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Omega Healthcare Investors 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

(Mark One)

x       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

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

                                                          For the transition period from                           to                         

Commission file number 1-11316

OMEGA HEALTHCARE

INVESTORS, INC.

(Exact name of Registrant as specified in its charter)

Maryland

 

38-3041398

(State of Incorporation)

 

(I.R.S. Employer Identification No.)

 

9690 Deereco Road, Suite 100, Timonium, MD 21093
(Address of principal executive offices)

(410) 427-1700
(Telephone number, including area code)

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 the filing requirements for the past 90 days.

Yes x

 

No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or non-accelerated filer.  See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one:)

Large accelerated filer o

 

Accelerated filer x

 

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o

 

No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as November 30, 2006.

Common Stock, $.10 par value

 

59,703,258

(Class)

 

(Number of shares)

 

 




OMEGA HEALTHCARE INVESTORS, INC.
FORM 10-Q
September 30, 2006

TABLE OF CONTENTS

 

 

Page
No.

PART I

 

Financial Information

 

 

 

 

 

 

 

Item 1.

 

Financial Statements:

 

 

 

 

Consolidated Balance Sheets

 

 

 

 

September 30, 2006 (unaudited) and December 31, 2005 (audited & restated)

 

2

 

 

 

 

 

 

 

Consolidated Statements of Operations (unaudited)

 

 

 

 

Three and nine months ended September 30, 2006 and 2005 (restated)

 

3

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows (unaudited)

 

 

 

 

Nine months ended September 30, 2006 and 2005 (restated)

 

4

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements

 

 

 

 

September 30, 2006 (unaudited)

 

5

 

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition

 

 

 

 

and Results of Operations

 

26

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

52

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

53

 

 

 

 

 

PART II

 

Other Information

 

 

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

54

 

 

 

 

 

Item 1A.

 

Risk Factors

 

54

 

 

 

 

 

Item 5.

 

Other Information

 

54

 

 

 

 

 

Item 6.

 

Exhibits

 

55

 

 




PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements

OMEGA HEALTHCARE INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(Unaudited)

 

(Restated)

 

ASSETS

 

 

 

 

 

Real estate properties

 

 

 

 

 

Land and buildings at cost

 

$

1,240,398

 

$

996,127

 

Less accumulated depreciation

 

(180,270

)

(157,255

)

Real estate propertiesnet

 

1,060,128

 

838,872

 

Mortgage notes receivablenet

 

32,185

 

104,522

 

 

 

1,092,313

 

943,394

 

Other investmentsnet

 

37,327

 

28,918

 

 

 

1,129,640

 

972,312

 

Assets held for sale – net

 

737

 

1,243

 

Total investments

 

1,130,377

 

973,555

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

3,948

 

Accounts receivable – net

 

39,488

 

15,018

 

Other assets

 

13,189

 

37,769

 

Total assets

 

$

1,183,054

 

$

1,030,290

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Revolving line of credit

 

$

157,500

 

$

58,000

 

Unsecured borrowings – net

 

484,735

 

505,429

 

Other long – term borrowings

 

41,410

 

2,800

 

Accrued expenses and other liabilities

 

27,813

 

19,563

 

Income tax liabilities

 

5,038

 

3,299

 

Operating liabilities for owned properties

 

98

 

256

 

Total liabilities

 

716,594

 

589,347

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock

 

118,488

 

118,488

 

Common stock and additional paid-in-capital

 

695,948

 

663,607

 

Cumulative net earnings

 

279,357

 

237,069

 

Cumulative dividends paid

 

(585,397

)

(536,041

)

Cumulative dividends – redemption

 

(43,067

)

(43,067

)

Unamortized restricted stock awards

 

 

(1,167

)

Accumulated other comprehensive income

 

1,131

 

2,054

 

Total stockholders’ equity

 

466,460

 

440,943

 

Total liabilities and stockholders’ equity

 

$

1,183,054

 

$

1,030,290

 

 

Note – The balance sheet at December 31, 2005 has been restated and derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

See notes to consolidated financial statements.

2




OMEGA HEALTHCARE INVESTORS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
(in thousands, except per share amounts)

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005
(Restated)

 

2006

 

2005
(Restated)

 

Revenues

 

 

 

 

 

 

 

 

 

Rental income

 

$

33,153

 

$

24,858

 

$

93,056

 

$

70,329

 

Mortgage interest income

 

1,054

 

1,221

 

3,392

 

4,417

 

Other investment income – net

 

994

 

867

 

2,878

 

2,364

 

Miscellaneous

 

42

 

141

 

483

 

4,453

 

Total operating revenues

 

35,243

 

27,087

 

99,809

 

81,563

 

 

 

 

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

8,360

 

6,182

 

23,414

 

17,872

 

General and administrative

 

5,669

 

2,235

 

10,331

 

6,470

 

Provision for impairment on real estate properties

 

 

3,072

 

 

3,072

 

Provision for uncollectible mortgages, notes and accounts receivable

 

179

 

 

179

 

83

 

Leasehold expiration expense

 

 

 

 

750

 

Total operating expenses

 

14,208

 

11,489

 

33,924

 

28,247

 

 

 

 

 

 

 

 

 

 

 

Income before other income and expense

 

21,035

 

15,598

 

65,885

 

53,316

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest and other investment income

 

189

 

25

 

371

 

90

 

Interest

 

(11,190

)

(7,709

)

(30,246

)

(21,431

)

Interest – amortization of deferred financing costs

 

(439

)

(539

)

(1,513

)

(1,570

)

Interest – refinancing costs

 

 

 

(3,485

)

 

Provision for impairment on equity securities

 

 

 

 

(3,360

)

Gain on sale of equity securities

 

2,709

 

 

2,709

 

 

Change in fair value of derivatives

 

1,764

 

(16

)

9,672

 

(427

)

Total other expense

 

(6,967

)

(8,239

)

(22,492

)

(26,698

)

 

 

 

 

 

 

 

 

 

 

Income before gain on assets sold

 

14,068

 

7,359

 

43,393

 

26,618

 

Gain on assets sold – net

 

1,188

 

 

1,188

 

 

Income from continuing operations before income taxes

 

15,256

 

7,359

 

44,581

 

26,618

 

Provision for income taxes

 

(600

)

(588

)

(1,739

)

(1,776

)

Income from continuing operations

 

14,656

 

6,771

 

42,842

 

24,842

 

(Loss) from discontinued operations

 

(33

)

(1,087

)

(554

)

(7,061

)

Net income

 

14,623

 

5,684

 

42,288

 

17,781

 

Preferred stock dividends

 

(2,480

)

(2,481

)

(7,442

)

(8,904

)

Preferred stock conversion and redemption charges

 

 

 

 

(2,013

)

Net income available to common

 

$

12,143

 

$

3,203

 

$

34,846

 

$

6,864

 

 

 

 

 

 

 

 

 

 

 

Income per common share:

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.21

 

$

0.08

 

