related personal property were assigned to subsidiaries of
SNH and (b) Mariner agreed to manage the Facilities transferred to the SNH
during a transition period that was expected to last less than six months. As of
December 31, 2000, the transition period has ended and management of the
Facilities is being performed by SNH.

As specified in the Settlement Agreement, certain assets and
liabilities reflected on the accompanying combined balance sheet as of December
31, 2000 will remain with Mariner including liabilities subject to compromise,
unfavorable lease obligations and goodwill. In connection with the Settlement
Agreement, outstanding indebtedness of the Facilities was terminated (see Note
8) and Mariner paid SNH at closing approximately $2,335,000 to settle its
obligations for property taxes payable and certain employee accrued liabilities.
The aforementioned transaction has not been reflected in the accompanying
combined financial statements.

The Settlement Agreement is contingent upon SNH obtaining licenses and
other governmental approvals necessary to operate the Facilities. SNH has
applied for all of the required licenses and, as of January 31, 2001, the
required licenses for substantially all of these facilities have been received.

F-35

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies Basis of presentation

Basis of presentation

The accompanying combined financial statements have been prepared on
the basis of accounting principles applicable to going concerns and contemplate
the realization of assets and the settlement of liabilities and commitments in
the normal course of business. The financial statements do not include
adjustments, if any, to reflect the possible future effects on the
recoverability and classification of recorded assets or the amounts and
classifications of liabilities that may result from the outcome of these
uncertainties. The accompanying combined financial statements have also been
presented in conformity with the American Institute of Certified Public
Accountants Statement of Position 90-7, "Financial Reporting of Entities in
Reorganization Under the Bankruptcy Code" ("SOP 90-7"). SOP 90-7 requires the
segregation of liabilities subject to compromise by the Bankruptcy Court as of
the Petition Date and identification of all transactions and events that are
directly associated with the reorganization of the Facilities. Pursuant to SOP
90-7, prepetition liabilities are reported on the basis of the expected amounts
of such allowed claims, as opposed to the amounts for which those claims may be
settled. Under a confirmed plan of reorganization, those claims may be settled
at amounts substantially less than their allowed amounts.

Substantially all of the patient revenues and other income received by
the Facilities is deposited in and commingled with the Parent's general
corporate funds. Certain cash requirements of the Facilities were paid by the
Parent and were charged directly to the Facilities. General and administrative
costs of the Parent were allocated to the Facilities based upon management's
estimate of the actual costs based upon the Facilities' level of operations. The
Parent maintains insurance policies for the Facilities for workers'
compensation, general and professional liability and employee health and dental
insurance (see Note 9). In the opinion of management, the method for allocating
Mariner's corporate general and administrative and insurance expenses is
reasonable. It is not practicable to estimate additional costs, if any, that
would have been incurred if the Facilities were not controlled by Mariner.

Property and equipment

Property and equipment is presented at cost. Maintenance and repairs
are charged to operations as incurred and replacements and significant
improvements, which would extend the useful life are capitalized. Depreciation
and amortization are expensed over the estimated useful lives of the assets on a
straight-line basis as follows:

Building improvements..................................... 10 - 15 years
Furniture, fixtures and equipment......................... 3 - 15 years

Depreciation expense related to property and equipment for the years
ended December 31, 2000 and 1999 was approximately $1,307,000 and $880,000,
respectively.

Goodwill

Goodwill represents the excess of acquisition cost over the fair market
value of net assets acquired in the GranCare Merger. Goodwill of approximately
$53,177,000 was recorded at the Facilities and is being amortized on a
straight-line basis over 30 years. Management periodically re-evaluates goodwill

F-36

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies Basis of presentation (Continued)

and makes any adjustments, if necessary, whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable or the
estimated useful life has changed. Accumulated amortization at December 31, 2000
and 1999 was approximately $1,159,000 and $700,000, respectively. Amortization
of goodwill charged to expense was approximately $459,000 and $1,147,000 for the
years ended December 31, 2000 and 1999, respectively.

