10-Q 1 a2054218z10-q.txt 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR QUARTERLY PERIOD ENDED MAY 31, 2001 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from _____to_____. Commission File Number: 0-18942 ILM II SENIOR LIVING, INC. (Exact name of registrant as specified in its charter) Virginia 06-1293758 --------------------- ----------------------- (State of organization) (I.R.S. Employer Identification No.) 1750 Tysons Boulevard, Suite 1200, Tysons Corner, Va 22102 ------------------------------------------------------------------------------ (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (888) 257-3550 ------------------------- Securities registered pursuant to Section 12(b) of the Act: Name of each exchange on Title of Each Class Which Registered ------------------- --------------------------- None None Securities registered pursuant to Section 12(g) of the Act: Shares of Common Stock $.01 Par Value ------------------------------------- (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ------ ----- Shares of common stock outstanding as of May 31, 2001: 5,181,236 Page 1 of 28 ================================================================================

-2- ILM II SENIOR LIVING, INC PART I. FINANCIAL INFORMATION Item I. Financial Statements (see next page) -3- CONSOLIDATED BALANCE SHEETS -------------------------------------------------------------------------------- May 31, 2001 (Unaudited) and August 31, 2000 (Dollars in thousands, except per share data)

See accompanying notes. -------------------------------------------------------------------------------- PAGE 7 CONSOLIDATED STATEMENTS OF OPERATIONS -------------------------------------------------------------------------------- For the nine months and three months ended May 31, 2001 and 2000 (Unaudited) (Dollars in thousands, except per share data)

The above earnings and cash dividends paid per share of common stock are based upon the 5,181,236 shares outstanding for each period. See accompanying notes. -------------------------------------------------------------------------------- PAGE 8 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY -------------------------------------------------------------------------------- For the nine months ended May 31, 2001 and 2000 (Unaudited) (Dollars in thousands, except per share data)

See accompanying notes. -------------------------------------------------------------------------------- PAGE 9 CONSOLIDATED STATEMENTS OF CASH FLOWS -------------------------------------------------------------------------------- For the nine months ended May 31, 2001 and 2000 (Unaudited) (Dollars in thousands)

See accompanying notes. -------------------------------------------------------------------------------- PAGE 10 Notes to Consolidated Financial Statements (Unaudited) -------------------------------------------------------------------------------- 1. General The accompanying consolidated financial statements, footnotes and discussions should be read in conjunction with the consolidated financial statements and footnotes contained in ILM II Senior Living, Inc.'s (the "Company") Annual Report on Form 10-K for the year ended August 31, 2000. In the opinion of management, the accompanying interim consolidated financial statements, which have not been audited, reflect all adjustments necessary to present fairly the results for the interim periods. All of the accounting adjustments reflected in the accompanying interim consolidated financial statements are of a normal recurring nature. The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America for interim financial information, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of May 31, 2001, and revenues and expenses for each of the nine- and three-month periods ended May 31, 2001 and 2000. Actual results could differ from the estimates and assumptions used. Certain numbers in the prior period's financial statements have been reclassified to conform to the current period's presentation. The results of operations for the nine-month period ended May 31, 2001, are not necessarily indicative of the results that may be expected for the year ending August 31, 2001. The Company was incorporated on February 5, 1990 under the laws of the State of Virginia as a Virginia finite-life corporation, formerly PaineWebber Independent Mortgage Inc. II. On September 12, 1990, the Company sold to the public in a registered initial offering 5,181,236 shares of common stock, $.01 par value. The Company received capital contributions of $51,812,356, of which $200,000 represented the sale of 20,000 shares to an affiliate at that time, PaineWebber Group, Inc. ("PaineWebber"). For discussion purposes, the term "PaineWebber" will refer to PaineWebber Group, Inc., and all affiliates that provided services to the Company in the past. The Company elected to qualify and be taxed as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended, for each taxable year of operations. The Company originally invested the net proceeds of the initial public offering in six participating mortgage loans collateralized by senior housing facilities located in five different states ("Senior Housing Facilities"). All of the loans made by the Company were originally to Angeles Housing Concepts, Inc. ("AHC"), as mortgagor, a company specializing in the -------------------------------------------------------------------------------- PAGE 11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- development, acquisition and operation of Senior Housing Facilities and guaranteed by AHC's corporate parent, Angeles Corporation ("Angeles"). ILM II Holding, Inc. ("ILM II Holding"), a majority-owned subsidiary of the Company, now holds title to the five remaining Senior Housing Facilities which comprise the balance of the operating investment properties on the accompanying consolidated balance sheets, subject to certain mortgage loans payable to the Company. Such mortgage loans and the related interest expense are eliminated in the consolidation of the financial statements of the Company. The Company made charitable gifts of one share of the preferred stock in ILM II Holding to each of 111 charitable organizations so that ILM II Holding would meet the stock ownership requirements of a REIT as of January 30, 1997. The preferred stock has a liquidation preference of $1,000 per share plus any accrued and unpaid dividends. Dividends on the preferred stock accrue at a rate of 8% per annum on the original $1,000 liquidation preference and are cumulative from the date of issuance. It is anticipated that dividends will accrue and be paid at liquidation of ILM II Holding. Cumulative dividends accrued as of May 31, 2001 on the preferred stock in ILM II Holding totaled approximately $38,000. As part of the fiscal 1994 Settlement Agreement with AHC, ILM II Holding retained AHC as the property manager for all of the Senior Housing Facilities pursuant to the terms of a management agreement. The management agreement with AHC was terminated in July 1996. Subsequent to the effective date of the settlement agreement with AHC, in order to maximize the