$

0.61

 

$

0.27

 

Net income

 

$

0.21

 

$

0.06

 

$

0.60

 

$

0.13

 

Diluted:

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.20

 

$

0.08

 

$

0.61

 

$

0.27

 

Net income

 

$

0.20

 

$

0.06

 

$

0.60

 

$

0.13

 

 

 

 

 

 

 

 

 

 

 

Dividends declared and paid per common share

 

$

0.24

 

$

0.22

 

$

0.71

 

$

0.63

 

 

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding, basic

 

59,021

 

51,187

 

58,203

 

51,050

 

Weighted-average shares outstanding, diluted

 

59,446

 

51,479

 

58,407

 

51,386

 

 

 

 

 

 

 

 

 

 

 

Components of other comprehensive income:

 

 

 

 

 

 

 

 

 

Net income

 

$

14,623

 

$

5,684

 

$

42,288

 

$

17,781

 

Unrealized gain on common stock investment

 

 

730

 

1,580

 

730

 

Reclassification adjustment for gain on common stock investment

 

(1,740

)

 

(1,740

)

 

Unrealized loss on preferred stock investment

 

(172

)

(332

)

(763

)

(959

)

Total comprehensive income

 

$

12,711

 

$

6,082

 

$

41,365

 

$

17,552

 

 

See notes to consolidated financial statements.

3




OMEGA HEALTHCARE INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited (in thousands)

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005
(Restated)

 

Operating activities

 

 

 

 

 

Net income

 

$

42,288

 

$

17,781

 

Adjustment to reconcile net income to cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization (including amounts in discontinued operations)

 

23,432

 

19,068

 

Provision for impairment on real estate properties (including amounts in discontinued operations)

 

121

 

9,154

 

Provision for uncollectible mortgages, notes and accounts receivable

 

179

 

83

 

Provision for impairment on equity securities

 

 

3,360

 

Refinancing costs

 

3,485

 

 

Amortization of deferred financing costs

 

1,513

 

1,570

 

(Gains) losses on assets sold and equity securities – net

 

(3,516

)

3,492

 

Restricted stock amortization expense

 

4,224

 

856

 

Change in fair value of derivatives

 

(9,672

)

428

 

Income from accretion of marketable securities to redemption value

 

(1,155

)

(1,225

)

Other

 

(35

)

(1,532

)

Net change in accounts receivable

 

(24,650

)

(1,276

)

Net change in other assets

 

1,941

 

2,087

 

Net change in tax liabilities

 

1,739

 

1,776

 

Net change in operating assets and liabilities

 

8,121

 

(363

)

Net cash provided by operating activities

 

48,015

 

55,259

 

 

 

 

 

 

 

Cash flows from investing activities

 

 

 

 

 

Acquisition of real estate

 

(178,906

)

(120,696

)

Proceeds from sale of stock

 

7,573

 

 

Proceeds from sale of real estate investments

 

1,527

 

25,937

 

Capital improvements and funding of other investments

 

(5,416

)

(2,749

)

Proceeds from other investments

 

27,092

 

1,759

 

Investments in other investments

 

(29,238

)

(6,167

)

Collection of mortgage principal – net

 

10,588

 

60,869

 

Net cash used in investing activities

 

(166,780

)

(41,047

)

 

 

 

 

 

 

Cash flows from financing activities

 

 

 

 

 

Proceeds from credit facility borrowings

 

234,200

 

180,200

 

Payments on credit facility borrowings

 

(134,700

)

(114,500

)

Receipts from other long-term borrowings

 

39,000

 

 

Payments of other long-term borrowings

 

(390

)

(370

)

Prepayment of re-financing penalty

 

(755

)

 

Receipts from dividend reinvestment plan

 

29,161

 

2,415

 

Receipts/(payments) from exercised options – net

 

225

 

(984

)

Dividends paid

 

(49,356

)

(41,914

)

Redemption of preferred stock

 

 

(50,013

)

Payment on common stock offering

 

(178

)

(28

)

Deferred financing costs paid

 

(2,390

)

(333

)

Net cash provided by (used in) financing activities

 

114,817

 

(25,527

)

 

 

 

 

 

 

(Decrease) increase in cash and cash equivalents

 

(3,948

)

(11,315

)

Cash and cash equivalents at beginning of period

 

3,948

 

12,083

 

Cash and cash equivalents at end of period

 

$

 

$

768

 

Interest paid during the period

 

$

21,442

 

$

18,949

 

 

See notes to consolidated financial statements.

4




 

OMEGA HEALTHCARE INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Unaudited
September 30, 2006

NOTE 1 — BASIS OF PRESENTATION

Business Overview

We have one reportable segment consisting of investments in real estate.  Our business is to provide financing and capital to the long-term healthcare industry with a particular focus on skilled nursing facilities located in the United States.  Our core portfolio consists of long-term lease and mortgage agreements.  All of our leases are “triple-net” leases, which require the tenants to pay all property-related expenses.  Our mortgage revenue derives from fixed-rate mortgage loans, which are secured by first mortgage liens on the underlying real estate and personal property of the mortgagor.  Substantially all depreciation expenses reflected in the consolidated statements of operations relate to the ownership of our investment in real estate.

Restated Financial Data

We have restated certain historical results in the accompanying consolidated financial statements to correct errors in previously reported amounts related to income tax matters and certain debt and equity investments in Advocat Inc. (“Advocat”), as well as to record certain straight-line rental income.  See Note 2 — Restatement of Previously Issued Financial Statements.

Basis of Presentation

The accompanying unaudited consolidated financial statements for Omega Healthcare Investors, Inc. (“Omega” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In our opinion, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Certain reclassifications have been made to the 2005 financial statements for consistency with the presentation adopted for 2006.  Such reclassifications have no effect on previously reported earnings or equity.

Operating results for the three- and nine-month periods ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  For further information, refer to the financial statements and footnotes included in our annual report on Form 10-K/A for the year ended December 31, 2005.

Our consolidated financial statements include the accounts of Omega, all direct and indirect wholly owned subsidiaries and one variable interest entity (“VIE”) for which we are the primary beneficiary.  All inter-company accounts and transactions have been eliminated in consolidation of the financial statements.

FAS 123R Adoption

In December 2004, the Financial Accounting Standards Board (“FASB”) issued FAS No. 123 (revised 2004), Share-Based Payment (“FAS No. 123R”), which is a revision of FAS No. 123, Accounting for Stock-Based Compensation.  FAS No. 123R supersedes Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and amends FAS No. 95, Statement of Cash Flows.  We adopted FAS No. 123R on January 1, 2006.

