References in this report to "Alterra" refer to Alterra Healthcare Corporation and references to the "Company," "us" or "we" refer to Alterra and its subsidiaries.

ITEM 1.         BUSINESS

Overview

We are a national assisted living company operating assisted living residences and providing assisted living services in 26 states. Our growth in recent years and recent restructuring activities has had a significant impact on our results of operations and are important factors in explaining the changes in our results between 2001 and 2000. As of December 31, 2001 and 2000, we operated or managed 430 and 474 residences with aggregate capacity of approximately 20,182 and 22,100 residents, respectively. As of December 31, 2001, 47 of our residences were operated in joint venture arrangements with third parties. During 2001, we generated operating revenue of $508.8 million and realized income from operations of $17.9 million and pretax loss of $110.5 million, both prior to loss on disposal of assets.

Our statements in this annual report relating to matters that are not historical facts are forward-looking statements based on our management's belief and assumptions based upon currently available information. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we are unable to provide assurances that our expectations will prove to be correct. Forward-looking statements involve a number of risks and uncertainties including, but not limited to, uncertainty regarding the consequences of our restructuring, risks associated with continuing defaults under loan, lease and subordinated debenture obligations, risks associated with the continuing shortfall in our liquidity and the implementation of our restructuring plan, risks associated with the disposition of assets and termination of leases, substantial debt and operating lease payment obligations and current and pending maturities, risks associated with liability claims and insurance, competition, governmental regulation and other uncertainties outlined in our reports filed with the Securities and Exchange Commission. Should one or more of these risks materialize (or the consequences of one or more of these risks worsen) or should our underlying assumptions prove incorrect, our actual results of operation and our financial position in the future could differ materially from those forecasted or expected. We do not assume any duty to publicly update these forward-looking statements.

Throughout 2000 and 2001 we sought to implement several strategic initiatives designed to strengthen our balance sheet and to enable management to focus on stabilizing and enhancing our core business operations. The principal components of these strategic initiatives included (i) discontinuing our development activity; (ii) a reduction in our utilization of and reliance upon the use of joint venture arrangements; (iii) de-leveraging our balance sheet; and (iv) focusing our activities on improving the Company's cash flow. To implement these strategic initiatives and to address our short and long-term liquidity and capital needs, we completed an equity-linked investment in the Company of $203 million during the second and third quarters of 2000 (the "Equity Transaction"). At the time of the Equity Transaction, we believed that the net proceeds of that transaction, together with other anticipated financing transactions, would provide sufficient cash resources for us to complete our remaining construction activities and to cover operating cash deficits until we achieved positive operating cash flow.

In the second half of 2000, however, two issues emerged that have had a materially adverse impact on our liquidity. First, costs associated with operating our residences, labor and liability insurance costs in particular, increased in the second half of 2000. Second, due both to a generally unfavorable financing market for assisted living residences and the declining credit fundamentals at both the residence and corporate level, we were unable to complete our anticipated financing transactions in 2000 and 2001. These financing transactions were originally projected to yield cash proceeds that would have been used to fund a portion of our overall cash requirements. Virtually all of the net cash proceeds of the Equity Transaction were used to fund our operating cash flow deficits and construction costs for our remaining unopened residences.

By February 2001, our overall cash position had declined to a level which we believed to be insufficient to operate the Company. As we began 2001 our operations produced approximately $7.0 million per month of cash flow before monthly secured debt service and lease payments, and our monthly secured debt service and lease payments totaled approximately $12.0 million. In addition, we faced significant debt maturities in 2001 and 2002.

In February 2001 we retained financial advisors and special reorganization counsel to assist us in evaluating alternatives to restore the financial viability of our business. To conserve cash and protect the financial integrity of our operations, beginning in March 2001, we have elected not to make $10.4 million of scheduled debt service and lease payments, of which $6.6 million remained unpaid as of December 31, 2001. As a result, we continue to be in default under many of our major loan and lease facilities. In March 2001, we obtained a $7.5 million bridge loan to fund current operations from certain principal stock and debenture holders.

We believe that our operating cash flow has improved and will continue to improve due to cost and overhead reductions that we implemented and increases in monthly rents that we charge to our residents which were effective in 2001 and that we are implementing in 2002. Nevertheless, we believe that our operations will not produce sufficient cash flow to satisfy all of our existing obligations. Accordingly, we are seeking to negotiate restructurings of many of our principal secured debt and lease obligations and, upon completing these negotiations, will seek to restructure our principal unsecured debt obligations, comprised primarily of our outstanding convertible debentures. As we seek to complete our restructuring activities, it is our intention to maintain sufficient cash resources such that we can protect our operation by funding our on-going obligations to our employees, suppliers and other trade creditors on a timely basis.

In March of 2001 we began to implement a restructuring plan, the principal objectives of which are:

The principal components of our restructuring plan ("Restructuring Plan") are the disposition of selected assets and the restructuring of our capital structure, including our "senior capital" constituencies comprised principally by our secured indebtedness and leases (operating, capital and synthetic), our "junior capital" constituencies comprised principally by our convertible pay-in-kind (PIK) debentures, our other convertible subordinated debentures and our equity capitalization, and our remaining joint venture relationships. Discussions with various senior capital structure constituencies commenced in the spring of 2001 and are ongoing. While several binding restructuring arrangements have been executed, negotiations with respect to the majority of our secured debt and lease arrangements have not been concluded. Negotiations with junior capital structure constituencies have not commenced, as these negotiations are dependent upon the outcome of our negotiations with senior capital structure constituencies and the fact that, pursuant to the subordination provisions governing our convertible subordinated debentures, we are limited in our ability to restructure the convertible subordinated debentures until we have cured pending defaults related to our secured indebtedness. Given that significant restructuring discussions and negotiations are still to be concluded, we expect that we may be making modifications to the Restructuring Plan to address issues that arise during the course of these negotiations.

Portfolio Rationalization . The Restructuring Plan calls for the disposition of a substantial number of our residences (collectively, the "Disposition Assets") that we have determined to be non-strategic for one of a variety of reasons, including the geographic location of certain of these residences. The disposition of the residences included in the Disposition Assets are expected to be accomplished primarily by actively working with the lenders and lessors to identify new operators and selling assets through an organized sales process.

Beginning in April 2001, we started to market the Disposition Assets. Potential buyers, brokers and lenders were provided various information related to the Disposition Assets and confidentiality agreements have been executed with a number of interested parties. We recognized a pre-tax loss of $189.2 million during 2001 (in addition to the $22.5 million pre-tax loss recognized in 2000) to reflect the Disposition Assets at the lower of carrying value or estimated fair value less costs to sell and to write off the carrying value of assets associated with terminated residence leases. In addition, we are discussing a number of alternatives with our lenders and lessors to address any potential cash shortfalls that may result from the dispositions. A condition to our disposing of the Disposition Assets will be obtaining the consent of the applicable lender or lessor and, in certain cases, the consent of the applicable joint venture partner. As of December 31, 2001, 59 residences representing 2,774 resident capacity have either been sold or transferred to a new lessee. In addition, we sold 10 land parcels. As of December 31, 2001, approximately $150.5 million is reserved for losses relating to future asset sales or lease terminations.

Restructuring of Our Senior Indebtedness and Leases . In addition to active efforts to effect the sale or other disposition of the Disposition Assets, we have commenced discussions with many of our secured lenders and lessors to restructure certain of our debt and lease obligations.

The Company has a complex senior capital structure, comprised of at least 15 significant multi-residence secured credit facilities and five significant portfolios of operating residences that are leased from real estate investment trusts (REITs). Many of our secured credit facilities are structured to incorporate various so-called "bankruptcy-remote" features (i.e., structures designed to improve the applicable lender's rights and leverage in the event of a bankruptcy of the parent company, Alterra), including structuring the credit facility such that the fee owner of the mortgaged residences and the borrower under the credit facility is a newly formed subsidiary of Alterra whose sole activity is to own and operate the residences financed under that credit facility. The structure of certain of these credit facilities serves to limit the Company's ability to restructure these facilities through a bankruptcy, making it generally preferable for the Company to negotiate consensual restructurings with each group of lenders providing secured financing to the Company.

The Company commenced negotiations with its secured lenders and lessors during 2001. Each separate negotiation is unique and is based on the characteristics of the underlying credit facility, including the credit facility's collateral, terms and structure. Accordingly, our restructuring needs and objectives vary from one credit facility to the next. Depending on the particular credit facility, we are attempting to reset maturities, address any deficiencies, reset covenants, obtain waivers of default interest and penalties, and secure consent from the lenders and lessors for sales of residences included in their collateral or lease portfolio.

Secured Lender Negotiations. Management is actively seeking to restructure secured loan facilities that, in management's view, would generate significant deficiency claims (i.e., claims in excess of the value of the applicable mortgage portfolio) in the event the applicable lenders sought to call the loan and foreclose on their collateral. Management believes that four credit facilities representing $314.4 million in aggregate financing (secured by mortgages on 73 residences with a capacity of 4,261 beds) appear to represent significant potential deficiency claims in the range of $110 million to $180 million. In these negotiations, we are seeking to obtain a release of these potential deficiency claims against the Company in exchange for our agreement to cooperate with the applicable lenders to facilitate an orderly transition of ownership (and, in certain cases, management) of the mortgaged residences to the lenders or their designees (through deed-in-lieu of foreclosure transactions or so-called friendly foreclosures). In transitioning ownership of the mortgaged residences to the lenders, we are offering to provide interim or long-term management services to the lenders with respect to the mortgaged residences. As of March 2002, we have executed one definitive agreement of this type with one lender group with regard to a credit facility representing $50.5 million of financing secured by 14 residences with an aggregate capacity of 618 beds and are in active negotiations with the lenders of the other three "impaired" credit facilities.

In addition to these impaired credit facilities, we are also seeking to negotiate amendments and modifications with the applicable lenders with respect to our other principal secured credit facilities in order to, depending on the specific case, reset covenants, obtain consent to sell certain mortgaged residences, secure waivers of prior defaults and, in certain cases, to extend scheduled maturities. These credit facilities represent $434.9 million of financing secured by an aggregate of 146 residences with a capacity of 6,483 beds. Discussions with certain (but not all) of these lenders have commenced, but none have yet resulted in definitive binding restructuring agreements.

REIT Lessor Negotiations . We currently have five multi-residence portfolios leased from various REITs. These portfolios include an aggregate of 204 residences with a capacity of 8,928 beds. During 2001 we completed the restructuring of two of our leased portfolios (aggregate of 53 residences with 2,064 beds). These restructurings included the amendment of certain lease covenants and terms and, in one lease facility, the conversion of 42 individual leases into a single master lease. The cash rent due under one lease facility was modified through the application of various deposits held by the landlord to satisfy a portion of the cash rent obligation in the early years of the restructured master lease.

Restructuring negotiations are currently underway with the other three REIT lessors. In these restructuring negotiations, we are seeking to extend lease terms, revise covenants as necessary, secure approval for asset sales, and obtain additional funding for capital expenditures. In consideration for these modifications, the applicable REIT lessors are generally requesting that we convert individual leases into multi-residence master leases.

Restructuring of Junior Capital Structure . As of December 31, 2001, the Company's junior capital structure is comprised of approximately $395.2 million of unsecured debt and equity capitalization comprised of $5.5 million aggregate principal amount of 9.75% Series A Cumulative Convertible Preferred Stock due May 30, 2007 (the "Series A Stock") and 22.2 million shares of Common Stock. The principal components of the Company's unsecured indebtedness as of December 31, 2001 (amounts exclude accrued but unpaid interest) include:

The outstanding 5.25% Debentures, 7.00% Debentures and 6.75% Debentures (collectively, the "Original Debentures") are subordinated to all other "senior indebtedness" of the Company (as defined in the applicable indenture governing such debentures), and the PIK Debentures are subordinated to all "senior indebtedness" of the Company (as defined in the applicable indentures governing such debentures), other than the Original Debentures. Although defined somewhat differently in the several indentures governing the Original Debentures and the PIK Debentures (collectively, the "Subordinated Debentures"), "senior indebtedness" is defined to generally include indebtedness for borrowed money and other similar obligations of Alterra (other than the other series of Original Debentures).