potential returns to the Company's existing Shareholders while maintaining the Company's qualification as a REIT under the Internal Revenue Code, the Company formed a new corporation, ILM II Lease Corporation ("Lease II"), for the purpose of operating the Senior Housing Facilities under the terms of a facilities lease agreement (the "Facilities Lease Agreement"). All of the shares of capital stock of Lease II were distributed to the holders of record of the Company's common stock and the Senior Housing Facilities were leased to Lease II (see Note 2 for a description of the Facilities Lease Agreement). Lease II is a public company subject to the reporting obligations of the Securities and Exchange Commission. All responsibility for the day-to-day management of the Senior Housing Facilities, including administration of the property management agreement with AHC, was transferred to Lease II. On July 29, 1996, the management agreement with AHC was terminated and Lease II retained Capital Senior Management 2, Inc. ("Capital") to be the new property manager of its Senior Housing Facilities pursuant to a management agreement (the "Management Agreement"). -------------------------------------------------------------------------------- PAGE 12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- Terminated Agreement and Plan of Merger with Capital Senior Living Corporation ("CSLC") On February 7, 1999, the Company entered into an agreement and plan of merger, which was amended and restated on October 19, 1999, as subsequently amended, with CSLC and certain affiliates of CSLC. On June 22, 2000, holders of more than two-thirds of the outstanding shares of the Company's common stock voted in favor of approval of the proposed Agreement and Plan of Merger. On August 15, 2000, the Company caused ILM II Holding to complete the sale of its 75% co-tenancy interest in its senior living facility located in Santa Barbara, California ("Villa Santa Barbara"), to CSLC for $10,143,750. In consideration for the sale, the Company received $9,543,750 in cash and CSLC contributed $600,000 toward the Company's outstanding construction loan debt and assumed certain then current transaction expenses of the Company in connection with the previously announced proposed merger. The remaining 25% co-tenancy interest in Villa Santa Barbara was formerly owned by ILM Holding, Inc. ("Holding I"), a subsidiary of ILM Senior Living, Inc. ("ILM I") and was transferred to CSLC at the time the merger between ILM I and CSLC was consummated. A gain on the sale of approximately $6,160,000 was recognized in the consolidated statement of income for the year ended August 31, 2000. It is anticipated that this gain will result in a built-in gain tax which would be reduced by available net operating loss carryforwards from the period when the Company's subsidiary was a so-called "C" Corporation (prior to the Company's conversion of its subsidiary to a REIT for the year 1996). On February 8, 2001, the Company received notice from CSLC terminating the merger agreement. CSLC stated in its termination letter that it terminated the merger agreement because of its concerns relating to the Company's claimed election in 1996 to defer built-in gain taxes upon conversion of ILM II Holding from a "C" Corporation to a REIT. As previously reported in the Company's public filings, the Company claimed this election based upon the advice of its outside tax accountants, has operated since 1996 under the belief that such election was validly perfected, and pursued administrative relief with the Internal Revenue Service to ensure the availability of the Company's election to defer such corporate level built-in gain taxes. On May 8, 2001, the Internal Revenue Service notified the Company that it granted the requested administrative relief in this matter and, accordingly, the built-in gain tax has been deferred. -------------------------------------------------------------------------------- PAGE 13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- On November 13, 2000, the Company's Board of Directors voted to extend the Facilities Lease Agreement on a month-to-month basis beyond its original expiration date of December 31, 2000. On November 28, 2000, the Facilities Lease Agreement was extended through the earlier of the date on which the merger of the Company with CSLC was consummated or March 31, 2001, and on a month-to-month basis thereafter if the merger was not consummated by that time. Although there can be no assurance, the Facilities Lease Agreement is expected to continue on a month-to-month basis. 2. Operating Investment Properties Subject to Facilities Lease Agreement At May 31, 2001, through its consolidated subsidiary, the Company owned five Senior Housing Facilities. The name, location and size of the properties are as set forth below:

(1) Rentable units represent the number of apartment units and is a measure commonly used in the real estate industry. Resident capacity equals the number of bedrooms contained within the apartment units and corresponds to measures commonly used in the healthcare industry. Subsequent to the effective date of the Settlement Agreement with AHC, in order to maximize the potential returns to the existing Shareholders while maintaining the Company's qualification as a REIT under the Internal Revenue Code, the Company formed a new corporation, Lease II, for the purpose of operating the Senior Housing Facilities under the terms of a Facilities Lease Agreement dated September 1, 1995 between the Company's consolidated affiliate, ILM II Holding, as owner of the properties and lessor (the "Lessor"), and Lease II as lessee (the "Lessee"). The facilities lease is a "triple-net" lease whereby the Lessee pays all operating expenses, governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM II Holding, as Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. The Facilities Lease Agreement was originally scheduled to expire on December 31, 2000, unless earlier terminated at the election of the -------------------------------------------------------------------------------- PAGE 14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- Lessor in connection with the sale by the Lessor of the Senior Housing Facilities to a non-affiliated third party but on November 13, 2000, was extended beyond its original expiration date on a month-to-month basis. On November 28, 2000, the Facilities Lease Agreement was extended through the earlier of the date on which the merger of the Company with CSLC is consummated or March 31, 2001, and on a month-to-month basis thereafter if the merger is not consummated by that time. Because the merger was terminated prior to March 31, 2001, the Facilities Lease Agreement will continue on a month-to-month basis until the properties are liquidated or December 31, 2001, whichever comes first. During fiscal year 2000, Lease II paid annual base rent for the use of all of the Senior Housing Facilities in the aggregate amount of $3,995,586 per year ($4,035,600 per year in 1999). The reduction in base rent from the previous year was due to the sale of Villa Santa