-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, GV52J4RS6GY74JWkEuJBeprfSd2037zR0xjAckZsfUVqGZ4Gng46fBZePWhasBI9 c9KPIHdpUtUK/wUJH/EAkQ== 0001035704-98-000517.txt : 19980817 0001035704-98-000517.hdr.sgml : 19980817 ACCESSION NUMBER: 0001035704-98-000517 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980630 FILED AS OF DATE: 19980814 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMERICAN HEALTH PROPERTIES INC CENTRAL INDEX KEY: 0000808240 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 954084878 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 001-09381 FILM NUMBER: 98690734 BUSINESS ADDRESS: STREET 1: 6400 S FIDDLERS GREEN CIRCLE STREET 2: STE 1800 CITY: ENGLEWOOD STATE: CO ZIP: 80111 BUSINESS PHONE: 3037969793 MAIL ADDRESS: STREET 1: 6400 S FIDDLERS GREEN CIRCLE STREET 2: SUITE 1800 CITY: ENGLEWOOD STATE: CO ZIP: 80111 10-Q 1 FORM 10-Q FOR QUARTER ENDED JUNE 30, 1998 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________________ TO____________________ COMMISSION FILE NUMBER 1-9381
American Health Properties, Inc. (Exact name of registrant as specified in its charter) DELAWARE 95-4084878 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 6400 SOUTH FIDDLER'S GREEN CIRCLE 80111 SUITE 1800 (Zip Code) ENGLEWOOD, CO (Address of principal executive offices)
(303) 796-9793 (Registrant's telephone number, including area code) INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES X NO ____ SHARES OF REGISTRANT'S COMMON STOCK, $.01 PAR VALUE PER SHARE, OUTSTANDING AT AUGUST 11, 1998 -- 24,984,422 SHARES OF REGISTRANT'S PSYCHIATRIC GROUP DEPOSITARY SHARES, EACH REPRESENTING ONE-TENTH OF ONE SHARE OF PSYCHIATRIC GROUP PREFERRED STOCK, $.01 PAR VALUE, OUTSTANDING AT AUGUST 11, 1998 -- 2,083,931. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 AMERICAN HEALTH PROPERTIES, INC. JUNE 30, 1998 TABLE OF CONTENTS
PART I FINANCIAL INFORMATION PAGE CONSOLIDATED COMPANY Item 1. Consolidated Condensed Financial Statements: Balance sheets as of June 30, 1998 and December 31, 1997 . . . . . . . . . . . . . . . . . . . 2 Statements of operations for the three and six months ended June 30, 1998 and 1997 . . . . . . 3 Statements of cash flows for the six months ended June 30, 1998 and 1997 . . . . . . . . . . . 5 Notes to financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Item 2. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . 12 CORE GROUP Item 1. Core Group Combined Condensed Financial Statements: Balance sheets as of June 30, 1998 and December 31, 1997 . . . . . . . . . . . . . . . . . . . 22 Statements of operations for the three and six months ended June 30, 1998 and 1997 . . . . . . 23 Statements of cash flows for the six months ended June 30, 1998 and 1997 . . . . . . . . . . . 24 Notes to financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Item 2. Management's Discussion and Analysis of Core Group Combined Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . 29 PSYCHIATRIC GROUP Item 1. Psychiatric Group Combined Condensed Financial Statements: Balance sheets as of June 30, 1998 and December 31, 1997 . . . . . . . . . . . . . . . . . . . 36 Statements of operations for the three and six months ended June 30, 1998 and 1997 . . . . . . 37 Statements of cash flows for the six months ended June 30, 1998 and 1997 . . . . . . . . . . . 38 Notes to financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Item 2. Management's Discussion and Analysis of Psychiatric Group Combined Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . 45 PART II OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . 53 Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
1 3 AMERICAN HEALTH PROPERTIES, INC. CONSOLIDATED CONDENSED BALANCE SHEETS (In thousands except per share amounts)
June 30, December 31, 1998 1997 ------------ ------------ ASSETS (Unaudited) Real estate investments Real property and mortgage notes, net $ 855,815 $ 745,776 Construction in progress 11,325 4,729 Accumulated depreciation (112,211) (102,235) ------------ ------------ 754,929 648,270 Other notes receivable and direct financing leases 6,264 5,553 Other assets 13,678 13,696 Cash and short-term investments 1,854 23,053 ------------ ------------ $ 776,725 $ 690,572 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Bank loans payable $ 75,000 $ -- Mortgage notes payable 21,068 17,922 Notes and bonds payable 226,049 225,891 Accounts payable and accrued liabilities 13,781 13,193 Dividends payable 15,186 14,847 Deferred income 4,319 