Five Star Quality Care 10-K 2005
Documents found in this filing:
WASHINGTON, DC 20549
ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
o 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.
400 Centre Street, Newton, Massachusetts 02458
Securities to be registered pursuant to Section 12(b) of the Act:
Securities to be 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 ý No o
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 registrants 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. ý
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
Yes o No ý
The aggregate market value of the voting shares of the registrant held by non-affiliates was $35.6 million based on the $4.40 closing price per common share on the American Stock Exchange on June 30, 2004. For purposes of this calculation, an aggregate of 399,582.6 shares of common stock are held by the directors and officers of the registrant and have been included in the number of shares of common stock held by affiliates, which includes 35,000 shares of common stock held by Senior Housing Properties Trust.
Number of the registrants shares of common stock outstanding as of March 25, 2005: 12,227,634.
References in this Annual Report on Form 10-K to the Company, Five Star, FVE, we, us or our include Five Star Quality Care, Inc., and its consolidated subsidiaries, unless the context indicates otherwise.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information required in Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K is incorporated by reference from our definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 11, 2005, or our definitive Proxy Statement.
WARNING CONCERNING FORWARD LOOKING STATEMENTS
OUR ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 AND FEDERAL SECURITIES LAWS. THESE STATEMENTS REPRESENT OUR PRESENT BELIEFS AND EXPECTATIONS, BUT THEY MAY NOT OCCUR FOR VARIOUS REASONS. FOR EXAMPLE:
OUR FUTURE INSURANCE COSTS AND INSURANCE RESERVE CALCULATIONS MAY BE GREATER THAN WE NOW ANTICIPATE;
WE MAY BE UNABLE TO CARRY OUT OUR BUSINESS PLAN TO EXPAND BECAUSE WE ARE UNABLE TO LOCATE EXPANSION OPPORTUNITIES AT PRICES WE ARE WILLING OR ABLE TO PAY;
OUR RECEIVABLES RESERVES MAY BE INADEQUATE, ESPECIALLY THE RESERVES WHICH RELATE TO MEDICARE AND MEDICAID PAYMENTS BECAUSE SUCH PAYMENTS ARE SUBJECT TO GOVERNMENTAL AUDITS AND TO GOVERNMENT FISCAL POLICIES;
OUR PENDING ACQUISITION OF SIX ASSISTED LIVING COMMUNITIES MAY NOT BE CONCLUDED BECAUSE OF OUR FAILURE TO RECEIVE LICENSING, THIRD PARTY CONSENTS OR OTHERWISE;
WE MAY BE UNABLE TO MAINTAIN OR IMPROVE OUR FUTURE OCCUPANCY RATES AND AS A RESULT OUR REVENUES MAY DECLINE;
THE IMPROVING ECONOMY MAY RESULT IN WAGE PRESSURES WHICH INCREASE OUR FUTURE COSTS;
FUTURE MEDICARE AND MEDICAID RATES MAY BE LOWER THAN WE NOW ANTICIPATE;
SUNRISE SENIOR LIVING SERVICES INC.S, OR SLSS, OPERATIONS OF THE COMMUNITIES WHICH IT MANAGES FOR US MAY RESULT IN LOSSES TO US; OR
WE MAY BECOME SUBJECT TO FINES OR REGULATORY SANCTIONS WHICH MATERIALLY ADVERSELY AFFECT OUR FINANCIAL CONDITION OR PERFORMANCE.
IN ANY SUCH EVENT, OUR FUTURE FINANCIAL PERFORMANCE MAY CAUSE THE IMPROVEMENTS IMPLIED BY OUR RECENT PERFORMANCE TO REVERSE AND WE MAY EXPERIENCE LOSSES. IF OUR FINANCIAL RESULTS DO NOT CONTINUE TO IMPROVE, OUR STOCK PRICE LIKELY WILL DECLINE. YOU SHOULD NOT PLACE UNDUE RELIANCE UPON FORWARD LOOKING STATEMENTS.
EXCEPT AS MAY BE REQUIRED BY APPLICABLE LAW, WE DO NOT INTEND TO IMPLY THAT WE WILL RELEASE PUBLICLY THE RESULT OF ANY REVISION TO THE FORWARD LOOKING STATEMENTS CONTAINED IN THIS ANNUAL REPORT TO REFLECT THE FUTURE OCCURRENCE OF PRESENTLY UNANTICIPATED EVENTS.
FIVE STAR QUALITY CARE, INC.
2004 FORM 10-K ANNUAL REPORT
Table of Contents
Item 1. Business
We operate senior living communities, including independent living and congregate care communities, assisted living communities and nursing homes. As of December 31, 2004, excluding communities we managed under third party management contracts, we operated 148 communities containing 16,573 living units, including 96 primarily independent and assisted living communities containing 11,724 living units and 52 nursing homes containing 4,849 living units. Of our 96 primarily independent and assisted living communities, we lease 77 communities containing 10,308 living units from Senior Housing Properties Trust, or Senior Housing, our former parent, including 30 communities which are directly operated for our account by SLS, a wholly owned subsidiary of Sunrise Senior Living, Inc., or Sunrise, and we own or lease from parties other than Senior Housing 19 communities containing 1,416 living units. All but one of our nursing homes are leased from Senior Housing. Our 148 communities include 4,960 independent living apartments, 5,046 assisted living suites, 283 special care beds and 6,284 nursing beds. Our principal executive offices are located at 400 Centre Street, Newton, Massachusetts 02458, and our telephone number is (617) 796-8387.
We were created by Senior Housing in April 2000 to operate nursing homes repossessed or acquired from two former Senior Housing tenants. We were reincorporated in Maryland on September 17, 2001. 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, or AMEX. Pursuant to the transaction agreement governing this spin off:
Senior Housing capitalized us with approximately $50 million of equity, consisting of cash and working capital, primarily operating receivables, net of operating payables;
we agreed to lease 31 primarily independent and assisted living communities then operated by Marriott Senior Living Services, or MSLS, a wholly owned subsidiary of Marriott International Inc., or Marriott, upon their acquisition by Senior Housing which occurred in 2002, as described below;
we leased 53 nursing homes and two assisted living communities from Senior Housing;
we assumed one lease from the town of Campbell, Nebraska; and
we agreed to acquire FSQ, Inc., or FSQ, the former operating company of the healthcare business we owned in order to acquire the personnel, systems and assets necessary for our business.
During 2002, we commenced operations at 51 senior living communities, including the 31 communities then operated by MSLS, and currently operated by SLS, and 20 additional communities. In March and April 2002, we issued 3,823,000 common shares in an underwritten public offering raising net proceeds of $26.1 million. Also during 2002, we ceased operations at two communities, one of which was previously leased from Senior Housing and one of which was previously leased from the town of Campbell, Nebraska.
During 2003, we commenced operations at three senior living communities, which we lease from Senior Housing. Also during 2003, we ceased operations at seven communities, one of which was previously leased from Senior Housing. During 2003, we also acquired an institutional pharmacy located in Wisconsin for $1.8 million and we acquired a company insuring some of our workers compensation related risks for $1.3 million.
In March 2004, we ceased operations at one community that is leased from Senior Housing and was managed by SLS and we established an additional insurance company to insure a portion of our liability insurance.
In September 2004, we acquired an institutional pharmacy business located in Lincoln, Nebraska for approximately $3.0 million.
In November 2004, we acquired 100% of the capital stock of LTA Holdings, Inc., or LTA, for approximately $211 million, excluding closing costs. LTA owned, leased and operated 47 senior living communities with 2,636 living units, which primarily offer assisted living services, located in seven states. The majority of these 47 communities were built by LTA between 1997 and 2002, the average age of the 47 communities is approximately five years and 100% of the revenues at these communities were paid by residents from their private resources. In addition, LTA had two management contracts with third parties for 12 assisted living communities. We terminated one contract for 11 of these communities, on March 1, 2005.
To finance this acquisition, we entered into a $148.2 million sale leaseback transaction with Senior Housing for 31 of the communities acquired from LTA. We also entered into a $16.8 million mortgage loan with Senior Housing secured by five of our properties. We funded the balance of the purchase price with cash on hand, and by assuming Department of Housing and Urban Development, or HUD, insured long term mortgage debts and an operating lease for four communities from Health Care Property Investors, Inc., or HCPI.
In December 2004 and January 2005, we issued a total of 3,620,000 shares of common stock, or common shares, for net proceeds of $28.8 million. We used a portion of proceeds raised in this offering to pay off the $16.8 million mortgage loan with Senior Housing described above.
In January 2005, we agreed to acquire six assisted living communities for approximately $63.5 million from six limited liability companies known as Gordon Health Care Ventures, LLC, or Gordon. We intend to finance this acquisition with cash on hand, borrowings under our line of credit and mortgage or sale leaseback transactions for some of the communities being purchased or for certain other unencumbered communities which we currently own. Completion of this acquisition is subject to various conditions customary in multi-community healthcare transactions of this type, including completion of diligence, licensing and receiving third party consents. We expect this acquisition to close during the second quarter of 2005, but there is no assurance that it will close.
In March 2005, we acquired one assisted living community for a purchase price of $6.9 million, excluding closing costs, and commenced operations at that community. We funded the purchase price with cash on hand. This community has 62 living units and 100% of the revenues at this community are paid by residents from their private resources.
OUR GROWTH STRATEGY
We believe that the aging of the U.S. population will increase demand for existing independent living properties, assisted living communities and nursing homes. Our principal growth strategy is to profit from this demand by operating and acquiring properties that provide high quality services to residents who pay with private resources.
We seek to improve the profitability of our existing operations by increasing revenues and improving margins. We attempt to increase revenues by increasing rates and occupancies. We attempt to improve margins by limiting increases in expenses and improving operating efficiencies.
