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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

Commission File Number 001-16817

FIVE STAR QUALITY CARE, INC.

400 Centre Street, Newton, Massachusetts 02458

617-796-8387

Securities registered pursuant to Section 12(b) of the Act:

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

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

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

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes o    No ý

The aggregate market value of the voting shares of the registrant held by non-affiliates was $45.5 million based on the $5.59 closing price per common share on the American Stock Exchange on June 28, 2002. For purposes of this calculation, an aggregate of 315,732.6 common shares held by the directors and officers of the registrant and have been included in the number of shares held by affiliates, which includes 35,000 common shares held by Senior Housing Properties Trust.

Number of the registrant's Common Shares outstanding as of March 24, 2003: 8,452,634.

References in this Annual Report on Form 10-K to the "Company," "Five Star", "FVE", "we", "us" or "our" include Five Star Quality Care, Inc., and its consolidated subsidiaries, unless the context indicates otherwise.

DOCUMENTS INCORPORATED BY REFERENCE

Certain information required under Part III of this Annual Report on Form 10-K is to be incorporated herein by reference from our definitive Proxy Statement for the annual meeting of shareholders currently scheduled for May 6, 2003.

WARNING CONCERNING FORWARD LOOKING STATEMENTS

THIS ANNUAL REPORT ON FORM 10-K INCLUDES FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 AND THE FEDERAL SECURITIES LAWS. THESE FORWARD LOOKING STATEMENTS REFLECT OUR PRESENT BELIEFS AND EXPECTATIONS, BUT THEY ARE NOT GUARANTEED TO OCCUR. FOR EXAMPLE:

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THE LARGE INCREASES IN INSURANCE COSTS AND IN INSURANCE RESERVE CALCULATIONS WHICH WE EXPERIENCED IN 2002 MAY RECUR RATHER THAN BE EXCEPTIONAL.



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MEDICARE AND MEDICAID RATES MAY DECLINE MORE THAN WE NOW EXPECT BECAUSE OF FEDERAL AND STATE GOVERNMENT BUDGET DEFICITS OR OTHERWISE.



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WE MAY BE UNABLE TO CARRY OUT OUR BUSINESS PLAN TO EXPAND OUR OPERATIONS OF FACILITIES WHERE RESIDENTS PAY FOR SERVICES WITH PRIVATE RESOURCES BECAUSE WE ARE UNABLE TO LOCATE SUCH EXPANSION OPPORTUNITIES AT PRICES WE ARE WILLING OR ABLE TO PAY.



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WE MAY BE UNABLE TO COLLECT RECEIVABLE AMOUNTS WHICH WE BELIEVE ARE DUE FROM INTEGRATED HEALTH SERVICES, INC. OR FROM THE UNITED STATES DEPARTMENT OF HEALTH AND HUMAN SERVICES.



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WE MAY BE UNABLE TO COLLECT RECEIVABLE AMOUNTS WE BELIEVE ARE DUE TO US FROM THE STATE OF CONNECTICUT MEDICAID PROGRAM.



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WE MAY LOSE OUR PENDING LITIGATION WITH MARRIOTT INTERNATIONAL INC., AND MARRIOTT SENIOR LIVING LIVING SERVICES, INC.



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IF MARRIOTT TRANSFERS THE MANAGEMENT OF 31 SENIOR LIVING COMMUNITIES WHICH IT OPERATES FOR OUR ACCOUNT, THE REVENUES AT THESE COMMUNITIES MAY DECLINE, THE EXPENSES AT THESE COMMUNITIES MAY INCREASE AND OUR INCOME MAY DECLINE.



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THE SECTION TITLED "RISK FACTORS" BEGINNING ON PAGE 2 OF THIS REPORT 10-K INCLUDES A LISTING OF OTHER IMPORTANT MATTERS WHICH MAY ADVERSELY AFFECT OUR BUSINESS AND FINANCIAL PERFORMANCE MORE THAN WE ANTICIPATE AND MORE THAN MAY BE IMPLIED BY OUR FORWARD LOOKING STATEMENTS.

SINCE WE BECAME A SEPARATE PUBLIC COMPANY AT THE BEGINNING OF 2002, WE HAVE BEEN UNABLE TO OPERATE PROFITABLY. FORWARD LOOKING STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K MAY IMPLY THAT WE EXPECT TO OPERATE PROFITABLY IN THE FUTURE. HOWEVER, WE MAY BE UNABLE TO OPERATE PROFITABLY FOR THE REASONS SET FORTH ABOVE OR FOR OTHER REASONS. AN INVESTMENT IN OUR SECURITIES INVOLVES A HIGH DEGREE OF RISK OF LOSS, AND INVESTORS SHOULD NOT PLACE UNDUE RELIANCE UPON FORWARD LOOKING STATEMENTS WHICH MIGHT IMPLY OTHERWISE.

FIVE STAR QUALITY CARE, INC.
2002 FORM 10-K ANNUAL REPORT

Table of Contents

PART I

Item 1.    Business

GENERAL

        We are in the business of operating senior living communities, including independent living and congregate care communities, assisted living facilities and nursing homes. Our business includes 105 communities containing 14,140 living units, including 51 primarily independent and assisted living communities containing 9,188 units and 54 nursing homes containing 4,952 units. Of our 51 primarily independent and assisted living communities, we lease 40 containing 8,223 units from Senior Housing Properties Trust, our former parent, including 31 which are operated by Marriott Senior Living Services, Inc. ("MSLS"), a subsidiary of Marriott International, Inc. ("Marriott") and own and operate 11 communities containing 965 units. All of our nursing homes are leased from Senior Housing. Combined these 105 communities include 4,849 independent living apartments, 2,669 assisted living suites, 283 special care beds and 6,339 nursing beds. Our principal executive offices are located at 400 Centre Street, Newton, Massachusetts 02458, and our telephone number is 617-796-8387.

OUR HISTORY

        We were created by Senior Housing in April 2000 to operate nursing homes repossessed or acquired from two former Senior Housing tenants. On December 31, 2001, Senior Housing distributed substantially all of our outstanding shares to its shareholders and we became a separate publicly owned company listed on the American Stock Exchange. Pursuant to the transaction agreement governing this spin off: Senior Housing capitalized us with $50 million of equity, consisting of cash and working capital, primarily operating receivables, net of operating payables; we agreed to lease 31 primarily independent and assisted living communities operated by MSLS upon their acquisition by Senior Housing; we leased 55 nursing homes from Senior Housing; assumed one lease from the town of Campbell, NE; and we agreed to acquire FSQ, Inc. ("FSQ"), the former operating company of the healthcare business we owned in order to acquire the personnel, systems and assets necessary for our business.

        During 2002, we acquired or began to lease 51 senior living communities containing 9,188 units, including the 31 communities operated by MSLS and 20 additional communities. Also during 2002 we ceased operations at two of our facilities, one of which was previously leased from Senior Housing and one of which was previously leased from the town of Campbell, NE.

OUR GROWTH STRATEGY

        We believe that the aging of the U.S. population will increase demand for existing senior living apartments, independent living properties, assisted living communities and nursing homes. Our growth strategy is to capitalize on this demand by leasing or acquiring communities that provide high quality services to residents who pay with private resources. During 2002, we added 51 primarily independent and assisted living communities to our business which generate 89% of their revenue from residents' private resources, not Medicare or Medicaid. Our nursing homes derive a majority of their revenues from Medicare and Medicaid. In the future we may decide to expand our nursing home operations; however, if we do so, we expect to price such acquisitions at levels which take account of the risks associated with Medicare and Medicaid revenues.

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RISK FACTORS

        Since we became a separate public company at the end of 2001, we have been unable to operate profitably. Ownership of our securities involves a high degree of risk. The following is a summary of the material risks:

A small percentage decline in our revenues or increase in our expenses can have a large percentage impact upon our profits.

        Our operating revenues for 2002 are $522.2 million, and our loss is $13.2 million. A small percentage decline in our revenues or increase in our expenses might have a dramatic negative impact upon our income or may produce greater losses.

Our growth strategy may not succeed.

        Our business plan includes acquiring additional senior living communities, some of which may be owned and some of which may be leased. An acquisition strategy involves risks. For example: we may be unable to locate communities available for purchase at acceptable prices; we may be unable to negotiate acceptable lease terms; we may be unable to access the capital to acquire or operate additional communities; acquired operations may bring with them contingent liabilities which mature; to the extent we incur acquisition financing, our leverage may increase and combining our present operations with newly acquired operations may be disruptive. For these reasons and others, our business plan to grow may not succeed, the benefits which we hope to achieve by growing may not be achieved and our existing operations may suffer from a lack of management attention or financial resources if such attention and resources are devoted to a failed growth strategy.

Medicare or Medicaid rate reductions or a failure of those rates to match increasing costs could increase our losses.

        At some of our communities, operating revenues for nursing home services are received from the Medicare and Medicaid programs and 39% of our total revenues in 2002 was derived from these programs. This percentage of our total revenues derived from Medicare and Medicaid in 2002 is derived primarily from the 52 nursing home communities we lease from Senior Housing. Since 1998, a Medicare prospective payment system has generally lowered Medicare rates paid to senior living communities including many of those that we operate. In October 2002, temporary increases in Medicare payment rates expired. Our Medicare revenues totaled $68.4 million and $35.4 million during 2002 and 2001, respectively. Assuming our 2003 census of Medicare residents is comparable to 2002, we estimate that our revenues received from Medicare in 2003 will decline by approximately $6.9 million over 2002 revenues received from Medicare. Our Medicaid revenues totaled $142.6 million and $127.9 million during 2002 and 2001, respectively. Some of the states in which we operate have reduced or are expected to reduce Medicaid funding to address state budget shortfalls. The magnitude of the combined Medicare and Medicaid rate reductions cannot currently be estimated, but it may be material. Further Medicare and Medicaid rates declines may have a dramatic negative impact on our revenues and may produce greater losses.

Nursing home and senior living operators like us are being subjected to increased litigation and insurance costs.