Barbara on August 15, 2000. Beginning September 1, 2000, annual base rent is $3,555,427 (excluding Villa Santa Barbara). Lease II also pays variable rent, on a quarterly basis, for each Senior Housing Facility in an amount equal to 40% of the excess of the aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $11,634,000. Variable rent was $759,000 and $237,000 for the nine- and three-month periods ended May 31, 2001, respectively, compared to $1,081,000 and $363,000 for the nine- and three-month periods ended May 31, 2000, respectively. Lease II has retained Capital to be the property manager of the Senior Housing Facilities and the Company has guaranteed the payment of all fees due to Capital pursuant to a Management Agreement which commenced on July 29, 1996. For the nine- and three-month periods ended May 31, 2001, Capital earned property management fees from Lease II of $558,000 and $149,000, respectively. For the nine- and three-month periods ended May 31, 2000, Capital earned property management fees from Lease II of $738,707 and $213,191, respectively. On September 18, 1997, Lease II entered into an agreement with Capital Senior Development, Inc., an affiliate of Capital, to manage the development process for the potential expansion of several of the Senior Housing Facilities. Capital Senior Development, Inc. will receive a fee equal to 7% of the total development costs of these expansions if they are pursued. The Company will reimburse Lease II for all costs related to these potential expansions including fees to Capital Senior Development, Inc. For the nine- and three-month periods ended May 31, 2001, and 2000, Capital Senior Development, Inc. earned no fees from Lease II for managing pre-construction development activities for potential expansions of the Senior Housing Facilities. -------------------------------------------------------------------------------- PAGE 15 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- 3. Related Party Transactions Jeffry R. Dwyer, Secretary and Director of the Company, is a shareholder of Greenberg Traurig, Counsel to the Company and its affiliates since 1997. For the nine- and three-month periods ended May 31, 2001, Greenberg Traurig earned fees from the Company of $991,000 and $411,000, respectively. For the nine- and three-month periods ended May 31, 2000, Greenberg Traurig earned fees from the Company of $603,000 and $231,000. ACCOUNTS RECEIVABLE--RELATED PARTY at May 31, 2001 and August 31, 2000, includes variable rent due from Lease II. ACCOUNTS PAYABLE--RELATED PARTY at May 31, 2001, includes accrued legal fees due to Greenberg Traurig, Counsel to the Company and its affiliate and a related party, as described above. At August 31, 2000, ACCOUNTS PAYABLE--RELATED PARTY includes $40,000 of expense reimbursements payable to Lease II. 4. Legal Proceedings and Contingencies Feldman Litigation On May 8, 1998 Andrew A. Feldman and Jeri Feldman, as Trustees for the Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990, commenced a purported class action on behalf of that trust and all other shareholders of the Company and ILM I in the Supreme Court of the State of New York, County of New York naming the Company, ILM I and their Directors as defendants. The class action complaint alleged various theories of redress and a broad range of damages. On October 15, 1999, the parties entered into a Stipulation of Settlement that was filed with the Court and approved by order dated October 21, 1999. In issuing that order the Court entered a final judgment dismissing the action and all non-derivative claims of the settlement class against the defendants with prejudice. This litigation was settled at no cost to the Company and ILM I. As part of the settlement, CSLC increased its proposed merger consideration payable to the Company and ILM I shareholders and was also responsible for a total of approximately $1.1 million (approximately 40% of which is allocable to the Company) in plaintiffs' attorneys fees and expenses upon consummation of the proposed merger. If the proposed merger was not consummated and if the Company and ILM I were to consummate an extraordinary transaction with a third party, then the Company and ILM I would be responsible for the plaintiffs' attorneys fees and expenses. On August 15, 2000, the merger of ILM I with CSLC was consummated and on February 28, 2001, CSLC terminated the proposed merger with the Company. Because of these events and based upon the Stipulation of Settlement, if the Company was to consummate an -------------------------------------------------------------------------------- PAGE 16 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- extraordinary transaction with a third party, the Company would be responsible for the Company's share of the plaintiff"s attorney's fees and expenses. Built-in Gain Tax The assumption of ownership of the Senior Housing Facilities through ILM II Holding, which was organized as a so-called "C" corporation for tax purposes, has resulted in a possible future tax liability which would be payable upon the ultimate sale of the Senior Living Facilities (the "built-in gain tax"). The amount of such tax would be calculated based on the lesser of the total net gain realized from the sale transaction or the portion of the net gain realized upon a final sale which is attributable to the period during which the properties were held in a "C" corporation. Any future appreciation in the value of the Senior Housing Facilities subsequent to the conversion of ILM II Holding to a REIT would not be subject to the built-in gain tax. The built-in gain tax would most likely not be incurred if the properties were to be held for a period of at least ten years from the date of the conversion of ILM II Holding to a REIT. However, since the end of the Company's original anticipated holding period as defined in the Articles of Incorporation is December 31, 2001, the properties may not be held for an additional ten years. Based on management's current estimate of the increase in the values of the Senior Housing Facilities which occurred between April 1994 and January 1996, as supported by independent appraisals, a sale of the Senior Housing Facilities within ten years of the date of the conversion of ILM II Holding to a REIT could result in a built-in gain tax of as much as $2.5 million, which could be reduced by approximately $270,000, using available net operating loss carryforwards of ILM II Holding of $780,000 that were incurred prior to its conversion to REIT status. ILM II Holding also has net operating losses that were incurred after its conversion to REIT status of approximately $4.2 million. The sale of the Company's interest in Villa Santa Barbara resulted in the recognition of a built-in gain of approximately $600,000, which was offset by pre-conversion net operating losses. As of August 31, 2000, the potential built-in gain tax relating to the Senior Housing Facilities is as much as $2.3 million, which could be further reduced by approximately $50,000, using the remaining available pre-conversion net operating loss carryforwards of ILM II Holding of approximately $150,000. To avoid this built-in gain tax, the Directors have recommended to the Shareholders an amendment to the Articles of Incorporation to extend the Company's scheduled liquidation date. Based in part upon advice from the Company's outside tax accountants, commencing in 1996, the Company has acted as though it had made an election in its 1996 tax return to allow the Company to avoid a corporate level tax upon conversion of ILM II Holding from a "C" Corporation to a REIT. Because proof of a formal -------------------------------------------------------------------------------- PAGE 17 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -------------------------------------------------------------------------------- election had not then been obtained, the Company pursued administrative relief with the Internal Revenue Service to ensure the availability of the benefits of this election. On May 8, 2001, the Internal Revenue Service notified the Company that it granted the requested administrative relief in this matter and, accordingly, the built-in gain tax has been deferred. 5. Construction Loan Financing During 1999 the Company obtained a construction loan facility with a major bank that provided the Company with up to $8.8 million to fund the capital costs of potential expansion programs. The construction loan facility was collateralized by a first mortgage of the Senior Housing Facilities and collateral assignment of the Company's leases of such properties. The loan was scheduled to expire on December 31, 2000, with possible extensions through September 29, 2003. Principal was due at expiration. Interest was payable monthly at a rate equal to LIBOR plus 1.10% or Prime plus 0.5%. On June 7, 1999, the Company borrowed approximately $1.2 million under the construction loan facility to fund the pre-construction capital costs incurred through April 1999, of the potential expansions of the Senior Housing Facilities. On August 16, 2000, the Company repaid approximately $600,000 of principal on the construction loan facility in connection with the sale of Villa Santa Barbara and the lender sold the remaining loan to CSLC. As part of this transaction, the Company agreed that the term of the loan would not be extended beyond December 31, 2000. On November 28, 2000, the Company and CSLC agreed that the maturity date of the loan would be extended until the date on which the merger of the Company with CSLC was consummated or the date on which the merger agreement was terminated, whichever occurred first. On February 28, 2001, CSLC terminated the proposed merger with the Company, and on April 3, 2001, the remaining principal balance plus accrued interest was repaid in full. Amounts outstanding under the loan at May 31, 2001, and August 31, 2000, were $0 and $570,000, respectively. Loan origination fees of $144,000 were paid in connection with this loan facility and were being amortized over the life of the loan. On April 3, 2001, unamortized loan origination fees totaling $29,867 were amortized to expense with repayment of the loan. Capitalized interest at May 31, 2001, and August 31, 2000, was $107,059 and $79,310, respectively. 6. Subsequent Event In June 2001, the Company's Board of Directors declared a quarterly dividend for the three-month period ended May 31, 2001. On July 16, 2001, a dividend of $0.1622 per share of common stock, totaling approximately $840,000 will be paid to Shareholders of record as of June 30, 2001. -------------------------------------------------------------------------------- PAGE 18 Management's Discussion and Analysis of Financial Condition and Results of Operations -------------------------------------------------------------------------------- General The Company offered shares of its common stock to the public from September 12, 1990 to May 10, 1991 pursuant to a Registration Statement filed under the Securities Act of 1933, as amended. Capital contributions of $51,812,356 were received by the Company (including $200,000 contributed by PaineWebber) and, after deducting selling expenses and offering costs and allowing for adequate cash reserves, approximately $42.9 million was available to be invested in participating first mortgage loans collateralized by Senior Housing Facilities. The Company originally invested the net proceeds of the initial public offering in six participating mortgage loans collateralized by Senior Housing Facilities located in five different states. All of the loans made by the Company were originally with AHC. As previously reported, AHC defaulted on the scheduled mortgage loan payments due to the Company on March 1, 1993. Its parent company, Angeles, subsequently filed for bankruptcy. In fiscal 1994, a Settlement Agreement was executed whereby ownership of the properties was transferred from AHC to certain designated affiliates of the Company which were majority owned by the Company. Subsequently, these affiliates were merged into ILM II Holding, which is majority owned by the Company. ILM II Holding holds title to the five remaining Senior Housing Facilities which comprise the balance of operating investment properties in the accompanying consolidated balance sheets, subject to certain mortgage loans payable to the Company. As part of the fiscal 1994 Settlement Agreement with AHC, ILM II Holding retained AHC as the property manager for all of the Senior Housing Facilities pursuant to the terms of the Agreement. As discussed further below, the Agreement with AHC was terminated in July 1996. Subsequent to the effective date of the Settlement Agreement with AHC, in order to maximize the potential returns to the Company's existing Shareholders while maintaining its qualification as a REIT under the Internal Revenue Code, the Company formed a new corporation, Lease II, for the purpose of operating the Senior Housing Facilities under the terms of a Facilities Lease Agreement. As of August 31, 1995, Lease II, which is taxable as a so-called "C" corporation and not as a REIT, was a wholly owned subsidiary of the Company. On September 1, 1995 the Company, after receiving the required regulatory approval, distributed all of the shares of capital stock of Lease II to the holders of record of the Company's common stock. The Facilities Lease Agreement is between the Company's consolidated affiliate, ILM II Holding, as owner of the Senior Housing Facilities and Lessor, and Lease II as Lessee. The facilities lease is a "triple-net" lease whereby the Lessee pays all operating expenses, -------------------------------------------------------------------------------- PAGE 19 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM II Holding, as the Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. The Facilities Lease Agreement was originally scheduled to expire on December 31, 2000, unless earlier terminated at the election of the Lessor in connection with the sale by the Lessor of the Senior Housing Facilities to a non-affiliated third party but on November 13, 2000, was extended beyond its original expiration date on a month-to-month basis. On November 28, 2000, the Facilities Lease Agreement was