All of our Subordinated Debentures are currently in default due to our failure to make coupon payments on the Original Debentures and due to cross default provisions triggered by payment defaults on our secured debt.

As a result of several notices of default received by the Company with respect to secured indebtedness that by its terms may be accelerated by the applicable lenders, neither we nor the applicable indenture trustees for the Subordinated Debentures are permitted by the subordination provisions of the indentures governing the respective Subordinated Debentures to make any payment or distribution on account of the Subordinated Debentures (other than the payment of PIK coupons on the PIK Debentures). As a result, we did not make cash interest payments on the Original Debentures in July 2001 and January 2002 of $5.5 million and $5.8 million, respectively. In the event that the Company is dissolved, liquidated or reorganized, all amounts due in payment of the Company's "senior indebtedness" must be paid or provided for before any payment may be made on account of the Subordinated Debentures. Accordingly, unless and until we are able to restructure our "senior indebtedness" obligations (including, without limitation, our several secured credit facilities) and resolve all pending defaults related to this indebtedness, we will not be permitted to make any interest or other payments to the holders of the Subordinated Debentures (other than the payment of PIK coupons on the PIK Debentures) or to restructure the Subordinated Debentures.

To the extent that the Company is not able to restructure its capital structure and is forced to liquidate, applicable principals of corporate law (specifically, the liquidation priority of debt over equity and the priority of preferred stock over common stock) and the subordination provisions governing the Subordinated Debentures would dictate that:

• All of our obligations relating to our secured and unsecured loans, including the Unsecured Notes and any deficiency claims relating to our secured loan facilities, would be required to be paid in full before any liquidation proceeds are distributed to the holders of our Subordinated Debentures;


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• All obligations relating to the PIK Debentures would be required to be paid in full before any liquidation proceeds are distributed to the holders of our Original Debentures;
• All obligations relating to the Original Debentures, as well as all other indebtedness of the Company, would be required to be paid in full before any liquidation proceeds are distributed to the holders of our Series A Stock and Common Stock; and
• All liquidation preferences related to our outstanding Series A Stock (approximately $5.7 million as of December 31, 2001) would be required to be paid in full before any liquidation proceeds are distributed to the holders of our Common Stock.

In seeking to restructure our junior capital structure, the relative rights in liquidation of our various junior capital constituencies will be a significant factor in determining the extent to which the claims and interests of these various constituencies will need to be modified or exchanged as the Company is restructured.

In light of the subordination provisions governing the Subordinated Debentures, we are currently prohibited from restructuring the Subordinated Debentures, the largest component of our junior capital structure. If we are able to successfully complete the restructuring of our secured credit facilities, we anticipate that we will seek to exchange an equity or equity-linked security of the Company for all or a portion of the outstanding Subordinated Debentures. The extent to which all of the Subordinated Debentures will be permitted to participate in this exchange offer, and the value and rights associated with this new equity or equity-linked security to be offered to the holders of the PIK Debentures and Original Debentures, respectively, will be contingent upon the value of the restructured Alterra and will be impacted by the subordination provision operative with respect to the various series of Subordinated Debentures.

We may seek to effect a restructuring of certain of the Subordinated Debentures by an exchange offer to the holders of such debentures. However, to successfully restructure the Subordinated Debentures we will need the consent of substantially all of the holders of these debentures to the terms of our exchange offer. In the alternative, the Company may seek to restructure certain components of its junior capital structure (most likely the Subordinated Debentures and the Company's equity capitalization) by reorganizing the Company pursuant to a filing of a largely pre-arranged restructuring plan under Chapter 11 of the United States Bankruptcy Code ("Chapter 11"). In a case commenced under Chapter 11, the Company can successfully restructure without the need of obtaining the active consent of substantially all of the holders of the Subordinated Debentures because Chapter 11 provides specific voting requirements and other mechanisms for completing a restructuring under court supervision.

Given the uncertainty as to the outcome of our many ongoing restructuring negotiations with senior capital structure constituencies, and given the impact of operative subordination provisions and corporate law doctrines governing the relative rights of holders of debt and equity interests in the Company, it is very difficult for us to predict what value, if any, various junior capital structure constituencies will receive in the restructured Alterra. While it is management's intention, to the extent practicable, to seek to restore value to our junior capital structure, no assurances may be given as to what value, if any, various junior capital structure constituencies will have in the restructured Company. See "Business - Factors Affecting Future Results and Regarding Forward Looking Statements - Uncertainty Regarding Consequences of Restructuring."

Joint Venture Arrangements . The Restructuring Plan calls for us to seek to acquire joint venture interests in certain of our residences in order to simplify our capital structure. In many cases, our acquisition of these joint venture interests (or termination of the applicable joint venture's interest in our residences) is necessary for us to satisfy restructuring requirements established by our senior lenders and lessors.

During 2001 we negotiated a series of agreements that resulted in the discontinuation of joint venture arrangements with respect to 42 residences. Specifically, in October 2001, we negotiated the buyout by the Company of joint venture partner interests in 15 residences in connection with a modification and settlement agreement with one investor group. Pursuant to this agreement, we issued $500,000 of promissory notes and modified certain terms of the joint venture arrangement relating to the remaining ten joint venture residences. In December 2001, we also terminated our joint venture with Pioneer Development Company by exchanging ownership interests in 12 joint venture entities jointly owned with this group, resulting in the Company and Pioneer each acquiring sole ownership in six of these residences. Also in December 2001, we terminated our joint venture with Manor Care, Inc. relating to 13 residences in connection with consummating a global settlement of various pending litigations and arbitration proceedings between the Company and Manor Care and its affiliates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."

We are engaged in buy-out negotiations with investor groups who currently have joint venture interests in 47 residences in the aggregate. No assurance may be given as to whether these negotiations will result in an agreement as to the Company acquiring 100% of these joint venture entities. If these negotiations fail, the Company's ability to restructure certain of its senior capital financing facilities may be adversely affected. If lenders or lessors providing financing to the Company with respect to residences operated by joint ventures seek to foreclose on their mortgages or to terminate their leases, and as a result joint venture entities have their right to operate such residences impaired, Alterra may be forced to defend damage claims asserted by certain of its joint venture partners.

Efforts to Secure New Equity. As we continue to restructure the Company, we may find it necessary to seek new equity investment in the Company to be funded upon completion of the restructuring in order to achieve financial stability, fund certain deferred expenditures and fund certain non-recurring costs of the restructuring. This investment would likely be contingent on a successful restructuring of the Company and, accordingly, would not be funded until negotiations, settlements and restructurings with our lenders, lessors, Subordinated Debenture and equity holders and joint venture partners have concluded. Any additional equity investment in the Company, if it can be arranged, may significantly dilute the equity interests of all parties holding (or receiving in the restructuring) equity or equity-linked securities in the restructured Alterra.

We offer a full range of assisted living services based upon individual resident needs. Prior to admission, residents are assessed by our staff to determine the appropriate level of personal care and service required. Subsequently, individual service agreements are developed by residence staff in conjunction with the residents, their families and their physicians. These plans are periodically reviewed, typically at six-month intervals, or when a change in medical or cognitive status occurs.

Frail-Elderly Services . We offer residents 24-hour assistance with activities of daily living ("ADLs"), ongoing health assessments, organized social activities, three meals a day plus snacks, housekeeping and personal laundry services. All residents are assessed at admission to determine the level of personal care and service required and placed in a care level ranging from basic care to different levels of advanced personal care. In addition, in some locations we offer our residents exercise programs and programs designed to address issues associated with early stages of Alzheimer's and other forms of dementia as more fully described below.

Personal care and supportive services are offered in different residence models which incorporate our philosophy of preserving residents' privacy, encouraging choice and fostering independence in a home-like setting.

Alzheimer's Dementia Services . We believe we are one of the leading providers of care to residents with cognitive impairments, including Alzheimer's and other dementias, in our free-standing Clare Bridge and Clare Bridge Cottage residences. Our programs provide the attention, personal care and services needed to help cognitively impaired residents maintain a higher quality of life. Specialized services include assistance with ADLs, behavior management and an activities program, the goal of which is to provide a normalized environment that supports residents' remaining functional abilities. Whenever possible, residents participate in all facets of daily life at the residence, such as assisting with meals, laundry and housekeeping.

Our specially designed, free-standing dementia residence models serve the programmatic needs of individuals with Alzheimer's disease and other dementias. Our dementia model residents typically require higher levels of personal care and services as a result of their progressive decline in cognitive abilities, including impaired memory, thinking and behavior. These residents require increased supervision because they are typically highly confused, wander prone and incontinent.

Access to Specialized Medical Services . In addition to our care and supportive services, we assist our residents with the coordination of access to medical services from third parties, including home health care, rehabilitation therapy, pharmacy services and hospice care. These providers are often reimbursed directly by the resident or a third party payor, such as Medicare. In the future, we may elect to provide these services directly using our own employees or through contracts or joint venture agreements with other providers.

Historically, we formed strategic alliances and joint ventures with established real estate development and financial partners. These alliances and joint ventures enabled us to develop and construct additional residences while reducing our investment and the associated risk. Although we discontinued developing and financing new residences utilizing joint venture and other off-balance sheet ownership structures beginning in 2000, we continue to have 47 residences that were operated in these types of arrangements as of December 31, 2001.

During 2001 we negotiated a series of agreements that resulted in the discontinuation of joint venture arrangements with respect to 42 residences. Specifically, in October 2001, we negotiated the buyout by the Company of joint venture partner interests in 15 residences in connection with a modification and settlement agreement with one investor group. In December 2001, we also terminated our joint venture with Pioneer Development Company by exchanging ownership interests in 12 joint venture entities jointly owned with this group, resulting in the Company and Pioneer each acquiring sole ownership in six of these residences. Also in December 2001, we terminated our joint venture with Manor Care, Inc. relating to 13 residences in connection with consummating a global settlement of various pending litigation and arbitration proceedings between the Company and Manor Care and its affiliates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."

We continue to be a party to various other joint venture arrangements established between 1995 and 1999, pursuant to which we and other third party partners jointly developed, constructed and are operating Alterra-branded assisted living residences. Generally, the Company and our joint venture partner formed and capitalized a limited partnership or a limited liability company that either acquired a fee interest or a leasehold interest in an assisted living residence under development by us. Our percentage equity interests in these joint venture entities varies from joint venture to joint venture, ranging from 9.8% minority interests to 60.0% majority interests. These joint venture entities typically retain us as manager pursuant to a market rate management agreement. Under certain of these arrangements, we have agreed to fund during a three-year period, the operating deficit requirements of the applicable joint venture once the available equity and debt financing is fully utilized. Pursuant to the operative agreements, we have the right to acquire (call option) the joint venture partner's equity interest in the joint venture entity at a price based upon an agreed upon return on investment or fair market value to the joint venture partner. Similarly, after a specified waiting period, the joint venture partner has the right to require us to purchase (put option) the partner's equity interest in the joint venture entity at a price based upon the appraised fair market value of the residence operated by the joint venture entity. In certain circumstances, the purchase price payable upon an exercise of the put option is based upon a fair market value determination based on an assumption that the applicable residence has achieved and is maintaining stabilized occupancy. Any losses from the operation of residences owned or leased by these joint venture structures are generally allocated on a basis consistent with the respective partner's interest in overall cash distributions and the economic substance of the joint venture arrangement, which may result in losses being disproportionately allocated to the joint venture partners to the extent of their invested capital. We intend to seek to negotiate with the applicable joint venture partners a conclusion of these remaining arrangements as a part of the Restructuring Plan.

Healthcare is an area of extensive and frequent regulatory change. The assisted living industry is relatively new and, accordingly, the manner and extent to which it is regulated at the federal and state levels is evolving.