5




FIN 46R

Financial Accounting Standards Board Interpretation No. 46R, Consolidation of Variable Interest Entities, (“FIN 46R”), addresses the consolidation by business enterprises of VIEs.  As a result of the adoption of FIN 46R, we consolidate all VIEs for which we are the primary beneficiary.  Generally, a VIE is an entity with one or more of the following characteristics: (a) the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support; (b) as a group the holders of the equity investment at risk lack (i) the ability to make decisions about an entity’s activities through voting or similar rights, (ii) the obligation to absorb the expected losses of the entity, or (iii) the right to receive the expected residual returns of the entity; or (c) the equity investors have voting rights that are not proportional to their economic interests, and substantially all of the entity’s activities either involve, or are conducted on behalf of, an investor that has disproportionately few voting rights.  FIN 46R requires a VIE to be consolidated in the financial statements of the entity that is determined to be the primary beneficiary of the VIE.  The primary beneficiary generally is the entity that will receive a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both.

In accordance with FIN 46R, we determined that we were the primary beneficiary of one VIE.  This VIE is derived from a financing relationship entered into between Omega and one company that is engaged in the ownership and rental of six skilled nursing facilities (“SNFs”) and one assisted living facility (“ALF”).  The consolidation of the VIE as of September 30, 2006 resulted in an increase in our consolidated total assets (primarily real estate) and liabilities (primarily indebtedness) of approximately $37.8 million.  The creditors of the VIE do not have recourse to our assets.

FIN 48 Evaluation

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”).  FIN 48 is an interpretation of FASB Statement No. 109, Accounting for Income Taxes, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes.  In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of our 2007 fiscal year.  We are currently evaluating the impact, if any, that FIN 48 will have on our financial statements.

NOTE 2 — RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

Summary of Restatement Items

Our Board of Directors, including our Audit Committee, concluded on October 24, 2006, to restate our audited financial results as of December 31, 2005 and 2004 and for the three years ended December 31, 2005, 2004 and 2003 and for other periods affected, including our unaudited financial statements for each quarterly period in 2004, 2005 and 2006 as necessary.  As a result, we have previously filed with the Securities and Exchange Commission (“SEC”) amendments to our Annual Report on Form 10-K for the period ending December 31, 2005 and our Quarterly Reports on Form 10-Q for the three-month periods ended March 31, 2006 and June 30, 2006, respectively, reflecting the restated matters (the “Restatement”).  The Restatement reflects the following adjustments that affect the three- and nine-months ended September 30, 2005.

1.               We recorded asset values for securities received from Advocat (and the increases therein) since the completion of the restructuring of Advocat obligations pursuant to leases and mortgages for the facilities then operated by Advocat in 2000.  These adjustments increased net income by $0.4 million and $0.8 million for the three and nine months ended September 30, 2005, respectively.  These adjustments increased total assets by $5.4 million as of December 31, 2005.  Changes in the fair value of the securities not currently recognized in net income were reflected in other comprehensive income.

6




2.               As a result of our holdings of Advocat securities, we recorded reserves related to a potential tax liability arising from our ownership of such securities.  This tax liability along with related interest expense had not been previously accrued for and this adjustment decreased net income by $0.6 million and $1.8 million for the three and nine months ended September 30, 2005, respectively.  The amount accrued represents the estimated liability, which remains subject to final resolution and therefore is subject to change.

3.               Subsequent to October 25, 2006, we made a correction to our accounting for certain leases because these leases contain provisions (such as increases in rent based on the lesser of a fixed amount or two times the Consumer Price Index (“CPI”)) that require us to record rental income on a straight-line basis subject to an appropriate evaluation of collectibility.  We had not previously recorded rental income on these leases on a straight-line basis.  As a result of this adjustment, our net income increased by $0.8 million and $2.1 million for the three and nine months ended September 30, 2005, respectively. In addition, net accounts receivable and retained earnings increased by $9.1 million as of December 31, 2005, to reflect the effects of this adjustment from inception of the affected leases.

Additional information about the decision to restate these financial statements can be found in our Current Report on Form 8-K, filed with the SEC on October 25, 2006.

Events Causing the Restatement — Advocat Restructuring

In November 2000, Advocat, an operator of various skilled nursing facilities owned by or mortgaged to us, was in default on its obligations to us.  As a result, we entered into an agreement with Advocat with respect to the restructuring of Advocat’s obligations pursuant to leases and mortgages for the facilities then operated by Advocat (the “Initial Advocat Restructuring”).  As part of the Initial Advocat Restructuring in 2000, Advocat issued to us (i) 393,658 shares of Advocat’s Series B non-voting, redeemable (on or after September 30, 2007), convertible preferred stock, which was convertible into up to 706,576 shares of Advocat’s common stock (representing 9.9% of the outstanding shares of Advocat’s common stock on a fully diluted, as-converted basis and accruing dividends at 7% per annum), and (ii) a secured convertible subordinated note in the amount of $1.7 million bearing interest at 7% per annum with a September 30, 2007 maturity.

Subsequent to the Initial Advocat Restructuring, Advocat’s operations and financial condition have improved and there has been a significant increase in the market value of Advocat’s common stock from approximately $0.31 per share at the time of the Initial Advocat Restructuring to the closing price on October 20, 2006 of $18.84.  As a result of the significant increase in the value of the common stock underlying the Series B preferred stock of Advocat held by us, on October 20, 2006 we again restructured our relationship with Advocat (the “Second Advocat Restructuring”) by entering into a Restructuring Stock Issuance and Subscription Agreement with Advocat (the “2006 Advocat Agreement”). Pursuant to the 2006 Advocat Agreement, we exchanged the Advocat Series B preferred stock and subordinated note issued in the Initial Advocat Restructuring for 5,000 shares of Advocat’s Series C non-convertible, redeemable (at our option after September 30, 2010) preferred stock with a face value of approximately $4.9 million and a dividend rate of 7% payable quarterly, and a secured non-convertible subordinated note in the amount of $2.5 million maturing September 30, 2007 and bearing interest at 7% per annum.  As part of the Second Advocat Restructuring, we also amended our Consolidated Amended and Restated Master Lease by and between one of our subsidiaries, as lessor, and a subsidiary of Advocat, as lessee, to commence a new 12-year lease term through September 30, 2018 (with a renewal option for an additional 12 year term) and Advocat has agreed to increase the master lease annual rent by approximately $687,000 to approximately $14 million commencing on January 1, 2007.

7




Management believes that certain of the terms of the Advocat Series B preferred stock previously held by us could be interpreted as affecting our compliance with federal income tax rules applicable to real estate investment trusts (“REITs”) regarding related party tenant income as described below.

In 2000 at the time of the Initial Advocat Restructuring, we determined that no value should be ascribed to the Advocat preferred stock and subordinated note and, as a result, no value was recorded on our financial statements at that time or in any subsequent period.  Management now believes that the accounting treatment in previous periods was incorrect and, in addition to the related party tenant issues described below, the Restatement reflects the appropriate carrying value (in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS No. 115”)) of the Advocat preferred stock of $4.6 million and $4.3 million and an embedded derivative (in accordance with FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS No. 133”)) of $9.0 million and $1.1 million on our restated balance sheets as of June 30, 2006 and December 31, 2005, respectively.  In addition, in accordance with FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan (“FAS No. 114”), the Advocat subordinated note of $1.7 million was fully reserved at September 30, 2006 and December 31, 2005, respectively.