In addition to managing our existing operations, we intend to continue to grow our business through acquisitions of independent and assisted living communities where residents private resources account for a large majority of revenues. Since we became a public company in late 2001, we added 94 primarily independent and assisted living communities to our business which generate approximately 87% of their revenue from residents private resources, rather than from Medicare or Medicaid. We prefer to purchase communities which have achieved or are close to stabilized operations. For example, the LTA communities which we acquired were 86% occupied as of December 31, 2004. We also try to make acquisitions where we can realize cost savings by combining operations with our existing operations.
Starting in the mid 1990s, a large number of independent and assisted living communities were developed with financing from private equity and real estate opportunity funds. We believe that many of these communities are now at or approaching stabilized operations and many of these financial investors are now anxious to sell. For example: in 2002, we acquired 15 independent and assisted living communities which were assembled and developed by Constellation Health Services, Inc., a division of Constellation Energy Group, Inc., f/k/a Baltimore Gas and Electric Company; and the controlling shareholder of LTA prior to our acquisition of LTA was a private equity fund. We expect to pursue similar acquisitions for the next several years.
We also intend to expand our institutional pharmacy business. We acquired our first pharmacy in Wisconsin in 2003. During 2004, we acquired a second pharmacy located in Nebraska. Whenever we buy an institutional pharmacy business, we seek to grow its business by providing pharmacy services at our senior living communities within the same service area. We are currently interested in acquiring pharmacies in other areas where we own senior living communities.
Although expansion of our nursing home business is not our primary growth strategy, we have in the past considered acquiring additional nursing homes. Most nursing homes are financially dependent upon the Medicare and Medicaid programs. Accordingly, we believe the potential for profitable operations of nursing homes is limited by government rate setting. In these circumstances, we are only interested in expanding our nursing home operations at prices which we believe take into account the risks inherent in government funding. In the past few years, we have been unable to buy nursing homes at prices we consider appropriate, but we intend to investigate such opportunities in the future.
We have only recently been able to operate profitably. Ownership of our securities involves a high degree of risk. The following is a summary of the material risks of ownership of our securities.
A small percentage decline in our revenues or increase in our expenses could have a material negative impact upon our operating results.
For the year ended December 31, 2004, our revenues were $628.0 million and our expenses were $624.7 million. A small percentage decline in our revenues or increase in our expenses could have a material negative impact upon our operating results.
Our growth strategy may not succeed.
Our business plan includes acquiring additional senior living communities and institutional pharmacies. This growth strategy involves risks including the following:
we may be unable to locate senior living communities or pharmacies available for purchase at acceptable prices;
we may be unable to access capital to make acquisitions or operate acquired businesses;
acquired operations may bring with them contingent liabilities which mature;
to the extent we incur acquisition debt or leases, our operating leverage may increase; and
combining our present operations with newly acquired operations may disrupt operations or cost more than anticipated when acquisition prices are determined.
For these reasons and others:
the pending acquisition of the Gordon facilities may not be completed; or, if it is completed those facilities operations may not be profitably integrated into our existing operations;
our business plan to grow may not succeed;
the benefits which we hope to achieve by growing may not be achieved;
we may suffer declines in profitability or suffer recurring losses; and
our existing operations may suffer from a lack of management attention or financial resources if such attention and resources are devoted to a failed growth strategy.
Our insurance costs have increased and may continue to increase.
In several well publicized instances, private litigation by residents of senior living communities for alleged abuses has resulted in large damage awards against other operating companies. Today, some lawyers and law firms specialize in bringing litigation against senior living companies. As a result of this litigation and potential litigation, our cost of liability insurance has increased dramatically during the past few years. Workers compensation and employee health insurance costs have also increased in recent years. To partially offset these increases, we have increased the
amounts of our self insurance by use of higher deductibles and captive insurance companies. Medical liability insurance reform has become a topic of political debate and some states have enacted legislation to limit future liability awards. However, if such reforms are not generally adopted, we expect our insurance costs may continue to increase. Although our reserves for self insurance have been determined with guidance from third party professionals, our reserves may prove inadequate. Increasing insurance costs and increasing reserves may materially negatively affect our results of operations.
Licensing and Medicare and Medicaid laws require operators of senior living communities to comply with extensive standards governing operations. There are also various laws prohibiting fraud by senior living operators, including criminal laws that prohibit false claims for Medicare and Medicaid and that regulate patient referrals. In recent years, the federal and state governments have devoted increased resources to monitoring quality of care at senior living communities and to anti-fraud investigations. When quality of care deficiencies are identified or improper billing is uncovered, various sanctions may be imposed, including denial of new admissions, exclusion from Medicare or Medicaid program participation, monetary penalties, governmental oversight or loss of licensure. Our communities receive notices of sanctions from time to time. A result of this extensive regulatory system and increasing enforcement initiatives has been to increase our costs of monitoring quality of care compliance and billing procedures, and we expect these costs may continue to increase. Also, if we become subject to regulatory sanctions, our business may be adversely affected and we might experience financial losses.
Some of our operations, especially our nursing homes, receive significant revenues from the Medicare and Medicaid programs. During the year ended December 31, 2004, approximately 41% of our total revenues was received from these programs. The federal government and some states are now experiencing fiscal deficits. Historically, when governmental deficits have increased, cut backs in Medicare and Medicaid funding have often followed. These cut backs sometimes include rate reductions, but more often result in a failure of Medicare and Medicaid rates to increase by sufficient amounts to offset increasing costs. We cannot now predict whether future Medicare and Medicaid rates will be sufficient to cover our future cost increases. Future Medicare and Medicaid rate declines or a failure of these rates to cover increasing costs would result in our experiencing lower earnings or losses.
Sunrises management of 30 of our communities may have adverse consequences to us.
In March 2003, Marriott sold its subsidiary which manages 30 communities for us to Sunrise. We believe Sunrises financial condition and reputation as an operator of senior living communities is weaker than the financial condition and reputation of Marriott. The operations and the financial results which we realize from the communities managed for us by Sunrise have declined and become more volatile since this sale and this decline and volatility may continue in the future.
We are subject to possible conflicts of interest and we have engaged in, and will continue to engage in for the foreseeable future, transactions with related parties.
Our business is subject to possible conflicts of interest as follows:
our Chief Executive Officer, Evrett W. Benton, and our Chief Financial Officer, Bruce J. Mackey Jr., are also part-time employees of Reit Management and Research LLC, or RMR. RMR is the manager for Senior Housing and we purchase various services from RMR pursuant to a shared services agreement;
our managing directors, Barry M. Portnoy and Gerard M. Martin, are also managing trustees of Senior Housing. Messrs. Portnoy and Martin also own RMR and another entity that leases office space to us; and
under our shared services agreement with RMR, in the event of a conflict between Senior Housing and us, RMR may act on behalf of Senior Housing rather than on our behalf.
We do not believe that these conflicts adversely affect our business.
On December 31, 2001, Senior Housing distributed substantially all of its ownership of our shares to its shareholders. As a condition to the spin off, we entered into agreements with Senior Housing which, among other things, limit ownership of more than 9.8% of our voting shares, restrict our ability to take any action that could jeopardize the tax status of Senior Housing as a real estate investment trust and limit our ability to acquire real estate of types which are owned by Senior Housing or other real estate investment trusts managed by RMR.
One hundred twenty-eight of the 148 senior living communities we currently operate are leased from Senior Housing for total annual minimum rent of $95.8 million.
As a result of the agreements entered into in connection with the spin off, our leases with Senior Housing and our shared services agreement with RMR, Senior Housing, RMR and their respective affiliates play a significant role in our business and we do not anticipate any changes to that role for the foreseeable future. Future business dealings between us, Senior Housing, RMR and their respective affiliates may be on terms less favorable to us than we could achieve on an arms length basis.
Our business requires regular capital expenditures.
Physical characteristics of senior living communities are mandated by various governmental authorities. Changes in these regulations may require us to make significant expenditures. In the future, our communities may require significant expenditures to address ongoing required maintenance and to make them attractive to residents. Our available financial resources may be insufficient to fund these expenditures.
Our business is highly competitive and we may be unable to operate profitably.
We compete with numerous other companies that provide senior living services, including home healthcare companies and other real estate based service providers. Historically, nursing homes have been somewhat protected from competition by state laws requiring certificates of need to develop new communities; however, these barriers are being eliminated in many states. Also, there are few barriers to competition for home healthcare or for independent and assisted living services. Growth in the availability of nursing home alternatives, including assisted living communities, has had and may in the future have the effect of reducing the occupancy or profitability at nursing homes, including those we operate. Many of our existing competitors are larger and have greater financial resources than we do. Accordingly, we cannot provide any assurances that we will be able to attract a sufficient number of residents to our communities or that we will be able to attract employees and keep wages and other employee benefits, insurance costs and other operating expenses at levels which will allow us to compete successfully or to operate profitably.
We may not achieve the anticipated benefits of our recently completed acquisition of LTA.
The financial benefits we expect to realize from our acquisition of LTA are largely dependent upon our ability to increase the occupancy of the LTA communities and to realize cost savings by combining the LTA operations and our existing operations. If our management of the LTA communities does not increase revenues and lower costs, we may not achieve the anticipated benefits and we may experience losses.
Anti-takeover provisions in our governing documents and in our material agreements may prevent shareholders from receiving a takeover premium for their shares.
Our charter places restrictions on the ability of any person or group to acquire beneficial ownership of more than 9.8% (in number of shares or value, whichever is more restrictive) of any class of our equity securities. Additionally, the terms of our leases with Senior Housing and our shared services agreement with RMR provide that our rights under these agreements may be cancelled by Senior Housing and RMR, respectively, upon the acquisition by any person or group of more than 9.8% of our voting stock, and upon other change in control events, as defined in those documents. If the breach of these ownership limitations causes a lease default, shareholders causing the default may become liable to us or to other shareholders for damages. Additionally, on March 10, 2004, we entered into a rights agreement whereby in the event a person or group of persons acquires or attempts to acquire 10% or more of our outstanding common shares, our shareholders, other than such person or group, will be entitled to purchase additional shares or other securities or property at a discount. These agreements and other provisions in our charter and bylaws may increase the difficulty of acquiring control of us by means of a tender offer, open market purchases, a proxy fight or otherwise, if the acquisition is not
approved by our board of directors. Other provisions in our governing documents which may deter takeover proposals include the following:
staggered terms for members of our board of directors; the power of our board of directors, without a shareholders vote, to authorize and issue additional shares and classes of shares on terms that it determines;
a 75% shareholder vote and cause requirements for removal of directors; and
advance notice procedures with respect to nominations of directors and shareholder proposals.