Our assisted living residences are subject to regulation and licensing by state and local health and social service agencies and other regulatory authorities. In some states in which we operate, the term "assisted living" may have a statutory definition limited to a particular type of program or population. Some of our assisted living residences may fall into other licensing categories or may be independent apartments where services are provided by a licensed home healthcare agency. Although regulatory requirements vary from state to state, these requirements generally address, among other things: personnel education, training and records; staffing levels; facility services, including administration and assistance with self-administration of medication, and limited nursing services; physical residence specification; furnishing of residence units; food and housekeeping services; emergency evacuation plans; and residence rights and responsibilities. New Jersey and Kentucky also require each assisted living residence to obtain a Certificate of Need ("CON") prior to its opening. Our residences are also subject to various state or local building codes and other ordinances, including safety codes. We anticipate that the states which are establishing regulatory frameworks for assisted living residences will require licensing of assisted living residences and will establish varying requirements with respect to this licensing.

We have obtained all required licenses for each of our residences. Each of our licenses must be renewed annually or biannually.

Like other healthcare facilities, assisted living residences are subject to periodic survey or inspection by governmental authorities. From time to time in the ordinary course of business, government agencies issue deficiency reports and impose remedial action. We review these reports and remedial actions and seek to take appropriate corrective action. Although most inspection deficiencies are resolved through a plan of correction, the reviewing agency typically is authorized to take action against a licensed facility where deficiencies are noted in the inspection process. Action may include imposition of fines, imposition of a provisional or conditional license, or suspension or revocation of a license or other sanctions. Any failure by us to comply with applicable requirements could have a material adverse effect on our business, financial condition and results of operations.

We are currently a defendant in a criminal negligence action involving one of our residents. It is possible that if convicted of a crime, the Company's ability to obtain and renew certain of our licenses and to participate in certain government payor programs could be materially and adversely affected.

Federal and state anti-remuneration laws, such as the Medicare/Medicaid anti-kickback law, govern some financial arrangements among healthcare providers and others who may be in a position to refer or recommend patients to providers. These laws prohibit, among other things, direct and indirect payments that are intended to induce the referral of patients to, the arranging for services by, or the recommending of, a particular provider of healthcare items or services. The Medicare/Medicaid anti-kickback law has been broadly interpreted to apply to contractual relationships between healthcare providers and sources of patient referral. State anti-remuneration laws vary from state to state. Violation of these laws can result in loss of licensure, civil and criminal penalties, and exclusion of healthcare providers or suppliers from participation in (i.e., furnishing covered items or services to beneficiaries) the Medicare and Medicaid programs. Although we receive only a minor portion of our total revenues from Medicaid waiver programs and are otherwise not a Medicare or Medicaid provider or supplier, we may be subject to these laws because (i) applicable state laws typically apply regardless of whether Medicare or Medicaid payments are at issue and, in certain cases, (ii) some of our assisted living residences maintain contracts with healthcare providers and practitioners, including pharmacies, home health organizations and hospices, through which the healthcare providers make their healthcare products or services (some of which may be covered by Medicare or Medicaid) available to our residents. There can be no assurance that these laws will be interpreted in a manner consistent with our practices.

In order to comply with the terms of the revenue bonds used to finance nine of our residences, we are required to lease a minimum of 20% of the apartments in each of the nine residences to low or moderate income persons as defined pursuant to the Internal Revenue Code of 1986, as amended.

We are subject to the Fair Labor Standards Act which governs matters including minimum wage, overtime and other working conditions. A portion of our personnel is paid at rates related to the federal minimum wage and, accordingly, increases in the minimum wage will result in an increase in our labor costs.

We are not aware of any non-compliance by the Company with applicable regulatory requirements that would have a material adverse effect on our financial condition or results of operations.

The long-term care industry is highly competitive and, given the relatively low barriers to entry and continuing healthcare costs containment pressures, we expect that the assisted living segment of the industry will become increasingly competitive in the future. We compete with other providers of elderly residential care on the basis of the breadth and quality of our services, the quality of our residences and, with respect to private pay patients or residents, price. We also compete with other providers of long-term care in the acquisition and development of additional residences. Our current and potential competitors include national, regional and local operators of long-term care residences, extended care centers, assisted/independent living centers, retirement communities, home health agencies and similar providers, many of which have significantly greater financial and other resources than we have. In addition, we compete with a number of tax-exempt nonprofit organizations which can finance capital expenditures on a tax-exempt basis or receive charitable contributions unavailable to us and which are generally exempt from income tax. While our competitive position varies from market to market, we believe that we compete favorably in substantially all of the markets in which we operate based on key competitive factors such as the breadth and quality of services offered, residence quality, recruitment and retention of qualified healthcare personnel, and reputation among local referral sources.

Sterling House®, Crossings®, WovenHearts®, Wynwood®, Clare Bridge®, and Clare Bridge Cottage® are registered service marks of ours and we claim service mark protection in the marks Alternative Living Services ^SM , Clare Bridge ^SM and Alterra ^SM .

At December 31, 2001, we employed approximately 7,900 full-time employees and 3,400 part-time employees. None of our employees are represented by a collective bargaining group.

Our business, results of operations and financial condition are subject to many risks, including those set forth below. Through its Restructuring Plan, the Company is seeking to materially restructure many of its principal senior and junior credit instruments, the result of which restructurings are expected to have a material impact on the value attributable to and the rights of the holders of the Company's equity and equity-linked securities, including the Common Stock and the several series of outstanding Subordinated Debentures. In addition, the following important factors, among others, could cause our actual results to differ materially from those expressed in our forward-looking statements in this report and presented elsewhere by us from time to time. When used in this report, the words "believes," "anticipates" and similar expressions are intended to identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events. The following discussion highlights some of these risks and others are discussed in other sections of this Form 10-K or in other documents filed by us with the Securities and Exchange Commission.

Uncertainty Regarding Consequences of Restructuring . While it is management's intention, to the extent practicable, to seek to restore value to the various constituencies comprising our junior capital structure, in light of uncertainty as to the outcome of restructuring negotiations with our secured lenders and lessors and the impact of subordination provisions governing our Subordinated Debentures and corporate law doctrines relating to the relative rights of holders of debt and equity interests in the Company, no assurances may be given as to the value, if any, various junior capital structure constituencies will have in the restructured Company. Similarly, as our Restructuring Plan is largely dependent upon our ability to negotiate consensual restructuring arrangements with our principal lenders and lessors, no assurances may be given as to whether we will be able to restructure the Company and, if not, the extent to which various capital structure constituencies, including the holders of our Subordinated Debentures and our Common Stock, will be entitled to a distribution of any value in consideration of their interest in the Company.

Risks Associated with Continuing Defaults under Loan, Lease and Subordinated Debenture Obligations. We did not make loan and lease payments to many of our secured lenders and lessors during 2001 and are now in default with respect to these obligations. Any payment default or other default with respect to outstanding obligations could cause the lender to foreclose upon the residences securing the indebtedness or, in the case of a lease, to terminate the lease, with a consequent loss of income and asset value to us. Management believes that, despite the pendency of these defaults, during the near term the majority of these secured lenders and lessors will continue to participate in restructuring discussions with us. No assurances may be given, however, that this will be the case. In fact, one of our lessors has terminated our leases for 11 residences and other lenders and lessors have begun to exercise various remedies. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." As many of our principal credit, lease and other financing facilities are cross-defaulted to a material default occurring under other credit, lease or financing facilities, our continuing payment defaults under certain of our credit facilities has resulted in our being in default under many other loan and lease facilities. A component of our Restructuring Plan is seeking to secure waivers of these cross-defaults from the applicable lenders and lessors.

In addition, the Company's convertible debentures include subordination provisions that prohibit payments to the debenture holders (other than payment-in-kind coupon payments) after the occurrence of a payment default on the Company's senior indebtedness. As such, the Company is currently prohibited from making interest and principal payments related to its Subordinated Debentures until such time that no payment-related defaults exist related to its senior indebtedness. As a result of failing to make these payments due to the governing subordination provisions, the Company is in default of its outstanding Subordinated Debentures.

Risks Associated with Continuing Shortfall in Liquidity and Implementation of Restructuring Plan. As a result of on-going operating losses and significant current or upcoming debt maturities, we expect that our projected cash needs during 2002 will exceed our projected identified cash resources. In light of our current financial condition and ongoing restructuring activities and the difficult financing and operating environment for healthcare service companies generally, our access to additional capital is significantly reduced. If we are unable to successfully implement our Restructuring Plan we will not have sufficient liquidity to make our scheduled debt and lease payments and will not be in a position to continue to operate as a going concern. See "Substantial Debt and Operating Lease Payment Obligations; Current and Pending Maturities," and "Management's Discussion and Analysis and Results of Operations -- Liquidity and Capital Resources."

Risks Associated with the Disposition of Assets and Termination of Leases. A key component of our Restructuring Plan relates to the disposition of a number of residences that are owned or leased by the Company. This disposition strategy involves a number of risks and uncertainties. Availability of financing for assisted living properties is currently limited due to substantial reductions in lending activity by traditional financing sources including commercial banks, other secured lenders and REITs. As such, potential purchasers of Company residences may be limited in their ability to obtain necessary financing which may affect both the price at which Company assets may be sold and the ability of potential purchasers to execute transactions. In addition, the residences that the Company intends to sell or otherwise dispose of generally are in lease-up or have historically operated at a loss. Both the availability of financing and number of potential purchasers tend to be more limited for residences that have historically operated at a loss. In addition, many operating companies within the assisted living sector have encountered financial and operating difficulties similar to those experienced by the Company. This may limit the universe of potential purchasers as those other assisted living companies may be financially or operationally incapable of effecting acquisition transactions or may be attempting to sell or otherwise dispose of assets from their own portfolios. Finally, with respect to a number of residences included in our Disposition Assets, we are not free to sell or dispose of the residence without the consent of the applicable lender or lessor and, in certain cases, the consent of our joint venture partners.

Substantial Debt and Operating Lease Payment Obligations; Current and Pending Maturities. We had lease expense of $69.4 million and $82.4 million for the years ended December 31, 2001 and 2000, respectively. Our total indebtedness as of December 31, 2001 was $1.2 billion, and our net interest expense was $77.9 million and $62.6 million for the years ended December 31, 2001 and 2000, respectively. Approximately $1.1 billion of our total indebtedness matures before December 31, 2002, or is in default as of December 31, 2001.

Historically, we have not had sufficient earnings to cover fixed charges. Earnings were insufficient to cover fixed charges by $94.0 million and $71.7 million in 2001 and 2000, respectively, prior to non-recurring charges, the loss on disposal and other one-time adjustments. Even if we are able to substantially restructure our credit and lease obligations, given the significant leverage employed in financing our operations there can be no assurance that we will generate sufficient cash flow to meet our future obligations.

Joint Ventures and Related Mandatory Purchase Obligations. As of December 31, 2001, 47 of our operating residences were jointly owned or operated with venture partners. While we typically receive a fee for managing residences developed through joint ventures, we share with our joint venture partners any profits or losses realized from the operation or sale of these residences and, in certain cases, have agreed to fund operating deficits arising after all available equity and debt financing is utilized. We are obligated under our joint venture arrangements to purchase the equity interests of our joint venture partners upon the election of the joint venture partners at a price based on the appraised value of the residence operated by the applicable joint venture. As a result of these provisions, we might become obligated to acquire additional interests in residences developed through joint ventures on terms or at times that would otherwise not be acceptable to us, including times during which we may not have adequate liquidity to fund acquisitions. In addition, we are currently seeking to negotiate the buy-out of joint venture interests held by third parties in the majority of our remaining joint venture residences. If we are not able to negotiate the buy-out of these joint venture interests, our ability to restructure certain of our secured debt and lease facilities may be adversely affected. To the extent that loan and lease arrangements financing joint venture residences are not restructured, the exercise of foreclosure, lease termination and other remedies by lenders and lessors will result in the forfeiture of such joint ventures' investment in our residences. In these circumstances, we believe it may be possible that the Company may be forced to defend damage claims asserted by certain of its joint venture partners.