Impairment of long-lived assets

Statement of Financial Accounting Standards No. 121, "Accounting for
the Impairment of Long-Lived Assets to be Disposed Of," requires impairment
losses to be recognized for long-lived assets when indicators of impairment are
present and the undiscounted cash flows estimated to be generated by the
long-lived assets are not sufficient to recover the assets' carrying amount.
Goodwill is also evaluated for recoverability by estimating the projected
undiscounted cash flows, excluding interest, of the related business activities.

The impairment loss of long-lived assets, including goodwill, is
measured by comparing the carrying amount of the asset to its fair value with
any excess of the carrying value over the fair value written off. Fair market
value is determined by various valuation techniques including discounted cash
flow (see Note 7).

Non-current liabilities

Non-current liabilities principally include unfavorable lease
obligations related to facilities acquired in the GranCare Merger. The
unfavorable lease obligations are amortized as a reduction of rent expense over
the remaining lease term.

Revenue recognition

Net patient revenue includes patient revenues payable by patients and
amounts reimbursable by third party payors under contracts. Patient revenues
payable by patients are recorded at established billing rates. Patient revenues
to be reimbursed by contracts with third-party payors are recorded at the amount
estimated to be realized under these contractual arrangements. Revenues from
Medicare and Medicaid are generally based on reimbursement of the reasonable
direct and indirect costs of providing services to program participants or, for
the Facilities' cost reporting periods beginning January 1, 1999, determined
under the Prospective Payment System ("PPS"). Management separately estimates
revenues due from each third party with which it has a contractual arrangement
and records anticipated settlements with these parties in the contractual period
during which services were rendered.

The amounts actually reimbursable under Medicare and Medicaid cost
reimbursement programs for periods prior to January 1, 1999 are determined by
filing cost reports that are then subject to audit and retroactive adjustment by
the payor.

Legislative changes to state or federal reimbursement systems may also
retroactively affect recorded revenues. Changes in estimated revenues due in
connection with Medicare and Medicaid may be recorded by management subsequent
to the year of origination and prior to final settlement based on improved
estimates. Such adjustments and final settlements with third party payors are
reflected in

F-37

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies Basis of presentation (Continued)

operations at the time of the adjustment or settlement. Medicare revenues
represented 21% and 23%, and Medicaid revenues represented 55% and 53% of net
revenues for the years ended December 31, 2000 and 1999, respectively. On
January 1, 1999, Mariner transitioned the Facilities to PPS for services to
Medicare patients. Revenue recorded for 1999 consists of the aggregate payments
expected from Medicare for individual claims at the appropriate payment rates,
which include reimbursement for ancillary services.

In April 1995, the Health Care Finance Administration ("HCFA") issued a
memorandum to its Medicare fiscal intermediaries as a guideline to assess costs
incurred by inpatient providers relating to payment of occupational and speech
language pathology services furnished under arrangements that include contracts
between therapy providers and inpatient providers. While not binding on the
fiscal intermediaries, the memorandum suggested certain rates to assist the
fiscal intermediaries in making annual "prudent buyer" assessments of speech and
occupational therapy rates paid by inpatient providers. In addition, HCFA has
promulgated new salary equivalency guidelines effective April 1, 1998, which
updated the then current physical therapy and respiratory therapy rates and
established new guidelines for occupational therapy and speech therapy. These
new payment guidelines were in effect until the Facilities transitioned to PPS,
at which time payment for therapy services were included in the PPS rate. HCFA,
through its intermediaries, is also subjecting physical therapy, occupational
therapy and speech therapy to a heightened level of scrutiny resulting in
increasing audit activity. A majority of the Facilities' provider and
rehabilitation contracts provided for indemnification of the facilities for
potential liabilities in connection with reimbursement for rehabilitation
services. There can be no assurance that actions ultimately taken by HCFA with
regard to reimbursement rates for such therapy services will not materially
adversely affect the Facilities results of operations.

Laws and regulations governing the Medicare and Medicaid programs are
complex and subject to interpretation. Management believes that the Facilities
are in compliance with all applicable laws and regulations, and is not aware of
any pending or threatened investigations involving allegations of potential
wrongdoing. While no such regulatory inquiries have been made, compliance with
such laws and regulations can be subject to future government review and
interpretation as well as significant regulatory action including fines,
penalties, and exclusion from the Medicare and Medicaid programs.