extended though the earlier of the date on which the merger of the Company with CSLC was consummated or March 31, 2001, and on a month-to-month basis thereafter if the merger was not consummated by that time. As discussed fully under the "Agreement and Plan of Merger with Capital Senior Living Corporation" below, the merger was terminated by CSLC prior to March 31, 2001, and, although there can be no assurance, the Facilities Lease Agreement is expected to continue on a month-to-month basis. During fiscal year 2000, Lease II paid annual base rent for the use of all the Senior Housing Facilities in the aggregate amount of $3,995,586 per year ($4,035,600 per year in 1999). The reduction in base rent from the previous year is due to the sale of Villa Santa Barbara on August 15, 2000. Beginning on September 1, 2000, annual base rent is $3,555,427 (excluding Villa Santa Barbara). Lease II also paid variable rent, on a quarterly basis, for each Senior Housing Facility in an amount equal to 40% of the excess, if any, of the aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $11,634,000. Variable rental income for the nine- and three-month periods ended May 31, 2001, was $759,000 and $237,000, respectively, compared to $1,081,000 and $363,000 for the nine- and three-month periods ended May 31, 2000, respectively. The Company completed its restructuring plans by qualifying ILM II Holding as a REIT for Federal tax purposes. In connection with these plans, on November 21, 1996, the Company requested that PaineWebber sell all of its stock in ILM II Holding to the Company for a price equal to the fair market value of the 1% economic interest in ILM II Holding represented by the common stock. On January 10, 1997, this transfer of the common stock of ILM II Holding was completed at an agreed upon fair value of $40,000, representing a $35,000 increase in fair value. This increase in fair value is based on the increase in values of the Senior Housing Facilities which occurred between April 1994 and January 1996, as supported by independent appraisals. -------------------------------------------------------------------------------- PAGE 20 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- With this transfer completed, effective January 23, 1997, ILM II Holding recapitalized its common stock and preferred stock by replacing the outstanding shares with 50,000 shares of new common stock and 275 shares of non-voting, 8% cumulative preferred stock issued to the Company. The number of authorized shares of preferred stock and common stock in ILM II Holding were also increased as part of the recapitalization. Following the recapitalization, the Company made charitable gifts of one share of the Preferred Stock in ILM II Holding to each of 111 charitable organizations so that ILM II Holding would meet the stock ownership requirements of a REIT as of January 30, 1997. The Preferred Stock has a liquidation preference of $1,000 per share plus any accrued and unpaid dividends. Dividends on the Preferred Stock accrue at a rate of 8% per annum on the original $1,000 liquidation preference and are cumulative from the date of issuance. It is anticipated that dividends will accrue and be paid at liquidation. Cumulative dividends in arrears as of May 31, 2001, on the Preferred Stock in ILM II Holding totaled approximately $38,000. The assumption of ownership of the Senior Housing Facilities through ILM II Holding, which was organized as a so-called "C" corporation for tax purposes, has resulted in a possible future tax liability which would be payable upon the ultimate sale of the Senior Living Facilities (the "built-in gain tax"). The amount of such tax would be calculated based on the lesser of the total net gain realized from the sale transaction or the portion of the net gain realized upon a final sale which is attributable to the period during which the properties were held in a "C" corporation. Any future appreciation in the value of the Senior Housing Facilities subsequent to the conversion of ILM II Holding to a REIT would not be subject to the built-in gain tax. The built-in gain tax would most likely not be incurred if the properties were to be held for a period of at least ten years from the date of the conversion of ILM II Holding to a REIT. However, since the end of the Company's original anticipated holding period as defined in the Articles of Incorporation is December 31, 2001, the properties may not be held for an additional ten years. Based on management's current estimate of the increase in the values of the Senior Housing Facilities which occurred between April 1994 and January 1996, as supported by independent appraisals, a sale of the Senior Housing Facilities within ten years of the date of the conversion of ILM II Holding to a REIT could result in a built-in gain tax of as much as $2.5 million, which could be reduced by approximately $270,000, using available net operating loss carryforwards of ILM II Holding of $780,000 that were incurred prior to its conversion to REIT status. ILM II Holding also has net operating losses that were incurred after its conversion to REIT status of approximately $4.2 million. The sale of the Company's -------------------------------------------------------------------------------- PAGE 21 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- interest in Villa Santa Barbara resulted in the recognition of a built-in gain of approximately $600,000, which was offset by pre-conversion net operating losses. As of August 31, 2000, the potential built-in gain tax relating to the Senior Housing Facilities is as much as $2.3 million, which could be further reduced by approximately $50,000, using the remaining available pre-conversion net operating loss carryforwards of ILM II Holding of approximately $150,000. To avoid this built-in gain tax, the Directors have recommended to the Shareholders an amendment to the Articles of Incorporation to extend the Company's scheduled liquidation date. Based upon advice from the Company's financial advisors, commencing in 1996, the Company has acted as though it had made an election in its 1996 tax return to allow the Company to avoid a corporate level built-in gain tax upon conversion of ILM II Holding from a "C" Corporation to a REIT. Because proof of a formal election had not then been obtained, the Company pursued administrative relief with the Internal Revenue Service to ensure the availability of the benefits of this election. On May 8, 2001, the Internal Revenue Service notified the Company that it granted the requested administrative relief in this matter and, accordingly, the built-in gain tax has been deferred. Because the ownership of the assets of ILM II Holding was expected to be transferred to the Company or its wholly-owned subsidiary, ILM II Holding was capitalized with funds to provide it with working capital only for a limited period of time. At the present time, ILM II Holding is not expected to have sufficient cash flow during fiscal year 2001 to (i) meet its obligations to make the debt service payments due under the loans, and (ii) pay for capital improvements and structural