Liability and Insurance. The provision of personal and healthcare services entails an inherent risk of liability. In recent years, participants in the long-term care industry have become subject to an increasing number of lawsuits alleging malpractice or related legal theories, including criminal prosecutions, many of which involved large claims and resulted in the incurrence of significant defense costs. In addition, compared to more institutional long-term care facilities, assisted living residences (especially dementia care residences) of the type we operate offer residents a greater degree of independence in their daily lives. This increased level of independence, however, may subject the resident and us to risks that would be reduced in more institutionalized settings. We currently maintain liability insurance intended to cover these claims in an amount that our current financial circumstance permits. There can be no assurance that claims in excess of this insurance or claims not covered by insurance, such as claims for punitive damages, will not be successfully asserted. A successful claim against us not covered by, or in excess of, our insurance could have a material adverse effect upon our financial condition and results of operations. Claims against us, regardless of their merit or eventual outcome, including pending criminal proceedings against the Company, may also have a material adverse effect upon our ability to attract or retain residents, to retain applicable licenses, or to expand our business, and may require us to devote substantial time to matters unrelated to day-to-day operations. In addition, insurance policies must be renewed annually. There can be no assurance that we will be able to obtain liability insurance in the future or that, if insurance is available, it will be available on acceptable economic terms or with coverages we or our lenders and lessors require, in light of our current financial circumstance.

Risk of Possible American Stock Exchange Delisting . Our Common Stock currently is listed on the American Stock Exchange ("AMEX") under the symbol "ALI." Our 5.25% Debentures currently are listed on AMEX under the symbol "ALI5L02." AMEX has notified us that we have fallen below certain of AMEX's continued listing guidelines and that it is reviewing our listing eligibility. In particular, we have incurred losses from continued operations for three of the past four fiscal years, have a stockholders' equity of less than $4.0 million and the price per share of our Common Stock as quoted on AMEX recently has been below the minimum bid price of $1.00 per share. We have provided AMEX with additional information and have been involved in ongoing discussions with AMEX in connection with its review of our listing eligibility. While AMEX has decided not to delist us at this time, they will continue to review our listing status.

If AMEX were to delist our securities, it is possible that the securities would continue to trade on the over-the-counter market. However, the extent of the public market for the securities and the availability of quotations would depend upon such factors as the aggregate market value of each class of securities, the interest in maintaining a market in such securities on the part of securities firms and other factors. There can be no assurance that any public market for our securities will exist in the event that our securities are delisted. In addition, if we fail to maintain the trading status of our Common Stock on a national trading exchange or system, the interest rate on the PIK Debentures will increase from 9.75% to 12.25% and the dividend accrual rate on our Series A Stock will increase from 9.75% to 12.25%.

Residence Management, Staffing and Labor Costs. We compete with other providers of assisted living services and long-term care with respect to attracting and retaining personnel. We are dependent upon our ability to attract and retain management personnel responsible for the day-to-day operations of each of our residences. Any inability of ours to attract or retain qualified residence management personnel could have a material adverse effect on our financial condition or results of operations. In addition, a possible shortage of nurses or trained personnel may require us to enhance our wage and benefits package in order to compete in the hiring and retention of personnel. We are also dependent upon the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. There can be no assurance that our labor costs will not increase, or that, if they do increase, they can be matched by corresponding increases in rates charged to residents. Any significant failure by us to attract and retain qualified management and staff personnel, to control our labor costs, or to pass on any increased labor costs to residents through rate increases would have a material adverse effect on our business, operating results and financial condition. In the event that the Company determines that it must seek to accomplish its Restructuring Plan through a court-supervised reorganization, we expect that the foregoing labor-related risks may be enhanced.

Competition. The long-term care industry is highly competitive and, given the relatively low barriers to entry and continuing healthcare cost containment pressures, we expect that the assisted living segment will become increasingly competitive in the future. We compete with other companies providing assisted living services as well as numerous other companies providing similar service and care alternatives, such as home health care agencies, congregate care facilities, retirement communities and skilled nursing facilities. As assisted living residences receive increased market awareness and the number of states which include assisted living services in their Medicaid programs increases, competition will increase from new market entrants, many of whom may have substantially greater financial resources than we have. There can be no assurance that increased competition will not adversely affect our ability to attract or retain residents or maintain our existing rate structures. Some of our present and potential competitors have, or may have access to, greater financial resources than those available to us. Consequently, there can be no assurance that we will not encounter increased competition in the future which could limit our ability to attract and retain residents, to maintain or increase resident service fees or to expand our business and could have a material adverse effect on our business, operating results and financial condition. We are not able to accurately predict the effect that the healthcare industry trend towards managed care will have on the assisted living marketplace. Managed care, an arrangement whereby service and care providers agree to sell specifically defined services to one or more public or private payors (frequently not the end user or resident) subject to a predefined system in an effort to achieve more efficiency with respect to utilization and cost, is not currently a significant factor in the assisted living marketplace. However, managed care plans sponsored by insurance companies or HMOs may in the future be a factor in the assisted living marketplace. There can be no assurance that we will not encounter increased competition or be subject to other competitive pressures that could affect our business, operating results or financial condition as a result of managed care. In the event that the Company determines that it must seek to accomplish its Restructuring Plan through a court-supervised reorganization, we expect that the foregoing competitive risks could pose an even greater challenge for the Company.

Government Regulation. Healthcare is an area of extensive and frequent regulatory change. The assisted living industry is relatively new, and, accordingly, the manner and extent to which it is regulated at the federal and state levels is evolving. Changes in the laws or new interpretations of existing laws may have a significant impact on our methods and costs of doing business. We are, and will continue to be, subject to varying degrees of regulation and licensing by health or social service agencies and other regulatory authorities in the various states and localities where we operate or intend to operate. We and our activities are subject to zoning, health and other state and local government laws and regulations. Zoning variances or use permits are often required for construction. Severely restrictive regulations could impair our ability to open additional residences at desired locations or could result in costly delays. Several of our residences have been financed by revenue bonds. In order to continue to qualify for favorable tax treatment of the interest payable on these bonds, the financed residences must comply with federal income tax requirements, principally pertaining to the maximum income level of a specified portion of the residents. Failure to satisfy these requirements constitutes an event of default under the bonds, thereby accelerating their maturity. Our success will depend in part upon our ability to satisfy applicable regulations and requirements and to procure and maintain required licenses in rapidly changing regulatory environments. Any failure to satisfy applicable regulations or to procure or maintain a required license could have a material adverse effect on our business, operating results and financial condition.

Our operations could also be adversely affected by, among other things, regulatory developments such as revisions in building code requirements for assisted living residences, mandatory increases in the scope and quality of care to be offered to residents, and revisions in licensing and certification standards. There can be no assurance that federal, state or local laws or regulations will not be imposed or expanded based on evolving regulatory interpretations or based on new statutory or regulatory provisions which adversely impact our business, financial condition, results of operations or prospects. Our residence operations are also subject to health and other state and local government regulations.

We are currently a defendant in a criminal negligence action involving one of our residents. It is possible that if convicted of a crime, the Company's ability to obtain and renew certain of our licenses and to participate in certain government payor programs could be materially and adversely affected.

We intend to review and, in appropriate circumstances, pursue opportunities for development and expansion into new products and services. These new products and services may include home health care, rehabilitation and pharmacy services, among others. The federal and state regulation of these additional products and services may be more extensive than that related to our assisted living operations. We have not in the past engaged in significant activities outside of our core assisted living business. As we expand into new products and services, we will be subject to additional federal, state and local laws and regulations. Non-compliance with these laws and regulations could have a material adverse effect on our business, financial condition, results of operations or prospects.

Dependence on Attracting Seniors with Sufficient Resources to Pay. We currently rely and, for the foreseeable future, we expect to rely, primarily on the ability of our residents to pay for services from their own and their families' financial resources. Generally, only elderly adults with income or assets meeting or exceeding the comparable median in the region where our assisted living residences are located can afford the fees for these residences. Inflation or other circumstances which adversely affect the ability of residents and potential residents to pay for assisted living services could have an adverse effect on us. In the event that we encounter difficulty in attracting seniors with adequate resources to pay for our services, we would be adversely affected. In the event that the Company determines that it must seek to accomplish its Restructuring Plan through a court-supervised reorganization, we expect that the foregoing risks could pose an even greater challenge for the Company.

Environmental Liability Risks Associated with Real Property. Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner or operator of real estate may be required to investigate and clean up hazardous or toxic substances or petroleum product releases at these properties, and may be held liable to a governmental entity or to third parties for property damage and for investigation and cleanup costs incurred by these parties in connection with the contamination. These laws typically impose clean up responsibility and liability without regard to whether the owner knew of or caused the presence of contaminants, and liability under these laws has been interpreted to be joint and several unless the harm is divisible and there is a reasonable basis for allocation or responsibility. The costs of investigation, remediation or removal of these substances may be substantial, and the presence of these substances, or the failure to properly remediate these properties, may adversely affect the owner's ability to sell or lease the property or to borrow using the property as collateral. In addition, some environmental laws create a lien on the contaminated site in favor of the government for damages and costs it incurs in connection with the contamination. Persons who arrange for the disposal or treatment of hazardous or toxic substances also may be liable for the costs of removal or remediation of these substances at the disposal or treatment facility, whether or not the facility is owned or operated by this person. Finally, the owner of a site may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from a site. In connection with our acquisition and financing of new residences, we typically secure an environmental assessment of the applicable residence. There can be no assurance, however, that environmental assessments would detect all environmental contamination which may give rise to material environmental liabilities. We believe that our respective residences are in compliance in all material respects with all applicable environmental laws. We have not been notified by any governmental authority, or are otherwise aware of any material non-compliance, liability or claim relating to hazardous toxic substances or petroleum products in connection with any of the residences we currently operate.

Anti-Takeover Provisions. Our Restated Certificate of Incorporation authorizes the issuance of 5,000,000 shares of preferred stock and 100,000,000 shares of Common Stock. Subject to the rules of the American Stock Exchange ("AMEX") upon which our Common Stock is listed, our Board of Directors have the power to issue any or all of the authorized and unissued shares without stockholder approval, and the preferred shares can be issued with rights, preferences and limitations as may be determined by our Board. The rights of the holders of our Common Stock will be subject to, and may be adversely affected by, the rights of any holders of preferred stock that may be issued in the future. We are obligated to issue additional shares of Common Stock or, in certain cases, preferred stock, upon the exercise of conversion or other rights under various outstanding warrants, convertible debentures and convertible preferred stock described in "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."

Authorized and unissued preferred stock and common stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could delay, discourage, hinder or preclude an unsolicited acquisition of the Company, could make it less likely that stockholders receive a premium for their shares as a result of any attempt and could adversely affect the market price of and the voting and other rights of the holders of outstanding shares of Common Stock. As a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law (the "DGCL") which, in general, prevents an "interested stockholder" (defined generally as a person owning 15% or more of the corporation's outstanding voting stock) from engaging in a "business combination" (as defined in Section 203) for three years following the date a person became an interested stockholder unless specific conditions are satisfied. In addition, the indenture relating to our approximately $112.0 million aggregate principal amount outstanding 5.25% Convertible Subordinated Debentures provides that, upon a "change of control" (as defined in that indenture), the holders of those debentures would have the right to require us to repurchase those debentures at 101% of their face value.

On December 10, 1998, we entered into a Rights Agreement with American Stock Transfer & Trust Company, as Rights Agent, pursuant to which we declared and paid a dividend of one preferred share purchase right (a "Right") for each outstanding share of our Common Stock. Each Right entitles the registered holder to purchase from us one one-hundredth of a share of Series A Junior Participating Preferred Stock, $.01 par value per share (the "Preferred Shares"), at a price of $130.00 per one one-hundredth of a Preferred Share. The Rights have anti-takeover effects, and they will cause substantial dilution to a person or group that attempts to acquire us without conditioning the offer on redemption of the Rights or on substantially all of the Rights also being acquired. The Rights should not interfere with any merger or other business combination approved by our Board since the Rights may be redeemed by us in accordance with the Rights Agreement.