        There are various federal and state laws prohibiting fraud by healthcare providers, including criminal provisions that prohibit filing false claims for Medicare and Medicaid payments and laws that govern patient referrals. The state and federal governments are devoting increasing resources to anti-fraud initiatives against healthcare providers. In some states, advocacy groups monitor the quality of care at senior living communities, and these groups may bring litigation against operators. Also, in several instances private litigation by nursing home patients has succeeded in winning very large

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damage awards for alleged abuses. The effect of this litigation and potential litigation has been to increase materially the costs of monitoring and reporting quality of care compliance. In addition, the cost of medical malpractice insurance has increased significantly and may continue to increase so long as the present litigation environment affecting the operations of nursing homes and other senior living communities continues. In 2002, we experienced significant increases in our costs related to professional liability insurance. In order to partially offset the increases in professional liability insurance related to the 74 communities that we operate, we increased the levels of self insurance of most of our communities. We expect our insurance costs to increase, and we cannot now predict the amount of such increase, or to what extent if at all we may be able to offset any increase through use of higher deductibles, retention amounts, self insurance or other means. Increases in costs which are not offset may have a dramatic negative impact on our expenses and reserves and may produce greater losses.

Our litigation with Marriott and MSLS is ongoing and its outcome is uncertain.

        As described in Item 3, "Legal Proceedings", and in the notes to our financial statements, we and Senior Housing are involved in litigation with Marriott and MSLS, the operator of 31 communities which we lease from Senior Housing. This litigation may be expensive and have unexpected outcomes.

The sale of MSLS to Sunrise may have adverse consequences to us.

        Marriott intends to sell MSLS to Sunrise Assisted Living, Inc. ("Sunrise"). We believe Sunrise's financial condition and reputation as an operator of senior living communities may be weaker than Marriott's and MSLS's financial condition and operating reputation. The operations and the financial results which we realize from the 31 senior living communities managed for us by MSLS may decline after Sunrise acquires MSLS.

Our facility based business requires regular capital expenditures.

        Physical characteristics of senior living communities are mandated by various governmental authorities. Changes in these regulations may require significant expenditures. Our leases with Senior Housing require us to maintain our communities in compliance with applicable laws. In the future, our communities may require significant expenditures to address ongoing required maintenance and make them attractive to residents. Our available financial resources may be insufficient to fund these expenditures.

If we fail to comply with complex regulations which govern our operations we may be subject to sanctions.

        State licensing and Medicare and Medicaid laws also require operators of nursing homes and assisted living communities to comply with extensive standards governing operations. Federal and State agencies administering these laws regularly inspect such communities and investigate complaints. During the past several years, the Federal Centers for Medicare and Medicaid Services, known as CMS, has increased its efforts to enforce Medicare and Medicaid standards and oversee state survey agencies which inspect senior living communities and investigate complaints. When deficiencies are identified, sanctions and remedies such as denials of payment for new Medicare and Medicaid admissions, civil money penalties, state oversight and loss of Medicare and Medicaid participation or licenses may be imposed. CMS and the states are increasingly using such sanctions and remedies when deficiencies, especially those involving findings of substandard care or repeat violations, are identified. We and MSLS receive notices of potential sanctions and remedies from time to time, and such sanctions have been imposed on some of our nursing homes and assisted living communities from time to time. As of December 31, 2002 none of the 105 communities we own or lease were under sanctions. If we or MSLS are unable to cure deficiencies which have been identified or which are identified in the future, such sanctions will be imposed and, if imposed, may have adverse financial consequences to us.

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Receivables from Integrated Health Services, the United States Department of Health and Human Resources and the State of Connecticut may not be collected.

        As described in the notes to our financial statements, we have asserted claims for the collection of $1.5 million due to us from the State of Connecticut and $1.3 million due to us from Integrated Health Services and the Department of Health and Human Services. If we are unsuccessful in collecting these amounts, we will incur related charges.

Anti-takeover provisions in our governing documents and in our material agreements may prevent you from receiving a takeover premium for your shares.

        Our charter places restriction on the ability of any person or group to acquire beneficial ownership of more than 9.8% of any class of our equity shares. Additionally, the terms of our leases with Senior Housing and our shared services agreement with Reit Management & Research LLC ("RMR") contain provisions whereby our rights under these agreements may be cancelled by Senior Housing and RMR, respectively, upon the acquisition by any person or group of more than 9.8% of our voting stock and upon other change in control events, as defined in those documents. If the breach of these ownership limitations causes a lease default, shareholders causing the default may become liable to us or to other shareholders for damages. Our charter and bylaws contain other provisions that may increase the difficulty of acquiring control of us by means of a tender offer, open market purchases, a proxy fight or otherwise, if the acquisition is not approved by our board of directors. These other anti-takeover provisions include the following:

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a staggered board of directors with separate terms for each class of directors;

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the availability, without a shareholders' vote, of additional shares and classes of shares that our board of directors may authorize and issue on terms that it determines;

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a 75% shareholder vote required for removal of directors for cause; and

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advance notice procedures with respect to nominations of directors and shareholder proposals.

        For all of these reasons, shareholders may be unable to cause a change of control of us or to realize a change of control premium for their common shares.

We are subject to possible conflicts of interest.

        Our continuing business is subject to possible conflicts of interest, as follows:

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Four of our five current directors are trustees of Senior Housing.

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Our Chief Executive Officer and our Chief Financial Officer are also part time employees of RMR. RMR is the investment manager for Senior Housing and we purchase various services from RMR pursuant to a shared services agreement.

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Our managing directors, Barry M. Portnoy and Gerard M. Martin, are also managing trustees of Senior Housing. Messrs. Portnoy and Martin also own RMR and another entity that leases office space to us.

        We do not believe that these conflicts have caused our business to be adversely affected. However, future business dealings between us and Senior Housing, RMR, Messrs. Portnoy and Martin and their affiliates may be on terms less favorable to us than we could achieve on an arm's length basis.

Our business is highly competitive and we may be unable to operate profitably.

        We compete with numerous other companies which provide senior living alternatives, including home healthcare companies and other real estate based service providers. Historically, nursing homes have been somewhat protected from competition by state laws requiring certificates of need to develop new communities; however, these barriers are being eliminated in many states. Also, there are few

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barriers to competition for home healthcare or for independent and assisted living services. Growth in availability of nursing home alternatives, including assisted living communities, has had and may in the future have the effect of reducing the occupancy or operating profitability at nursing homes including those we operate. Many of our existing competitors are larger and have greater financial resources than we do. Accordingly, we cannot provide any assurances that we will be able to attract a sufficient number of residents to our communities or that we will be able to attract employees and keep wages and other employee benefits, insurance costs and other operating expenses at levels which will allow us to operate profitably.

Our existing contracts with Senior Housing and others may inhibit our ability to grow.

        So long as we maintain our shared services agreement with RMR or are a tenant under a lease with Senior Housing then we will not acquire or finance any real estate without first giving Senior Housing or any other publicly owned real estate investment trust or other entity managed by RMR the opportunity to acquire or finance real estate investments of the type in which Senior Housing or any other publicly owned real estate investment trust or other entity managed by RMR, respectively, invest. These agreements may make it difficult, more expensive or impossible for us to invest in other real estate in the future. Also, because of our various relationships with Senior Housing and RMR, competitors of those companies may be unwilling to lease senior living communities to us or conduct business with us. These circumstances may prevent us from realizing some growth opportunities.

Our owned and leased properties are subject to real estate risks.

        At December 31, 2002, we owned 11 senior living communities and leased 94 senior living communities from Senior Housing. Our leases require that we pay for and indemnify Senior Housing from all liabilities associated with the ownership or operation of the communities we lease from Senior Housing which arise prior to or during the terms of our leases. Also, we may acquire or lease additional real estate in the future. Accordingly, our business is subject to risks associated with real estate, including:

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costs associated with uninsured damages, including damages for which insurance may be unavailable or unavailable on commercially reasonable terms;

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costs and damages caused by eminent domain takings;

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costs that may be required for maintenance and repair; and

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the need to make expenditures due to changes in laws and other regulations, including the Americans with Disabilities Act.

Our business exposes us to environmental risks.

        Under various laws in the United States, operators of real estate may be required to investigate and clean up hazardous substances present at their properties, including but not limited to medical waste, mishandled petroleum products and asbestos containing materials, and may be held liable for property damage or personal injuries that result from such contamination. These laws also expose us to the possibility that we become liable to reimburse the government for damages and costs it incurs in connection with the contamination. As the owner of real estate leased to us, Senior Housing may be also subject to similar liabilities, and we have agreed to indemnify Senior Housing from costs it incurs at our leased properties related to environmental hazards which arise prior to or during the terms of our leases. We can give you no assurance that environmental liabilities are not present in our operated communities or that costs we incur to remediate contamination or the presence of asbestos will not have a material adverse effect on our business and financial condition.

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TYPES OF SERVICES

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

        Senior Apartments.    Senior apartments are marketed to residents who are generally capable of caring for themselves. Residence is usually restricted on the basis of age. Purpose built communities may have special function rooms, concierge services, high levels of security and assistance call systems for emergency use. Residents at these communities who need healthcare or assistance with the activities of daily living are expected to contract independently for these services with home healthcare companies. Our business at December 31, 2002, included no senior apartments.

        Independent Living Apartments.    Independent living apartments, or congregate communities, also provide high levels of privacy to residents and require residents to be capable of relatively high degrees of independence. Unlike a senior apartment community, an independent living apartment usually bundles several services as part of a regular monthly charge, for example, one or two meals per day in a central dining room, weekly maid service and a social director. Additional services are generally available from staff employees on a fee-for-service basis. In some congregate care communities, separate parts of the community are dedicated to assisted living or nursing services. At December 31, 2002, our business included 4,849 independent living apartments in 34 communities; ten of these communities are operated by us and 24 are operated by MSLS for our account.

        Assisted Living Suites.    Assisted living suites are typically comprised of one bedroom units which include private bathrooms and efficiency kitchens. Services bundled within one charge usually include three meals per day in a central dining room, daily housekeeping, laundry, medical reminders and 24 hour availability of assistance with the activities of daily living such as dressing and bathing. Professional nursing and healthcare services are usually available at the community on call or at regularly scheduled times. At December 31, 2002, our business included 2,669 assisted living suites in 48 communities; 20 of these communities are operated by us and 28 are operated by MSLS for our account.

        Specialty Care Suites.    Specialty care suites offer specialized programs for patients suffering from specific illnesses, usually Alzheimer's disease. At December 31, 2002, our business included 283 specialty care suites in nine communities all of which are operated by MSLS for our account.