repairs in accordance with the terms of the Facilities Lease Agreement. Although ILM II Holding is not expected to fully fund its scheduled debt service payments to the Company, the estimated current values of the Senior Housing Facilities are well in excess of the mortgage principal amounts plus accrued interest at May 31, 2001. As a result, the Company is expected to recover the full amount that would be due under the loans upon sale of the Senior Housing Facilities. Terminated Agreement and Plan of Merger with Capital Senior Living Corporation On February 7, 1999, the Company entered into an agreement and plan of merger, which was amended and restated on October 19, 1999, as subsequently amended, with CSLC and certain affiliates of CSLC. On June 22, 2000, holders of more than two-thirds of the outstanding shares of the Company's common stock voted in favor of approval of the proposed Agreement and Plan of Merger. -------------------------------------------------------------------------------- PAGE 22 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- On August 15, 2000, the Company caused ILM II Holding to complete the sale of its 75% co-tenancy interest in its senior living facility located in Santa Barbara, California ("Villa Santa Barbara"), to CSLC for $10,143,750. In consideration for the sale, the Company received $9,543,750 in cash and CSLC contributed $600,000 toward the Company's outstanding construction loan debt and assumed certain then current transaction expenses of the Company in connection with the previously announced proposed merger. The remaining 25% co-tenancy interest in Villa Santa Barbara was formerly owned by ILM Holding, Inc. ("Holding I"), a subsidiary of ILM Senior Living, Inc. ("ILM I") and was transferred to CSLC at the time the merger between ILM I and CSLC was consummated. A gain on the sale of approximately $6,160,000 has been recognized in the accompanying consolidated statement of income for the year ended August 31, 2000. It is anticipated that this gain will result in a built-in gain tax which would be reduced by available net operating loss carryforwards from the period when the Company's subsidiary was a so-called "C" Corporation (prior to the Company's conversion of its subsidiary to a REIT for the year 1996). On February 8, 2001, the Company received notice from CSLC terminating the merger agreement. CSLC stated in its termination letter that it terminated the merger agreement because of its concerns relating to the Company's claimed election in 1996 to defer built-in gain taxes upon conversion of ILM II Holding from a "C" Corporation to a REIT. As previously reported in the Company's public filings, the Company claimed this election based upon the advice of its outside tax accountants; has operated since 1996 under the belief that such election was validly perfected; and pursued administrative relief with the Internal Revenue Service to ensure the availability of the Company's election to defer such corporate level built-in gain taxes. On May 8, 2001, the Internal Revenue Service notified the Company that it granted the requested administrative relief in this matter and, accordingly, the built-in gain tax has been deferred. As noted above, the Facilities Lease Agreement, which was scheduled to expire on December 31, 2000, was extended through the earlier of the date on which the merger of the Company with CSLC was consummated or March 31, 2001, and on a month-to-month basis thereafter if the merger was not consummated by that time. Although there can be no assurance, the Facilities Lease Agreement is expected to continue on a month-to-month basis. Liquidity and Capital Resources Occupancy levels for the five remaining properties in which the Company has invested averaged 85% and 91% for the three months ended May 31, 2001 and 2000, respectively. -------------------------------------------------------------------------------- PAGE 23 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- The Company's net operating cash flow is expected to be relatively stable and predictable due to the structure of the Facilities Lease Agreement. Beginning September 1, 2000, the annual base rental payments owed to ILM II Holding (excluding Villa Santa Barbara) are $3,555,427 and will remain at that level for the remainder of the lease term, including any month-to-month extensions. In addition, the Senior Housing Facilities are currently generating gross revenues which are in excess of the specified threshold in the variable rent calculation, as discussed further above, which became effective in January 1997. The Company had been pursuing the potential for future expansion of several of the Senior Housing Facilities which are located in areas that had particularly strong markets for senior housing to increase cash flow and shareholder value. Potential expansion candidates include the facilities located in Omaha, Nebraska; St. Louis County, Missouri; and Fort Myers, Florida. As part of this expansion program, during fiscal year 1999, approximately one acre of land located adjacent to the Omaha facility was acquired for approximately $135,000. The Fort Myers facility includes a vacant parcel of approximately one and one-half acres which could accommodate an expansion of the existing facility or the construction of a new free-standing facility. Preliminary feasibility evaluations have been completed for all of these potential expansions and pre-construction design and construction-cost evaluations have been completed for expansions of the facilities located in Omaha and Fort Myers. To date, no construction has been started and expansion plans had been temporarily suspended. The Company will carefully evaluate the costs and benefits before proceeding with the construction of any of these expansions. Depending on the extent of any expansions deemed appropriate, such plans would result in the need for substantial capital. During 1999, the Company secured a construction loan facility with a major bank that provided the Company with up to $8.8 million to fund the capital costs of the potential expansion programs. The construction loan facility was secured by a first mortgage of the Senior Housing Facilities and collateral assignment of the Company's leases of such Senior Housing Facilities. The loan was scheduled to expire on December 31, 2000, with possible extensions through September 29, 2003. Principal was due at expiration. Interest was payable at a rate equal to LIBOR plus 1.10% or Prime plus 0.5%. Loan origination costs in connection with this loan facility were being amortized over the life of the loan. On June 7, 1999, the Company borrowed approximately $1.2 million under the construction loan facility to fund the pre-construction capital costs incurred through April 1999, of the potential expansions of the Senior Housing Facilities. On August 16, 2000, the Company -------------------------------------------------------------------------------- PAGE 24 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- repaid approximately $600,000 of principal on the construction loan facility and the lender sold the loan to CSLC. As