ITEM 2.

PROPERTIES

The table below shows, by state, the number and the associated capacity of the residences that we own, lease, hold equity interest in or manage on behalf of third parties, as of December 31, 2001.

1. Owned residences are those that are wholly or majority owned by us.
2. Leased residences are those that we operate and lease from a third party.
3. Unconsolidated residences are those residences managed by us, but operated by an entity in which we own a minority equity interest.
4. Managed residences are those residences that we manage under management arrangements but in which we do not possess an ownership interest or possess a de minimus ownership position.

Of our 430 operating residences, 75% are five years old or less and 95% are ten years old or less. The number of residences that we own, lease, or manage has decreased subsequent to December 31, 2000, due to recent asset sales and lease terminations. See "Restructuring Activities - Portfolio Rationalization" above.

From time to time, we are involved in various legal proceedings relating to claims arising in the ordinary course of our business. Neither we nor any of our subsidiaries is a party to any legal proceeding, the outcome of which, individually or in the aggregate, is expected to have a material adverse affect on our financial condition or results of operations, with the possible exception of the matters described below.

We elected not to fund certain debt service and lease payment obligations due during 2001 without the consent of the applicable lender or lessor. Through additional payments, prepayments associated with asset sales and application of escrowed amounts, as of December 31, 2001, we had $6.6 million of delinquent outstanding scheduled debt service to lenders or lessors who hold mortgages on, or from whom we lease, 82 residences in the aggregate (3,316 resident capacity). We have received a written notice of acceleration from lenders with respect to indebtedness aggregating $210.2 million. In addition, indebtedness of approximately $58.4 million has fully matured and is past due. Many of our other credit and lease facilities are in technical default as a result of these payment defaults associated with other loan and lease facilities, but several of these lenders and lessors have executed limited in time waivers. We are also in default under various financial and other covenants contained in certain of our credit and lease arrangements. We have received written notices of default from most of these lenders or lessors, three lessors have terminated leases for 17 residences (940 resident capacity) and other lenders have elected to apply deposits and reserve funds of ours held by such lenders against the past due payments. Five lenders have activated or are in the process of activating "cash traps" of bank accounts relating to the operation of residences mortgaged to such lenders, either pursuant to arrangements set forth in the applicable loan documents or as subsequently negotiated with the Company. One of our lenders has commenced litigation in state court in Milwaukee, Wisconsin, seeking the appointment of a receiver for the 20 residences that serve as collateral for the $51.7 million of remaining mortgage financing provided by this lender. As a result of a negotiated forbearance agreement, the receivership action has been stayed temporarily by this lender as restructuring discussions are underway. We are also in litigation with a former lessor with respect to their damage claim associated with the early termination of their 11 residence lease portfolio.

The Company's Subordinated Debentures include subordination provisions that prohibit the Company from making interest payments to the debenture holders (other than payment-in-kind coupon payments) after the occurrence of payment defaults on the Company's senior indebtedness. As such, we defaulted in making coupon payments on our 5.25%, 6.75% and 7.00% Debentures aggregating approximately $5.5 million and $5.8 million in July 2001 and January 2002, respectively.

We are seeking to address all of our pending defaults of our senior and junior capital structure obligations through our Restructuring Plan. However, our Restructuring Plan is largely dependent upon our ability to negotiate consensual modifications and waivers with our various capital structure constituents. Absent an agreed upon resolution with these third parties, our lenders, lessors, and debenture holders may begin exercising remedies under their applicable financing agreements that could substantially hinder or disrupt our efforts to restructure the Company and result in a liquidation of the Company.

As noted above, the Company is a defendant in a criminal negligence action involving one of the Company's residences. It is possible that if convicted of a crime, the Company's ability to obtain and renew certain of its licenses and to participate in certain government payor programs could be materially and adversely affected.

We did not submit any matters to a vote of security holders during the fourth quarter of our fiscal year ended December 31, 2001.

Our Common Stock is listed and traded on the American Stock Exchange (AMEX) under the symbol "ALI." The Common Stock has been listed on the AMEX since August 6, 1996, the date of our initial public offering. The number of holders of record of the Common Stock as of March 26, 2002, was approximately 310.

The following table sets forth, for the periods indicated, the high and low closing prices for the Common Stock as reported on AMEX.

We have never paid or declared cash dividends and currently intend to retain any future earnings for the operation and expansion of our business. Due to the absence of legal capital under applicable Delaware law, we have not declared or paid pay-in-kind dividends on our outstanding Series A Stock since January 2001. In light of pending defaults under various of our loan, lease, and debenture obligations, we are contractually prohibited from paying dividends on our outstanding capital stock until such time as such defaults are cured or waived. Any determination to pay cash dividends in the future will be at the discretion of the Board of Directors and will be dependent on our financial condition, results of operations, contractual restrictions, capital requirements, business prospects, restrictive debt covenants and other factors as the Board of Directors deems relevant.

The selected consolidated historical financial data presented below for each of the five years ended December 31, 2001 has been derived from our audited consolidated financial statements appearing elsewhere in this report. The selected consolidated financial data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and notes thereto included in this report (in thousands, except per share data).

We are a national assisted living company operating assisted living residences and providing assisted living services in 26 states. Our growth in recent years and ongoing restructuring activities have had a significant impact on our results of operations and are an important factor in explaining the changes in our results between 2001 and 2000. As of December 31, 2001 and 2000, we operated or managed 430 and 474 residences with aggregate capacity of approximately 20,200 and 22,100 residents, respectively. During 2001 we generated operating revenue of $508.8 million and realized income from operations of $17.9 million and a pretax loss of $110.5 million, both prior to loss on disposal of assets.

In light of pending payment and covenant defaults under many of our senior credit facilities and all of our outstanding series of convertible debentures, we are seeking to implement a Restructuring Plan that contemplates the disposition of a significant portion of our residences and the restructuring of our secured indebtedness, leases (operating, capital and synthetic), convertible debentures, joint venture arrangements and equity capitalization. The pending Restructuring Plan, and recent developments impacting our liquidity and operating results, are summarized under the caption "Business - Restructuring Activities," which is incorporated in this Item 7 by this reference.

In response to the Securities and Exchange Commission's Release Numbers 33-8040, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, and 33-8056, Commission Statement about Management's Discussion and Analysis of Financial Condition and Results of Operations, we have identified the following critical accounting policies that affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities.

On an ongoing basis, we evaluate our estimates, including those related to revenue recognition and the allowance for doubtful accounts receivable and asset impairment. We state these accounting policies in the notes to our consolidated financial statements and at relevant sections in this discussion and analysis. Our estimates are based on information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results could vary from those estimates and those estimates could be different under different assumptions or conditions.

The consolidated financial statements include the accounts of the Alterra Healthcare Corporation and its majority-owned subsidiaries. Results of operations of the majority-owned subsidiaries are included from the date of acquisition. All significant inter-company balances and transactions with such subsidiaries have been eliminated in the consolidation. Investments in other affiliated companies in which we have a minority ownership position are accounted for on the equity method.

Included in the consolidated financial statements are the accounts of certain wholly owned subsidiaries that have been formed as "special purpose entities" (SPEs) in accordance with the requirements of certain of our lenders. Mortgage lenders imposing SPE requirements typically require that, in connection with providing mortgage financing with respect to a pool of residences, the residences actually be owned by one or more SPEs, which become the borrower or borrowers under the mortgage financing arrangement. Although lender requirements with respect to such SPEs vary, a SPE may be required to maintain separate corporation records and books of account, not commingle its assets with those of the parent company, have a separate board of directors from the parent company (including at least one individual board member who is independent of the parent company), maintain arm's length relationships with the parent company, not guarantee or become obligated for the debts of any other entity, including the parent company, or hold its credit as being available to satisfy the obligations of others and not pledge its assets for the benefit of any other entity, including the parent company. Given the separate corporate existence of certain of these SPEs and the fact that the assets of each SPE are subject to the prior claims of the individual creditors of the SPE, neither the creditors nor stockholders of the Company (or of any other of its subsidiaries) have any right to the assets of these SPEs except indirectly by virtue of its (or the subsidiary's) equity interest in such SPEs.

Resident service fee revenue, which is recorded when services are rendered, consists primarily of resident service fees that are reported at net realizable amounts.

We must make estimates of the uncollectibility of our accounts receivable related deferred rent and other revenue or income. We specifically analyze accounts receivable and historical bad debts when evaluating the adequacy of the allowance for doubtful accounts receivable. These estimates have a direct impact on our net income, because a higher bad debt allowance would result in lower net income. The Securities and Exchange Commission's Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition , provides guidance on the application of generally accepted accounting principles to selected revenue recognition issues. We believe that our revenue recognition policy is appropriate and in accordance with generally accepted accounting principles and SAB No. 101.

Property and equipment are stated at cost, net of accumulated depreciation. Property and equipment under capital leases are stated at the present value of minimum lease payments. Depreciation is computed over the estimated lives of the assets using the straight-line method. Buildings and improvements are depreciated over 20 to 40 years, and furniture, fixtures, and equipment are depreciated over three to seven years. Maintenance and repairs are expensed as incurred.

Goodwill represents the costs of acquired net assets in excess of their fair market values. Amortization of goodwill is computed using the straight-line method over the expected periods to be benefited, generally 40 years. We periodically evaluate goodwill for impairment based upon expectations of undiscounted cash flows in relation to the net capital investment in the entity.

We apply Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of , to recognize and measure impairment of long-lived assets. We review each long-lived asset for impairment whenever events or circumstances indicate that the carrying value of a real estate investment may not be recoverable. The review of recoverability is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the real estate investment's use and eventual disposition. These cash flows consider factors such as expected future operating income, trends and prospects, as well as the effects of leasing demand, competition and other factors. If impairment exists due to the inability to recover the carrying value of a real estate investment, an impairment loss is recorded to the extent that the carrying value exceeds estimated fair market value.

Assets held for sale are carried at the lower of carrying amount or fair value, less costs to sell. Depreciation and amortization are suspended during the period held for sale. We are required to make subjective assessments as to whether there are impairments in the value of our real estate properties. These assessments have a direct impact on our net income, because taking an impairment loss results in an immediate negative adjustment to net income.

The Company is seeking to negotiate restructurings of several of its principal secured debt and lease obligations and, upon completing these negotiations, will seek to restructure its principal unsecured debt obligations, comprised primarily of the outstanding convertible debentures. Furthermore, at December 31, 2001, the Company was in violation of certain debt covenants. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Residence Service Fees. Residence service fees for the year ended December 31, 2001 were $502.7 million representing an increase of $49.8 million, or 11.0%, from the $452.9 million for the comparable 2000 period. This increase resulted primarily from rate increases instituted during the past 12 months. Average rates were $2,879 and $2,571 as of December 31, 2001 and 2000, respectively. Company-wide occupancy was 81.5% and 84.9% as of December 31, 2001 and 2000, respectively.

Other Revenues. Other revenues for the year ended December 31, 2001 were $6.2 million, a decrease of $7.4 million over the $13.6 million of other revenue for the year ended December 31, 2000. The decrease is attributable to reduced development and franchise activity and a reduction in management fees on residences which were either managed for third parties or for entities in which we held a minority ownership position. Management fees include charges for transitional services to recruit and train staff, initial and recurring fees for use of our name and branding, initial and recurring fees for use of our methodologies, services for assisting with finance processing, and ongoing management services provided to operate the residence.

Residence Operating Expenses . Residence operating expenses for the year ended December 31, 2001 increased to $351.7 million from $313.5 million in the year ended December 31, 2000. Operating expenses as a percentage of resident service fees for the year ended December 31, 2001 and 2000 were 70.0% and 69.2%, respectively. This percentage increase resulted primarily from increases in labor and employee benefit related costs due to increased competition for personnel, an increase in insurance costs, and increases in utility costs.