The market value for Advocat’s common stock has increased significantly since the completion of the Initial Advocat Restructuring.  In connection with exploring the potential disposition of the Advocat Series B preferred stock as part of the Second Advocat Restructuring, we were advised by our tax counsel that due to the structure of the Initial Advocat Restructuring, Advocat may be deemed to be a “related party tenant” under applicable federal income tax rules and, in such event, rental income from Advocat would not be qualifying income under the gross income tests that are applicable to REITs.

In order to maintain qualification as a REIT, we annually must satisfy certain tests regarding the source of our gross income.  The applicable federal income tax rules provide a “savings clause” for REITs that fail to satisfy the REIT gross income tests, if such failure is due to reasonable cause.  A REIT that qualifies for the savings clause will retain its REIT status but will pay a tax under section 857(b)(5) and related interest.

We currently plan to submit to the IRS a request for a closing agreement to resolve the “related party tenant” issue.  While we believe there are valid arguments that Advocat should not be deemed a “related party tenant,” the matter is not free from doubt, and we believe it is in our best interest to request a closing agreement in order to resolve the matter, minimize potential interest charges and obtain assurances regarding its continuing REIT status.  By submitting a request for a closing agreement, we intend to establish that any failure to satisfy the gross income tests was due to reasonable cause.  In the event that it is determined that the “savings clause” described above does not apply, we could be treated as having failed to qualify as a REIT for one or more taxable years.  If we fail to qualify for taxation as a REIT for any taxable year, our income will be taxed at regular corporate rates, and we could be disqualified as a REIT for the following four taxable years.

As noted above, we have completed the Second Advocat Restructuring and have been advised by tax counsel that we will not receive any non-qualifying related party tenant income from Advocat in future fiscal years.  Accordingly, we do not expect to incur tax expense associated with related party tenant income in future periods commencing January 1, 2007.  We will continue to accrue an income tax liability related to this matter during 2006.

Recording of Rental Income

During the course of preparing the Restatement due to the issues related to Advocat described above, we determined that we should correct our accounting for certain leases because these leases contain provisions (such as increases in rent based on the lesser of a fixed amount or two times CPI) that require us to record rental income on a straight-line basis subject to an appropriate evaluation of collectibility.  Historically, we have recorded rental income for leases with these provisions based on

8




contractual scheduled rent payments, rather than on a straight-line basis.  In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 13, Accounting for Leases and Financial Accounting Standards Board Technical Bulletin No. 88-1 Issues Related to Accounting for Leases, we have determined that the recording of rental revenue associated with these leases should be on a straight-line basis.  As a result of this adjustment, our net income will increase by $1.1 million and $3.0 million for the three and nine months ended September 30, 2005, respectively.  In addition, accounts receivable and retained earnings will increase by $9.1 million as of December 31, 2005, to reflect the effects of this adjustment from inception of the affected leases.

The following table sets forth the effects of the adjustments related to the Restatement on our consolidated balance sheet as of December 31, 2005:

CONSOLIDATED BALANCE SHEETS
(Audited)
(in thousands
)

 

 

As of December 31, 2005,

 

 

 

As Reported

 

Adjustments

 

Restated

 

ASSETS

 

 

 

 

 

 

 

Real estate properties

 

 

 

 

 

 

 

Land and buildings at cost

 

$

996,127

 

$

 

$

996,127

 

Less accumulated depreciation

 

(157,255

)

 

(157,255

)

Real estate properties — net

 

838,872

 

 

838,872

 

Mortgage notes receivable — net

 

104,522

 

 

104,522

 

 

 

943,394

 

 

943,394

 

Other investments — net

 

23,490

 

5,428

 

28,918

 

 

 

966,884

 

5,428

 

972,312

 

Assets held for sale — net

 

1,243

 

 

1,243

 

Total investments

 

968,127

 

5,428

 

973,555

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

3,948

 

 

3,948

 

Accounts receivable — net

 

5,885

 

9,133

 

15,018

 

Other assets

 

37,769

 

 

37,769

 

Total assets

 

$

1,015,729

 

$

14,561

 

$

1,030,290

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

Revolving line of credit

 

$

58,000

 

$

 

$

58,000

 

Unsecured borrowings — net

 

505,429

 

 

505,429

 

Other long-term borrowings

 

2,800

 

 

2,800

 

Accrued expenses and other liabilities

 

19,563

 

 

19,563

 

Income tax liabilities

 

 

3,299

 

3,299

 

Operating liabilities for owned properties

 

256

 

 

256

 

Total liabilities

 

586,048

 

3,299

 

589,347

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

Preferred stock

 

118,488

 

 

118,488

 

Common stock and additional paid-in-capital

 

663,607

 

 

663,607

 

Cumulative net earnings

 

227,701

 

9,368

 

237,069

 

Cumulative dividends paid

 

(536,041

)

 

(536,041

)

Cumulative dividends — redemption

 

(43,067

)

 

(43,067

)

Unamortized restricted stock awards

 

(1,167

)

 

(1,167

)

Accumulated other comprehensive income

 

160

 

1,894

 

2,054

 

Total stockholders’ equity

 

429,681

 

11,262

 

440,943

 

Total liabilities and stockholders’ equity

 

$

1,015,729

 

$

14,561

 

$

1,030,290

 

 

9




The effects of the adjustments related to the Restatement for the three and nine months ended September 30, 2005 are summarized below:

 

 

Three Months Ended September 30, 2005

 

 

 

As Reported(1)

 

Adjustments

 

Restated

 

Revenues

 

 

 

 

 

 

 

Rental income

 

$

24,099

 

$

759

 

$

24,858

 

Mortgage interest income

 

1,221

 

 

1,221

 

Other investment income – net

 

457

 

410

 

867

 

Miscellaneous

 

141

 

 

141

 

Total operating revenues

 

25,918

 

1,169

 

27,087

 

 

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

Depreciation and amortization

 

6,182

 

 

6,182

 

General and administrative

 

2,235

 

 

2,235

 

Provision for impairment on real estate properties

 

3,072

 

 

3,072

 

Provision for uncollectible mortgages, notes and accounts receivable

 

 

 

 

Leasehold expiration expense

 

 

 

 

Total operating expenses

 

11,489

 

 

11,489

 

 

 

 

 

 

 

 

 

Income before other income and expense

 

14,429

 

1,169

 

15,598

 

Other income (expense):

 

 

 

 

 

 

 

Interest and other investment income

 

25

 

 

25

 

Interest

 

(7,709

)

 

(7,709

)

Interest – amortization of deferred financing costs

 

(539

)

 

(539

)

Provision for impairment on equity securities

 

 

 

 

 

Change in fair value of derivatives

 

 

(16

)

(16

)

Total other expense

 

(8,223

)

(16

)

(8,239

)

 

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

6,206

 

1,153

 

7,359

 

Provision for income taxes

 