        Nursing Homes.    Nursing homes generally provide extensive nursing and healthcare services similar to those available in hospitals, without the high costs associated with operating theaters, emergency rooms or intensive care units. A typical purpose built nursing home includes mostly two-bed units with a separate bathroom in each unit and shared dining and bathing facilities. Some private rooms are often available for those residents who can afford to pay higher rates or for patients whose medical conditions require segregation. Nursing homes are generally staffed by licensed nursing professionals 24 hours per day. At December 31, 2002, our business included 6,339 nursing home beds in 75 communities; 52 of these communities are operated by us and 23 are operated by MSLS for our account.

OPERATING STRUCTURE

        We have five regional offices, which are located in Maryland, Georgia, California, Wisconsin and Nebraska. Each regional office generally oversees multiple states and is responsible for approximately twenty communities. Each region is headed by a regional director of operations with extensive experience in the senior living industries. Each regional office is typically supported by a clinical or wellness director, a rehabilitation director, a regional accounts manager, a human resources specialist

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and a sales and marketing specialist. Regional staff are responsible for: overseeing all aspects of community-based operations, including marketing and sales activities; resident care; the hiring of community executives, care managers and other community-based personnel; compliance with applicable local and state regulatory requirements; and implementation of our development and acquisition plans within their region.

        We employ about 75 people in our corporate headquarters. Corporate staff members are responsible for: the establishment of company wide policies and procedures relating to resident care; employee hiring; training; retention; information technology; state and federal reimbursement assistance; state licensing and certification maintenance; legal; community design and development; community operations; and accounting and finance functions including, accounts payable, payroll, general finance and accounting, and tax planning and compliance. The centralization of these activities improves efficiency and permits community staff to focus on the delivery of services to our residents.

INDEPENDENT AND ASSISTED LIVING COMMUNITY STAFFING

        Each of the independent and assisted living communities we operate for our own account has an executive director responsible for the day-to-day operations of the community, including: quality of care; resident services; sales and marketing; and financial performance. The executive director is supported by department heads who oversee the care and service of the residents, a wellness director, who is responsible for coordinating the services necessary to meet the health care needs of our residents and a marketing director, who is responsible for selling our services. Other key positions include the dining services coordinator, the activities coordinator, and the maintenance coordinator.

NURSING HOME STAFFING

        Each of our nursing homes is managed by a state-licensed administrator who is supported by other professional personnel, including a director of nursing, activities director, marketing director, social services director, business office manager, and physical, occupational and speech therapists. Our directors of nursing are state-licensed nurses who supervise our registered nurses, licensed practical nurses and nursing assistants. Staff size and composition vary depending on the size and occupancy of each nursing home and on the type of care provided by the nursing home. The nursing homes contract with physicians who provide medical services.

EMPLOYEES

        As of March 14, 2003, we had approximately 6,873 employees, including 4,364 full time equivalents. Approximately 677 employees, including 396 full time equivalents, are represented under seven collective bargaining agreements, all of which have remaining terms of one to two years. We have no other employment agreements. We believe relations with our union and non-union employees to be good.

GOVERNMENT REGULATION AND REIMBURSEMENT

        Our operations must comply with numerous federal, state and local statutes and regulations. Also, the healthcare industry depends significantly upon federal and federal/state programs for revenues and, as a result, is vulnerable to the budgetary policies of both the federal and state governments.

        Senior Apartments.    Generally, government programs do not pay for housing in senior apartments. Rents are paid from the residents' private resources. Accordingly, the government regulations that apply to these types of properties are generally limited to zoning, building and fire codes, Americans with Disabilities Act requirements and other life safety type regulations applicable to residential real estate. Government rent subsidies and government assisted development financing for low income senior housing are exceptions to these general statements. The development and operation of subsidized senior housing properties are subject to numerous governmental regulations.

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        Independent Living Apartments.    Government benefits generally are not available for services at independent living apartments and the resident charges in these communities are paid from private resources. However, a number of Federal Supplemental Security Income program benefits pay housing costs for elderly or disabled residents to live in these types of residential communities. The Social Security Act requires states to certify that they will establish and enforce standards for any category of group living arrangement in which a significant number of supplemental security income residents reside or are likely to reside. Categories of living arrangements which may be subject to these state standards include independent living apartments and assisted living communities. Because independent living apartments usually offer common dining facilities, in many locations they are required to obtain licenses applicable to food service establishments in addition to complying with land use and life safety requirements. In many states, independent living apartment communities are licensed by state or county health departments, social service agencies or offices on aging with jurisdiction over group residential communities for seniors. To the extent that independent living apartments include units in which assisted living or nursing services are provided, these units are subject to applicable state licensing regulations, and if the communities receive Medicaid or Medicare funds, to certification standards. In some states, insurance or consumer protection agencies regulate independent living apartments in which residents pay entrance fees or prepay other costs. One community which we acquired in 2002 includes 32 independent living apartments where rent rates are regulated by the requirement of a tax exempt bond fiduciary.

        Assisted Living Communities.    According to the National Academy for State Health Policy, approximately 41 states provide or are approved to provide Medicaid payments for residents in some assisted living communities under waivers granted by the Federal Centers for Medicare and Medicaid Services, known as CMS, or under Medicaid state plans, and four other states are planning some Medicaid funding by preparing or requesting waivers to fund assisted living demonstration projects. Because rates paid to assisted living community operators are lower than rates paid to nursing home operators, some states use Medicaid funding of assisted living as a means of lowering the cost of services for residents who may not need the higher intensity of health-related services provided in nursing homes. States that administer Medicaid programs for assisted living communities are responsible for monitoring the services at, and physical conditions of, the participating communities. Different states apply different standards in these matters, but generally we believe these monitoring processes are similar to the concerned states' inspection processes for nursing homes.

        In light of the large number of states using Medicaid to purchase services at assisted living communities and the growth of assisted living in the 1990s, a majority of states have adopted licensing standards applicable to assisted living communities. According to the National Academy for State Health Policy, 32 states and the District of Columbia have licensing statutes or standards specifically using the term "assisted living". 36 states have requirements for facilities servicing people with Alzheimer's disease or dementia. The majority of states have revised their licensing regulations recently or are reviewing their policies or drafting or revising their regulations. State regulatory models vary; there is no national consensus on a definition of assisted living, and no uniform approach by the states to regulating assisted living communities. Most state licensing standards apply to assisted living communities whether or not they accept Medicaid funding. Also, according to the National Academy for State Health Policy, six states require certificates of need from state health planning authorities before new assisted living communities may be developed. Based on our analysis of current economic and regulatory trends, we believe that assisted living communities that become dependent upon Medicaid payments for a majority of their revenues may decline in value because Medicaid rates may fail to keep up with increasing costs. We also believe that assisted living communities located in states that adopt certificate of need requirements or otherwise restrict the development of new assisted living communities may increase in value because these limitations upon development may help ensure higher occupancy and higher non-governmental rates.

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        Two federal government studies provide background information and make recommendations regarding the regulation of, and the possibility of increased governmental funding for, the assisted living industry. The first study, an April 1999 report by the General Accounting Office to the Senate Special Committee on Aging on assisted living communities in four states, found a variety of residential settings serving a wide range of resident health and care needs. The General Accounting Office found that consumers often receive insufficient information to determine whether a particular community can meet its needs and that state licensing and oversight approaches vary widely. The General Accounting Office anticipates that as the states increase the use of Medicaid to pay for assisted living, federal financing will likewise grow, and these trends will focus more public attention on the place of assisted living in the continuum of long-term care and upon state standards and compliance approaches. The second study, a National Study of Assisted Living for the Frail Elderly, was funded by the U.S. Department of Health and Human Services Assistant Secretary for Planning and Evaluation and reported on the effects of different service and privacy arrangements on resident satisfaction, aging in place and affordability. In 2001 and 2002, the Senate Special Committee on Aging held hearings on assisted living and its role in the continuum of care and on community-based alternatives to nursing homes. We cannot predict whether these studies will result in governmental policy changes or new legislation, or what impact any changes may have. Based upon our analysis of current economic and regulatory trends, we do not believe that the federal government is likely to have a material impact upon the current regulatory environment in which the assisted living industry operates unless it also undertakes expanded funding obligations, and we do not believe a materially increased financial commitment from the federal government is presently likely. However, we do anticipate that assisted living communities will increasingly be licensed and regulated by the various states, and that in the absence of federal standards, the states' policies will continue to vary widely.

        Nursing Homes-Reimbursement.    About 59% of all nursing home revenues in the U.S. in 2001 came from government Medicare and Medicaid programs, including about 48% from Medicaid programs. Nursing homes are among the most highly regulated businesses in the country. The federal and state governments regularly monitor the quality of care provided at nursing homes. State health departments conduct surveys of resident care and inspect the physical condition of nursing home properties. These periodic inspections and occasional changes in life safety and physical plant requirements sometimes require nursing home operators to make significant capital improvements. These mandated capital improvements have in the past usually resulted in Medicare and Medicaid rate adjustments, albeit on the basis of amortization of expenditures over expected useful lives of the improvements. A new Medicare prospective payment system, often referred to as PPS, was phased in over three years beginning with cost reporting years starting on or after July 1, 1998. Under this new Medicare payment system, capital costs are part of the prospective rate and are not facility specific. This new Medicare payment system and other recent legislative and regulatory actions with respect to state Medicaid rates are limiting the reimbursement levels for some nursing home services. At the same time federal and state enforcement and oversight of nursing homes are increasing, making licensing and certification of these communities more rigorous. These actions have adversely affected our revenues and increased our expenses.

        The current Medicare payment system was established by the Balanced Budget Act of 1997, and was intended to reduce the rate of growth in Medicare payments for skilled nursing facilities. Before the current Medicare payment system, Medicare rates were facility-specific and cost-based. Under the current Medicare payment system, skilled nursing facilities receive a fixed payment for each day of care provided to residents who are Medicare beneficiaries. Each resident is assigned to one of 44 care groups depending on that resident's medical characteristics and service needs. Per diem payment rates are based on these care groups. Medicare payments cover substantially all services provided to Medicare residents in skilled nursing facilities, including ancillary services such as rehabilitation therapies. The new Medicare payment system is intended to provide incentives to providers to furnish only necessary services and to deliver those services efficiently. During the three year phase-in period,

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Medicare rates for skilled nursing facilities were based on a blend of facility specific costs and rates established by the new Medicare payment system. According to the General Accounting Office, between fiscal year 1998 and fiscal year 1999, the first full year of the new Medicare payment system phase-in, the average Medicare payment per day declined by about 9%.