Lease Expense . Lease expense for the year ended December 31, 2001 was $69.4 million, compared to $82.4 million in the comparable period in 2000. This decrease is the result of the termination of 20 residence leases and a change during the second quarter of 2001 in the accounting for two synthetic leases (includes the financing of $174.4 million on 26 residences representing 2,159 beds and the corporate office building) where the synthetic lessor no longer bears economic risk and, as a result, these previously unconsolidated synthetic lease SPEs are now consolidated.

Lease Income . We earned $21.3 million of lease income for year ended December 31, 2001, compared to $28.2 million for the comparable period in 2000, on residences owned or leased by us and leased or subleased to unconsolidated joint ventures. This decrease in lease income occurred due to a reduction in the number of unconsolidated joint ventures from 84 to 47 as of December 31, 2000 and 2001, respectively. Lease payment obligations of the unconsolidated joint venture entities are generally equivalent to the debt service payable by us on the leased residences, and thereby offset our costs associated with obtaining and maintaining financing for such residences .

General and Administrative Expense . For the year ended December 31, 2001, general and administrative expenses were $42.4 million prior to $6.5 million of restructuring costs, compared to $45.3 million before $5.1 million of non-recurring expenses for the comparable 2000 period, representing a decrease of general and administrative expense as a percentage of operating revenue from 9.7% in 2000 to 8.3% in 2001. The $6.5 million of restructuring costs represents fees and other costs associated with the retention of restructuring professionals and associated activities. The $5.1 million of non-recurring expenses in 2000 consisted of $3.3 million related to employee severance costs and the termination of several internal software development and systems projects associated with our corporate downsizing and a $1.8 million bad debt expense related to a management fee note which was deemed to be uncollectible due to the acquisition of the related residences in the second quarter of 2000.

Loss on Disposal . During the year ended December 31, 2001, the Company's Board of Directors adopted a plan to dispose of 82 residences representing 130 beds. During the second quarter of 2001, the Company recognized a pre-tax loss of $163.5 million (net of $3.6 million gain on sale) to reflect the Disposition Assets at the lower of carrying value or estimated fair value less costs to sell and to write off the carrying value of assets associated with terminated residence leases. As of December 31, 2001, 59 residences and ten land parcels have either been sold or transferred to a new lessee. The Company recognized an additional pre-tax loss of $25.8 million upon sale or transfer of these assets. As of December 31, 2001, approximately $150.5 million is reserved for losses relating to future asset sales or lease terminations.

During the year ended December 31, 2000, the Company's Board of Directors adopted a plan to dispose of 67 residences with aggregate capacity of 2,377 residents and 33 parcels of land. In accordance with SFAS 121, "Accounting for Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of," we recorded a loss on disposal on 31 of the 67 residences where we estimated net sales proceeds using undiscounted cash flows, net of disposal costs, were less than the book value by $22.2 million net of subsequent gains.

Depreciation and Amortization . Depreciation and amortization for the year ended December 31, 2001 was $42.2 million, representing an increase of $6.0 million, or 16.6%, from the $36.2 million of depreciation and amortization for the comparable 2000 period. This increase is the result of a change during the second quarter in the accounting for two synthetic leases (relating to 26 residences and the corporate office building) where the synthetic lessor no longer bears economic risk and, as a result, these previously unconsolidated synthetic lease SPEs are now consolidated.

Non-recurring Charge . A non-recurring charge of $4.2 million was recorded in the fourth quarter of 2000 relating to severance of various general and administrative positions of $1.1 million, the termination of a management contract of $2.0 million and the discontinuance of our pharmacy joint venture of $1.1 million. No similar charge was recorded in 2001.

Interest Expense, Net . Interest expense, net of interest income, was $73.1 million for the year ended December 31, 2001, prior to $4.8 million of bank penalties compared to $61.2 million of interest expense prior to $1.4 million of bank amendment fees for 2000. Gross interest expense (before interest capitalization and interest income) for the 2001 period was $73.2 million prior to the bank penalties compared to $71.1 million for the 2000 period, an increase of $2.1 million. We capitalized $1.9 million of interest expense in the 2001 period compared to $4.0 million in the 2000 period. This decrease in capitalized interest is a result of our decision to reduce development and construction activity in 2001. Our average construction in progress balance was $16.3 million during the twelve months ended December 31, 2001, compared to $65.1 million in the 2000 period. Interest income for the 2001 period was $2.0 million as compared to $5.9 million for the 2000 period. This decrease was due primarily to lower restricted cash balances in place in 2001 related primarily to lease financing transactions.

Amortization of Financing Costs. Amortization of financing costs for the year ended December 31, 2001 was $9.8 million, representing an increase of $1.2 million from the $8.6 million of amortized financing costs for the comparable 2000 period. This increase resulted primarily from recognizing a full year of amortization associated with the PIK Debentures during 2001 versus four months of amortization in the prior year.

PIK Interest, Net . "Pay-In-Kind" (PIK) interest for the year ended December 31, 2001 includes $24.3 million of interest expense on the various PIK Debentures which were issued in May and August 2000. This is an increase of $11.8 million from the $12.5 million of PIK interest expense for the year ended December 31, 2000. This increase resulted primarily from recognizing a full year of interest expense in 2001 versus a partial year in 2000.

Equity in Losses of Unconsolidated Affiliates. Equity in losses of unconsolidated affiliates for the twelve months ended December 31, 2001, was $16.9 million, representing an increase of $2.1 million from $14.8 million of losses for the comparable 2000 period. Our joint venture partners have not made substantial capital contributions to a number of joint ventures for several quarters. Therefore, we have absorbed the losses of those unconsolidated joint ventures in excess of capital contributed by the joint venture partner. The increase in equity in losses of unconsolidated affiliates was also impacted by a slower lease-up of residences which are held in unconsolidated joint ventures.

Minority Interest in Profits/Losses of Consolidated Subsidiaries. Minority interest in profits of consolidated subsidiaries for the year ended December 31, 2001 was $426,000, representing a decrease of $838,000 from $1.3 million for the comparable period in 2000. The decrease was primarily attributable to the decrease in the number of residences that were owned by us in consolidated joint venture arrangements resulting from the joint venture settlements completed during 2001.

Extraordinary Item . During the year ended December 31, 2000, we recorded a gain on the early extinguishment of debt of $8.5 million (net of tax) relating to our retirement of $41.4 million of convertible debt related to the Equity Transaction. EITF 96-19, "Debtor's Accounting for a Modification or Exchange of Debt Instruments," requires recognition of a gain or loss by the debtor for early extinguishment of debt.

Income Taxes. For the period ended December 31, 2001, we recorded a current state and local income tax provision of $120,000. The income tax expense for the period ended December 31, 2001 reflects the treatment of PIK interest as non-deductible interest. We do not currently anticipate that the interest expense which we will incur in the future related to the PIK debentures will be deductible for income tax purposes.

As of December 31, 2001, we do not have a deferred tax asset. In accordance with Statement of Financial Accounting Standards No. 109, we are required to continuously evaluate the recoverability of deferred tax assets based on the criteria that it is "more likely than not" that the deferred taxes will be recoverable through future taxable income. This evaluation is made based on our internal projections which are routinely updated to reflect more recent operating trends. Based on our current financial projections, we are uncertain that we will recover these net deferred tax assets through future taxable income. In addition, the utilization of the $299.3 million Net Operating Loss "NOL" carryforward could be subject to limitations based on the change of control provisions in the Internal Revenue Code. Accordingly, we have established a valuation allowance against the entire net deferred tax assets.

Residence Service Fees. Residence service fees for year ended December 31, 2000 were $452.9 million representing an increase of $103.1 million, or 29.5%, from the $349.8 million for the comparable 1999 period. Substantially all of this increase resulted from occupancy growth at certain of our recently opened residences and the addition of newly constructed residences and from residences we acquired. We operated or managed 474 and 450 residences at December 31, 2000 and 1999, respectively.

Other Revenues. Other revenues for the year ended December 31, 2000 were $13.6 million, a decrease of $12.8 million over the $26.4 million of other revenue for the year ended December 31, 1999. The decrease is attributable to reduced development activity which resulted in lower development fees and management fees on residences which were either managed for third parties or for entities in which we held a minority ownership position. In addition, during the second quarter of 2000, we purchased 49 residences which we previously either managed for third parties or for entities in which we held minority ownership positions. Management fees include charges for transitional services to recruit and train staff, initial and recurring fees for use of our name and branding, initial and recurring fees for use of our methodologies, services for assisting with finance processing, and ongoing management services provided to operate the residence.

Residence Operating Expenses . Residence operating expenses for the year ended December 31, 2000 increased to $313.5 million from $224.2 million in the year ended December 31, 1999 due to the increased number of residences operated during the 2000 period. Operating expenses as a percentage of resident service fees for the year ended December 31, 2000 and 1999 were 69.2% and 64.1%, respectively. This percentage increase resulted primarily from increases in labor and employee benefit related costs due to increased competition for personnel and increases in liability insurance costs that resulted from the most recent liability insurance policy renewal on July 1, 2000. The increase in marginal expenses was also impacted by a slower lease-up of residences in some areas of the country.

Lease Expense . Lease expense for the year ended December 31, 2000 was $82.4 million, compared to $69.4 million in the comparable period in 1999. This increase was primarily attributable to the incurrence of a full year of lease expense in 2000 related to leases entered into in 1999.

Lease Income . We earned $28.2 million of lease income for year ended December 31, 2000, compared to $25.5 million for the comparable period in 1999, on residences owned or leased by us and leased or subleased to unconsolidated joint ventures. Lease payment obligations of the unconsolidated joint venture entities are generally equivalent to the debt service payable by us on the leased residences, and thereby offset our costs associated with obtaining and maintaining financing for such residences .

General and Administrative Expense . For the year ended December 31, 2000, general and administrative expenses were $45.3 million prior to $5.1 million of non-recurring expenses, compared to $42.6 million before a $2.3 million write-off for failed acquisitions, corporate downsizing, and corporate office relocation costs for the comparable 1999 period, representing a decrease to 9.7% of operating revenue in 2000 from 11.3% in 1999. The $5.1 million of non-recurring expenses consist of $3.3 million related to employee severance costs and the termination of several internal software development and systems projects associated with our corporate downsizing and a $1.8 million bad debt expense related to a management fee note which was deemed to be uncollectible due to the acquisition of the related residences in the second quarter.

Loss on Disposal . During the year ended December 31, 2000, the Company's Board of Directors adopted a plan to dispose of 67 residences with aggregate capacity of 2,377 residents and 33 parcels of land. In accordance with SFAS 121, "Accounting for Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of," we recorded a loss on disposal on 31 of the 67 residences where we estimated net sales proceeds using undiscounted cash flows, net of disposal costs, are less than the book value by $22.2 million net of subsequent gains.

Depreciation and Amortization . Depreciation and amortization for the year ended December 31, 2000 was $36.2 million, representing an increase of $15.0 million, or 70.9%, from the $21.2 million of depreciation and amortization for the comparable 1999 period. This increase resulted primarily from depreciation of fixed assets on the larger number of new residences that were owned by us during the year ended December 31, 2000, versus the comparable period in 1999. In addition, we acquired 19 residences with a capacity for 944 residents in December 1999 and January 2000 which were previously leased by us from a healthcare REIT and have therefore incurred depreciation on these assets.

Non-recurring Charge . A non-recurring charge of $4.2 million was recorded in the fourth quarter of 2000 relating to severance of various general and administrative positions of $1.1 million, the termination of a management contract of $2.0 million and the discontinuance of our pharmacy joint venture of $1.1 million, representing a decrease of $43.1 million, compared to a non-recurring charge of $47.3 million in 1999 to exit development activities.