For all of these reasons, shareholders may be unable to cause a change of control of us or to realize a change of control premium for their common shares.
A significant increase in our labor costs could have a material adverse effect on us.
We compete with other operators of senior living communities with respect to attracting and retaining qualified personnel responsible for the day to day operations of each of our communities. A shortage of nurses or other trained personnel may require us to increase the wages and benefits offered to our employees in order to attract and retain these personnel or to hire more expensive temporary personnel. No assurance can be given that our labor costs will not increase or that any increase will be matched by corresponding increases in rates charged to residents. Any significant failure by us to control our labor costs or to pass on any increased labor costs to residents through rate increases could have a material adverse effect on our business, financial condition and results of operations.
Circumstances that adversely affect the ability of the elderly to pay for our services could have a material adverse effect on us.
Approximately 59% of our total revenues from our communities for the year ended December 31, 2004 were attributable to private pay sources. We expect to continue to rely on the ability of our residents to pay for our services from their own financial resources. Inflation or other circumstances that adversely affect the ability of the elderly to pay for our services could have a material adverse effect on our business, financial condition and results of operations.
TYPES OF COMMUNITIES
Our present business plan contemplates the ownership, leasing and management of independent living apartments or congregate care communities, assisted living communities, specialty care suites and nursing homes. Some communities combine more than one type of service in a single building or campus.
Independent Living Apartments or Congregate Care Communities. Independent living apartments, or congregate care communities, provide high levels of privacy to residents and require residents to be capable of relatively high degrees of independence. 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 or services of a social director may be included in the base charge. Additional services are generally available from staff employees on a fee for service basis. In some independent living properties, separate parts of the community are dedicated to assisted living or nursing services. As of March 25, 2005, our business includes 4,960 independent living apartments in 38 communities.
Assisted Living Communities. Assisted living communities are typically comprised of one bedroom units 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 community on call or at regularly scheduled times. As of March 25, 2005, our business includes 5,046 assisted living suites in 95 communities.
Specialty Care Suites. Specialty care suites offer specialized programs for patients suffering from specific illnesses, usually Alzheimers disease. As of March 25, 2005, our business includes 283 specialty care suites in 9 communities.
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 rooms with a separate bathroom in each room and shared dining and bathing facilities. Some private rooms are available for those residents who pay higher rates or for residents whose medical conditions require segregation. Nursing homes are staffed by licensed nursing professionals 24 hours per day. As of March 25, 2005, our business includes 6,284 nursing home beds in 78 communities.
We have several regional offices, which are located throughout the country. Each regional office is responsible for multiple communities and is headed by a regional director of operations with extensive experience in the senior living industry. Each regional office is typically supported by a clinical or wellness director, a rehabilitation services director, a regional accounts manager, a human resources specialist and a sales and marketing specialist. Regional staff are responsible for all our community operations within the region, including:
marketing and sales;
hiring of community personnel;
compliance with applicable legal and regulatory requirements; and
supporting our development and acquisition plans within their region.
Our home office staff performs the following tasks:
general oversight of our regional staff and pharmacy operations;
the establishment of company wide policies and procedures relating to resident care;
human resources policies and procedures;
Medicare and Medicaid billing;
licensing and certification maintenance;
budgeting and supervision of maintenance and capital expenditures;
implementation of our growth strategy; and
accounting and finance functions, including operations budgeting, accounts receivable and collections, accounts payable, payroll, financial reporting, and tax planning and compliance.
INDEPENDENT AND ASSISTED LIVING COMMUNITY STAFFING
Each of the independent and assisted living communities we operate for our own account has an executive director responsible for the day to day operations of the community, including quality of care, resident services, sales and marketing, financial performance and staff supervision. The executive director is supported by department heads, who oversee the care and service of the residents, a wellness director, who is responsible for coordinating the services necessary to meet the health care needs of our residents and a marketing director, who is responsible for selling our services. Other key positions include the dining services coordinator, the activities coordinator and the property maintenance coordinator.
Each of our nursing homes is managed by a state licensed administrator who is supported by other professional personnel, including a director of nursing, an activities director, a marketing director, a social services director, a business office manager, and physical, occupational and speech therapists. Our directors of nursing are state licensed nurses who supervise our registered nurses, licensed practical nurses and nursing assistants. Staff size and composition vary depending on the size and occupancy of each nursing home and on the type of care provided by the nursing home. Our nursing homes also contract with physicians who provide certain medical services.
PHARMACY OPERATIONS AND STAFFING
Our pharmacy operations provide goods and services to operators and residents of senior living communities; we do not sell to the public generally. At each pharmacy, we have an executive director who is a state licensed pharmacist and who manages the pharmacy and supervises billing. The executive director is responsible for the day to day operations of the pharmacy including sales and marketing, financial performance, compliance with regulatory codes regarding the dispensing of controlled substances and staff supervision. Other pharmacy personnel include licensed dispensing pharmacists, a director of pharmacy consultation, a medical records director, a nurse consultant, pharmacy technicians and billing personnel.
As of March 25, 2005, we had approximately 9,000 employees, including 5,300 full time equivalents. Approximately 550 employees, including 350 full time equivalents, are represented under five collective bargaining agreements which have remaining terms of one to three years. We have no other employment agreements. We believe our relations with our union and non-union employees are good.
GOVERNMENT REGULATION AND REIMBURSEMENT
Our operations must comply with numerous federal, state and local statutes and regulations. Also, the healthcare industry depends significantly upon federal and state programs for revenues and, as a result, is vulnerable to the budgetary policies of both the federal and state governments.
Independent Living Communities. Government benefits generally are not available for services at independent living communities and the resident charges in these communities 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 communities. 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 communities. Because independent living communities 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 communities are licensed by state or county health departments, social service agencies or offices on aging with jurisdiction over group residential communities for seniors. To the extent that independent living communities include units in which assisted living or nursing services are provided, these units are subject to applicable state licensing regulations, and if the communities receive Medicaid or Medicare funds, to certification standards. In some states, insurance or consumer protection agencies regulate independent living communities in which residents pay entrance fees or prepay for services.
Assisted Living Communities. According to the National Academy for State Health Policy, or the National Academy, a majority of states provide or are approved to provide Medicaid payments for residents in some assisted living communities under waivers granted by the Federal Centers for Medicare and Medicaid Services, or CMS, or under Medicaid state plans, and certain other states are planning some Medicaid funding by preparing or requesting waivers to fund assisted living demonstration projects. Because rates paid to assisted living community operators are generally 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 communities are responsible for monitoring the services at,
and physical conditions of, the participating communities. 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 communities and the growth of assisted living in recent years, a majority of states have adopted licensing standards applicable to assisted living communities. A majority of states have licensing statutes or standards specifically using the term assisted living and have requirements for communities servicing people with Alzheimers disease or dementia. 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 communities. Most state licensing standards apply to assisted living communities whether or not they accept Medicaid funding. Also, according to the National Academy, a few states require certificates of need from state health planning authorities before new assisted living communities may be developed. Based on our analysis of current economic and regulatory trends, we believe that assisted living communities 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 communities located in states that adopt certificate of need requirements or otherwise restrict the development of new assisted living communities may increase in value because these limitations upon development may help ensure higher occupancy and higher non-governmental rates.
The US. Department of Health and Human Services, the Government Accountability Office and the Senate Special Committee on Aging have recently studied and reported on the development of assisted living and its role in the continuum of long-term care and as an alternative to nursing homes. In 2003, the Government Accountability Office recommended that CMS strengthen its oversight of state Medicaid waiver programs and state quality assurance programs. Also in 2003, a working group of assisted living providers, consumers and regulatory organizations made recommendations to the Senate Special Committee on Aging on a range of subjects, including staffing, funding and regulation of assisted living. We cannot predict whether these studies and reports 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 communities will increasingly be licensed and regulated by the various states, and that, in the absence of federal standards, the states policies will continue to vary widely.
Nursing Homes-Reimbursement. About 61% of all nursing home revenues in the U.S. in 2003 (the most recent date for which information seems to be publicly available) came from publicly funded programs, including about 46% from Medicaid programs and 12% from the Medicare program. 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 Medicare prospective payment system, or the PPS, was phased in over three years beginning with cost reporting years starting on or after July 1, 1998. Under the PPS, capital costs are part of the prospective rate and are not community specific. The PPS and other recent legislative and regulatory actions with respect to state Medicaid rates are limiting the reimbursement levels for some nursing home services. At the same time, federal and state enforcement and oversight of nursing homes are increasing, making licensing and certification of these communities more rigorous.
The PPS was established by the Balanced Budget Act of 1997, and was intended to reduce the rate of growth in Medicare payments for skilled nursing communities. Before the current Medicare payment system, Medicare rates were community specific and cost based. Under the current Medicare payment system, skilled nursing facilities receive a fixed payment for each day of care provided to residents who are Medicare beneficiaries. Each resident is assigned to one of 44 care groups depending on that residents medical characteristics and service needs. Per diem payment rates are established for each of these care groups. Medicare payments cover substantially all services provided to Medicare residents in skilled nursing communities, including ancillary services such as rehabilitation therapies. The PPS 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 communities were based on a blend of community specific costs and rates established by the new Medicare payment system. According to the Government Accountability Office, between fiscal year 1998 and fiscal year 1999, the first full year of the changed Medicare payment system phase in, the average Medicare payment per day declined by about 9%.