        Since November 1999, Congress has provided some relief from the impact of the Balanced Budget Act of 1997. Effective April 1, 2000, the Medicare, Medicaid and SCHIP Balanced Budget Refinement Act of 1999 temporarily boosted payments for certain skilled nursing cases by 20% and allowed skilled nursing facilities to transition more rapidly to the federal payment system. This Act also increased the new Medicare payment rates by 4% for fiscal years 2001 and 2002 and imposed a two-year moratorium on some therapy limitations for skilled nursing patients covered under Medicare Part B. In December 2000, the Medicare, Medicaid and SCHIP Benefits Improvement and Protection Act of 2000 was approved. Effective April 1, 2001 to October 1, 2002, this Act increased the nursing component of the payment rate for each care group by 16.66%. This Act also increased annual inflation adjustments for fiscal year 2001, increased rehabilitation care group rates by 6.7%, and maintained the previously temporary 20% increase in the other care group rates established in 1999. However, as of October 1, 2002, the 4% across-the-board increase in Medicare payment rates and the 16.66% increase in the nursing component of the rates expired. The 20% increase for the skilled nursing care groups and the 6.7% increase in rehabilitation care group rates will expire when the current resource utilization groups are refined.

        Because of the current federal budget deficit and other federal government priorities, such as homeland security and the war on terrorism, we do not expect the federal government to restore the Medicare rate increases which expired on October 1, 2002. Assuming our 2003 census of Medicare residents is comparable to 2002, we estimate that our revenues received from Medicare in 2003 will decline by approximately $6.9 million over 2002 revenues received from Medicare. Similarly, because of budget deficits in most states, we expect that Medicaid rate increases will be less than our cost increases in 2003 and in some instances Medicaid rates may decline. This combination of events may make it increasingly difficult for us to meet our financial obligations and negatively affect our financial condition and results of operations.

        Nursing Homes-Survey And Enforcement.    CMS has undertaken an initiative to increase the effectiveness of Medicare and Medicaid nursing home survey and enforcement activities. CMS' initiative follows a July 1998 General Accounting Office investigation which found inadequate care in a significant proportion of California nursing homes and the CMS' July 1998 report to Congress on the effectiveness of the survey and enforcement system. In 1999, the U.S. Department of Health and Human Services Office of Inspector General issued several reports concerning quality of care in nursing homes, and the General Accounting Office issued reports in 1999 and 2000 which recommended that CMS and the states strengthen their compliance and enforcement practices to better ensure that nursing homes provide adequate care. Since 1998, the Senate Special Committee on Aging has been holding hearings on these issues. CMS is taking steps to focus more survey and enforcement efforts on nursing homes with findings of substandard care or repeat violations of Medicare and Medicaid standards and to identify chain operated facilities with patterns of noncompliance. CMS is increasing its oversight of state survey agencies and requiring state agencies to use enforcement sanctions and remedies more promptly when substandard care or repeat violations are identified, to investigate complaints more promptly, and to survey facilities more consistently. In addition, CMS has adopted regulations expanding federal and state authority to impose civil money penalties in instances of noncompliance. Medicare survey results and nursing staff hours per resident for each nursing home are posted on the internet at http://www.medicare.gov. When deficiencies under state licensing and Medicare and Medicaid standards are identified, sanctions and remedies such as denials of payment for new Medicare and Medicaid admissions, civil monetary penalties, state oversight and loss of Medicare and Medicaid participation or licensure may be imposed. We receive notices of potential sanctions and remedies from time to time, and such sanctions have been imposed from time to time on us. If we are

10

unable to cure deficiencies which have been identified or that are identified in the future, such sanctions may be imposed, and if imposed, may adversely affect our ability to meet our financial obligations and negatively affect our financial condition and results of operations.

        In 2000 and 2002 CMS issued reports on its study linking nursing staffing levels with quality of care, and CMS is assessing the impact that minimum staffing requirements would have on community costs and operations. In a report presented to Congress in 2002, the Department of Health and Human Services found that 90% of nursing homes lack the nurse and nurse aide staffing necessary to provide adequate care to residents. The Bush administration has indicated that it does not intend to impose minimum staffing levels or to increase Medicare or Medicaid rates to cover the costs of increased staff at this time, but CMS is now publishing the nurse staffing level at each nursing home on its internet site to increase market pressures on nursing home operators.

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

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

        Other Matters.    A number of legislative proposals that would affect major reforms of the healthcare system have been introduced in the U.S. Congress and many state governments, such as programs for national health insurance, additional Medicare and Medicaid reforms and federal and state cost containment measures. We cannot predict whether any of these legislative proposals will be adopted or, if adopted, what effect, if any, these proposals would have on our business.

LIABILITY INSURANCE

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

        We have liability insurance for the 74 properties, which we now operate. Only one of these communities is located in Florida and none are located in Texas. The Florida community has no nursing home beds. Our current liability insurance expires in June 2003; we expect our insurance costs to increase, and we cannot now predict the amount of any such increase, or to what extent, if at all, we may be able to offset any increase through use of higher deductibles, retention amounts, self insurance or other means.

        MSLS is responsible for obtaining insurance for the 31 senior living communities which MSLS manages for us. These 31 communities include six in Florida (885 independent living apartments, 442 assisted living suites and 95 nursing home beds), and five in Texas (900 independent living apartments,

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239 assisted living suites, 108 special care beds and 357 nursing beds). As of December 31, 2002, liability insurance for these communities' operations is provided in part by an insurance company subsidiary of Marriott International Inc., the current parent of MSLS. Marriott intends to sell MSLS to Sunrise. We do not know if Sunrise will be able to provide similar levels of insurance for our managed communities nor the cost of such insurance which may be provided by Sunrise.

COMPETITION

        The senior living services business is highly competitive. We compete with service providers offering alternate types of services, such as home healthcare services, as well as other companies providing facility based services. Many of these service providers are larger and have more resources than us.

        Our management team has been recently assembled within the past three years, and, although we believe it is experienced and highly talented, it does not have extensive experience working together. We expect we may expand our business with Senior Housing; however, Senior Housing is not obligated to provide us with opportunities to lease additional properties. As of December 31, 2002 we have debt totaling $16.1 million, and have large lease obligations and limited financeable assets; and many of our competitors have greater financial resources than we do. For all of these reasons and others, we cannot provide you any assurance that we will be able to compete successfully for business in the senior living industry.

ENVIRONMENTAL MATTERS

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

•

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


•

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

        The presence or discovery of any material environmental containments could have a material adverse impact on us.

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Item 2.    Properties

OUR SENIOR LIVING COMMUNITIES

        At December 31, 2002, our business included 105 senior living communities:

(1)

Include amounts for periods prior to our acquisition or the commencement of our lease.

OWNED COMMUNITIES

        In April 2002, we purchased five senior living communities from ILM II Senior Living, Inc. and its subsidiary ILM II Holding, Inc. for $45.5 million. In October 2002, we purchased an additional seven senior living communities from Constellation Health Services, Inc. for $27.0 million. To finance our October 2002 purchase we sold one community we had purchased in April 2002 to Senior Housing for $12.7 million and assumed $15.8 million of mortgage debt. Our 11 owned communities contain 965 exclusively independent and assisted living units and are located in six states. The following table provides additional information about these communities and their operations as of and for the year ended December 31, 2002:

(1)

Includes data for periods prior to our acquisition.

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SENIOR HOUSING LEASE NO. 1 COMMUNITIES

        We lease and operate 54 senior living communities which are owned by Senior Housing and leased to us under one combined lease. These 54 communities include 52 nursing homes and two assisted living communities; four of the nursing homes also contain some assisted living units or independent living apartments. These 54 communities have 4,952 beds or living units and are located in 12 states. The following table provides additional information about these communities and their operations as of and for the year ended December 31, 2002:

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SENIOR HOUSING LEASE NO. 2 COMMUNITIES

        We lease 31 senior living communities from Senior Housing which are leased to us under one combined lease and managed by MSLS. These communities contain 7,476 living units and are located in 13 states. The following table provides additional information about these communities and their current operations as of and for MSLS's fiscal year ended January 3, 2003:

(1)

Includes data for periods prior to the commencement of our lease.

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SENIOR HOUSING LEASE NO. 3 COMMUNITIES

        We lease and operate nine independent and assisted living senior living communities which are owned by Senior Housing and leased to us under one combined lease. These nine communities have 747 living units and are located in four states. The following table provides additional information about these communities and their operations as of and for the year ended December 31, 2002:

(1)

Includes data for periods prior to the commencement of our lease.

OUR SENIOR HOUSING LEASES

        Certain of our subsidiaries lease the communities described above in three separate leases; and we have guaranteed our subsidiaries obligations under these leases. These leases have been filed as exhibits to this Annual Report on Form 10-K. If you want more information about any lease, you should read the entire lease. The following is a summary of the material terms of these leases:

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

        Minimum Rent.    As of December 31, 2002, aggregate minimum rent under our leases is $76.2 million per year: lease No. 1: $6.9 million per year; lease No. 2: $63.0 million per year; and lease No. 3: $6.3 million per year.

        Percentage Rent.    We are required to pay additional rent with respect to each lease. This rent is a percentage of the increase in resident revenues at the leased properties over a base year calculated as follows:

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        Term.    The terms of these leases are as follows:

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

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

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

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

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

•

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



•

business interruption insurance;



•

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



•

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



•

worker's compensation insurance if required by law; and



•

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

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

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

        Non Economic Circumstances.    If we determine that continued operations of one or more facilities is not economically practical, we may negotiate with Senior Housing to include a substitute property under the leases or close or sell that community, including Senior Housing's ownership in the property. In the event of such a sale, Senior Housing receives the net proceeds and our rent for the remaining communities in the affected lease is reduced according to a formula set forth in the lease.