 

(588

)

(588

)

Income from continuing operations

 

6,206

 

565

 

6,771

 

Loss from discontinued operations

 

(1,087

)

 

(1,087

)

Net income

 

5,119

 

565

 

5,684

 

Preferred stock dividends

 

(2,481

)

 

(2,481

)

Preferred stock conversion and redemption charges

 

 

 

 

Net income available to common

 

$

2,638

 

$

565

 

$

3,203

 

 

 

 

 

 

 

 

 

Income per common share:

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.07

 

$

0.01

 

$

0.08

 

Net income

 

$

0.05

 

$

0.01

 

$

0.06

 

Diluted:

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.07

 

$

0.01

 

$

0.08

 

Net income

 

$

0.05

 

$

0.01

 

$

0.06

 

 

 

 

 

 

 

 

 

Dividends declared and paid per common share

 

$

0.22

 

$

 

$

0.22

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding, basic

 

51,187

 

 

51,187

 

Weighted-average shares outstanding, diluted

 

51,479

 

 

51,479

 

 

 

 

 

 

 

 

 

Components of other comprehensive income:

 

 

 

 

 

 

 

Net income

 

$

5,119

 

$

565

 

$

5,684

 

Unrealized gain on common stock investment

 

730

 

 

730

 

Reclassification adjustment for gains on common stock investment

 

 

 

 

Unrealized (loss) on preferred stock investment

 

 

(332

)

(332

)

Total comprehensive income

 

$

5,849

 

$

233

 

$

6,082

 


(1)            Includes current period reclassification for discontinued operations.

10




 

 

 

Nine Months Ended September 30, 2005

 

 

 

As Reported (1)

 

Adjustments

 

Restated

 

Revenues

 

 

 

 

 

 

 

Rental income

 

$

68,251

 

$

2,078

 

$

70,329

 

Mortgage interest income

 

4,417

 

 

4,417

 

Other investment income – net

 

1,139

 

1,225

 

2,364

 

Miscellaneous

 

4,453

 

 

4,453

 

Total operating revenues

 

78,260

 

3,303

 

81,563

 

 

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

Depreciation and amortization

 

17,872

 

 

17,872

 

General and administrative

 

6,470

 

 

6,470

 

Provision for impairment on real estate properties

 

3,072

 

 

3,072

 

Provision for uncollectible mortgages, notes and accounts receivable

 

83

 

 

83

 

Leasehold expiration expense

 

750

 

 

750

 

Total operating expenses

 

28,247

 

 

28,247

 

 

 

 

 

 

 

 

 

Income before other income and expense

 

50,013

 

3,303

 

53,316

 

Other income (expense):

 

 

 

 

 

 

 

Interest and other investment income

 

90

 

 

90

 

Interest

 

(21,431

)

 

(21,431

)

Interest – amortization of deferred financing costs

 

(1,570

)

 

(1,570

)

Provision for impairment on equity securities

 

(3,360

)

 

(3,360

)

Change in fair value of derivatives

 

 

(427

)

(427

)

Total other expense

 

(26,271

)

(427

)

(26,698

)

 

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

23,742

 

2,876

 

26,618

 

Provision for income taxes

 

 

(1,776

)

(1,776

)

Income from continuing operations

 

23,742

 

1,100

 

24,842

 

Loss from discontinued operations

 

(7,061

)

 

(7,061

)

Net income

 

16,681

 

1,100

 

17,781

 

Preferred stock dividends

 

(8,904

)

 

(8,904

)

Preferred stock conversion and redemption charges

 

(2,013

)

 

(2,013

)

Net income available to common

 

$

5,764

 

$

1,100

 

$

6,864

 

 

 

 

 

 

 

 

 

Income per common share:

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.25

 

$

0.02

 

$

0.27

 

Net income

 

$

0.11

 

$

0.02

 

$

0.13

 

Diluted:

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.25

 

$

0.02

 

$

0.27

 

Net income

 

$

0.11

 

$

0.02

 

$

0.13

 

 

 

 

 

 

 

 

 

Dividends declared and paid per common share

 

$

0.63

 

$

 

$

0.63

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding, basic

 

51,050

 

 

51,050

 

Weighted-average shares outstanding, diluted

 

51,386

 

 

51,386

 

 

 

 

 

 

 

 

 

Components of other comprehensive income:

 

 

 

 

 

 

 

Net income

 

$

16,681

 

$

1,100

 

$

17,781

 

Unrealized gain (loss) on common stock investment

 

730

 

 

730

 

Reclassification adjustment for gains on common stock investment

 

 

 

 

Unrealized (loss) gain on preferred stock investment

 

 

(959

)

(959

)

Total comprehensive income

 

$

17,411

 

$

141

 

$

17,552

 


(1)            Includes current period reclassification for discontinued operations.

 

11




 

NOTE 3 — PROPERTIES

In the ordinary course of our business activities, we periodically evaluate investment opportunities and extend credit to customers.  We also regularly engage in lease and loan extensions and modifications. Additionally, we actively monitor and manage our investment portfolio with the objectives of improving credit quality and increasing returns.  In connection with portfolio management, we may engage in various collection and foreclosure activities.

If we acquire real estate pursuant to a foreclosure, lease termination or bankruptcy proceeding and do not immediately re-lease or sell the properties to new operators, the assets will be included on the balance sheet as “foreclosed real estate properties,” and the value of such assets is reported at the lower of cost or estimated fair value.

The table below summarizes our number of properties and investment by category for the nine months ended September 30, 2006:

 

 

 

 

Mortgage

 

 

 

Total

 

 

 

Leased

 

Notes

 

Facilities

 

Healthcare

 

Facility Count

 

Property

 

Receivable

 

Held for Sale

 

Facilities

 

Balance at December 31, 2005

 

192

 

32

 

3

 

227

 

Properties sold/mortgages paid

 

 

(15

)

(3

)

(18

)

Properties acquired

 

32

 

 

 

32

 

Properties transferred to assets held for sale

 

(2

)

 

2

 

 

Properties transferred to purchase/leaseback

 

7

 

(7

)

 

 

Balance at September 30, 2006

 

229

 

10

 

2

 

241

 

 

 

 

 

 

 

 

 

 

 

Investment ($000’s)

 

 

 

 

 

 

 

 

 

Balance at December 31, 2005

 

$

996,127

 

$

104,522

 

$

1,243

 

$

1,101,892

 

Properties transferred to assets held for sale

 

(1,354

)

 

1,354

 

 

Properties sold/mortgages paid

 

 

(48,990

)

(1,860

)

(50,850

)

Properties acquired

 

178,906

 

 

 

178,906

 

Properties transferred to purchase/leaseback

 

61,750

 

(22,750

)

 

39,000

 

Impairment on properties

 

(121

)

 

 

(121

)

Capital expenditures and other

 

5,090

 

(597

)

 

4,493

 

Balance at September 30, 2006

 

$

1,240,398

 

$

32,185

 

$

737

 

$

1,273,320

 

 

Leased Property

Our leased real estate properties, represented by 227 long-term care facilities and two rehabilitation hospitals at September 30, 2006, are leased under provisions of single leases and master leases with initial terms typically ranging from 5 to 15 years, plus renewal options.  Substantially all of our leases contain provisions for specified annual increases over the rents of the prior year and are generally computed in one of three methods depending on specific provisions of each lease as follows: (i) a specific annual increase over the prior year’s rent, generally 2.5%; (ii) an increase based on the change in pre-determined formulas from year to year (i.e., such as increases in the CPI); or (iii) specific dollar increases over prior years.  Under the terms of the leases, the lessee is responsible for all maintenance, repairs, taxes and insurance on the leased properties.