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 State Childrens Health Insurance Program Balanced Budget Refinement Act of 1999 temporarily boosted payments for certain skilled nursing cases by 20% and allowed skilled nursing communities to transition more rapidly to the federal payment system. This Act also increased the Medicare payment rates by 4% for fiscal years 2001 and 2002 and imposed a two year moratorium on some therapy limitations for skilled nursing residents covered under Medicare Part B. In December 2000, the Medicare, Medicaid and State Childrens Health Insurance Program Benefits Improvement and Protection Act of 2000 was approved. Effective April 1, 2001 to October 1, 2002, this Act increased the nursing component of the payment rate for each care group by 17%. This Act also increased annual inflation adjustments for fiscal year 2001, increased rehabilitation care group rates by 7%, maintained the previously temporary 20% increase in the other care group rates established in 1999, and extended the moratorium on some therapy reimbursement rate caps through 2002. However, as of October 1, 2002, the 4% across the board increase in Medicare payment rates and the 17% increase in the nursing component of the rates expired. Effective October 1, 2003, CMS increased the annual inflation update to skilled nursing community rates by 3% per year, and added an additional 3% for the year beginning October 1, 2003, to account for inflation underestimates in prior years. The 20% increase for the skilled nursing care groups and the 7% increase in rehabilitation care group rates will expire when the current resource utilization groups are refined, currently anticipated to be effective October 1, 2005, for fiscal year 2006. Effective December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 set a new moratorium on implementation of some therapy reimbursement rate caps through 2005.
Nursing Homes-Survey and Enforcement. CMS has undertaken an initiative to increase the effectiveness of Medicare and Medicaid nursing home survey and enforcement activities. CMSs initiative follows a July 1998 Government Accountability Office investigation which found inadequate care in a significant proportion of California nursing homes and CMSs 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 Government Accountability Office issued reports in 1999, 2000, 2002, 2003 and 2004 which recommended that CMS and the states strengthen their compliance and enforcement practices, including federal oversight of state actions, 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 communities with patterns of noncompliance. CMS is also increasing its 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 communities 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 and nursing staff hours per resident for each nursing home are posted on the Medicare website at www.medicare.gov. CMS plans to post fire safety survey results and sprinkler status of nursing homes on the Medicare website in 2005. When deficiencies under state licensing and Medicare and Medicaid standards are identified, sanctions and remedies such as denials of payment for new Medicare and Medicaid admissions, civil monetary penalties, state oversight and loss of Medicare and Medicaid participation or licensure may be imposed. We receive notices of potential sanctions and remedies from time to time, and such sanctions have been imposed from time to time on us. If we are unable to cure deficiencies which have been identified or that are identified in the future, additional sanctions may be imposed, and if imposed, may adversely affect our ability to meet our financial obligations and negatively affect our financial condition and results of operations.
In 2000 and 2002, CMS issued reports on its study linking nursing staffing levels with quality of care, and CMS is assessing the impact that minimum staffing requirements would have on community costs and operations. In a report presented to Congress in 2002, the Department of Health and Human Services 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 CMS is publishing the nurse staffing level at each nursing home on the internet (www.medicare.gov) to increase market pressures on nursing home operators.
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 communities 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 took effect in 2003, with civil and criminal sanctions for noncompliance. An adverse determination concerning any of our licenses or eligibility for Medicare or Medicaid reimbursement or the costs of required compliance with applicable federal or state regulations could adversely affect our ability to meet our financial obligations and negatively affect our financial condition and results of operations.
Nursing Homes-Certificates of Need. Most states limit the number of nursing homes by requiring developers to obtain certificates of need before new communities may be built. Also, such states 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 may make nursing homes more valuable by limiting competition.
Other Matters. Under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, Medicare beneficiaries may receive prescription drug benefits beginning in 2006 by enrolling in private health plans or managed care organizations, or if they remain in traditional Medicare, by enrolling in stand alone prescription drug plans. A number of legislative proposals that would affect major reforms of the healthcare system have been introduced in the U.S. Congress and many are being considered by some state governments, such as programs for national health insurance, the option of block grants for states rather than federal matching money for certain state Medicaid services, additional Medicare and Medicaid reforms and federal and state cost containment measures. In connection with recent fiscal pressures on state governments, legislation and regulation to reduce Medicaid nursing home payment rates in some states are possible in the future. We cannot predict whether any of these legislative or regulatory proposals will be adopted or, if adopted, what effect, if any, these proposals would have on our business.
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 has been particularly significant. As a result, liability insurance costs are rising and, in some cases, such insurance is not available to some senior living operators. We have liability insurance for the properties which we now operate. Only one of these communities is located in Florida and such community has no nursing home beds. SLS is responsible for obtaining insurance for the senior living communities which SLS manages for us. As of December 31, 2004, five of these communities were located in Florida (884 independent living apartments, 331 assisted living suites and 95 nursing home beds).
In recent years, our insurance costs for workers compensation and employee healthcare have also increased significantly. This is especially so with respect to workers compensation insurance in California where we operated six communities with approximately 575 employees as of December 31, 2004, and where SLS operated two communities with approximately 300 employees for our account.
To partially offset these insurance cost increases, we have taken several actions including the following:
we have increased the deductible or retention amounts for which we are liable under our liability insurance;
we have established an offshore captive insurance company which participates in our liability insurance program. Some of our premiums for liability insurance are paid to this company which may retain some of these amounts and the earnings on these amounts based upon our actual claims experiences;
we have acquired another offshore insurance company and established a captive insurance program for our workers compensation insurance obligations in those states which permit such arrangements. This program may allow us to reduce our net workers compensation insurance costs by allowing us to retain the earnings on our reserves, provided our claims experience is as projected by various statutory and actuarial formulas;
we have increased the amounts which some of our employees are required to pay for health insurance coverage and as co-payments for health services and pharmaceutical prescriptions and decreased the amount of certain healthcare benefits;
we have increased the deductible or retention amounts for our health insurance obligations;
we have hired professional advisors to help us establish programs to reduce our insured workers compensation and professional and general liabilities, including a program to monitor and pro-actively settle liability claims and to reduce workplace injuries;
we have hired professionals to help us establish appropriate reserves for our retained liabilities and captive insurance programs; and
we have hired an asset manager for the SLS managed communities who, among other duties, monitors various insurance programs for these communities.
Our current insurance arrangements generally are renewable in June 2005. We do not know if our insurance charges and self-insurance reserve requirements will continue to increase, and we cannot now predict the amount of any such increase, or to what extent, if at all, we may be able to offset any increase through use of higher deductibles, retention amounts, self insurance or other means in the future.
The senior living services business is highly competitive. We compete with service providers offering alternate types of services, such as home healthcare services, as well as other companies providing community based services. Our management team has been assembled within the past four 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 large lease obligations and limited financeable assets. Many of our competitors have greater financial resources than we do. For all of these reasons and others, we cannot provide any assurance that we will be able to compete successfully for business in the senior living industry.
Under various federal, state and local laws, owners as well as tenants and operators of real estate may be required to investigate and clean up hazardous substances released or otherwise present 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 such hazardous substances. Under our leases, we have also agreed to indemnify Senior Housing for any such liabilities related to the leased communities. 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 environmental surveys of our leased and owned communities. 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 a prior owner, operator or occupant of our communities did not create a material environmental condition not known to us which might have been revealed by more in depth study of the properties or that 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. The presence or discovery of any material environmental contaminants at our communities could have a material adverse impact on us.
Our internet website address is www.5sqc.com. Copies of our governance guidelines, code of ethics and the charters of our audit, quality of care, compensation and nominating and governance committees may be obtained free of charge by writing to our Secretary, Five Star Quality Care, Inc., 400 Centre Street, Newton, MA 02458 or at our website. We make available, free of charge, through our website, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as soon as reasonably practicable after such forms are electronically filed with the Securities and Exchange Commission. Any shareholder or other interested party who desires to communicate with our independent directors, individually or as a group, may do so by filling out a report on our website. Our board also provides a process for security holders to send communications to our entire board. Information about the process for sending communications to our board can be found on our website. Our website address is included several times in this Annual Report on Form 10-K as a textual reference only and the information in the website is not incorporated by reference into this Annual Report on Form 10-K.
Item 2. Properties
OUR SENIOR LIVING COMMUNITIES
As of December 31, 2004, excluding communities we managed under third party management contracts, our business included 148 senior living communities which may be categorized into three groups as follows:
(1) Includes amounts and data for periods prior to commencement of our lease or ownership.
COMMUNITIES WE OPERATE AND LEASE FROM SENIOR HOUSING
As of December 31, 2004, we operated 98 communities which are leased from Senior Housing. These communities have 7,733 living units and are located in 19 states. The following table provides additional information about these communities and their operations.
(1) Includes amounts and data for periods prior to commencement of our lease.
COMMUNITIES WE LEASE FROM SENIOR HOUSING AND SLS MANAGES
As of December 31, 2004, we leased 30 of our communities from Senior Housing and SLS managed these communities for us. These communities have 7,275 living units and are located in 13 states. The following table provides additional information about these communities and their operations.
COMMUNITIES WE OPERATE AND OWN OR LEASE FROM PARTIES OTHER THAN SENIOR HOUSING
As of December 31, 2004, our business included 20 communities we owned or leased from parties other than Senior Housing which had 1,565 living units located in nine states. The following table provides additional information about these communities and their operations:
(1) Includes amounts and data for periods prior to commencement of our lease or ownership.
OUR SENIOR HOUSING LEASES
We have four leases with Senior Housing, three for the communities that we operate and one for the communities managed by SLS. The material terms of these leases include the following:
Minimum rent. Our minimum rent obligations for the communities we operate is approximately $31.8 million per year, and for the communities managed by SLS is approximately $64.0 million per year.
Percentage rent. We are required to pay additional rent under our leases. This rent is payable and calculated separately for the lease relating to the communities that SLS manages for us and for the three leases, on a combined basis, relating to the communities we operate. The percentage rent equals 4% of the amount by which gross revenues of properties subject to the three leases for the communities we operate or the communities managed by SLS, as the case may be, in a year exceeds gross revenues of the properties under the three leases or the SLS lease, as the case may be, in a base year. The base year for the communities we recently acquired from LTA and lease from Senior Housing is 2006 and percentage rent begins in 2007. The base year for all other communities we lease from Senior Housing is 2005 and percentage rent begins in 2006.