Use of estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
certain estimates and assumptions that may affect the amounts reported in these
financial statements and related notes. The actual results could differ from
these estimates.

Income taxes

The Parent files a consolidated federal income tax return. Throughout
the years and periods presented herein, the Facilities' operations were included
in the Parent's income tax returns. The income tax provision reported in the
combined financial statements is an allocation of the Parent's total income tax
provision. The Facilities' allocation was determined based on a calculation of
income taxes as if the Facilities were a separate taxpayer, in accordance with
Statement of Financial Accounting

F-38

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies Basis of presentation (Continued)

Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Income taxes paid
was zero for all periods presented.

Non-current deferred income taxes arise primarily from timing
differences resulting from the recognition of rent expense for tax and financial
reporting purposes and from the use of accelerated depreciation for tax
purposes. Current deferred income taxes result from timing differences in the
recognition of revenues and expenses for tax and financial reporting purposes
which are expected to reverse within one year.

3. Proceedings Under Chapter 11 of the Bankruptcy Code

On January 18, 2000, Mariner and certain of its respective
subsidiaries, including those subsidiaries operating the Facilities, filed
voluntary petitions for relief under Chapter 11 of the Bankruptcy Code (the
"Chapter 11 Proceedings"). Mariner is presently operating its business as a
debtor-in-possession and is subject to the jurisdiction of the Bankruptcy Court
while a plan of reorganization is formulated. As a debtor-in-possession, Mariner
is authorized to operate its business but may not engage in transactions outside
its ordinary course of business without the approval of the Bankruptcy Court.

While the Chapter 11 Proceedings constituted a default under Mariner's
and such subsidiaries' various financing arrangements, Section 362 of the
Bankruptcy Code imposes an automatic stay that generally precludes any creditors
and other interested parties under such arrangements from taking any remedial
action in response to any such resulting default outside of the Chapter 11
Proceedings with obtaining relief from the automatic stay from the Bankruptcy
Court.

On January 19, 2000, Mariner received approval from the Bankruptcy
Court to pay prepetition and postpetition employee wages, salaries, benefits and
other employee obligations. The Bankruptcy Court also approved orders granting
authority to pay prepetition claims of certain critical vendors, utilities and
patient obligations. All other prepetition liabilities at December 31, 2000 are
disclosed in Note 5 as liabilities subject to compromise. The Facilities have
been and intend to continue to pay postpetition claims to all vendors and
providers in the ordinary course of business.

4. Going Concern and Issues Affecting Liquidity

The accompanying combined financial statements have been prepared
assuming that the Facilities will continue to operate as a going concern. The
Facilities have violated certain covenants of its loan agreement, have
experienced significant losses and have a working capital deficiency of
approximately $11,673,000 and a divisional deficit of approximately $34,687,000
as of December 31, 2000. Mariner and certain of its subsidiaries, including
those subsidiaries operating the Facilities, filed voluntary petitions for
relief under Chapter 11 of the Bankruptcy Code. These matters, among others,
raise substantial doubt about the Facilities ability to continue as a going
concern.

As described in Note 1, on May 10, 2000 the Bankruptcy Court approved a
settlement agreement between Mariner and SNH whereby the Facilities leased by
Mariner and related personal property were assigned to affiliates of SNH. SNH
agreed to provide working capital to the facilities. The agreement is effective
at the close of business on June 30, 2000 and is subject to obtaining regulatory
approvals in

F-37

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

4. Going Concern and Issues Affecting Liquidity (Continued)

the states where the Facilities are located. At December 31, 2000, $5,760,000
had been advanced to the facilities by SNH.

On December 31, 2000, SNH has approximately $173,000,000 available for
borrowing under a $270,000,000 bank credit facility. Management of SNH believes
that the available borrowings under the bank credit facility are sufficient to
provide the necessary working capital to the Facilities for operations
subsequent to the closing of the June 30, 2000 transaction.