Set forth below is a summary of the transactions that occurred in the nine months ended September 30, 2006.

Litchfield Transaction

On August 1, 2006, we completed a transaction with Litchfield Investment Company, LLC and its affiliates (“Litchfield”) to purchase 30 skilled nursing facilities and one independent living center for a total investment of approximately $171 million.  The facilities total 3,847 beds and are located in the states of Colorado (5), Florida (7), Idaho (1), Louisiana (13), and Texas (5). The facilities were subject to master leases with three national healthcare providers, which are existing tenants of the Company.  The

12




 

tenants are Home Quality Management, Inc. (“HQM”), Nexion Health, Inc. (“Nexion”), and Peak Medical Corporation, which was acquired by Sun Healthcare Group, Inc. (“Sun”) in December of 2005.  We used a combination of cash on hand and $150 million of credit facility borrowings to finance the Litchfield transaction.

Simultaneously with the close of the purchase transaction, the seven HQM facilities were combined into an Amended and Restated Master Lease containing 13 facilities between us and HQM.  In addition, the 18 Nexion facilities were combined into an Amended and Restated Master Lease containing 22 facilities between us and Nexion.

We entered into a Master Lease, Assignment and Assumption Agreement with Litchfield on the six Sun facilities.  These six facilities are currently under a master lease that expires on September 30, 2007.

Guardian LTC Management, Inc.

On September 1, 2006, we completed a $25.0 million investment with subsidiaries of Guardian LTC Management, Inc. (“Guardian”), an existing operator of ours.  The transaction involved the purchase and leaseback of a skilled nursing facility (“SNF”) in Pennsylvania and a termination of a purchase option on a combination SNF and rehabilitation hospital in West Virginia owned by us.  The facilities were included in an existing master lease with Guardian with an increase in contractual annual rent of approximately $2.6 million in the first year and the master lease now includes 17 facilities.  In addition, the master lease term was extended from October 2014 through August 2016.

In accordance with FASB Statement No. 13, Accounting Leases (“FAS No. 13”) and FASB Technical Bulletin No. 88-1, Issues Relating to Accounting for Leases (“FASB TB No. 88-1”), $19.2 million of the $25.0 million transaction amount will be accounted for as a lease inducement and is classified within accounts receivable — net on our consolidated balance sheet.  The lease inducement will be amortized as a reduction to rental income on a straight-line basis over the term of the new master lease.  The remaining payment to Guardian of $5.8 million will be allocated to the purchase of the Pennsylvania SNF.

Advocat, Inc.

On October 20, 2006, as part of the Second Advocat Restructuring, we amended our master lease with Advocat to commence a new 12-year lease term through September 30, 2018 (with a renewal option for an additional 12 year term) and Advocat agreed to increase the master lease annual rent by approximately $687,000 to approximately $14 million commencing on January 1, 2007.  See Note 2 — Restatement of Previously Issued Financial Statements.

The Second Advocat Restructuring will be accounted for as a new lease in accordance with FAS No. 13 and FASB TB No. 88-1.  The fair value of the assets exchanged in the restructuring (i.e., the Series B non-voting redeemable convertible preferred stock and the secured convertible subordinated note, with a fair value of $14.9 million and $2.5 million, respectively, at October 20, 2006) in excess of the fair value of the assets received (the Series C non-voting redeemable non-convertible preferred stock and the secured non-convertible subordinated note, with a fair value of $4.1 million and $2.5 million, respectively, at October 20, 2006) will be recorded as a lease inducement of approximately $10.8 million in the fourth quarter of 2006.  The $10.8 million lease inducement asset will be amortized as a reduction to rental income on a straight-line basis over the term of the new master lease.  The exchange of securities will also result in a gain in the fourth quarter of 2006 of approximately $3.0 million representing: (i) the fair value of the secured convertible subordinated note of $2.5 million, previously reserved; (ii) the realization of the gain on investments previously classified in other comprehensive income of approximately $1.1 million relating to the Series B non-voting redeemable convertible preferred stock; and (iii) a loss of approximately  

13




 

$0.6 million resulting from the change in the fair value of the embedded derivative from September 30, 2006 to October 20, 2006.  See also Note 8 — Investments in Debt and Equity Securities.

Haven Eldercare, LLC

·                  During the three months ended March 31, 2006, Haven Eldercare, LLC (“Haven”), an existing operator of ours, entered into a $39 million first mortgage loan with General Electric Capital Corporation (“GE Loan”).  Haven used the $39 million of proceeds to partially repay on a $62 million mortgage it has with us.  Simultaneously, we subordinated the payment of our remaining $23 million of the mortgage note, due in October 2012, to that of the GE Loan.  As a result of this transaction, the interest rate on our remaining mortgage note to Haven rose from 10% to approximately 15%, with annual escalators.

·                  In conjunction with the above transactions and the application of FIN 46R, we consolidated the financial statements and related real estate of this Haven entity into our financial statements.  The consolidation resulted in the following changes to our consolidated balance sheet as of September 30, 2006: (1) an increase in total gross investments of $39.0 million; (2) an increase in accumulated depreciation of $1.2 million; (3) an increase in other long-term borrowings of $39.0 million; and (4) a reduction of $1.2 million in cumulative net earnings for the nine months ended September 30, 2006 due to the increased depreciation expense.  General Electric Capital Corporation and Haven’s other creditors do not have recourse to our assets.  We have an option to purchase the mortgaged facilities for a fixed price in 2012.  Our results of operations reflect the effects of the consolidation of this entity, which is being accounted for similarly to our other purchase-leaseback transactions.

Acquisitions

The table below summarizes the acquisitions completed during the nine months ended September 30, 2006.  The purchase price includes estimated transaction costs.

100% Interest Acquired

 

Acquisition Date

 

Purchase Price ($000’s)

 

One facility in PA

 

September 1, 2006

 

$

5,800

 

Thirty-one facilities in 5 states

 

August 1, 2006

 

173,100

 

 

14




 

The acquired properties are included in our results of operations from the respective date of acquisition.  The following unaudited pro forma results of operations reflect these transactions as if each had occurred on January 1 of the year presented.  According to management, all significant adjustments necessary to reflect the effects of the acquisitions have been made.