Term. The terms of these leases are as follows:
Operating costs. Each lease is a so-called triple-net lease which requires us to pay all costs incurred in the operation of the communities, including the costs of personnel, service to residents, insurance and real estate and personal property taxes.
Rent during renewal term. Rent during each renewal term is the same as the minimum rent and percentage rent payable during the initial term.
Non economic circumstances. If we determine that continued operations of one or more communities is not economically practical, we may negotiate with Senior Housing to close or sell that community, including Senior Housings ownership in the property. In the event of such a sale, Senior Housing receives the net proceeds and our rent for the remaining communities in the affected lease is reduced according to formulas set forth in the leases.
Maintenance and alterations. We are required to operate continuously and maintain, at our expense, the leased communities 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 formulas set forth in the leases. At the end of each lease term, we are required to surrender the leased communities 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 Housings consent is generally required for any direct or indirect assignment or sublease of any of the communities. In the event of any assignment or subletting, we will remain liable under the applicable lease.
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 communities. We generally are required to maintain commercially reasonable insurance, including:
all-risk property insurance, in an amount equal to 100% of the full replacement cost of the communities;
business interruption insurance;
comprehensive general liability insurance, including bodily injury and property damage, in amounts as are generally maintained by companies providing senior living services;
flood insurance if any community is located in whole or in part in a flood plain;
workers compensation insurance if required by law; and
such additional insurance as may be generally maintained by companies providing senior living services, including professional and general liability insurance.
Each lease requires that Senior Housing be named as an additional insured under these policies.
Damage, destruction, condemnation and environmental matters. If any of the leased communities is damaged by fire or other casualty or taken for a public use, we are generally obligated to rebuild unless the community cannot be restored. If the community 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, and our rent is adjusted pro rata. We are also required to remove and dispose of any hazardous substance at the leased communities in compliance with all applicable environmental laws and regulations.
Events of default. Events of default under each lease include the following:
our failure to pay rent or any other sum when due;
our failure to maintain the insurance required under such lease;
any person or group acquiring ownership of 9.8% or more of our outstanding voting stock or any change in our control or sale of a material portion of our assets without Senior Housings consent;
the occurrence of certain events with respect to our insolvency or dissolution;
our default under indebtedness which gives the holder the right to accelerate;
our being declared ineligible to receive reimbursement under Medicare or Medicaid programs for any of the leased communities which participate in such programs or the revocation of any material license required for our operations; and
our failure to perform any terms, covenants or agreements of the leases and the continuance thereof for a specified period of time after written notice.
Remedies. Upon the occurrence of any event of default, each lease provides that, among other things, Senior Housing may, to the extent legally permitted:
accelerate the rents;
terminate the leases in whole or in part;
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;
make any payment or perform any act required to be performed by us under the leases; and
rent the property and recover from us the difference between the amount of rent which would have been due under the lease and the rent received from the re-letting.
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 any new management agreement or amend or modify any management agreement with SLS affecting any leased community without the prior written consent of Senior Housing.
Lease subordination. Our leases may be subordinated to any mortgages on properties leased from Senior Housing.
Financing limitations; security. We may not incur debt secured by our investments in our tenant subsidiaries. Further, our tenant subsidiaries are prohibited from incurring liabilities other than operating liabilities incurred in the ordinary course of business, liabilities secured by our accounts receivables or purchase money debt. We have pledged 100% of the equity interests of certain of our tenant subsidiaries to Senior Housing or its lenders, and we may pledge interests in our leases only if the pledge is consented to by Senior Housing.
FF&E reserves. We are required under our lease for the communities managed by SLS to make deposits into certain accounts that we own for replacements and improvements known as FF&E reserves. Senior Housing has a security and remainder interest in these accounts and in all property purchased with funding from these accounts.
SUNRISE SENIOR LIVING SERVICES, INC. MANAGEMENT AGREEMENTS
The following is a description of the material terms of our management agreements with SLS:
Term. Generally each of the management agreements has an initial term expiring in 2027, with one five year renewal term at SLS's option.
Community services. Our contract with SLS delegates to SLS the responsibility for operations of the managed communities, including obtaining and maintaining all 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. SLS also recruits, employs and directs all community based employees.
Central services. SLS also furnishes certain central administrative services, which are provided on a central or regional basis to all senior living communities managed by SLS. Such services include: (1) marketing and public relations; (2) human resources program development; (3) information systems development and support; and (4) centralized computer payroll and accounting.
FF&E reserves and capital improvements. SLS has established an FF&E reserve account under each management agreement 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 communities. The amount of this funding varies among the managed communities; however, for most communities it is currently set at 2.85% of gross revenues and will gradually increase to 3.5% of gross revenues. In 2004 and 2003, we deposited $8.6 million and $8.1 million into these accounts, respectively. 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 separately fund such repairs and improvements. Any such separate funding which we provide increases the amount of our owners priority, as described below. The amount of FF&E reserve funding required under our SLS management agreements is the same as the funding required by our Senior Housing lease for these communities. Also, under our lease, we have the option to request Senior Housing to provide any required separate 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 management services, SLS receives a base fee generally equal to 5% of the managed communities gross revenues, plus an incentive fee generally equal to 20% of operating cash flows in excess of owners priority amounts, as defined in the agreements. For its central services, SLS receives a fee generally equal to 2% of gross revenues. During 2004 and 2003, management and central services fees paid to SLS and SLSs predecessor, MSLS, totaled $19.3 million and $17.3 million, respectively.
Owners priority. We receive the profits of the SLS managed communities on a priority basis before SLS receives any incentive fees. The amount of the owners priority for each managed community is established based upon a specified rate of return on historical capital investments in these communities, including capital improvements during the term of the management agreements which are funded by us or Senior Housing in addition to the FF&E reserve. As of the year ended December 31, 2004 and 2003, the aggregate amount of owners priority for all communities managed by SLS was $72.5 million and $69.4 million, respectively.
Pooling. Twenty nine of the communities are subject to pooling arrangements whereby the calculation and payment of fees payable to SLS and owners priority for several groups of these 29 communities are combined.
Defaults and termination. The SLS management agreements contain various default and termination provisions. Our right to exercise termination options under the SLS management agreements is subject to approval by Senior Housing under the terms of the lease for these communities.
In the ordinary course of business we are involved in litigation incidental to our business; however, we are not aware of any other material pending legal proceeding affecting us for which we might become liable or the outcome of which we expect to have a material impact on us.
Our common shares are traded on the AMEX (symbol: FVE). The following table sets forth for the periods indicated the high and low sales prices for our common shares as reported by the AMEX:
The closing price of our common shares on the AMEX on March 24, 2005, was $8.10 per share.
As of March 18, 2005, there were 3,594 record holders of our common shares, and we estimate that as of such date there were approximately 55,000 beneficial owners of our common shares.
We have not paid any dividends in the past and do not expect to pay dividends in the foreseeable future.
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, 2004. Prior to December 31, 2001, we were owned by Senior Housing. The following data should be read in conjunction with, and is qualified in its entirety by reference to, Managements Discussion and Analysis of Financial Condition and Results of Operations, and our financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. As discussed under Managements Discussion and Analysis of Financial Condition and Results of Operations, we are a relatively new company and we have recently expanded our operations; as a result, our historical financial information is not fully reflective of our current operations. Accordingly, you should not place undue reliance on our historical financial information.
The following table presents selected financial data for the year ended December 31, 2000, derived from historical financial statements of our two predecessors, Integrated Health Services, Inc. and Mariner Post-Acute Network, Inc., prior to their acquisition by Senior Housing.
We were formed as a 100% owned subsidiary of Senior Housing. Effective July 1, 2000, we assumed the operations of healthcare communities from two bankrupt former tenants of Senior Housing. Pursuant to tax laws applicable to real estate investment trusts, Senior Housing engaged FSQ, an independent operating company formed by our managing directors, to manage these communities. At the time we assumed operations of these communities, we had not received substantially all of the required licenses for these communities. As a result, for the period from July 1, 2000 through December 31, 2000, we accounted for the operations of these communities using the equity method of accounting and we only recorded the net income from these operations. Thereafter, we obtained all necessary licenses to operate these communities, and on January 1, 2001, we began to consolidate the results of operations of these communities. On December 31, 2001, Senior Housing distributed substantially all of our shares to its shareholders in a spin off transaction and we became a separately traded public company. On January 2, 2002, in order to acquire the personnel, systems and assets necessary to operate these communities, we acquired FSQ by merger.
OVERVIEW OF INDUSTRY TRENDS
The senior living industry is experiencing growth as a result of demographic and various other factors. According to census data, the over age 75 population in the United States is growing much faster than the general population. As a general rule, economic factors that affect seniors will have a corresponding impact on the senior living industry. For example, general concerns regarding lower interest rates on savings and uncertainty of investment returns have impacted seniors during the past several years. On the other hand, the continuing strength of the home resale market in most areas of the country has been beneficial to seniors, since the equity from the sale of a home is a significant source of funding for senior living care for many people. In addition, overall economic conditions and general consumer confidence can impact the industry, as many adult children subsidize the cost for care of elderly parents and share in decisions regarding their care.
The independent and assisted living business is rapidly changing. The demand for these services increased significantly beginning with the emergence of the industry segment in the mid-1990s. However, the development of new independent and assisted living communities across the country outstripped demand during this period, resulting in oversupply of unit capacity, longer fill up times, price pressures and deep discounting. The growing demand for independent and assisted living services, together with minimal new development activity, reduced to some extent the oversupply in many markets in recent years. As a result, we have been able to increase occupancy and rates. We believe that new development will remain at sustainable levels over the next few years. The average length of stay in independent and assisted living communities is approximately three and a half and two years, respectively, which represents a challenge and an opportunity for us. We must find a number of new residents to maintain and build occupancy. However, we also have the opportunity to mark-to-market if we are able to attract new residents at higher current market rates, replacing prior residents that had lower or discounted rates.