Interest Expense, Net . Interest expense, net of interest income, was $61.2 million for the year ended December 31, 2000, prior to $1.4 million of bank amendment fees compared to $32.3 million of net interest expense for 1999. Gross interest expense (before interest capitalization and interest income) for the 2000 period was $71.1 million prior to the amendment fees paid compared to $47.6 million for the 1999 period, an increase of $23.4 million. This increase is primarily attributable to an increase in the amount of mortgage financing used in 2000 as compared to 1999. The 2000 period also includes fees paid related to amending bank agreements. We capitalized $4.0 million of interest expense in the 2000 period compared to $10.3 million in the 1999 period. This decrease in capitalized interest is a result of our decision to reduce development and construction activity in 2000. Our average construction in progress balance was $65.1 million during the twelve months ended December 31, 2000, compared to $117.8 million in the 1999 period. Interest income for the 2000 period was $5.9 million as compared to $5.1 million for the 1999 period. This increase was due to interest on additional restricted cash balances in place in 2000 related primarily to lease financing transactions.

Amortization of Financing Costs. Amortization of financing costs for the year ended December 31, 2000 was $8.6 million, representing an increase of $4.9 million from the $3.7 million of amortized financing costs for the comparable 1999 period. This increase resulted primarily from amortization of financing costs on the larger number of residences that were owned by us during the year ended December 31, 2000, versus the comparable period in 1999. In addition, we completed the Equity Transaction totaling $203.0 million in 2000 and have begun to amortize the $15.2 million of related costs.

PIK Interest, Net . PIK interest for the year ended December 31, 2000 includes $12.5 million of interest expense on the various PIK Debentures which were issued in May and August 2000. We had no similar PIK interest expense for the 1999 period.

Equity in Losses of Unconsolidated Affiliates. Equity in losses of unconsolidated affiliates for the twelve months ended December 31, 2000, was $14.8 million, representing an increase of $13.4 million from $1.4 million of losses for the comparable 1999 period. In the fourth quarter of 1999, we began reducing our reliance on joint venture arrangements. As such, our joint venture partners have not made substantial capital contributions to a number of joint ventures for several quarters. Therefore, we have absorbed the losses of those unconsolidated joint ventures in excess of capital contributed by the joint venture partner. The increase in equity in losses of unconsolidated affiliates was also impacted by a slower lease-up of residences that are held in unconsolidated joint ventures.

Minority Interest in Losses of Consolidated Subsidiaries. Minority interest in losses of consolidated subsidiaries for the year ended December 31, 2000 was $1.3 million, representing a decrease of $2.7 million from $4.0 million for the comparable period in 1999. The decrease was primarily attributable to the maturity in the residences that were owned by us in consolidated joint venture arrangements during the 2000 period. Throughout 2000, we had an average of 23 residences held in consolidated joint venture relationships compared to an average of 19 residences in consolidated joint venture relationships during the year ended December 31, 1999.

Extraordinary Item . During the year ended December 31, 2000, we recorded a gain on the early extinguishment of debt of $8.5 million (net of tax) relating to our retirement of $41.4 million of convertible debt related to the Equity Transaction. EITF 96-19, "Debtor's Accounting for a Modification or Exchange of Debt Instruments," requires recognition of a gain or loss by the debtor for early extinguishment of debt.

Cumulative Effect of Change in Accounting Principle. During the first quarter of 1999 we incurred a cumulative effect of a change in accounting principle of $3.8 million relating to the adoption of Statement of Position 98-5, which requires that costs of start-up activities and organization costs be expensed as incurred.

Income Taxes. For the period ended December 31, 2000, we recorded a current state income tax provision of $573,000 and a deferred tax provision of $14.1 million resulting in a total income tax provision of $14.7 million before the effect of the extraordinary item. The income tax expense for the period ended December 31, 2000 reflects the treatment of PIK interest as non-deductible interest. We do not currently anticipate that the interest expense which we will incur in the future related to the PIK debentures will be deductible for income tax purposes. During the period ended December 31, 1999, we recorded a current income tax benefit of $345,000 and recognized a $14.4 million deferred asset resulting in a current income tax benefit of $14.7 million before the cumulative effect of the change in accounting principle of $3.8 million.

As of December 31, 2000, our deferred tax asset was reduced to zero. In accordance with Statement of Financial Accounting Standards No. 109, we are required to continuously evaluate the recoverability of deferred tax assets based on the criteria that it is "more likely than not" that the deferred taxes will be recoverable through future taxable income. This evaluation is made based on our internal projections that are routinely updated to reflect more recent operating trends. Based on our current financial projections, we are uncertain that we will recover these net deferred tax assets through future taxable income. In addition, the utilization of the $131.3 million Net Operating Loss "NOL" carryforward could be subject to limitations based on the change of control provisions in the Internal Revenue Code. Accordingly, we have established a valuation allowance against the entire net deferred tax assets.

At December 31, 2001, we had $20.0 million in unrestricted cash and cash equivalents and a $1.1 billion working capital deficit compared to unrestricted cash and cash equivalents of $23.7 million and $129.2 million of working capital at December 31, 2000.

For the year ended December 31, 2001, the operating cash flow was $9.7 million compared to a cash flow deficit of $28.6 million for the year ended December 31, 2000.

During 2000 we obtained approximately $127.4 million of new conventional debt financing. Approximately $30.0 million of this financing was used to repay bridge financing and $30.0 million was used to repurchase 19 residences from a REIT lessor. The remaining conventional financing was used to fund construction of our remaining unopened residences.

During 2001 we completed seven sale/leaseback transactions with one of our major REITs for an aggregate purchase price of $26.5 million. The proceeds of these refinancings were used principally to retire mortgage and accrued interest obligations. We also negotiated extensions of loan maturities of between one to four years with respect to approximately $72.3 million of our secured debt during 2001.

On May 30, 2000, we completed the first closing of the Equity Transaction pursuant to which we issued $173.0 million of convertible debentures and convertible preferred shares to investors. The securities issued include: (i) $168.0 million of Series A, Series B and Series C PIK Debentures with an original conversion price of $4.00 per share ($400 per share of Series B stock for the Series B PIK Debentures), and a 9.75% semi-annual PIK coupon and a seven year maturity; and (ii) $5.0 million of Series A Stock with an original conversion price of $4.00 per share and a 9.75% semi-annual cumulative PIK dividend and a mandatory redemption in seven years. The Series A and Series C PIK Debentures and Series A Stock are convertible at any time at the respective holder's option into shares of Common Stock of the Company. The Series B PIK Debentures are convertible at any time at the respective holder's option into non-voting Series B preferred shares having rights (other than voting rights) substantially similar to the Company's Common Stock. The effective conversion price for these securities has been reduced from $4.00 to $2.68 per share as of December 31, 2001, pursuant to the anti-dilution provisions of these securities. See "Certain Relationships and Related Transactions." The Company may call the debentures and the Series A Stock at any time after May 30, 2003, if the Company's Common Stock trades at an average price of at least $8.00 per share for the preceding 30 trading day period. On August 10, 2000, we issued an additional $29.9 million of Series B PIK Debentures resulting in an aggregate transaction amount of $203.0 million. With the payment of the PIK coupons and accrued but undeclared dividends through December 31, 2001, we now have $229.5 million of convertible PIK Debentures and $5.5 million of Series A Stock outstanding (includes $591,000 of accrued but undeclared PIK dividends).

We used the proceeds from this transaction, net of $15.2 million of transaction costs, to: (i) repay $48.3 million of bridge loans previously funded by an affiliated group who participated as investors in the Equity Transaction, (ii) retire outstanding convertible debt with a book basis of $41.4 million in exchange for $26.9 million in new Series C PIK Debentures, (iii) acquire equity interests in 14 residences (618 resident capacity) previously managed by the Company for $21.0 million, (iv) acquire a 60% ownership interest in the operations of 26 residences (2,159 resident capacity) for $14.7 million, (v) repay $5.0 million of short-term borrowings under a bank line-of-credit, and (vi) provide funds for working capital and other corporate purposes, including funding construction of our remaining unopened residences.

In an effort to retain sufficient cash to fund operations of all our residences and address our short-term liquidity needs, in March 2001 we obtained a $7.5 million bridge loan provided by certain of our principal stock and convertible debenture holders (the "Bridge Loan") and elected not to fund certain of our debt service and lease payment obligations. As a result, we are currently in default under many of our credit and sale/leaseback facilities.

As an inducement to make the Bridge Loan, we issued the bridge lenders stock purchase warrants to purchase an aggregate of 60,000 shares of a newly designated Series B-1 class of our preferred stock having rights and terms substantially similar to our Series B preferred stock issuable upon conversion of our Series B PIK Debentures. Like our Series B preferred stock, each share of the new preferred stock has rights, other than voting rights, substantially similar to 100 shares of Common Stock of the Company. Accordingly, 60,000 shares of the new preferred stock represent six million Common Stock equivalent shares. The five-year warrants are exercisable at a price of $75 per share for 20,000 shares of the new preferred stock, $100 per share for 20,000 shares of the new preferred stock and $125 per share for 20,000 shares of the new preferred stock.

The $7.5 million Bridge Loan had an initial six-month term, is secured by first mortgages on several residences, and bears interest at an escalating interest rate, commencing at 10% per annum. At our election, the Bridge Loan was extended by an additional six months whereupon the Bridge Loan became convertible into convertible subordinated debentures of the Company having rights and terms substantially similar to our Series B PIK Debentures, but having a conversion price equal to $75 per share of Series B-1 preferred stock (a Common Stock equivalent price of $0.75 per share). The bridge lenders also are entitled to participate in any transaction involving the issuance by the Company of equity or equity-linked securities during the term of the Bridge Loan.

As a result of the Bridge Loan becoming convertible into convertible subordinated debentures and our issuance of a stock purchase warrant in connection with the Bridge Loan, the effective conversion price for the PIK Debentures and the Series A Stock has decreased from $4.00 to $2.68 per share of Common Stock for the Series A and Series C PIK Debentures and the Series A Stock and from $400 to $268 per share of Series B stock for the Series B PIK Debentures (the actual conversion price for the Series A and C PIK Debentures and the Series A Stock remains at $4.00 per share and for the Series B PIK Debentures remains at $400 per share; however, upon conversion of these convertible securities the holder thereof will also receive shares of Series B-1 preferred stock, in addition to Common Stock or Series B preferred stock, as applicable, in such amounts as to provide such holder an equity interest in the Company as though the conversion price for the Series A and C PIK Debentures and Series A Stock on the one hand, and the Series B PIK Debentures on the other hand, were decreased to $2.68 and $268 per share, respectively).

Historically, we financed our operations and growth through a combination of various forms of real estate financing (mortgage, synthetic lease and sale/leaseback financing), capital contributions from joint venture partners and the sale of our securities (Common Stock, preferred stock and Subordinated Debentures) and, to a lesser extent, cash from operations. At December 31, 2001, we had $1.2 billion of outstanding debt principally consisting of $416.8 million of subordinated Debentures having a weighted average interest rate of 8.02%, $109.2 million of fixed rate debt having a weighted average interest rate of 7.46%, capitalized and financing lease obligations of $208.6 million having a weighted average interest rate of 10.14%, $451.5 million of variable rate debt having a weighted average interest rate of 6.44%, and $14.4 million and $10.8 million of notes payable and short-term borrowings, respectively. Through December 31, 2001, we have also entered into approximately $611.3 million of sale/leaseback financings.

Our principal credit and financing agreements, including our Subordinated Debentures and our synthetic lease agreements, include cross-default provisions that provide that a material default under our other credit facilities constitutes a default under that credit or financing agreement. Accordingly, any material default arising under one of our credit or financing agreements could result (and, as discussed below, has resulted) in many of our other major credit and financing arrangements being in default. In addition, our principal credit and financing agreements include various financial covenants and other restrictions, including: (i) fixed charge coverage requirements, typically measured on a trailing four quarter basis and which generally increase over the term of the applicable credit agreement; (ii) maximum leverage ratios which limit our aggregate senior indebtedness to total capitalization; (iii) various minimum net worth or tangible net worth requirements; (iv) in some cases, property specific debt service coverage requirements and similar financial covenants of the type referenced above applicable to individual properties or to the pool of residences financed by the applicable lender; and (v) the maintenance of operating and other reserves for the benefit of the residences serving as collateral for the applicable lender. We are currently not in compliance with certain of these covenants, although we have negotiated limited in time waivers with certain lenders and lessors. Additionally, under some of our credit and sale/leaseback facilities we are required to secure lender or lessor consent prior to engaging in mergers, business combinations or change in control transactions.