part of the transaction, the Company agreed that the term of the loan would not be extended beyond December 31, 2000. On November 28, 2000, the Company and CSLC agreed that the maturity date of the loan would be extended until the date on which the merger of the Company with CSLC was consummated or the date on which the merger agreement was terminated, whichever occurred first. On February 8, 2001, CSLC terminated the proposed merger with the Company, and on April 3, 2001, the remaining principal balance plus accrued interest was repaid in full. Amounts outstanding under the loan at May 31, 2001, and August 31, 2000, were $0 and $570,000, respectively. At May 31, 2001, the Company had cash and cash equivalents of $1,395,000 compared to $11,258,000 at August 31, 2000. Remaining cash amounts will be used for the working capital requirements of the Company, along with the possible investment in the properties owned by ILM II Holding for certain capital improvements, and for dividends to the Shareholders. On December 15, 2000, a special distribution of $1.89 per share was paid to Shareholders of record as of November 1, 2000, distributing net proceeds from the sale of the Company's investment in Villa Santa Barbara. On January 15, 2001, the Company paid a quarterly dividend of $0.1622 per share to Shareholders of record as of December 15, 2000, and on April 16, 2001, the Company paid a quarterly dividend of $0.1622 per share to Shareholders of record as of March 30, 2001. Future capital improvements could be financed from operations or through borrowings, depending on the magnitude of the improvements, the availability of financing and the Company's incremental borrowing rate. The source of future liquidity and dividends to the Shareholders is expected to be through facilities lease payments from Lease II, interest income earned on invested cash reserves and proceeds from the future sales of the underlying operating investment properties. Such sources of liquidity are expected to be adequate to meet the Company's operating requirements on both a short-term and long-term basis. The Company generally will be obligated to distribute annually at least 90% of its taxable income to its Shareholders in order to continue to qualify as a REIT under the Internal Revenue Code. While the Company has potential liabilities pending due to ongoing litigation against the Company, the eventual outcome of this litigation cannot presently be determined. The Company will vigorously defend against all claims made against it and, at this time, it is not certain that the Company will have ultimate responsibility for any such claims. -------------------------------------------------------------------------------- PAGE 25 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Market Risk The Company believes its market risk is immaterial. Results of Operations FOR THE NINE MONTHS ENDED MAY 31, 2001 VERSUS THE NINE MONTHS ENDED MAY 31, 2000 Net income decreased $1,307,000 or 72.9% from income of $1,792,000 for the nine-month period ended May 31, 2000 compared to income of $485,000 for the nine-month period ended May 31, 2001. Total revenue was $3,581,000 representing a decrease of $535,000, or 13.0%, compared to the same period of the prior year. Rental income decreased $665,000 or 16.3%, to $3,419,000 for the nine-month period ended May 31, 2001, compared to $4,084,000 for the nine-month period ended May 31, 2001, due to decreased rental income earned pursuant to the terms of the Facilities Lease Agreement and primarily as a result of the sale of Villa Santa Barbara. Total expenses increased $772,000, or 33.2%, to $3,096,000 for the nine-month period ended May 31, 2001, compared to $2,324,000 for the nine-month period ended May 31, 2001. This overall increase in expenses is primarily attributable to a $555,000 or 54.3% increase in professional fees due to increased legal fees associated with the agreement and plan of merger with CSLC (as discussed in Note 1 to the financial statements). The $198,000 or 98.0% increase in general and administrative expenses to $400,000 for the nine-month period ended May 31, 2001, from $202,000 for the same period last year, is due to a variety of factors including increased Director and Officer insurance costs of $155,000 or 153.8%; investor servicing costs of $31,000 or 283.6%; and portfolio communications of $42,000 or 2818.1%. These increases were offset by a $29,000 or 79.7% decrease in postage and mailing costs and minor increases and decreases in other costs. FOR THE THREE MONTHS ENDED MAY 31, 2001, VERSUS THE THREE MONTHS ENDED MAY 31,2000 Net income decreased $414,000 or 74.7% to $140,000 for the third quarter ended May 31, 2001, compared to $554,000 for the third quarter ended May 31, 2000. Total revenue was $1,143,000 representing a decrease of $228,000 or 16.6%, compared to the same period of the prior year. Rental income decreased $238,000 or 17.4%, to $1,126,000 for the quarter ended May 31, 2001, compared to $1,364,000 for the quarter ended May 31, 2000, due to decreased rental income earned subsequent to the sale of Villa Santa Barbara and pursuant to the terms of the Facilities Lease Agreement. Total expenses increased $186,000, or 22.8%, to $1,003,000 for the three-month period ended May 31, 2001, compared to $817,000 for the three-month period ended May 31, 2000. This increase in expenses is primarily attributable to a $128,000 or 35.4% increase in professional fees due to increased use of financial and advisory professionals who were engaged to assist the Company with the agreement and -------------------------------------------------------------------------------- PAGE 26 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- plan of merger with CSLC (as discussed in Note 1 to the financial statements) as well as the sale of Villa Santa Barbara. The $43,000 or 52.4% increase in general and administrative expenses to $125,000 for the three-month period ended May 31, 2001, from $82,000 for the same period last year, is due to a variety of factors including investor servicing costs of $12,000 or 226.3%; and portfolio communications of $42,000 or 4083.1%. These increases in expenses were accompanied by minor increases and decreases in other expenses as well. -------------------------------------------------------------------------------- PAGE 27 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Forward-Looking Information CERTAIN STATEMENTS INCLUDED IN THIS QUARTERLY REPORT ON FORM 10-Q ("QUARTERLY REPORT") CONSTITUTE "FORWARD-LOOKING STATEMENTS" INTENDED TO QUALIFY FOR THE SAFE HARBORS FROM LIABILITY ESTABLISHED BY SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES ACT OF 1934, AS AMENDED (THE "EXCHANGE ACT"). THESE FORWARD-LOOKING STATEMENTS GENERALLY CAN BE IDENTIFIED AS SUCH BECAUSE THE CONTEXT OF THE STATEMENT WILL INCLUDE WORDS SUCH AS "BELIEVES," "COULD," "MAY," "SHOULD," "ENABLE," "LIKELY," "PROSPECTS," "SEEK," "PREDICTS," "POSSIBLE," "FORECASTS," "PROJECTS," "ANTICIPATES," "EXPECTS" AND WORDS OF ANALOGOUS IMPORT AND CORRELATIVE EXPRESSIONS THEREOF, AS WELL AS STATEMENTS PRECEDED OR OTHERWISE QUALIFIED BY: "THERE