3,758 ------------ ------------ 355,403 275,611 ------------ ------------ Commitments and contingencies Stockholders' equity Preferred stock $.01 par value; 1,000 shares authorized; 8-1/2% Cumulative Redeemable Preferred Stock, Series B; $2,500 liquidation value; 40 shares issued and outstanding 100,000 100,000 Psychiatric Group Preferred Stock; 208 shares issued and outstanding 2 2 Common stock $.01 par value; 100,000 shares authorized; 24,103 and 23,557 shares issued and outstanding 241 236 Additional paid-in capital 496,557 482,030 Cumulative net income 308,501 283,453 Cumulative dividends (483,979) (450,760) ------------ ------------ 421,322 414,961 ------------ ------------ $ 776,725 $ 690,572 ============ ============
The accompanying notes are an integral part of these financial statements. 2 4 AMERICAN HEALTH PROPERTIES, INC. CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (Unaudited) (In thousands) Three Months Ended June 30, Six Months Ended June 30, --------------------------- -------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- REVENUES Rental income $ 22,484 $ 17,817 $ 43,842 $ 35,627 Mortgage interest income 1,655 1,531 3,308 3,048 Additional rental and interest income 3,400 3,147 6,820 6,123 Other property income 384 34 719 34 Other interest income 220 242 461 1,272 ---------- ---------- ---------- ---------- 28,143 22,771 55,150 46,104 ---------- ---------- ---------- ---------- EXPENSES Depreciation and amortization 5,159 3,889 10,033 7,717 Property operating 1,352 77 2,567 88 Interest expense 5,308 4,478 10,250 10,585 General and administrative 2,322 1,948 4,428 3,828 Impairment loss on psychiatric real estate and notes receivable 2,730 -- 2,730 11,000 ---------- ---------- ---------- ---------- 16,871 10,392 30,008 33,218 ---------- ---------- ---------- ---------- Minority interest 47 47 94 94 ---------- ---------- ---------- ---------- INCOME BEFORE EXTRAORDINARY ITEM 11,225 12,332 25,048 12,792 EXTRAORDINARY LOSS ON DEBT PREPAYMENT -- -- -- (11,427) ---------- ---------- ---------- ---------- NET INCOME $ 11,225 $ 12,332 $ 25,048 $ 1,365 ========== ========== ========== ========== SERIES B PREFERRED DIVIDEND REQUIREMENT $ (2,150) $ -- $ (4,300) $ -- ========== ========== ========== ========== ATTRIBUTABLE TO CORE GROUP COMMON STOCK AND PSYCHIATRIC GROUP DEPOSITARY SHARES - INCOME BEFORE EXTRAORDINARY ITEM $ 9,075 $ 12,332 $ 20,748 $ 12,792 ========== ========== ========== ========== NET INCOME $ 9,075 $ 12,332 $ 20,748 $ 1,365 ========== ========== ========== ==========
The accompanying notes are an integral part of these financial statements. 3 5 AMERICAN HEALTH PROPERTIES, INC. CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (continued) (Unaudited) (In thousands except per share amounts)
Three Months Ended June 30, Six Months Ended June 30, --------------------------- --------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- ATTRIBUTABLE TO - CORE GROUP COMMON STOCK Income before extraordinary item $ 10,559 $ 11,129 $ 20,993 $ 21,059 Extraordinary loss on debt prepayment $ -- $ -- $ -- $ (11,427) Net income $ 10,559 $ 11,129 $ 20,993 $ 9,632 Basic per share amounts - Income before extraordinary item $ 0.44 $ 0.47 $ 0.88 $ 0.90 Extraordinary loss on debt prepayment $ -- $ -- $ -- $ (0.49) Net income $ 0.44 $ 0.47 $ 0.88 $ 0.41 Weighted average common shares 24,055 23,459 23,887 23,459 Diluted per share amounts - Income before extraordinary item $ 0.43 $ 0.47 $ 0.87 $ 0.89 Extraordinary loss on debt prepayment $ -- $ -- $ -- $ (0.48) Net income $ 0.43 $ 0.47 $ 0.87 $ 0.41 Weighted average common shares and dilutive potential common shares 24,314 23,643 24,154 23,646 Dividends declared per common share $ 0.5450 $ 0.5250 $ 1.0900 $ 1.0500 PSYCHIATRIC GROUP DEPOSITARY SHARES Net income (loss) $ (1,484) $ 1,203 $ (245) $ (8,267) Basic per share amounts - Net income (loss) $ (0.71) $ 0.58 $ (0.12) $ (3.97) Weighted average depositary shares 2,084 2,084 2,084 2,084 Diluted per share amounts - Net income (loss) $ (0.71) $ 0.57 $ (0.12) $ (3.97) Weighted average depositary shares and dilutive potential depositary shares 2,084 2,098 2,084 2,084 Dividends declared per depositary share $ 0.6400 $ 0.6300 $ 1.2800 $ 1.3800
The accompanying notes are an integral part of these financial statements. 4 6 AMERICAN HEALTH PROPERTIES, INC. CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands)