We elected not to fund $10.4 million of debt service and lease payment obligations due in 2001 without the consent of the applicable lender or lessor. Through additional payments, prepayments associated with asset sales and application of escrowed amounts, as of December 31, 2001, we had $6.6 million of delinquent outstanding scheduled debt service to lenders or lessors who hold mortgages on, or from whom we lease 82 residences in the aggregate (3,316 resident capacity). We have received a written notice of acceleration from lenders with respect to indebtedness aggregating $210.2 million. In addition, indebtedness of approximately $58.4 million has fully matured during 2001 and is past due. Many of our other credit and lease facilities are in technical default as a result of these payment defaults associated with other loan and lease facilities, but several of these lenders and lessors have executed limited in time waivers. We have received written notices of default from most of these lenders or lessors, three lessors have terminated leases for 17 residences (940 resident capacity) and other lenders have elected to apply deposits and reserve funds of ours held by such lenders against the past due payments. Five lenders have activated or are in the process of activating "cash traps" of bank accounts relating to the operation of residences mortgaged to such lenders, either pursuant to arrangements set forth in the applicable loan documents or as negotiated with the Company. One of our lenders has commenced litigation in state court in Milwaukee, Wisconsin, seeking the appointment of a receiver for the 20 residences that serve as collateral for the $51.7 million of remaining mortgage financing provided by this lender. As a result of a negotiated forbearance agreement, the receivership action has been stayed by this lender as restructuring discussions are underway. We are also in litigation with a former lessor with respect to their damage claim associated with the early termination of their 11 residence lease portfolio.

Our operations will require significant additional capital resources in the future in order to fund: (i) the professional fees and other related costs associated with our Restructuring Plan; (ii) our ongoing debt service and lease obligations, including maturities of our long-term debt and refinancing of short term debt; and (iii) our obligation to finance the operations of our remaining joint ventures. Additionally, growth in residence operating cash flow has been slower than projected as a result of (i) increased operating costs, including labor, utilities and liability insurance and, (ii) to a lesser extent, slower fill rates in our pre-stabilized residences and reduction in occupancy levels in certain of our stabilized residences. As a result of ongoing operating losses and these upcoming capital needs, we expect that our projected cash needs during 2002 will exceed our projected identified cash resources. To satisfy these cash shortfalls and to preserve the integrity of our operations, we are pursuing a Restructuring Plan which seeks, among other things, to dispose of a significant number of our residences which operate with cash shortfalls and to defer some of our debt service obligations until those disposition and negotiated restructurings of our principal debt and lease obligations can occur. See "Business - Restructuring Activities".

Management is actively seeking to restructure secured loan facilities that, in management's view, would generate significant deficiency claims (i.e., claims in excess of the value of the applicable mortgage portfolio) in the event the applicable lenders sought to call the loan and foreclose on their collateral. Management believes that four credit facilities representing $314.4 million in aggregate financing (secured by mortgages on 73 residences with a capacity of 4,261 beds) appear to represent significant potential deficiency claims in the range of $110 million to $180 million. In these negotiations, we are seeking to obtain a release of these potential deficiency claims against the Company in exchange for our agreement to cooperate with the applicable lenders to facilitate an orderly transition of ownership (and, in certain cases, management) of the mortgaged residences to the lenders or their designees (through deed-in-lieu of foreclosure transactions or so-called friendly foreclosures). In transitioning ownership of the mortgaged residences to the lenders, we are offering to provide interim or long-term management services to the lenders with respect to the mortgaged residences. As of March 2002, we have executed one definitive agreement of this type with one lender group with regard to a credit facility representing $50.5 million of financing secured by 14 residences with an aggregate capacity of 618 beds, and are in active negotiations with the lenders of the other three "impaired" credit facilities. See Note 18 to the Consolidated Financial Statements.

In addition to these impaired credit facilities, we are also seeking to negotiate amendments and modifications with the applicable lenders with respect to our other principal secured credit facilities in order to, depending on the specific case, reset covenants, obtain consent to sell certain mortgaged residences, secure waivers of prior defaults and, in certain cases, to extend scheduled maturities. These credit facilities represent $434.9 million of financing secured by an aggregate of 146 residences with a capacity of 6,483 beds. Discussions with certain (but not all) of these lenders have commenced, but none have yet resulted in definitive binding restructuring agreements.

We currently have five multi-residence portfolios leased from various REITs. These portfolios include an aggregate of 204 residences with a capacity of 8,928 beds. During 2001 we completed the restructuring of two of our leased portfolios (aggregate of 53 residences with 2,064 beds). These restructurings included the amendment of certain lease covenants and terms and, in one lease facility, the conversion of 42 individual leases into a single master lease. The cash rent due under one lease facility was modified through the application of various deposits held by the landlord to satisfy a portion of the cash rent obligation in the early years of the restructured master lease.

Restructuring negotiations are currently underway with the other three REIT lessors. In these restructuring negotiations, we are seeking to extend lease terms, revise covenants as necessary, secure approval for asset sales, and obtain additional funding for capital expenditures. In consideration for these modifications, the applicable REIT lessors are generally requesting that we convert individual leases into multi-residence master leases.

As of December 31, 2001, we have the following series of redeemable preferred stock and Subordinated Debentures outstanding:

The outstanding Original Debentures, comprised of the 5.25% Debentures, 7.00% Debentures and 6.75% Debentures, are subordinated to all other "senior indebtedness" of the Company (as defined in the applicable indenture governing such debentures), and the PIK Debentures are subordinated to all "senior indebtedness" of the Company (as defined in the applicable indentures governing such debentures), other than the Original Debentures. Although defined somewhat differently in the several indentures governing the Original Debentures and the PIK Debentures (collectively, the "Subordinated Debentures"), "senior indebtedness" is defined to generally include indebtedness for borrowed money and other similar obligations of Alterra (other than the other series of Original Debentures).

As a result of several notices of default received by the Company with respect to secured indebtedness that by its terms may be accelerated by the applicable lenders, neither we nor the applicable indenture trustees for the Subordinated Debentures are permitted by the subordination provisions of the indentures governing the respective Subordinated Debentures to make any payment or distribution on account of the Subordinated Debentures (other than the payment of PIK coupons on the PIK Debentures). As a result, we did not make cash interest payments on the Original Debentures in June 2001 and January 2002 of $5.5 million and $5.8 million, respectively. In the event that the Company is dissolved, liquidated or reorganized, all amounts due in payment of the Company's "senior indebtedness" must be paid or provided for before any payment may be made on account of the Subordinated Debentures. Accordingly, unless and until we are able to restructure our "senior indebtedness" obligations (including, without limitation, our several secured credit facilities) and resolve all pending defaults related to this indebtedness, we will not be permitted to make any interest or other payments to the holders of the Subordinated Debentures (other than the payment of PIK coupons on the PIK Debentures) or to restructure the Subordinated Debentures.

As of December 31, 2001, our current portion of long-term debt and short-term notes payable totaled $1.1 billion. These current maturities include $700.9 million of debt and lease obligations, $416.8 million of PIK Debentures and other Subordinated Debentures that are in default or pursuant to cross-default provisions may be declared in default and may be accelerated at the lender's election, and $25.2 million of short-term notes payable and borrowings. In 2002 our scheduled debt maturities include $150.8 million of secured debt and our 5.25% Debentures, which have an outstanding balance of $112.0 million at December 31, 2001 and mature in December 2002.

We are obligated under our existing joint venture arrangements to purchase the equity interests of our joint venture partners at fair market value upon the election of our partners (the "Put"). We may also exercise options to purchase these same joint venture interests either at uncapped fair market value in the case of certain joint venture arrangements (the "FMV Call") or at an agreed upon return on investment in the case of other arrangements (the "Formula Call"). For joint ventures with the FMV Call, we estimate that the amount required as of December 31, 2001 to acquire these joint venture interests would have been approximately $1.0 million. With respect to joint ventures that include Formula Calls, we estimate that the call price as of December 31, 2001 would have totaled approximately $49.0 million. However, we believe that the fair market value of these residences, in the aggregate, should the Put be exercised, is substantially less.

During 2001 we negotiated a series of arrangements that resulted in the discontinuation of joint venture arrangements with respect to 42 residences. Specifically, in October 2001 we negotiated the buyout by the Company of joint venture partner interests in 15 residences in connection with a modification and settlement agreement with one investor group. Pursuant to this agreement, we issued $700,000 of promissory notes and modified certain terms of the joint venture arrangement relating to the remaining ten joint venture residences. In December 2001 we also terminated our joint venture with Pioneer Development Company by exchanging ownership interests in 12 joint venture entities jointly owned with this group, resulting in the Company and Pioneer each acquiring sole ownership in six of these residences. Also in December 2001, we terminated our joint venture with Manor Care, Inc. relating to 13 residences in connection with consummating a global settlement of various pending litigations and arbitration proceedings between the Company and Manor Care and its affiliates. Pursuant to this settlement, the Company was released under its debt guaranty of a $57.7 million revolving line of credit established for this joint venture. The Company issued $12 million of notes in connection with this settlement and release transaction.

To address our long-term liquidity and capital needs, including our upcoming debt maturities, we intend to (i) continue our negotiations with our lenders, lessors, joint venture partners, and to seek to implement the Restructuring Plan (ii) continue to implement operating initiatives focused on overall rate and occupancy improvement and overhead reductions, (iii) dispose of under-performing and non-strategic residences in order to reduce associated financing costs, operating expenses and to generate cash, and (iv) seek to identify additional equity or equity-linked capital to be funded contingent upon the substantial completion of our restructuring. As our Restructuring Plan is largely dependent upon our ability to implement negotiated consensual restructuring arrangements with our various capital structure constituencies, no assurances may be given as to whether we will be able to restructure the Company or to restore value to various of our capital structure constituencies.

To date, inflation has not had a significant impact on us. Inflation could, however, affect our results of operations due to our dependence on our senior resident population who rely on liquid assets and relatively fixed incomes to pay for our services. As a result, we may not be able to increase residence service fees to account fully for increased operating expenses. In structuring our fees we attempt to anticipate inflation levels, but there can be no assurance that we will be able to anticipate fully or otherwise respond to any future inflationary pressures.

Market risk represents the risk of changes in value of a financial instrument, derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates and equity prices. Changes in these factors cause fluctuations in our earnings and cash flows.

We performed a sensitivity analysis that presents the hypothetical change in fair value of those financial instruments held by us at December 31, 2001 which are sensitive to changes in interest rates. Market risk is estimated as the potential change in fair value resulting from an immediate hypothetical one-percentage point parallel shift in the yield curve. The fair value of the debt included in the analysis is $451.5 million. Although not expected, a one-percentage point change in the interest rates would have caused our annual interest expense to change by approximately $4.5 million. Accordingly, a significant increase in London Inter Bank Offered Rate ("LIBOR") could have a material adverse effect on our earnings.

Although a majority of the debt and lease payment obligations we have as of or during the twelve months ended December 31, 2001 are not subject to floating interest rates, indebtedness that we may incur in the future may bear interest at a floating rate.

We do not presently use financial derivative instruments to manage our interest costs. We do not use foreign currency exchange rate forward contracts or commodity contracts and do not have foreign currency exposure as of December 31, 2001.

The Board of Directors
Alterra Healthcare Corporation

We have audited the accompanying consolidated balance sheets of Alterra Healthcare Corporation and subsidiaries (the Company) as of December 31, 2001 and 2000, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on the results of our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2001 and 2000, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations and was in violation of certain debt covenants and cross covenants as of December 31, 2001. As a result of the covenant violations and cross covenant violations, the Company is in default on the related debt. Additionally, the Company did not make certain scheduled loan principal and lease payments beginning in March of 2001. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

KPMG LLP

Chicago, Illinois
March 29, 2002

ALTERRA HEALTHCARE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2001 and 2000
(In thousands except share data)

See accompanying notes to consolidated financial statements.