 

 

Pro Forma

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005
(Restated)

 

2006

 

2005
(Restated)

 

 

 

(in thousands, except per share amounts)

 

Revenues

 

$

36,854

 

$

31,776

 

$

110,797

 

$

95,629

 

Net income

 

$

14,784

 

$

6,184

 

$

43,450

 

$

19,282

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share — Basic

 

$

0.21

 

$

0.07

 

$

0.62

 

$

0.16

 

Earnings (loss) per share — Diluted

 

$

0.21

 

$

0.07

 

$

0.62

 

$

0.16

 

 

Assets Sold or Held for Sale

Assets Sold

·                  On June 30, 2006, we sold two SNFs in California resulting in an accounting loss of approximately $0.1 million.

·                  On March 31, 2006, we sold a SNF in Illinois resulting in an accounting loss of approximately $0.2 million.

Held for Sale

·                  At September 30, 2006, we had two assets held for sale with a net book value of approximately $0.7 million.

·                  During the three months ended March 31, 2006, a $0.1 million provision for impairment charge was recorded to reduce the carrying value to its sales price of one facility that was under contract to be sold that was subsequently sold during the second quarter of 2006.

Mortgage Notes Receivable

Mortgage notes receivable relate to ten long-term care facilities.  The mortgage notes are secured by first mortgage liens on the borrowers’ underlying real estate and personal property.  The mortgage notes receivable relate to facilities located in five states, operated by seven independent healthcare operating companies.  We monitor compliance with mortgages and when necessary have initiated collection, foreclosure and other proceedings with respect to certain outstanding loans.  As of September 30, 2006, we had no foreclosed property, and none of our mortgages were in foreclosure proceedings.

Mortgage interest income is recognized as earned over the terms of the related mortgage notes.  Reserves are taken against earned revenues from mortgage interest when collection of amounts due becomes questionable or when negotiations for restructurings of troubled operators lead to lower expectations

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regarding ultimate collection.  When collection is uncertain, mortgage interest income on impaired mortgage loans is recognized as received after taking into account application of security deposits.

Hickory Creek Healthcare Foundation, Inc.

On June 16, 2006, we received approximately $10 million in proceeds on a mortgage loan payoff.  We held mortgages on 15 facilities located in Indiana, representing 619 beds.

Haven Eldercare, LLC.

During the three months ended March 31, 2006, Haven used the $39 million of proceeds from the GE Loan to partially repay on a $62 million mortgage it has with us.  Simultaneously, we subordinated the payment of its remaining $23 million on the mortgage note to that of the GE Loan (see Note — 3 Properties; Leased Property, above).

NOTE 4 — CONCENTRATION OF RISK

As of September 30, 2006, our portfolio of domestic investments consisted of 241 healthcare facilities, located in 27 states and operated by 33 third-party operators.  Our gross investment in these facilities, net of impairments and before reserve for uncollectible loans, totaled approximately $1.3 billion at September 30, 2006, with approximately 98% of our real estate investments related to long-term care facilities.  This portfolio is made up of 227 long-term healthcare facilities, two rehabilitation hospitals owned and leased to third parties, fixed rate mortgages on 10 long-term healthcare facilities and two facilities held for sale.  At September 30, 2006, we also held miscellaneous investments of approximately $37 million, consisting primarily of secured loans to third-party operators of our facilities.

At September 30, 2006, approximately 25% of our real estate investments were operated by two public companies:  Sun (17%) and Advocat (8%).  Our largest private company operators (by investment) were CommuniCare Health Services, Inc. (“CommuniCare”) (15%), Haven (9%), HQM (8%), Guardian (7%), Nexion (6%) and Essex Healthcare Corporation (6%).  No other operator represents more than 4% of our investments.  The three states in which we had our highest concentration of investments were Ohio (22%), Florida (14%) and Pennsylvania (9%) at September 30, 2006.

For the three-month period ended September 30, 2006, our revenues from operations totaled $35.2 million, of which approximately $6.6 million were from Sun (19%), $5.1 million from CommuniCare (14%) and $3.7 million from Advocat (10%).  For the nine-month period ended September 30, 2006, our revenues from operations totaled $99.8 million, of which approximately $18.2 million were from Sun (18%), $15.2 million from CommuniCare (15%) and $10.8 million from Advocat (11%).  No other operator generated more than 10% of our revenues from operations for the three- and nine-month periods ended September 30, 2006.

Sun and Advocat are subject to the reporting requirements of the SEC and are required to file with the SEC annual reports containing audited financial information and quarterly reports containing unaudited interim financial information.  Sun’s and Advocat’s filings with the SEC can be found at the SEC’s website at www.sec.gov.  We are providing this data for information purposes only, and you are encouraged to obtain Sun’s and Advocat’s publicly available filings from the SEC.

NOTE 5 — DIVIDENDS

In order to qualify as a REIT, we are required to distribute dividends (other than capital gain dividends) to our stockholders in an amount at least equal to (A) the sum of (i) 90% of our “REIT taxable income” (computed without regard to the dividends paid deduction and our net capital gain), and (ii) 90% of the net income (after tax), if any, from foreclosure property, minus (B) the sum of certain items of non-cash

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income. In addition, if we dispose of any built-in gain asset during a recognition period, we will be required to distribute at least 90% of the built-in gain (after tax), if any, recognized on the disposition of such asset. Such distributions must be paid in the taxable year to which they relate, or in the following taxable year if declared before we timely file our tax return for such year and paid on or before the first regular dividend payment after such declaration. In addition, such distributions are required to be made pro rata, with no preference to any share of stock as compared with other shares of the same class, and with no preference to one class of stock as compared with another class except to the extent that such class is entitled to such a preference. To the extent that we do not distribute all of our net capital gain or do distribute at least 90%, but less than 100% of our “REIT taxable income,” as adjusted, we will be subject to tax thereon at regular ordinary and capital gain corporate tax rates.  In addition, our $200 million revolving senior secured credit facility (“Credit Facility”) has certain financial covenants that limit the distribution of dividends paid during a fiscal quarter to no more than 95% of our aggregate cumulative funds from operations (“FFO”) as defined in the loan agreement governing the Credit Facility (the “Loan Agreement”), unless a greater distribution is required to maintain REIT status.  The Loan Agreement defines FFO as net income (or loss) plus depreciation and amortization and shall be adjusted for charges related to: (i) restructuring our debt; (ii) redemption of preferred stock; (iii) litigation charges up to $5.0 million; (iv) non-cash charges for accounts and notes receivable up to $5.0 million; (v) non-cash compensation related expenses; (vi) non-cash impairment charges; and (vii) tax liabilities in an amount not to exceed $8.0 million.

Common Dividends

On October 24, 2006, the Board of Directors announced a common stock dividend of $0.25 per share, an increase of $0.01 per common share compared to the prior quarter, which was paid November 15, 2006 to common stockholders of record on November 3, 2006.

On July 17, 2006, the Board of Directors declared a common stock dividend of $0.24 per share.  The common dividend was paid August 15, 2006 to common stockholders of record on July 31, 2006.