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

•

any person or group acquiring ownership of 9.8% of our outstanding voting stock;



•

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



•

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



•

our failure to maintain the insurance required under such lease;



•

the occurrence of certain events with respect to our insolvency;



•

the institution of a proceeding for our dissolution;



•

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



•

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



•

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

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

•

accelerate the rent;



•

terminate the leases in whole or in part;



•

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



•

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

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

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

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

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

        FF&E Reserves.    As a result of a lease amendment specific to the lease for the 31 communities managed by MSLS, effective October 1, 2002, we are required to make deposits into accounts we own for replacements and improvements. Senior Housing has a security and remainder interest in these accounts and in all property purchased with funding from these accounts. Prior to this amendment, we were required to pay these deposits to Senior Housing and we recorded them as rent expense on our consolidated statement of operations. From the period January 11, 2002, the date we began to lease these communities, through September 30, 2002, we deposited $5.4 million into escrow accounts owned by Senior Housing that we recorded as rent expense. The amount and use of these escrows are unchanged by the amendment; however subsequent to September 30, 2002, we do not record rent expense as a result of these deposits.

MARRIOTT SENIOR LIVING SERVICES MANAGEMENT AGREEMENTS

        The 31 communities leased from Senior Housing and managed by MSLS are each subject to a management agreement with MSLS. If you want more information about these agreements, you should read the representative form of management agreement which has been filed as an exhibit to this Annual Report on Form 10-K. The following is a description of the material terms of the management agreements:

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

        Community Services.    Our contract with MSLS delegates to MSLS the responsibility for operations of the managed communities, including obtaining and maintaining all insurance, establishing resident care policies and procedures, carrying out and supervising all necessary repairs and maintenance, procuring food, supplies, equipment, furniture and fixtures, and establishing prices, rates and charges for services provided. MSLS also recruits, employs and directs all community based employees.

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

        FF&E Reserves and Capital Improvements.    MSLS has established a reserve account under each management agreement, referred to as an FF&E Reserve, to cover the expected recurring cost of replacements and renewals to the furniture, furnishings, fixtures, soft goods, case goods, vehicles and equipment, and for building repairs and maintenance which are normally capitalized. The FF&E Reserve accounts are funded from the operating revenues of the managed communities. The amount of this funding varies somewhat among the managed communities; however, for most communities it is currently set at 2.85% of gross revenues and is expected to gradually increase to 3.5%. In the event major capital improvements are required, or if the amounts set aside in the FF&E Reserve accounts are inadequate for required repairs, we may be required to separately fund such repairs and improvements. Any such separate funding which we provide increases the amount of our owner's priority, described below. Also, under our lease we have the option to request Senior Housing to provide any required separate funding in return for rent adjustments to provide Senior Housing a return on its investment according to a formula set forth in the lease.

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        Fees.    For its management services, MSLS receives a base fee generally equal to 5% of the managed communities' gross revenues, plus an incentive fee generally equal to 20% of operating cash flows in excess of owner's priority amounts, as defined in the agreements. For its central services, MSLS receives a fee generally equal to 2% of gross revenues. Generally, through the earlier of (i) the end of June 2004 or (ii) the date on which certain performance criteria have been met, payment of up to one half of this central services fee (i.e., 1% of gross revenues) is conditional, and is waived if specified annual profit targets are not achieved. During 2002 management and central services fees paid to MSLS totaled $16.6 million.

        Owner's Priority.    We receive the profits of the MSLS managed communities on a priority basis before MSLS receives any incentive fees for community services or any conditional central services fees. The amount of the owner's priority for each managed community is established based upon a specified rate of return on historical capital investments in these communities, including capital improvements during the term of the management agreements which are funded by us or Senior Housing in addition to the FF&E Reserve. For fiscal years 2002 and 2001, the aggregate amount of owner's priority for all 31 communities was $69.3 million and $68.9 million, respectively.

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

•

Defaults and Termination. The MSLS management agreements contain various default and termination provisions. Our right to exercise termination options under the MSLS management agreements is subject to approval by Senior Housing under the terms of the lease for these 31 MSLS communities. The default and termination rights under these management contracts are the subject of litigation between us and Senior Housing on one side, and MSLS and Marriott on the other side. See Item 3., "Legal Proceedings".

Item 3. Legal Proceedings

        In January 2002 we leased 31 senior living communities with 7,476 living units from Senior Housing. At the time these properties were leased and through today they were and are managed by MSLS, a 100% owned subsidiary of Marriott. Because of the manner in which this transaction was structured, we and Senior Housing both became parties to the management contracts with MSLS, we are primarily responsible for all matters affecting the properties operations and MSLS's management. Many of the management services provided to these 31 communities by MSLS are in practice provided by Marriott.

        Shortly after we began to lease these communities, we began to question the financial and operations management provided by MSLS and Marriott. Among other matters, we questioned: (i) whether Marriott's pooled insurance costs were fairly allocated to the communities and to other operations of Marriott; (ii) whether Marriott realized unfair profits by purchasing goods and services for these communities from Marriott affiliated businesses; (iii) whether Marriott and MSLS improperly charged the communities for home office personnel and costs which should have been borne by Marriott and MSLS in return for their management fees; (iv) whether excessive amounts of the 31 communities revenues were retained by MSLS and Marriott as working capital cash and used for other Marriott operations without compensation to us; (v) whether deposits received from the communities' residents were improperly retained by Marriott or MSLS and used interest free for their own purposes; (vi) whether MSLS and Marriott were directing business away from the managed communities to other properties which MSLS operates for its own account; (vii) whether adequate collection procedures were in effect to reduce bad debt expenses or if uncollectable revenues were accrued to inflate management fees; (viii) whether MSLS and Marriott refused to prepare a plan to close a chronically loss producing property in order to continue collecting management fees; and (ix) generally whether the managed

20

communities are being properly marketed and managed. Marriott and MSLS denied that they breached their obligations under the management contracts; however, as result of these inquiries and other demand notices, Marriott has to date paid us a total of approximately $2.3 million.

        In July 2002, Marriott publicly announced its intention to exit the senior living management business and hired an investment bank to auction MSLS. We and Senior Housing submitted a combined bid for MSLS, but that bid was not accepted. During this auction process, we and Senior Housing asserted that the management contracts require our approval for, or otherwise restricted, the sale of MSLS. Marriott denied this assertion.

        On November 27, 2002, Marriott and MSLS sued us in the Circuit Court for Montgomery County, Maryland. This lawsuit seeks a declaration that Marriott and MSLS have not breached the management contracts, or, if they have breached, that such breach(es) is (are) not sufficiently material to permit termination of the management contracts. We and Senior Housing have answered that there have been material breaches sufficient to terminate the management contracts and have counter-claimed for money damages. A preliminary injunction was issued in this case on January 8, 2003, upon Marriott's and MSLS's request, which prohibits us from terminating the management contracts until completion of the trial. We and Senior Housing have appealed the preliminary injunction ruling. No schedule for that appeal has as yet been established. A preliminary trial date has been established for this Maryland case in April 2004.

        Also on November 27, 2002, we and Senior Housing sued Marriott and MSLS in the Superior Court for Middlesex County, Massachusetts. An amended complaint was filed on January 27, 2003. Among other matters, this lawsuit sought a declaration that we and Senior Housing may terminate the management agreements in the event of a sale of MSLS. In December 2002, our and Senior Housing's request for a preliminary injunction to prevent the sale of MSLS until trial was denied. Thereafter on December 30, 2002, Marriott announced that it has entered an agreement to sell MSLS to Sunrise. A hearing on our and Senior Housing's request for a preliminary determination of the rights of the parties upon completion of the proposed sale was held on February 21, 2003. At the same February 21 hearing, the court also considered Marriott's and MSLS's motion to dismiss the amended complaint. On March 4, 2003, the Massachusetts Court granted the motion to dismiss. We and Senior Housing intend to seek reconsideration of this decision and are considering whether to appeal the Massachusetts court decision.

        We believe that Marriott and MSLS have materially breached the management agreements. We also believe that the management agreements may be terminated if MSLS is sold to Sunrise. However, the factual and legal issues involved in this litigation are complex and the final outcome of this litigation cannot be predicted. Also, this litigation is likely to be expensive to conduct and the total amount of this expense cannot be estimated at this time.

        We continue to pay rent for the 31 communities involved in this litigation. If the management contracts are terminated, we believe we will be able to operate the communities involved in this litigation. We are unable to predict whether MSLS owned by Sunrise will be able to manage these communities or whether that management may adversely affect our ability to meet our financial obligations.

        In the ordinary course of business we are involved in other litigation incidental to our business; however, we are not aware of any other material pending legal proceeding affecting us for which we might become liable or the outcome of which we expect to have a material impact on us, except the litigation with Marriott and MSLS described above.

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

        None.

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PART II

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

        Our common shares are traded on the American Stock Exchange under the symbol "FVE". The following table sets forth for the periods indicated the high and low closing price for our common shares as reported by the American Stock Exchange:

        The closing price of our common shares on the American Stock Exchange on March 24, 2003, was $1.18 per share.

        As of March 14, 2003, there were 4,367 shareholders of record of our common shares, and we estimate that as of such date there was approximately 72,000 beneficial owners of our common shares. Our charter places a restriction on the ability of any person or group to acquire beneficial ownership of more than 9.8% of any class of our equity shares. Additionally, the terms of our leases with Senior Housing and our agreement with RMR contain provisions whereby our rights under these agreements may be cancelled by Senior Housing and RMR, respectively, upon the acquisition by any person or group of more than 9.8% of any of our voting stock and upon other change in control events, as defined in those agreements. If the breach of these ownership limitations causes a lease default, shareholders causing the default may become liable to us or to other shareholders for damages.

        We do not expect to pay dividends in the foreseeable future.

Item 6. Selected Financial Data

        The following table presents selected financial data which has been derived from our historical financial statements for the period from April 27, 2000 (the date we commenced operations) through December 31, 2002. The following data should be read in conjunction with, and is qualified in its entirety by reference to, our financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. As discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operations", we are a relatively new company and our historical financial

22

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

        The following table presents selected financial data derived from historical financial statements of our two predecessors. The following data should be read in conjunction with the financial statements and notes thereto entitled Combined Financial Statements of the Forty-two Communities Acquired by Senior Housing Properties Trust from Integrated Health Services, Inc. and Combined Financial Statements of Certain Mariner Post-Acute Network Communities (Operated by subsidiaries of Mariner Post-Acute Network) included in this Annual Report on Form 10-K, and "Management's Discussion and Analysis of Financial Condition and Results of Operations-Historical Results of Operations-Mariner Predecessor" and "Historical Results of Operations-Integrated Predecessor". The following table presents the information from 1998 to 2000.