The skilled nursing segment is a more mature segment of the senior living industry, and has seen both demand and price increases in recent years, with little new unit capacity entering the market. We expect this growth in demand to continue over the next several years, but with new alternatives available to seniors such as home health care and the growing independent and assisted living market, this growth in demand may be reduced and in some cases reversed. In addition, while we have had overall Medicare and Medicaid rate increases over the last two years, we are not sure that future rates will increase as fast as our costs. In fact, due to both federal and state budget shortfalls we expect in some areas that our rates may decline. The average length of stay in nursing homes is approximately one and a half years. We believe that many of our skilled nursing facilities benefit from significant barriers to entry from competitors, including the significant cost and length of time to develop competitive facilities, the difficulty in finding acceptable development sites in the geographical areas in which our facilities are located and some states certificate of need and license processes.
OVERVIEW OF FIVE STARS REVENUES AND EXPENSES
We earn our revenues primarily by providing housing and services to our residents. Approximately 62% of our revenues come from private pay sources, meaning that residents or their families pay from their own funds (or from the proceeds of their long-term care policies). All private pay residents are billed in advance for the next months housing and care.
Our most significant expenses are:
Wages and benefits includes wages for our employees working at our communities and wage related expenses such as health insurance, workers compensation insurance and other standard benefits.
Other operating expenses includes utilities, housekeeping, dietary, maintenance, marketing, insurance and community level administrative costs.
Management fee to SLS management fee related to the 30 communities SLS manages for us.
Rent expense we lease 132 of our 148 senior living communities from two entities, Senior Housing and HCPI.
General and administrative expenses wage related costs for headquarters and regional staff supporting our communities are the largest component of this category. Other significant items are travel, marketing and legal and professional services.
Depreciation and amortization expense we incur depreciation expense on buildings and furniture and equipment. We incur amortization expense related to costs associated with our revolving credit facility and other debt.
Interest expense interest on outstanding balances on our revolving credit facility as well as other debt.
The following information should be read in conjunction with the consolidated financial statements included in this Annual Report on Form 10-K.
Year ended December 31, 2004 versus year ended December 31, 2003
The following tables present an overview of our portfolio for the years ended December 31, 2004 and 2003:
Comparable Communities (communities that we operated continuously since January 1, 2003):
The 7% increase in net revenues from residents is due primarily to higher per diem charges to residents and our beginning operations at three additional communities in May 2003, one community in May 2004 and 47 communities in November 2004. The 5% increase in net revenues from residents at the communities that we have operated continuously since January 1, 2003 is due primarily to 4% higher per diem charges to residents and a 1% increase in occupancy. The increase in revenues from our two pharmacies is a result of our acquiring these pharmacies during the third quarters of 2003 and 2004.
Our 4% increase in wages and benefits costs is primarily due to wage increases as well as wages related to the three communities we began to operate in May 2003, one community we began to operate in May 2004 and the 47 communities we acquired in November 2004. The 7% increase in other operating expenses, which include utilities, housekeeping, dietary, maintenance, insurance and community level administrative costs is primarily a result of increased charges from third parties, our operation of three additional communities beginning in May 2003, one community we began to operate in May 2004, and our 47 communities acquired in November 2004. The operating expenses for the communities that we have operated continuously since January 1, 2003 have increased by 3% principally due to wage and benefit increases. The increase in pharmacy expenses is a result of our acquiring these pharmacies during the third quarters of 2003 and 2004. Management fees related to the 30 communities that SLS manages for us increased by 12% because of the increased revenues at these communities and a contractual increase in the effective management fee calculation. The 8% rent expense increase is due to the addition of communities that we began to lease in 2003 and 2004, and our payment of additional rent for capital improvements which were funded by Senior Housing since January 1, 2003.
The 15% increase in general and administrative expenses for the year ended December 31, 2004 is primarily due to costs resulting from our increased operations, as well as increases in wages and benefits for our corporate and regional staff.
The 2% increase in depreciation expense for the year ended December 31, 2004 is primarily attributable to our purchase of furniture and fixtures related to the communities managed by SLS and our acquisition of 16 communities as a result of the LTA acquisition in November 2004, offset by our sale of seven communities in 2003.
Our interest and other income increased by $1.4 million primarily due to the amounts received in connection with our January 2004 settlement with Marriott and MSLS, whereby we and Senior Housing were each paid $1.3 million. Under the terms of the settlement, we and Senior Housing, and Marriott and MSLS, agreed to dismiss all claims and counterclaims asserted in the litigation.
We accrued $120,000 for federal alternative minimum income taxes during the year ended December 31, 2004. This provision was not required for the year ended December 31, 2003. There is no provision for regular income taxes because we have net operating loss carry forwards.
Loss from discontinued operations for the year ended December 31, 2004 was $699,000, compared to a loss of $1.4 million for the year ended December 31, 2003. This decrease is primarily the result of our ceasing operations at one property in 2004 compared with our ceasing operations at seven properties in 2003.
Year ended December 31, 2003 versus year ended December 31, 2002
The following tables present an overview of our portfolio for the years ended December 31, 2003 and 2002:
Comparable Communities (communities that we operated continuously since January 1, 2002):
The 10% increase in net revenues from residents is attributable primarily to our beginning operations at 15 communities in October 2002, and at three communities in May 2003. The 4% increase in net revenues from residents at the communities we operated throughout 2003 and 2002 is due primarily to 3% higher per diem charges to residents
and a 1% increase in occupancy. The pharmacy revenue increase is a result of our acquiring a pharmacy during the third quarter of 2003. The 2% increase in revenues from Medicare and Medicaid is a result of our higher Medicare census throughout 2003.
Our 14% increase in wages and benefits costs is primarily due to expenses at the 18 communities we began to operate since October 2002, as well as increases in workers compensation and employee health insurance costs. The 4% increase in other operating expenses, which include utilities, housekeeping, dietary, maintenance, insurance and community level administrative costs is primarily due to the expenses at the 18 communities we began to operate since October 2002, as well as higher professional and general liability insurance costs. The operating expenses for the communities that we have operated continuously since January 1, 2002 have increased by 2% primarily due to increases in employee health, workers compensation and professional and general liability insurance costs. The pharmacy expenses are a result of our acquiring a pharmacy during the third quarter of 2003. Management fees related to the 31 communities managed for us by SLS increased by 4%, primarily because these arrangements commenced on January 11, 2002; therefore, 2003 includes 11 more days than 2002. Rent expense to Senior Housing increased by 3%, primarily due to rents for communities we began to lease since October 2002, and rent increases which resulted from Senior Housings purchase of improvements at leased communities, partially offset by a lease modification entered into in October 2002 which changed the ownership of certain FF&E reserve escrows.
The 13% increase in our general and administrative expenses is primarily due to costs resulting from our increased operations and to legal costs incurred in connection with our litigation with Marriott and MSLS which was settled in January 2004.
The $1.8 million increase in depreciation expense is attributable to our purchase of seven communities in 2002, as well as to capitalized improvements to some of our communities which increased our depreciable assets.
The $68,000 decrease in interest and other income is due to lower cash balances and lower interest rates in 2003, partially offset by interest earned on mortgage notes receivable.
The $1.4 million decrease in the loss from discontinued operations is primarily attributable to our dispositions of these operations in 2002, as well as the recovery of some accounts receivable that were previously written off.
LIQUIDITY AND CAPITAL RESOURCES
Our current assets at December 31, 2004 were $76.0 million, compared to $55.5 million at December 31, 2003. This increase is primarily attributable to our acquisition of LTA in November 2004, and our equity offering in December 2004. At December 31, 2004 and 2003, we had cash and cash equivalents of $26.2 million and $17.6 million, respectively. Our current liabilities were $59.1 million at December 31, 2004, compared to $58.1 million at December 31, 2003.
In 2003, information became available to us which resulted in our recording $7.2 million of additional paid in capital. This amount was the result of our having received more working capital assets and our having assumed fewer liabilities than we had previously recorded at the time of our spin off from Senior Housing.
We lease 128 communities from Senior Housing under four leases. Our leases with Senior Housing require us to pay minimum rent of $95.8 million annually and percentage rent beginning in 2006. We believe we are in compliance with the terms of our leases with Senior Housing.
Our revenues from services to residents at our communities is the primary source of cash to fund operating expenses, including rent, principal and interest payments on our debt and capital expenditures. At some of our communities, operating revenues for nursing home services are received from the Medicare and Medicaid programs. For each of 2004 and 2003, 41% of our total revenues were derived from these programs. Medicare and Medicaid revenues were earned primarily from the 51 nursing homes we lease from Senior Housing. Since 1998, the PPS has generally lowered Medicare rates paid to senior living communities, including many that we operate. In October 2004 and 2003, Medicare rates increased by approximately 3% and 6%, respectively. Our Medicare revenues totaled $109.8 million and $86.1 million for the years ended December 31, 2004 and 2003, respectively. Our Medicaid revenues totaled $152.1 million and $148.6 million for the years ended December 31, 2004 and 2003, respectively. Some of the states in which we operate have not raised rates by amounts sufficient to offset increasing costs or are expected to reduce Medicaid funding.
The magnitude of the potential Medicaid rate reductions cannot currently be estimated, but it may be material and may affect our future results of operations. Further Medicare and Medicaid rate declines may have a dramatic negative impact on our revenues and may produce losses.
Recent increases in the costs of insurance, especially tort liability insurance, workers compensation and employee health insurance, which are affecting the senior living industry, may continue to have an adverse impact upon our future results of operations. Also, we believe Marriotts sale of its senior living management business to Sunrise has had, and may continue to have, an adverse impact on our financial results.
Also, prior to July 2004, pursuant to existing contract terms, a portion of our management fees payable to SLS were conditional, based on exceeding a threshold of net operating income that was not achieved and, therefore, was not being paid. As of July 2004, this portion of the management fee is no longer conditional and we are now required to pay the full fee. We expect the annual amount of this additional management fee to be approximately $3.0 million per year. We expect improvements in our operations will offset this increased cost, but our efforts in this regard may not be successful.