5. Liabilities Subject to Compromise

"Liabilities subject to compromise" represents liabilities incurred
prior to the commencement of the Chapter 11 Proceedings. These liabilities,
consisting primarily of long-term debt and certain accounts payable, represent
the Facilities' estimate of known or potential prepetition claims to be resolved
in connection with the Chapter 11 Proceedings. Such claims remain subject to
future adjustments based on negotiations, actions of the Bankruptcy Court,
further developments with respect to disputed claims, future rejection of
executory contracts or unexpired leases, determination as to the value of any
collateral securing claims, treatment under the plan of reorganization and other
events. Payment for these amounts will be established in connection with the
plan of reorganization.

A summary of the principal categories of claims classified as
liabilities subject to compromise at December 31, 2000 is as follows (in
thousands):

Accounts payable and accrued expenses.......................... $6,223
Long-term debt................................................. 888
--------
$7,111
========

6. Impairment of Long-Lived Assets

The revenues recorded by the Facilities under PPS are substantially
less than the cost-based reimbursement it received previously. The
implementation of PPS resulted in a greater than expected decline in
reimbursement for inpatient services. Management determined that these revenue
declines are other than temporary and are expected to have a materially adverse
effect on future revenues and cash flow. As a result of such indicators of
impairment, in the third quarter of 1999, a detailed analysis of the Facilities'
long-lived assets and their estimated future cash flows was completed. The
analysis resulted in the identification and measurement of an impairment loss of
approximately $36,322,000.

Each analysis included management's estimate of the undiscounted cash
flows to be generated by these assets with a comparison to their carrying value.
If the undiscounted future cash flow estimates were less than the carrying value
of the asset then the carrying value was written down to estimated fair value.
Goodwill associated with an impaired asset was included with the carrying value
of that asset in performing both the impairment test and in measuring the amount
of impairment loss related to the asset. Fair value was estimated based on the
present value of future cash flows.

F-40

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

6. Impairment of Long-Lived Assets (Continued)

The following is a summary of the impairment losses recognized during
1999 by asset category (in thousands):

1999
----------
Goodwill................................................... $30,378
Property and equipment..................................... 5,944
----------
$36,322
==========
7. Debt

On December 28, 1990, a mortgage loan agreement was entered into for
$15,000,000 with HRPT Properties, secured by two nursing home facilities'
(Northwest Health Care Center and River Hills West Health Care Center) land,
building and improvements. The interest rate on the note was 11.5%. The loan was
repaid in September 1998 as part of the sale-leaseback transaction discussed in
Note 6.

On March 28, 1992, a loan agreement was entered into with HRPT
Properties for the purpose of funding renovations to the Christopher East
facility, maturing on January 31, 2013. Advances to AMS Properties, Inc. totaled
approximately $883,000 for the years ended December 31, 2000 and 1999. The loan
is interest bearing and principal is payable upon maturity. The interest rate on
the note is 13.75%. The Bankruptcy Proceedings are considered an Event of
Default as defined in the loan agreement. Current portion of long-term debt at
December 31, 1999 includes the principal balance of the note. In consideration
of the terms of the Settlement Agreement, the Christopher East note obligation
was terminated in July 2000. Interest paid was approximately $60,000 and
$181,000 during the years ended December 31, 2000 and 1999, respectively.

8. Transactions with Affiliates

Mariner provided various services to the Facilities including, but not
limited to, financial, legal, insurance, information systems, employee benefit
plans and certain administrative services, as required. The combined financial
statements reflect charges for certain corporate general and administrative
expenses from Mariner's corporate office to the Facilities. Such corporate
charges represent allocations based on determinations management believes to be
reasonable (5% of total revenues). Administrative costs charged by Mariner were
approximately $2,133,000 and $4,347,000 for the years ended December 31, 2000
and 1999, respectively. For the year ended December 31, 2000, fees charged by
SNH for management services were approximately $1,968,000, all of which have
been paid.

The Facilities participated in the various benefit plans of Mariner,
primarily the profit sharing and 401(k) plans. These plans include matching
provisions for employee contributions to the 401(k) plan. The financial
statements reflect charges for benefits attributable to the Facilities'
employees. Such amounts totaled approximately $108,000 and $221,000 for the
years ended December 31, 2000 and 1999, respectively.