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

OVERVIEW

        We were incorporated in Delaware in April 2000 and reincorporated in Maryland in September 2001. We were formed as a 100% owned subsidiary of Senior Housing. Effective July 1, 2000, we assumed the operations of healthcare communities from two bankrupt former tenants of Senior Housing. Pursuant to tax laws applicable to REITs, Senior Housing engaged FSQ, Inc., an independent operating company formed by our managing directors, to manage these communities. At the time we assumed operations of these communities, we had not received substantially all of the required licenses for these communities. As a result, for the period from July 1, 2000, through December 31, 2000, we accounted for the operations of these communities using the equity method of accounting and we only recorded the net income from these operations. Thereafter, we obtained all necessary licenses to operate these communities, and on January 1, 2001, we began to consolidate the results of operations of these communities. On December 31, 2001, Senior Housing distributed substantially all of our shares to its shareholders in a spin off transaction and we became a separately traded public company. Also, on January 2, 2002, in order to acquire the personnel, systems and assets necessary to operate these communities, we acquired FSQ, Inc. by merger.

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

        Our revenues consist primarily of payments for services provided to residents at our communities. The payments are either made by the residents, their families or insurers, referred to as private pay revenues, or by the Medicare and Medicaid programs. On a pro forma basis, after giving full year effect to the 51 communities we leased or acquired in 2002, for the year ended December 31, 2002, private pay revenues represented 61% of our total revenues. Our expenses consist primarily of rent, wages and benefits of personnel, food, supplies, insurance and other resident care costs, as well as taxes, and other property related costs.

OUR HISTORICAL RESULTS OF OPERATIONS

        As described above, until completion of the spin off, we operated as a subsidiary of Senior Housing. Our past operations as Senior Housing's subsidiary prior to 2002 differ from our 2002 and current operations as an independent public company. Specifically, in the 2000 and 2001 periods we operated only 56 communities for Senior Housing, which owned the real estate as well as the operations. Effective December 31, 2001, we began to lease these 56 communities (now 54 communities) from Senior Housing which continued to own the real estate. In January 2002, we began to lease an additional 31 communities from Senior Housing that are managed by MSLS. In April 2002, we acquired and began to operate five additional senior living communities. In October 2002, we began to operate 15 additional owned or leased senior living communities. Also, our principal source of financing for us as a subsidiary of Senior Housing prior to 2002 was intercompany advances from Senior Housing, an entity with financial resources substantially in excess of ours. Because of these differences, we believe that our historical results of operations for periods prior to 2002 described below are not comparable to our 2002 operations or our expected future operations. The following tables present an overview of our portfolio for the years ended December 31, 2002 and 2001 which

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shows the differences in the size of our operations during these periods and "Same Store" results for the communities' operations, including periods prior to their acquisition by us.

Year ended December 31, 2002, versus year ended December 31, 2001

        Revenues from residents for 2002 were $522.2 million, an increase of 136% over revenues from residents of $221.2 million for 2001. This increase is attributable primarily to our lease of 31 communities on January 11, 2002, our acquisition of five communities on April 1, 2002, and our acquisition or lease of 15 communities on October 25, 2002. Revenues from residents at the communities we operated throughout 2002 and 2001 were $229.4 million and $221.4 million, respectively, an increase of 4%. This increase is due primarily to higher per diem charges to residents and slightly higher occupancy. Revenues from residents at the 105 communities we operated at December 31, 2002, were $562.7 million for 2002, an increase of 4% over revenues from residents of $541.3 million in 2001 (including revenues which relate to periods prior to our operation of some of these communities). This increase is principally attributable to higher per diem charges to residents offset somewhat by a 1% decline in occupancy. About 39% of our revenues from residents in 2002 were received from Medicare and Medicaid, compared to 78% in 2001. This decrease is due largely to our lease of 40 and acquisition of 11 communities during 2002, all of which are focused on services to residents who pay with private resources.

        Since 1998, a Medicare prospective payment system has generally lowered Medicare rates paid to senior living communities including many that we operate. In October 2002, temporary increases in Medicare payment rates expired. Our Medicare revenues totaled $68.4 million and $35.4 million during 2002 and 2001, respectively. These amounts do not include communities where operations were ceased by us in 2002. This increase is due to the addition to our business in January 2002 of 31 communities which are operated for us by MSLS and an increase in Medicare revenue at the 54 nursing homes which we operated in both 2001 and 2002 caused primarily by the 16% increase in Medicare resident days at these nursing homes. Because the Medicare rate increases expired in October 2002, assuming

25

our 2003 census of Medicare residents is comparable to 2002, we estimate that our revenues received from Medicare in 2003 will decline by approximately $6.9 million over 2002 revenues received from Medicare.

        Our 31 communities which are managed by MSLS generated $26.9 million, or 10%, of their revenue in 2002 from Medicare, versus $26.9 million, or 10%, in 2001. Our 54 nursing homes generated $41.5 million, or 18% of their revenue in 2002 from Medicare, versus $35.4 million, or 16%, in 2001. The 20 independent and assisted living communities which we operate for our own account do not participate in the Medicare program and generate no Medicare revenues.

        Some state governments have reduced or are planning to reduce Medicaid rates to address state budget shortfalls. In 2002, 29% of our total revenues, or $142.6 million, were Medicaid revenues, versus $127.9 million in 2001, an increase of 11%. These amounts do not include revenues at communities where our operations ceased in 2002. This increase is due to the addition to our business in January 2002 of 31 communities operated for us by MSLS which generate some Medicaid revenues and an increase in Medicaid revenue at our 54 nursing homes caused primarily by the 6% increase in Medicaid rates at these nursing homes. The magnitude of possible future Medicaid rate reductions cannot currently be estimated, but it may be material.

        Our 31 communities which are managed by MSLS generated $10.2 million, or 4% of their revenue in 2002, from Medicaid, versus $9.9 million, or 4%, in 2001, from Medicaid. Our 54 nursing homes generated $132.3 million or 58% of their revenue in 2002 from Medicaid, versus $127.9 million, or 58% in 2001. The 20 independent and assisted living communities which we operate for our own account do not participate in the Medicaid program and generate no Medicaid revenues.

        Interest income increased by $205,000 in 2002 compared to 2001 due to earnings on higher cash balances in the 2002 period.

        Expenses for 2002 were $532.9 million, an increase of 142% over expenses of $220.0 million for 2001. Our wages and benefits costs increased from $155 million to $237.7 million, or 53%, primarily due to expenses at the 51 communities we leased or acquired in 2002. Other operating expenses, which include utilities, housekeeping, dietary, maintenance, insurance and community level administrative costs, rose from $47.9 million to $182.5 million or 281%, again primarily due to expenses at the 51 communities we leased or acquired in 2002. During 2001, MSLS did not manage any communities for us and we were a subsidiary of Senior Housing that did not lease any communities. As a result, we did not incur management fees to MSLS or rent expense in 2001. Community level operating expenses related to the communities we operated throughout 2002 and 2001, were $212.8 million and $202.7 million, respectively, an increase of 5%. This increase is principally attributable to higher insurance premiums, an increase in reserves for the self funded portion of our insurance programs and higher wage and benefit costs, which were partially offset by a decrease in expenses from our reduced use of higher cost, third party staffing. Community level operating expenses at the 105 communities that we operated at December 31, 2002, were $467.5 million for 2002, an increase of 7% over community expenses for 2001 (including expenses which relate to periods prior to our operation at some of these communities). This increase resulted principally from higher insurance premiums, an increase in reserves for the self funded portion of our insurance programs and higher wage and benefit costs.

        Our general and administrative expenses for 2002 were $15.4 million, a decrease of 1% over 2001, primarily due to operational start up costs incurred during 2001 which we did not incur in 2002 which were only partially offset by increased costs in 2002 associated with operating as a separate, publicly owned company and the legal and other costs incurred in connection with our litigation with Marriott and MSLS.

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        Depreciation expense in 2002 was $1.9 million, an increase of 46% over depreciation expense of $1.3 million in 2001. The increase is attributable to our purchase of 11 communities in 2002.

        Loss from discontinued operations for 2002 was $2.8 million, an increase of $2 million over the loss in 2001. This increase was the result of reserves recorded for Medicaid receivables due from the State of Connecticut related to community closure costs and an asset impairment charge related to a closed community.

        As a result of the factors described above, our net loss for 2002 was $13.2 million, compared to a profit of $527,000 in 2001. Our net loss per share in 2002 was $1.74. Assuming the shares outstanding as of December 31, 2001, were outstanding for all of 2001, our earnings per share would have been $0.11 for 2001.

Year ended December 31, 2001, versus year ended December 31, 2000

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

        Revenues for 2001 were $221.3 million. On a combined basis, the two predecessor entities had revenues of $220.7 million for 2000. This increase was due mainly to an increase in the average daily rate received during these periods.

        Expenses for 2001 were $219.9 million. On a combined basis, the predecessor entities had expenses of $253.4 million for 2000. The decrease is due primarily to rent and interest expenses which were included in the 2000 expenses of our predecessors but were zero in 2001 because, after Senior Housing's repossessions and foreclosures, rent and interest payments on our predecessors' leases and mortgages ceased.

Period from April 27, 2000 (date our operations commenced) through December 31, 2000

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

        During 2000 we accounted for our investment in these operating businesses using the equity method of accounting. As a result, the reported revenues include only our equity in earnings of these investees. Revenues for 2000 were $2.2 million and represent the net amount of net patient revenues in excess of expenses of these operations for the 2000 period. Net patient revenues at the operating businesses for the period ended December 31, 2000, were $114.5 million and expenses incurred for the period were $112.0 million.