On April 18, 2006, the Board of Directors declared a common stock dividend of $0.24 per share, an increase of $0.01 per common share compared to the prior quarter.  The common dividend was paid May 15, 2006 to common stockholders of record on April 28, 2006.

On January 17, 2006, the Board of Directors declared a common stock dividend of $0.23 per share, an increase of $0.01 per common share compared to the prior quarter.  The common stock dividend was paid February 15, 2006 to common stockholders of record on January 31, 2006.

Series D Preferred Dividends

On October 24, 2006, the Board of Directors declared the regular quarterly dividends for the 8.375% Series D Preferred Stock to stockholders of record on November 3, 2006.  The stockholders of record of the Series D Preferred Stock on November 3, 2006 were paid dividends in the amount of $0.52344 per preferred share on November 15, 2006.  The liquidation preference for our Series D Preferred Stock is $25.00 per share. Regular quarterly preferred dividends for the Series D Preferred Stock represent dividends for the period August 1, 2006 through October 31, 2006.

On July 17, 2006, the Board of Directors declared regular quarterly dividends of approximately $0.52344 per preferred share on the Series D Preferred Stock that were paid August 15, 2006 to preferred stockholders of record on April 28, 2006.

On April 18, 2006, the Board of Directors declared regular quarterly dividends of approximately $0.52344 per preferred share on the Series D Preferred Stock that were paid May 15, 2006 to preferred stockholders of record on April 28, 2006.

On January 17, 2006, the Board of Directors declared regular quarterly dividends of approximately $0.52344 per preferred share on the Series D Preferred Stock that were paid February 15, 2006 to preferred stockholders of record on January 31, 2006.

 

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NOTE 6 — TAXES

So long as we qualify as a REIT and, among other things, we distribute 90% of our taxable income, we will not be subject to Federal income taxes on our income, except as described below. We are permitted to own up to 100% of a “taxable REIT subsidiary” (“TRS”).  Currently, we have two TRSs that are taxable as corporations and that pay federal, state and local income tax on their net income at the applicable corporate rates.  These TRSs had net operating loss carry-forwards as of September 30, 2006 of $11.6 million.  These loss carry-forwards were fully reserved with a valuation allowance due to uncertainties regarding realization.

During the fourth quarter of 2006, we determined that certain terms of the Advocat Series B non-voting, redeemable convertible preferred stock could be interpreted as affecting our compliance with federal income tax rules applicable to REITs regarding related party tenant income.  As such, Advocat, one of our lessees, may be deemed to be a “related party tenant” under applicable federal income tax rules.  In such event, our rental income from Advocat would not be qualifying income under the gross income tests that are applicable to REITs.  In order to maintain qualification as a REIT, we annually must satisfy certain tests regarding the source of our gross income.  The applicable federal income tax rules provide a “savings clause” for REITs that fail to satisfy the REIT gross income tests if such failure is due to reasonable cause.  A REIT that qualifies for the savings clause will retain its REIT status but will pay a tax under section 857(b)(5) and related interest.  We currently plan to submit to the IRS a request for a closing agreement to resolve the “related party tenant” issue.  While we believe there are valid arguments that Advocat should not be deemed a “related party tenant,” the matter is not free from doubt, and we believe it is in our best interest to request a closing agreement in order to resolve the matter, minimize potential interest charges and obtain assurances regarding our continuing REIT status.  By submitting a request for a closing agreement, we intend to establish that any failure to satisfy the gross income tests was due to reasonable cause (see Note 2 — Restatement of Previously Issued Financial Statements).  In the event that it is determined that the “savings clause” described above does not apply, we could be treated as having failed to qualify as a REIT for one or more taxable years.  If we fail to qualify for taxation as a REIT for any taxable year, our income will be taxed at regular corporate rates, and we could be disqualified as a REIT for the following four taxable years.

As a result of the potential related party tenant issue described above and further discussed in Note 2 — Restatement of Previously Issued Financial Statements, we have recorded a $0.6 million and $1.7 million provision for income taxes, including related interest expense, for the three and nine months ended September 30, 2006, respectively, and $0.6 million and $1.8 million for the three and nine months ended September 30, 2005, respectivelyThe amount accrued represents the estimated liability and interest, which remains subject to final resolution and therefore is subject to change.  In addition, in October 2006, we restructured our Advocat relationship and have been advised by tax counsel that we will not receive any non-qualifying related party tenant income from Advocat in future fiscal years.  Accordingly, we do not expect to incur tax expense associated with related party tenant income in future periods commencing January 1, 2007.  We will continue to accrue an income tax liability related to this matter during 2006.

NOTE 7 — STOCK-BASED COMPENSATION

Stock Options

Prior to January 1, 2006, we accounted for stock based compensation using the intrinsic value method as defined by APB Opinion No. 25, Accounting for Stock Issued to Employees.  Effective January 1, 2006, we adopted FAS No. 123R using the modified prospective method.  Accordingly, we have not restated prior period amounts.  The additional expense to be recorded in 2006 as a result of this adoption is approximately $3 thousand.  Under the provisions of FAS No. 123R, the “Unamortized restricted stock awards” line on our consolidated balance sheet, a contra-equity line representing the amount of unrecognized share-based compensation costs, is no longer presented.  Accordingly, for the nine-month period ended September 30, 2006, the amount that had been on the “Unamortized restricted stock awards”

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line was reversed through the “Common stock and additional paid-in-capital” line on our consolidated balance sheet.

Under the terms of our 2000 Stock Incentive Plan (the “2000 Plan”), we reserved 3,500,000 shares of common stock.  The exercise price per share of an option under the 2000 Plan cannot be reduced after the date of grant, nor can an option be cancelled in exchange for an option with a lower exercise price per share.  The 2000 Plan provides for non-employee directors to receive options that vest over three years while other grants vest over the period required in the agreement applicable to the individual recipient.  Directors, officers, employees and consultants are eligible to participate in the 2000 Plan.  At September 30, 2006, there were outstanding options for 52,581 shares of common stock granted to eight eligible participants under the 2000 Plan.  Additionally, 355,655 shares of restricted stock have been granted under the provisions of the 2000 Plan, and as of September 30, 2006, there were no shares of unvested restricted stock outstanding under the 2000 Plan.

At September 30, 2006, under the 2000 Plan, there were outstanding options for 50,912 shares of common stock granted to eight participants currently exercisable with a weighted-average exercise price of $13.58, with exercise prices ranging from $2.96 to $37.20.  There were 559,960 shares available for future grants as of September 30, 2006.  A breakdown of the options outstanding under the 2000 Plan as of September 30, 2006, by price range, is presented below:

Option Price
Range

 

Number

 

Weighted Average
Exercise Price

 

Weighted Average
Remaining Life
(Years)

 

Number
Exercisable

 

Weighted Average
Price on Options
Exercisable

 

$2.96 -  $3.81

 

11,918

 

$

3.41