Our revolving credit facility limits our ability to incur debt as more fully described below in Debt Instruments and Covenants. The terms of our leases with Senior Housing contain provisions whereby Senior Housing may cancel our rights under these agreements upon the acquisition by any person or group of more than 9.8% of our voting stock, and upon other change of control events. These leases also limit our ability to create, incur, assume or guarantee indebtedness.
In August 2003, we sold a community in Bloomfield, Connecticut for $3.5 million, $3.15 million of which was paid in the form of a promissory note from the purchaser secured by a mortgage on that property. This note is payable in monthly installments of $8,750 of principal, plus interest which accrues on the unpaid principal balance at a rate of 8% per year. This note matures on August 26, 2009, but we have the right to require prepayment as of August 31, 2008.
In December 2003, we sold five group homes in Maryland for $3.55 million, $3.11 million of which was paid in the form of a promissory note from the purchaser secured by a mortgage on those five properties. This note is payable in monthly installments of $1,700 of principal, plus interest which accrues on the unpaid principal balance at a rate of 9%. This note matures on November 30, 2018, but we have the right to require prepayment earlier by giving notice after November 30, 2009.
During 2003, Senior Housing agreed to sell us two nursing homes in Michigan that we leased from Senior Housing. The purchase price is $10.5 million, the appraised value of the properties. On April 19, 2004, we purchased one of these properties from Senior Housing for $5.9 million. We financed this acquisition with $5.0 million of proceeds we received from a new HUD insured mortgage and by using cash on hand. We expect the second purchase to occur during 2005 and we intend to finance the second sale with proceeds that we receive from a second HUD insured mortgage and with available cash. The second property is currently leased from Senior Housing on a combined basis with 97 other properties. Under the terms of our lease with Senior Housing, upon completion of the sale, the annual rent payable under the combined lease will be reduced by 10% of the sale prices we pay to Senior Housing.
In November 2004, we acquired 100% of the capital stock of LTA for approximately $211 million, excluding closing costs. To finance this acquisition, we entered into a $148.2 million sale leaseback transaction with Senior Housing for 31 of the communities acquired from LTA. We also entered a $16.8 million mortgage loan with Senior Housing secured by five of our properties. We funded the balance of the purchase price with cash on hand and by assuming HUD insured long term mortgage debt and an operating lease for four communities from HCPI.
In December 2004 and January 2005, we issued a total of 3,620,000 common shares for net proceeds in the amount of $28.8 million. A portion of proceeds raised in this offering were used to pay off the $16.8 million mortgage loan with Senior Housing described above.
On January 21, 2005, we agreed to purchase six assisted living communities for approximately $63.5 million from Gordon. We intend to finance this acquisition with cash on hand, borrowings under our line of credit and mortgage or sale leaseback transactions for some of the communities being purchased or for certain other communities which we currently own. Completion of this acquisition is subject to various conditions customary in multi-community
healthcare transactions of this type, including completion of diligence, licensing and receiving third party consents. We expect this acquisition to close during the second quarter of 2005, but there is no assurance that it will close.
We will be required to comply with Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, for our fiscal year ending December 31, 2005 if our public float exceeds $75 million as of June 30, 2005, or in any event for our fiscal year ending December 31, 2006. Based on the closing price of our stock on March 24, 2005, our public float was $99.0 million. As such, we have commenced our plan for complying with Section 404 and are currently in the process of documenting our processes and controls. We expect to devote substantial time and effort and incur substantial costs in complying with Section 404 in fiscal year 2005 and beyond.
Despite the commitments, contingencies and limitations described above, we believe that a combination of our efforts to increase revenues and contain costs, our ability to borrow on our revolving credit facility, our ability to sell to Senior Housing certain capital improvements made to communities leased from Senior Housing and the possibility of sales or financings of our owned communities will be sufficient to meet our working capital needs, operating expenses, rent payments to Senior Housing, debt service and capital expenditures for the next 12 months and the foreseeable future.
As of December 31, 2004, our contractual obligations were as follows (dollars in thousands):
(1) These amounts represent amounts due under several HUD insured mortgages.
(2) These amounts represent minimum lease payments through 2014 and 2020. It does not include percentage rent that may be payable under these leases.
(3) This amount represents our obligation to purchase a property from Senior Housing. This obligation is contingent upon our receiving HUD insured financing for a significant part of this purchase price.
(4) These amounts include liabilities for continuing care contracts which require residents to make advance payments, some of which are refundable and continuously carried as liabilities and some of which are not refundable and are carried as liabilities until they are recognized as revenues over the periods during which we expect to provide the service. These amounts also include insurance reserves related to workers compensation and professional liability insurance as well as deferred gains related to property sales.
Debt Instruments and Covenants
In October 2002, we entered into a revolving credit facility. The interest rate on borrowings on this facility is LIBOR plus a spread. The maximum amount available under this facility is $12.5 million, and is subject to limitations based upon qualifying collateral. The borrower under this facility is a subsidiary that we organized with the intention that it be bankruptcy-remote. Certain of our other subsidiaries sell or contribute their accounts receivable to the borrower on a true sale basis and make certain representations and other undertakings in favor of the borrower in connection with each sale. The seller subsidiaries have granted security interests in their assets to secure their obligations to the borrower. We guarantee the obligations of the seller subsidiaries obligations to the borrower subsidiary and have pledged the stock or membership interests in each of the seller subsidiaries to the borrower. The borrower has in turn collaterally assigned these undertakings, guarantees and collateral to the revolving credit facility lenders, and has granted a security interest in the purchased receivables and all of its other assets to secure its obligations under the facility. The facility is available for acquisitions, working capital and general business purposes. The facility contains covenants and
events of default requiring the maintenance of collateral, minimum net worth and certain other financial ratios, and places limits on our ability to incur or assume debt or create liens with respect to certain of our properties, and other customary provisions. The accounts receivable collateralizing the facility totaled $16.6 million as of December 31, 2004. In certain circumstances and subject to available collateral and lender approvals, the maximum amounts which we may draw under this credit agreement may be increased to $25.0 million. The termination date of the facility is October 24, 2005. As of December 31, 2004, no amounts were outstanding under the facility. At March 25, 2005, we believe we are in compliance with all applicable covenants under this revolving credit agreement and no amounts were outstanding under the facility. We have begun negotiations with a bank concerning a substitute credit facility to become effective before our current credit facility expires; however, we can provide no assurance that these negotiations will be successfully concluded.
On April 19, 2004, we purchased a property from Senior Housing for $5.9 million. We financed this acquisition with $5.0 million in proceeds we received from a HUD insured mortgage and with cash on hand. The interest cost on this debt is 5.6% per year. Principal and interest is due monthly through April 2039. This mortgage contains standard HUD mortgage covenants. At March 25, 2005, we believe we are in compliance with all material covenants of this mortgage.
As part of our recent LTA acquisition, we assumed $30.9 million of HUD insured mortgage debt. The interest cost on this debt is a weighted average rate of 7.1% per year. Principal and interest is due monthly through varying dates ranging from February 2032 to June 2039. Mortgage premiums totaling $6.5 million were recorded in accounting for the acquisition of the mortgaged properties in order to record the assumed mortgages at their estimated fair value. The mortgage premiums will be amortized as a reduction to interest expense over the period the mortgages remain outstanding. These mortgages are secured by seven of our communities and contain standard HUD mortgage covenants. At March 25, 2005, we believe we are in compliance with all material covenants of these mortgages.
Off Balance Sheet Arrangements
We have no off balance sheet arrangements as defined in Regulation S-K, Item 303(a)(4)(iii).
Related Party Transactions
On December 31, 2001, Senior Housing distributed substantially all of its ownership of our shares to its shareholders. In order to effect this spin off and to govern relations after the spin off, we entered into agreements with Senior Housing, pursuant to which it was agreed, among other things, that:
so long as Senior Housing remains a real estate investment trust, or a REIT, we may not waive the share ownership restrictions in our charter on the ability of any person or group to acquire more than 9.8% of any class of our equity shares without, among other requirements, the consent of Senior Housing and our determination that the exception to the ownership limitations would not cause a default under any of our leases;
so long as we are a tenant of Senior Housing, we will neither permit any person or group to acquire more than 9.8% of any class of our voting stock or permit the occurrence of other change in control events, as defined, nor will we take any action that, in the reasonable judgment of Senior Housing or HRPT Properties Trust (another REIT which owns shares of Senior Housing), or HRPT, might jeopardize the tax status of Senior Housing or HRPT as REITs;
Senior Housing has the option, upon the acquisition by a person or group of more than 9.8% of our voting stock and upon other change in control events, as defined, to cancel all of our rights under the leases we have with Senior Housing; and
so long as we maintain our shared services agreement with RMR, we will not acquire or finance any real estate without first giving Senior Housing, HRPT or any other publicly owned REIT or other entity managed by RMR, the opportunity to acquire or finance real estate investments of the type in which Senior Housing, HRPT or any other publicly owned REIT or other entity managed by RMR, respectively, invest.
At the time of our spin off from Senior Housing, all of the persons serving as our directors were trustees of Senior Housing. Our two managing directors, Messrs. Martin and Portnoy, are currently the managing trustees of Senior Housing.
Of the 148 senior living communities we currently operate, 128 are leased from Senior Housing for total annual minimum rent of $95.8 million.
During 2003, we and Senior Housing were jointly involved in litigation with Marriott, the operator of the senior living communities which we leased from Senior Housing. We and Senior Housing equally shared the costs of this litigation. This litigation was settled in January 2004.