Through March 31, 1998, the Facilities participated in a program for
insurance of workers' compensation risks through a captive insurance subsidiary
of Mariner. Effective March 31, 1998, Mariner purchased a fully-insured workers'
compensation policy with no deductible or retention with a

F-41

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

8. Transactions with Affiliates (Continued)

catastrophic policy in place to cover any loss above $500,000 per occurrence.
Additionally, in 1998 Mariner purchased general and professional liability
insurance through a third party. The maximum loss exposure with respect to this
policy is $100,000 per occurrence.

Mariner obtains and provides insurance coverage for health, life and
disability, auto, general liability and workers' compensation through its
self-insurance and outside insurance programs and allocates to the Facilities
based on its estimate of the actual costs incurred on behalf of the Facilities.
Total insurance costs allocated were approximately $2,537,000 and $4,876,000 for
the years ended December 31, 2000 and 1999, respectively. These costs are
included in facility general and administrative costs in the accompanying
combined statements of operations.

The Facilities purchased certain therapy services from rehabilitation
subsidiaries of Mariner. These purchases amounted to approximately $0 and
$2,955,000 for the years ended December 31, 2000 and 1999, respectively.

9. Commitments and Contingencies

As discussed in Note 1, the Facilities are party to various agreements
between GranCare and SNH. SNH is the lessor with respect to the Facilities
leased by two subsidiaries of GranCare (the "Tenant Entities") under operating
leases. Pursuant to a Collateral Pledge Agreement dated October 31, 1997,
Mariner provided an unlimited guaranty to SNH, which is secured by a cash
collateral deposit of $15,000,000, the earned interest on which is retained by
SNH. In June 2000, the Facilities ceased payment of rents. As part of the
Settlement Agreement, Mariner was released from its lease obligations.

Rent expense, net of amortization of unfavorable lease obligation, for
all operating leases was approximately $8,748,000 and $9,314,000 for the years
ended December 31, 2000 and 1999, respectively.

From time to time, the Facilities have been subject to various legal
proceedings in the ordinary course of business. In the opinion of management,
except as described below, there are currently no proceedings which could
potentially have a material adverse effect on the Facilities' financial position
or results of operations after taking into account the insurance coverage
maintained by Mariner. Although management believes that any of the proceedings
discussed below will not have a material adverse impact on the Facilities if
determined adversely to the Facilities, given the Facilities' current financial
condition, lack of liquidity and the current lack of aggregate limit under
Mariner's current GL/PL insurance policy, settling a large number of cases
within the Company's $1 million self-insured retention limit could have a
material adverse effect on the Facilities.

On August 26, 1996, a class action complaint was asserted against
GranCare in the Denver, Colorado District Court. On March 15, 1998, the Court
entered an Order in which it certified a class action in the matter. On June 10,
1998, Mariner filed a Motion to Dismiss all claims and Motion for Summary
Judgment Precluding Recovery of Medicaid Funds and these motions were partially
granted by the Court on October 30, 1998. Plaintiffs filed a writ with the
Colorado Supreme Court and an appeal with the Colorado Court of Appeals. The
Supreme Court writ has been denied, the Court of Appeals matter has been briefed
and Oral Argument was set for January 18, 2000. In accordance with the Chapter
11 Proceedings and more particularly, Section 362 of the Bankruptcy Code, this
matter was

F-42

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

9. Commitments and Contingencies (Continued)

stayed on January 18, 2000. However, Mariner did agree to limited
relief from the stay in order to allow for certain parts of the appeal to
continue. On January 4, 2001, the Court of Appeals reversed the District Court's
decision. Mariner is currently considering whether to pursue a request for
rehearing and/or appeal to the Colorado Supreme Court. The Company intends to
vigorously contest the remaining allegations of class status.

10. Income Taxes

The components of the net deferred tax asset are approximately as
follows (in thousands):

December 31,
------------------------
Deferred tax assets: 2000 1999
-------- ---------

Bad debts........................................................................ $325 $598
Amounts related to property and equipment........................................ 1,681 1,585
Payroll and benefits............................................................. 271 620
Unfavorable lease obligations and other liabilities.............................. 11,304 12,736
NOL carryforwards................................................................ 11,878 7,205
-------- ---------
Total deferred tax assets........................................................... 25,459 22,744
Less valuation allowance............................................................ (25,459) (22,744)
-------- ---------
Net deferred tax asset.............................................................. $-- $--
======== =========

The Facilities have established a full valuation allowance, which
completely offsets all net deferred tax assets generated from the Facilities'
net losses because its future realizability is uncertain. The net change in the
valuation allowance was an increase of approximately $2,715,000 and $4,789,000
at December 31, 2000 and 1999, respectively.