Historical Results Of Operations-Mariner Predecessor—2000

        Our Mariner Predecessor conducted operations of 17 communities leased from Senior Housing for a period of time in 2000. The 2000 operations of the Mariner Predecessor during the period prior to its acquisition by Senior Housing differ from our operations as follows:

•

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



•

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

        We believe that because of these differences, these historical results of operations are not comparable to our operations. Specifically, the historical operations include: revenues and operating expenses for only 17 communities, one of which has since been closed, while currently we generate revenues and incur operating expenses at 105 communities; depreciation expenses which relate to real

27

estate and amortization expenses which relate to goodwill, while we have less depreciable assets and no amortizing goodwill; expenses related to allocation of corporate overhead by the parent of these operations, while we incur different corporate expenses; rent expense under a lease which has been cancelled; charges for impairments of long lived assets of substantial amounts, while we have incurred lesser such charges; and interest expense incurred on debt which is different from our debt and internal costs.

        In 2000, our Mariner predecessor had revenues of $85.3 million, incurred expenses of $92.6 million, and realized a net loss of $7.4 million.

Historical Results Of Operations-Integrated Predecessor—2000

        Our Integrated Predecessor conducted operations of 42 communities leased from or mortgaged to Senior Housing for a period of time in 2000. The operations of the Integrated Predecessor during the period prior to its acquisition by Senior Housing differ from our operations as follows:

•

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



•

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

        We believe that because of these differences, the historical results of operations are not comparable to our operations. Specifically, the historical operations include: revenues and operating expenses for only 42 communities, one of which has since been closed, while we currently generate revenues and incur operating expenses at 105 communities; depreciation expenses which relate to real estate and amortization expenses which relate to intangible assets, while our depreciable and amortizable assets are less substantial; expenses related to corporate overhead and management fees charged by the parent of the Integrated Predecessor, while we incur different corporate expenses; rent expense under a lease which has been canceled; charges for impairments of long lived assets of substantial amounts, while we have incurred lesser such charges; and interest expense incurred on debt which is different from our debt and internal costs.

        In 2000, our Integrated predecessor had revenues of $135.4 million, incurred expenses of $160.6 million and realized a net loss of $25.3 million.

LIQUIDITY AND CAPITAL RESOURCES

        Our total assets at December 31, 2002, were $133.2 million compared to $68 million at December 31, 2001. The increase is primarily a result of our capital raising, acquisition and leasing activities in 2002. At December 31, 2002, we had cash and cash equivalents of $10.3 million and $8.7 million available on our revolving credit facility. For 2002 and 2001: cash provided by (and used in) operating activities was $9.9 million and ($293,000), respectively, cash used in investing activities was $48.6 million and $2.2 million, respectively and cash provided by financing activities was $25.1 million and $21.1 million, respectively.

        We lease 94 communities from Senior Housing. Our leases with Senior Housing require us to pay a total of $76.2 million of minimum rent annually. Percentage rent on these leases begins in 2003 and 2004. We expect percentage rent to be modest relative to our total rental obligations. If events of default under the leases occur, Senior Housing has the ability to accelerate our rent payments. At March 24, 2003, we believe we are in compliance with the terms of our leases.

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        Our primary source of cash to fund operating expenses, including rent, principal and interest payments on our mortgage debt and routine capital expenditures, is our revenues from services to residents at our communities. Changes in laws and regulations which impact Medicare or Medicaid rates, on which some of our communities rely, may materially affect our future results. In October 2002 temporary increases in Medicare payment rates expired. Assuming our 2003 census of Medicare residents is comparable to 2002, we estimate that our revenues received from Medicare in 2003 will decline by approximately $6.9 million over 2002 revenues received from Medicare. Some of the states in which we operate have reduced or are planning to reduce Medicaid funding to address state budget shortfalls. The magnitude of combined Medicare and Medicaid revenue reductions cannot currently be estimated, but it may be material. We expect recent increases in the costs of insurance, especially tort liability insurance, workers compensation and employee health insurance costs, which are affecting the senior living industry, will continue to have a material adverse impact upon our future results of operations. As discussed in note 17 to our financial statements, a failure by Integrated Health Services, the United States Department of Health and Human Services or the State of Connecticut to make payments that we believe are due to us would have a material adverse impact upon our future results and deny us access to those cash proceeds to which we believe we are entitled. It is also possible that our litigation with Marriott and MSLS and potential transfer of the related management agreements, as discussed in note 17 to our financial statements, may have an adverse impact on our financial results or increase our working capital requirements. Despite these contingencies, however, we believe that a combination of some or all of our efforts to increase revenues, contain or reduce costs, our ability to borrow on the revolving credit facility, our ability to obtain financing from Senior Housing for capital improvements made to communities leased from Senior Housing and the possibility of sales or financings of our owned communities will be sufficient to meet our working capital needs, operating expenses, rent payments to Senior Housing, debt service and capital expenditures in the short term, or next 12 months, and in the normal course of our business for the foreseeable future.

Debt Instruments and Covenants

        In October 2002, we entered into a revolving credit facility. The interest rate on borrowings on this facility is LIBOR plus a spread. The maximum amount available under this facility is $12.5 million, and is subject to limitations based upon qualifying collateral. The borrower under this facility is a subsidiary that we organized with the intention that it be "bankruptcy-remote". Certain of our other subsidiaries sell or contribute their healthcare accounts receivable to the borrower on a true sale basis and make certain representations and other undertakings in favor of the borrower in connection with each sale. The seller subsidiaries have granted security interests in their assets to secure their obligations to the borrower. We guarantee the obligations of the seller subsidiaries obligations to the borrower subsidiary and have pledged the stock or membership interests in each of the seller subsidiaries to the borrower. The borrower has in turn collaterally assigned these undertakings, guarantees and collateral to the revolving credit facility lenders, and has granted a security interest in the purchased receivables and all of its other assets to secure its obligations under the facility. The facility is available for acquisitions, working capital and general business purposes. The facility contains covenants and events of default requiring the maintenance of collateral, minimum net worth and certain other financial ratios, among other customary provisions. The accounts receivable collateralizing the facility totaled $19.2 million, net of allowances of $1.5 million, as of December 31, 2002. In certain circumstances and subject to available collateral and lender approvals the maximum amounts which we may draw under this credit agreement may be increased to $25.0 million. As of December 31, 2002, no loans were outstanding under the facility. At March 24, 2003, we believe we are in compliance with all applicable covenants under this revolving credit agreement and no loans are outstanding.

        In connection with our October 2002 acquisition of a community, we assumed HUD insured mortgages totaling approximately $15.8 million. The weighted average interest cost on this debt is 8.98% per year. Principal and interest is due monthly through 2033. These mortgages are not recourse

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to us and are secured by one of our owned communities with 229 living units. A portion of this debt is refinanceable in June 2003 and all of this debt may be refinanced beginning in 2004. This mortgage debt was recorded, as required by generally accepted accounting principles, or GAAP, at its estimated fair value on the date we assumed it, or $16.2 million. The approximate $400,000 difference between our contractual obligation and our carry value is being amortized over the estimated period the mortgages will remain outstanding. These mortgages contain standard HUD mortgage covenants. At March 24, 2003, we believe we are in compliance with all material covenants of these mortgages.

Related Parties

        On December 31, 2001, Senior Housing distributed substantially all of our shares to its shareholders. In order to effect this spin off and to govern relations after the spin off, we entered into agreements with Senior Housing, and others. Among other matters, these agreements provide:

•

We may not waive our corporate charter restrictions on ownership of more than 9.8% of any class of our equity shares by any person or group without the prior consent of Senior Housing and our determination that the exception to these restrictions would not cause a default under any of our leases;



•

If any person or group acquires more than 9.8% of our voting stock and upon other change in control events, Senior Housing may terminate our rights under our leases with Senior Housing;



•

So long as we are a tenant of Senior Housing, we will neither permit any person or group to acquire more than 9.8% of our voting stock or permit the occurrence of other change in control events, as defined, nor will we take any action that, in the reasonable judgment of Senior Housing or HRPT Properties Trust, might jeopardize the tax status of Senior Housing or HRPT Properties as a REIT;



•

So long as we maintain our shared services agreement with RMR or are a tenant under a lease with Senior Housing then we will not acquire or finance real estate without first giving Senior Housing or any other publicly owned REIT or other entity managed by RMR the right to acquire or finance real estate investments of the type in which Senior Housing or the other entities, respectively, invest; and



•

Upon Senior Housing's purchase of the 31 communities managed by MSLS, we would acquire operating assets associated with these communities and begin to lease these communities from Senior Housing for minimum annual rent of $63 million.

        As of December 31, 2002, we leased 94 of our 105 senior living communities from Senior Housing for aggregate annual minimum rent of $76.2 million. In the future, we may transact additional business with Senior Housing. We believe that our current leases with Senior Housing were entered into on reasonable commercial terms. However, because of the historical and continuing relationships which we have, these continuing and possibly expanding business relationships may not be arm's length and may not be on the same or as favorable terms as we enter with third parties with whom we did not have such relationships.

        During 2002 we acquired seven senior living communities from a third party for $27 million. Prior to this acquisition Senior Housing waived its right to acquire these assets, subject to a continuing right to acquire or finance these assets in the event we determine to sell or finance them. To finance the cash portion of our purchase, we sold a senior living community to Senior Housing, which we purchased in April 2002, for $12.7 million, its approximate carrying value. Simultaneous with our acquisition, Senior Housing acquired eight other senior living communities from the same third party. We acquired operating assets and liabilities related to these eight communities. We began to lease these eight communities and the community we sold to Senior Housing for minimum annual rent of

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$6.3 million. The terms of this transaction with Senior Housing were negotiated on our behalf by our independent director who is not on the board of Senior Housing.

        As discussed more fully in Item 3. "Legal Proceedings", during 2002, we and Senior Housing became jointly involved in litigation with Marriott and MSLS, the operator of 31 of the senior living communities which we leased from Senior Housing beginning in 2002. We believe that Marriott and MSLS have materially breached the management agreements for these 31 communities. We also believe that the management agreements may be terminated if MSLS is sold to Sunrise. Marriott announced that it had entered an agreement to sell MSLS to Sunrise on December 30, 2002. However, the factual and legal issues involved in this litigation are complex and the final outcome of this litigation cannot be predicted. Also, this litigation is likely to be expensive to conduct and the total amount of this expense cannot be estimated at this time.