Since January 1, 2004, we have entered into or agreed to enter into multiple transactions with Senior Housing, including the following:
On March 1, 2004, Senior Housing purchased from us one independent and assisted living community with 229 units located in Maryland. The purchase price was $24.1 million, the appraised value of the property. Simultaneous with this purchase, our existing leases with Senior Housing were modified as follows:
the lease for 53 nursing homes and the lease for 13 independent and assisted living communities were combined into one lease and the property acquired on March 1, 2004 was added to this combined lease;
the combined lease maturity date was changed to December 31, 2020 from December 31, 2018 and 2019 for the separate leases;
our minimum rent for the combined lease of 53 nursing homes and 14 independent living communities was increased by $2.4 million;
for all of our leases with Senior Housing, the amount of additional rent to be paid to Senior Housing was changed to 4% of the increase in revenues at the leased properties beginning in 2006. Prior to the lease combination, the percentage and the beginning time period for the nursing home lease and the independent and assisted living community lease was 3% in 2004 and 4% in 2005, respectively; and
all other lease terms remain substantially unchanged.
In 2003, Senior Housing evicted a nursing home tenant that had defaulted on its obligations to Senior Housing. Until May 2004, we managed this nursing home for Senior Housings account. Effective on May 1, 2004, we agreed with Senior Housing to add this nursing home to a multi-property lease from Senior Housing and to increase the annual rent by $180,000. All other lease terms remained unchanged.
One of the properties we lease from Senior Housing was subject to a ground lease from an unaffiliated third party. We were responsible for paying the ground rent of $307,000 per year. On June 3, 2004, Senior Housing exercised an option to purchase this land for $3.6 million and acquired the landlords rights and obligations under the ground lease. We now pay the ground rent to Senior Housing.
On November 18, 2004, Senior Housing loaned us $117.0 million in connection with our acquisition of LTA. Such loan was repaid on November 19, 2004 with the proceeds we received from a $148.2 million sale leaseback with Senior Housing for 31 of the 47 acquired communities and a $16.8 million mortgage loan from Senior Housing secured by five of our communities. This mortgage was repaid in December 2004.
During 2004, pursuant to the terms of our leases with Senior Housing, we sold to Senior Housing $9.5 million of improvements we had made to its properties, and our annual rent payable to Senior Housing was increased by 10% of Senior Housings purchase price, or $945,700.
We obtained a workers compensation insurance policy for the year beginning June 15, 2003, from a third party insurer. This third party insurer ceded a portion of the premiums we paid to a Bermuda based company, Affiliates Insurers, Limited, or Affiliates, which was owned by RMR. Affiliates was organized by RMR to assist us in creating a partial self insurance program on an expedited basis. On December 8, 2003, we acquired Affiliates from RMR for an amount equal to RMRs cost of organizing and capitalizing that company, approximately $1.3 million.
Our Chief Executive Officer and Chief Financial Officer are also officers and employees of RMR. These officers devote a substantial majority of their business time to our affairs and the remainder to RMRs business which is separate from our business. We believe the compensation we pay to these officers reasonably reflects their division of business time; however, periodically, these individuals may divide their business time differently than they do currently and their compensation from us may become disproportionate to this division.
RMR provides management and administrative services to us under a shared services agreement. RMR is compensated at an annual rate equal to 0.6% of our total revenues. Aggregate fees earned by RMR for services during 2004, 2003 and 2002, were $3.7 million, $3.4 million and $2.9 million, respectively. RMR also provides the internal audit function for us and for other publicly owned companies to which it provides management services. We pay a pro rata share of RMRs costs in providing that function. Our audit committee approves the identity and salary of the individual serving as our director of internal audit, as well as the pro rata share of the costs which we pay. The fact that RMR has responsibilities to other entities, including one of our landlords, Senior Housing, could create conflicts; and in the event of such conflicts between Senior Housing and us, the shared services agreement allows RMR to act on behalf of Senior Housing rather than on our behalf. RMR is owned by Messrs. Martin and Portnoy who are our managing directors. Messrs. Martin and Portnoy each have material interests in the transactions between us and RMR described above. All transactions between us and RMR are approved by our independent directors. Our compensation committee has approved the renewal of the shared services agreement for its current term which will end December 31, 2005.
Messrs. Martin and Portnoy own the building in which our headquarters is located. Our lease for space was originally executed by FSQ. This lease expires in 2011. We paid rent, which includes our proportional share of utilities and real estate taxes, under this lease during 2004, 2003 and 2002 of $561,000, $569,000 and $539,000, respectively.
Until March 31, 1997, Mr. Portnoy was a partner of Sullivan & Worcester LLP, our counsel and counsel to Senior Housing, RMR and affiliates of each of the foregoing, and he received payments from that firm during 2004, 2003 and 2002 in respect of his retirement.
Wells Fargo & Company beneficially owns 8.1% of our common shares. Wells Fargo Bank, N.A., an affiliate of Wells Fargo & Company, became the transfer agent and registrar for our common shares, effective as of December 13, 2004.
Critical Accounting Policies
Our critical accounting policies concern revenue recognition, our assessment of the net realizable value of our accounts receivable, the realizable value of long term assets, accounting for long term care contracts, accounting for business combinations and our assessment of reserves related to our self insurance programs.
Our revenue recognition policies involve judgments about Medicare and Medicaid rate calculation methodologies. These judgments are based principally upon our experience with these programs and our knowledge and familiarity with the current rules and regulations of these programs. We recognize revenues when services are provided and these amounts are reported at their estimated net realizable amounts. Some Medicare and Medicaid revenues are subject to audit and retroactive adjustment.
Our policies for valuing accounts receivable involve significant judgments based upon our experience, including consideration of the age of the receivable, the terms of the agreements with our residents or their third party payors, the resident or payors stated intent to pay, the resident or payors financial capacity and other factors which may include litigation or appeal proceedings.
We monitor our long term assets to determine whether any impairment of these assets may have occurred. If the facts and circumstances indicate that an impairment may have occurred, we evaluate the assets carrying value to determine whether an impairment charge is required. This process includes a review of historical and projected future financial results realized or to be realized from the affected assets, market conditions affecting the sale of similar assets and the like. This process requires that estimates be made and errors in our judgments or estimates could have a material effect on our financial statements.
At certain of our communities, we offer long term care contracts under which residents pay a one time deposit in exchange for reduced charges during their stay. The one time deposits may be refundable or non-refundable, or partially refundable and partially non-refundable. We record such deposits as a long term obligation and amortize the non-refundable portion of such deposits into revenue over our estimate of the periods during which future services will be provided. We base these estimates on our experience and actuarial information.
Since we became a separate public company, each of our acquisitions has been accounted for as a purchase business combination in accordance with Statement of Financial Accounting Standards No. 141. Purchase accounting requires that we make certain judgments and estimates based on our experience, including determining the fair value and useful lives of assets acquired and the fair value of liabilities assumed. Some of our judgments and estimates are also based upon published industry statistics and in some cases third party appraisals.
Our critical accounting policies for determining reserves for the self funded part of our insurance programs and for our self insurance programs involve significant judgments based upon our experience, including projected settlements for pending claims, known incidents which we expect may result in claims, estimates of incurred but not yet reported claims and incidents, claims experience, estimated litigation costs and other factors. We also periodically receive and rely upon recommendations from professional consultants in establishing these reserves.
In the future we may need to revise the judgments, estimates and assessments we use to formulate our critical accounting policies to incorporate information which is not now known. We cannot predict the effect changes to these premises underlying our critical accounting policies may have on our future results of operations, although such changes could be material and adverse.
Inflation and Deflation
Inflation in the past several years in the U.S. 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. Also our ability to increase rates paid by Medicare and Medicaid will be limited despite inflation.
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.
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.
We are exposed to risks associated with market changes in interest rates. We manage our exposure to this market risk through our monitoring of available financing alternatives. Other than as described below we do not now anticipate any significant changes in our exposure to fluctuations in interest rates or in how we manage this risk in the future.
Changes in market interest rates also affect the fair value of our debt obligations; increases in market interest rates decrease the fair value of our fixed rate debt, while decreases in market interest rates increase the fair value of our fixed rate debt. For example: based upon discounted cash flow analysis, if prevailing interest rates were to decline by 10% and other credit market considerations remained unchanged, the market value of our $42.6million mortgage debt outstanding on December 31, 2004, would increase by about $4.2 million; and, similarly, if prevailing interest rates were to increase by 10%, the market value of our $42.6 million mortgage debt would decline by about $4.2 million.
Our revolving credit facility bears interest at floating rates and matures in October 2005. As of December 31, 2004, we had no amounts outstanding under this revolving credit facility. We borrow in U.S. dollars and borrowings under our revolving credit facility are subject to interest at LIBOR plus a spread. Accordingly, we are vulnerable to changes in U.S. dollar based short term rates, specifically LIBOR. A change in interest rates would not affect the value of any outstanding floating rate debt but would affect our operating results. For example, if the maximum amount of our credit facility of $12.5 million were drawn and interest rates decrease or increase by 1% per annum, our interest expense would decrease or increase by $125,000 per year, or $0.01 per share, based on currently outstanding
common shares, respectively. If interest rates were to change gradually over time, the impact would be spread over time.
Our exposure to fluctuations in interest rates may increase in the future if we incur debt to fund acquisitions or otherwise.
As of March 25, 2005, we have no commercial paper, derivatives, swaps, hedges, joint ventures or partnerships.
The information required by this Item is included in Item 15 of this Annual Report on Form 10-K.
We have had no changes in or disagreements with our accountants on accounting and financial disclosure.
As of the end of the period covered by this report, our management carried out an evaluation, under the supervision and with the participation of our President and Chief Executive Officer and our Treasurer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 of the Exchange Act. Based upon that evaluation, our President and Chief Executive Officer and our Treasurer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.
There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
In March 2004, we adopted a code of business conduct and ethics that applies to all our representatives, including our officers and directors. Our code of business conduct and ethics is posted on our website, www.5sqc.com. A printed copy of our code of business conduct and ethics is also available free of charge to any shareholder who requests a copy. We intend to disclose any amendments or waivers to our code of business conduct and ethics applicable to our principal executive officer, principal financial officer, principal accounting officer or controller (or any person performing similar functions) on our website.
The remainder of the information required by Item 10 is incorporated by reference to our definitive Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year.