The provision for income taxes varies from the amount determined by
applying the Federal statutory rate to pre-tax loss as a result of the
following:

Years Ended December 31,
------------------------
2000 1999
---------- ---------

Federal statutory income tax rate................................................... (34.0)% (34.0)%
Increase (decrease) in taxes resulting from:
State and local taxes, net of federal tax benefits............................ (4.7) (1.4)
Permanent book/tax differences, primarily resulting from goodwill
amortization............................................................... 2.1 0.9
Impairment of assets.......................................................... -- 23.6
Change in valuation allowance................................................. 36.6 10.9
---------- ---------
Effective tax rate.................................................................. --% --%
========== =========

F-43

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

NOTES TO COMBINED FINANCIAL STATEMENTS (Continued)

11. Concentrations of Credit Risk

Financial instruments that potentially subject the Facilities to
concentration of credit risk consist principally of trade receivables. There
have been, and the Facilities expect that there will continue to be, a number of
proposals to limit reimbursement allowable to skilled nursing facilities. Should
the related government agencies suspend or significantly reduce contributions to
the Medicare or Medicaid programs, the Facilities' ability to collect its
receivables would be adversely impacted.

Management believes that the remaining receivable balances from various
payors, including individuals involved in diverse activities, subject to
differing economic conditions, do not represent a concentration of credit risk
to the

Facilities. Management continually monitors and adjusts its allowance
for doubtful accounts associated with its receivables.

12. Fair Value of Financial Instruments

The Facilities financial instruments include notes payable. Fair values
for fixed rate debt instruments were estimated based on the present value of
cash flows that would be paid on the note over the remaining note term using the
Facilities' current incremental borrowing rate rather than the stated interest
rate on the notes. The fair values of the financial instruments approximate
their carrying values.

F-44

CERTAIN MARINER POST-ACUTE NETWORK FACILITIES (OPERATED BY
SUBSIDIARIES OF MARINER POST-ACUTE NETWORK)
(DEBTOR IN POSSESSION AS OF JANUARY 20, 2000)

SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(Dollars in thousands)
Years ended December 31, 2000 and 1999

Balance at Charged
beginning of (Credited) to Write-offs / Balance at
Description year operations Recoveries Other end of year
---------------------------------- ------------ ------------- ------------ ---------- ------------

Year ended December 31, 2000:
Allowance for doubtful
accounts:................... $1,534 $1,758 $(1,458) $-- $1,834
----------- ------------- ---------- -------- ----------
$1,534 $1,758 $(1,458) $-- $1,834
============ ============= ========== ======== ==========
Year ended December 31, 1999:
Allowance for doubtful
accounts:................... $2,927 $4,233 $(5,468) $(158) $1,534
----------- ------------- ---------- -------- ----------
$2,927 $4,233 $(5,468) $(158) $1,534
============ ============= ========== ======== ==========

F-45

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

FIVE STAR QUALITY CARE, INC.

By: /s/ Evrett W. Benton
Evrett W. Benton
President and Chief Executive Officer

Dated: March 29, 2002

Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons, or by their
attorney-in-fact, in the capacities and on the dates indicated.

Signature Title Date
--------- ----- ----

/s/ Evrett W. Benton President and Chief March 29, 2002
Evrett W. Benton Executive Officer

/s/ Bruce J. Mackey Jr. Chief Financial Officer March 29, 2002
Bruce J. Mackey Jr. and Treasurer

/s/ Barry M. Portnoy Managing Director March 29, 2002
Barry M. Portnoy

/s/ Gerard M. Martin Managing Director March 29, 2002
Gerard M. Martin

/s/ Bruce M. Gans Director March 29, 2002
Bruce M. Gans

/s/ John L. Harrington Director March 29, 2002
John L. Harrington

/s/ Arthur G. Koumantzelis Director March 29, 2002
Arthur G. Koumantzelis