        We have an agreement with RMR to provide administrative services to us. RMR is owned by Messrs. Martin and Portnoy, who are our managing directors and members of our board of directors. RMR is compensated at an annual rate equal to 0.6% of our total revenues. Aggregate fees paid to RMR for services during 2002 were $2.9 million. The fact that RMR has responsibilities to other entities, including our landlord, Senior Housing, could create conflicts and, in the event of such conflicts between Senior Housing and us, the shared services agreement allows RMR to prefer its responsibility to Senior Housing. The terms of our shared services agreement are annually reviewed and approved by our directors who are not owners or employees of RMR, and we believe these terms are commercially reasonable. However, because of these historical and continuing relationships our shared services agreement may not be arm's length and may not be on the same or as favorable terms as we might enter with third parties with whom we did not have such relationships.

        Our Chief Executive Officer and Chief Financial Officer are also officers and employees of RMR. These officers devote a substantial majority of their business time to our affairs and the remainder to RMR's affairs which are separate from ours. We believe the compensation we pay to these officers reflects their division of business time. However, periodically, these individuals may divide their business time differently than they do currently and their compensation from us may become disproportionate to this division.

        During 2002 we acquired FSQ, an entity owned by Messrs. Martin and Portnoy, in a merger transaction that was entered into as part of our spin off from Senior Housing. We acquired all of the stock of FSQ and Messrs. Martin and Portnoy each received 125,000 of our common shares. The board of trustees of Senior Housing received an opinion from an internationally recognized investment banking firm, to the effect that the merger was fair, from a financial point of view, to us. The terms of this merger were approved by Senior Housing's trustees other than Messrs. Martin and Portnoy.

        Messrs. Martin and Portnoy own the building in which our headquarters is located. Our lease for space was originally executed by FSQ when FSQ was owned by Messrs. Martin and Portnoy. This lease expires in 2011. During 2002, we paid rent under this lease of $539,000. We believe that this lease and the rent rate were commercially reasonable at the time they were entered. However, because of this historical and continuing relationship among us, FSQ and Messrs. Portnoy and Martin, this lease may not be arm's length and it may not be on the same or as favorable terms as we might have with third parties with whom we did not have such relationships.

        In March 2003, Senior Housing terminated a lease for a nursing home community in St. Joseph, Missouri and evicted the tenant, which was not current in its rent obligations to Senior Housing. We have agreed to manage this nursing home until it is re-leased or sold. We will be paid a management fee of 5% of the gross revenues from this nursing home.

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        Until March 31, 1997, Mr. Portnoy was a partner of Sullivan & Worcester LLP, our counsel and counsel to Senior Housing, RMR and affiliates of each of the foregoing, and he received payments from that firm during 2002 in respect of his retirement.

Critical Accounting Policies

        Our most critical accounting policies concern revenue recognition, our assessment of the net realizable value of our accounts receivable, the realizability of long term assets, accounting for long term care contracts, accounting for business combinations and our assessment of reserves related to our self insurance programs.

        Our revenue recognition policies involve judgments about Medicare and Medicaid methodologies. These judgments are based principally upon our experience with these programs. We recognize revenues when services are provided and revenues are earned and these amounts are reported at their estimated net realizable amounts. Some Medicare and Medicaid revenues are subject to audit and retroactive adjustment.

        Our policies for valuing accounts receivable involve significant judgments based upon our experience, including consideration of the age of the receivable, the terms of the agreements with our residents or their third party payors, the resident or payors stated intent to pay, the resident or payors financial capacity and other factors which may include litigation or appeal proceedings.

        We monitor our long-term assets to determine whether any impairment of these assets may have occurred. If the facts and circumstances indicate that an impairment may have occurred, we evaluate the asset's carrying value to determine whether an impairment charge is required. This process includes a review of historical and projected future financial results realized or to be realized from the affected assets, market for sale and the like. This process requires that estimates be made and errors in our judgments or estimates could have a material effect on our financial statements.

        At certain of our facilities, we offer long-term care contracts under which residents pay a one-time deposit in exchange for reduced charges during their stay. The one-time deposits may be refundable or non-refundable, or partially refundable and partially non-refundable. We record such deposits as a long-term obligation and amortize the non-refundable portion of such deposits into revenue over our estimate of the periods during which future services will be provided. We base these estimates on our experience, actuarial information and other factors.

        During 2002, we began to lease or acquire 51 communities. We accounted for each of these transactions as a purchase business combination in accordance with Statement of Financial Accounting Standards No. 141. Purchase accounting requires that we make certain judgments and estimates based on our experience, including determining the fair value and useful lives of assets acquired and the fair value of liabilities assumed. Some of our judgments and estimates are also based upon published industry statistics.

        Our policies for determining reserves for the self funded part of our insurance programs and for our self insurance programs involve significant judgments based upon our experience, including projected settlements for pending claims, known incidents which we expect may result in claims, estimates of incurred but not yet reported claims and incidents, claims experience, estimated litigation costs and other factors. We also periodically receive and rely upon recommendations from professional consultants in establishing these reserves.

        In the future we may need to revise the judgments, estimates and assessment we use to formulate our critical accounting policies to incorporate information which is not now known. We cannot predict the effect changes to these premises underlying our critical accounting policies may have on our future results of operations, although such changes could be material and adverse.

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Inflation and Deflation

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

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

Seasonality

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

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

        We are exposed to risks associated with market changes in interest rates. We manage our exposure to this market risk through our monitoring of available financing alternatives. Our strategy to manage exposure to changes in interest rates is unchanged since December 31, 2001. Other than as described below we do not now anticipate any significant changes in our exposure to fluctuations in interest rates or in how we manage this risk in the future.

        Changes in market interest rates also affect the fair value of our debt obligations; increases in market interest rates decrease the fair value of our fixed rate debt, while decreases in market interest rates increase the fair value of our fixed rate debt. For example: based upon discounted cash flow analysis, if prevailing interest rates were to decline by 10% and other credit market considerations remained unchanged, the market value of our $15.8 million mortgage debt outstanding on December 31, 2002, would increase by about $1.3 million; and, similarly, if prevailing interest rates were to increase by 10%, the market value of our $15.8 million mortgage debt would decline by about $1.1 million.

        Our revolving credit facility bears interest at floating rates and matures in October 2005. As of December 31, 2002, we had zero outstanding under this revolving credit facility. We borrow in U.S. dollars and borrowings under our revolving credit facility are subject to interest at LIBOR plus a spread. Accordingly, we are vulnerable to changes in U.S. dollar based short term rates, specifically LIBOR. A change in interest rates would not affect the value of any outstanding floating rate debt but would affect our operating results. For example, if the maximum amount of our credit facility of $12.5 million were drawn and interest rates decrease or increase by 1% per annum, our interest expense would decrease or increase by $125,000 per year, or $0.02 per share, respectively. If interest rates were to change gradually over time, the impact would be spread over time.

        Our exposure to fluctuations in interest rates may increase in the future if we incur debt to fund acquisitions or otherwise.

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Item 8. Financial Statements and Supplementary Data

        The information required by this Item is included elsewhere in this Annual Report on Form 10-K. Our financial statements and financial statement schedules begin on Page F-1 (see index in Item 15(a)).

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

        None.

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PART III

Item 10. Directors and Executive Officers of the Registrant

        The information required by Item 10 is incorporated by reference to our definitive Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year.

Item 11. Executive Compensation

        The information required by Item 11 is incorporated by reference to our definitive Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters

        Equity Compensation Plan Information. The following table provides a summary as of December 31, 2002, of common shares reserved for issuance pursuant to our 2001 Stock Option and Stock Incentive Plan.

(1)

650,000 of our common shares were reserved for issuance pursuant to our 2001 Stock Option and Stock Incentive Plan. Under the plan we may make share awards, options, grants and other rights.

        The remainder of the information required by Item 12 is incorporated by reference to our definitive Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year.

Item 13. Certain Relationships and Related Transactions

        The information required by Item 13 is incorporated by reference to our definitive Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year.

Item 14. Controls and Procedures

        a)    Within the 90 days prior to the date of this report, our management carried out an evaluation, under the supervision and with the participation of our President and Chief Executive Officer and Treasurer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c) and 15d-14(c). Based upon that evaluation, our President and Chief Executive Officer and Treasurer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic SEC filings.

        b)    There have been no significant changes in our internal controls or in other factors that could significantly affect those controls since our evaluation of these controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

35

Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a)

Index to Financial Statements and Financial Statement Schedules

(b)

Reports on Form 8-K

        During the fourth quarter of 2002, we filed the following Current Reports on Form 8-K:

(i)

Current Report on Form 8-K, filed November 12, 2002, reporting information under Items 2 and 7 relating to the acquisition and lease of 15 senior living communities as well as the sale/leaseback of a single community. In accordance with Item 7(a)(4) of Form 8-K, the required financial statements were filed by amendment on January 9, 2003.



(ii)

Current Report on Form 8-K, filed November 29, 2002, reporting information under Items 5 and 7 relating to legal proceedings and an ongoing dispute with Marriott and MSLS.

(c)

Exhibits

36

37

38

39

(d)

Financial Statement Schedules

(i)

Schedule II-Valuation and Qualifying Accounts for the year ended December 31, 2000 of Forty-two Facilities Acquired by Senior Housing Properties Trust from Integrated Health Services, Inc.

(ii)

Schedule II-Valuation and Qualifying Accounts for the year ended December 31, 2000 of Certain Mariner Post-Acute Network Facilities (Operated by subsidiaries of Mariner Post-Acute Network, Inc.)

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

40

Report of Independent Auditors

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

        We have audited the accompanying consolidated balance sheet of Five Star Quality Care, Inc. as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders' equity and cash flows for the years ended December 31, 2002 and 2001, and the period April 27, 2000 (inception) through December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

        In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Five Star Quality Care, Inc. as of December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for the years ended December 31, 2002 and 2001, and the period April 27, 2000 (inception) through December 31, 2000, in conformity with accounting principles generally accepted in the United States.

F-1

FIVE STAR QUALITY CARE, INC.

CONSOLIDATED BALANCE SHEET

(dollars in thousands, except share data)

The accompanying notes are an integral part of these financial statements.

F-2

FIVE STAR QUALITY CARE, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

(dollars in thousands, except per share data)