CAN BE NO ASSURANCE" OR "NO ASSURANCE CAN BE GIVEN." SIMILARLY, STATEMENTS THAT DESCRIBE THE COMPANY'S FUTURE PLANS, OBJECTIVES, STRATEGIES OR GOALS ALSO ARE FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS MAY ADDRESS FUTURE EVENTS AND CONDITIONS CONCERNING, AMONG OTHER THINGS, THE COMPANY'S CASH FLOWS, RESULTS OF OPERATIONS AND FINANCIAL CONDITION; THE CONSUMMATION OF ACQUISITION AND FINANCING TRANSACTIONS AND THE EFFECT THEREOF ON THE COMPANY'S BUSINESS, ANTICIPATED CAPITAL EXPENDITURES, PROPOSED OPERATING BUDGETS AND ACCOUNTING RESERVES; LITIGATION; PROPERTY EXPANSION AND DEVELOPMENT PROGRAMS OR PLANS; REGULATORY MATTERS; AND THE COMPANY'S PLANS, GOALS, STRATEGIES AND OBJECTIVES FOR FUTURE OPERATIONS AND PERFORMANCE. ANY SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN SUCH FORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO A NUMBER OF ASSUMPTIONS REGARDING, AMONG OTHER THINGS, GENERAL ECONOMIC, COMPETITIVE AND MARKET CONDITIONS. SUCH ASSUMPTIONS NECESSARILY ARE BASED ON FACTS AND CONDITIONS AS THEY EXIST AT THE TIME SUCH STATEMENTS ARE MADE, THE PREDICTION OR ASSESSMENT OF WHICH MAY BE DIFFICULT OR IMPOSSIBLE AND, IN ANY CASE, BEYOND THE COMPANY'S CONTROL. FURTHER, THE COMPANY'S BUSINESS IS SUBJECT TO A NUMBER OF RISKS THAT MAY AFFECT ANY SUCH FORWARD-LOOKING STATEMENTS AND ALSO COULD CAUSE ACTUAL RESULTS OF THE COMPANY TO DIFFER MATERIALLY FROM THOSE PROJECTED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. ALL FORWARD-LOOKING STATEMENTS CONTAINED IN THIS QUARTERLY REPORT ARE EXPRESSLY QUALIFIED IN THEIR ENTIRETY BY THE CAUTIONARY STATEMENTS IN THIS PARAGRAPH. MOREOVER, THE COMPANY DOES NOT INTEND TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS TO REFLECT ANY CHANGES IN GENERAL ECONOMIC, COMPETITIVE OR MARKET CONDITIONS AND DEVELOPMENTS BEYOND ITS CONTROL. READERS OF THIS QUARTERLY REPORT ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON ANY OF THE FORWARD-LOOKING STATEMENTS SET FORTH HEREIN AND THAT ACTUAL FUTURE RESULTS MAY DIFFER. -------------------------------------------------------------------------------- PAGE 28 Part II--Other Information -------------------------------------------------------------------------------- Item 1. through 4. NONE Item 5. Other Information The Company's Board of Directors has, on Schedule 14A filed with the Securities and Exchange Commission on July 6, 2001, recommended to the Company's shareholders that the Company's Articles of Incorporation be amended to extend the Company's finite-life existence until December 31, 2008. The Articles of Incorporation currently provide for the automatic termination of the Company's finite-life existence on December 31, 2001. In view of the impending termination deadline and the failure to consummate a merger with Capital Senior Living Corporation, the Company thought it was prudent to conduct a "market check" and authorized management to work expeditiously with the Company's legal and financial advisors to identify prospective purchasers of the Company's capital stock or assets (by means of merger, strategic business combination, tender offer or sale of the Company's senior living properties) and to elicit bona fide offers for transactions to be consummated on or prior to December 31, 2001 which would maximize current shareholder value. After having reviewed expressions of interest received from seven prospective purchasers (of 26 prospective purchasers contacted), the Company pursued what it considered to be the most attractive potential opportunity and highest offer--a major real estate investment fund's interest in acquiring substantially all of the Company's assets for a purchase price of $50.5 million, subject to adjustment for the assumption of pre-closing liabilities. After several meetings and conversations between the purchaser and the Company and after the Company considered its alternatives, it determined that continuation of discussions or negotiations with this potential purchaser was unlikely to result in a transaction which would maximize current shareholder value because the proposed purchase price, after adjustment for the Company's liabilities, transaction costs and taxes, would likely result in a lower net per share consideration payable to the Company's shareholders. Although the Company is no longer actively soliciting proposals from additional prospective purchasers, the Company is continuing to explore with its financial and legal advisors strategic alternatives to maximize current shareholder value (and will duly consider any bona fide offers which are received regarding the acquisition of the Company or its assets) and believes that, although there can be no assurance that such transactions would be entered into or consummated in the near-term, if at all, such transactions are more likely to be identified and accomplished in a stronger industry environment and healthier overall domestic economy. -------------------------------------------------------------------------------- PAGE 29 PART II--OTHER INFORMATION -------------------------------------------------------------------------------- One alternative to a sale transaction being studied, on a preliminary basis, by the Company at this time is a leveraged financing transaction whereby the Company would seek to obtain first mortgage loans secured by all or substantially all of the Company's assets, a portion of the net proceeds from which could be made available to the Company's shareholders in the form of an extraordinary distribution or used to purchase the outstanding Common Stock by means of self-tender offer or otherwise. The Company has engaged in preliminary discussions to date with several prospective lending sources to assess the viability of obtaining this type of mortgage financing and the intended use of net proceeds as described above. There can be no assurance that such a transaction would be entered into or consummated or, if consummated, as to the timing thereof. The Company further believes that extending the Company's finite-life existence could assist in the avoidance of the corporate level built-in gains tax assessment upon a sale of the Company's senior living properties or capital stock. Based upon applicable law, the built-in gains tax would most likely not be assessed if the Company's senior living properties were held for a period of at least 10 years (i.e., until 2006) from the date of conversion of ILM II's subsidiary to a REIT. If the finite-life existence of the Company is not extended and the Company is unable to consummate an extraordinary corporate transaction by December 31, 2001, the Company will be required to liquidate its senior living properties on that date. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: None (b) Reports on Form 8-K: None -------------------------------------------------------------------------------- PAGE 30 ILM II SENIOR LIVING, INC. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BY: ILM II SENIOR LIVING, INC. By: /s/ J. William Sharman, Jr. ------------------------------------- J. William Sharman, Jr. President and Director Dated: JULY 12, 2001 -28-

ILM II SENIOR LIVING INC /VA 10-Q