Six Months Ended June 30, ------------------------------ 1998 1997 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 25,048 $ 1,365 Extraordinary loss on debt prepayment -- 11,427 Depreciation, amortization and other non-cash items 11,319 9,033 Deferred income 481 (249) Impairment loss on psychiatric real estate and notes receivable 2,730 11,000 Change in other assets (388) (1,415) Change in accounts payable and accrued liabilities 616 3,244 ------------ ------------ 39,806 34,405 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Acquisition and construction of real estate properties (114,105) (15,923) Mortgage note receivable fundings (179) (3,684) Principal payments on mortgage notes receivable 39 35 Other notes receivable (1,236) 114 Direct financing leases 525 158 Administrative capital expenditures (61) (11) ------------ ------------ (115,017) (19,311) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Borrowings (payments) on bank loans payable 75,000 (39,500) Proceeds from notes payable issuance -- 218,965 Prepayment of notes payable -- (163,176) Principal payments on mortgage notes payable (229) -- Financing costs paid (7) (2,152) Proceeds from sale of common stock 9,475 -- Proceeds from exercise of stock options 2,653 100 Dividends paid (32,880) (27,856) ------------ ------------ 54,012 (13,619) ------------ ------------ INCREASE (DECREASE) IN CASH AND SHORT-TERM INVESTMENTS (21,199) 1,475 CASH AND SHORT-TERM INVESTMENTS, BEGINNING OF PERIOD 23,053 1,480 ------------ ------------ CASH AND SHORT-TERM INVESTMENTS, END OF PERIOD $ 1,854 $ 2,955 ============ ============
The accompanying notes are an integral part of these financial statements. 5 7 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 1. GENERAL American Health Properties, Inc., a Delaware corporation (the Company, which term refers to the Company and its subsidiaries unless the context otherwise requires), is a self-administered real estate investment trust (REIT) that commenced operations in 1987. The Company has investments in health care properties, including acute care, rehabilitation, long-term acute care and psychiatric hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities. The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes. The Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares with respect to dividend payments and liquidation rights. Attribution of the components of the Company's capital structure to its Core Group and Psychiatric Group for financial accounting and reporting purposes does not affect the legal title to assets or responsibility for liabilities of the Company, and each holder of Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to the risks associated with an investment in the Company and all of its businesses, assets and liabilities. Basis of Presentation The consolidated condensed financial statements of the Company included herein have been prepared by the Company without audit and include all normal, recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results of operations pursuant to the rules and regulations of the Securities and Exchange Commission. These financial statements should be read in conjunction with those included in the Company's annual report on Form 10-K for the year ended December 31, 1997. The financial statements of the Core Group and the Psychiatric Group, which are included elsewhere herein, should also be read in conjunction with these financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. New Accounting Standards In the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Company's financial statements. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", establishes standards for reporting financial and descriptive information about reportable operating segments. In general, reportable operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The required adoption in 1998 of SFAS No. 131 is not expected to have a material impact on the Company's financial statements. 6 8 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employer's Disclosures about Pensions and Other Post Retirement Benefits". SFAS No. 132 revises employer's disclosures about pension and other post retirement benefits to the extent practicable, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures that are no longer useful. The required adoption in 1998 of SFAS No. 132 is not expected to have a material impact on the Company's financial statements. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. It also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The required adoption in 1999 of SFAS No. 133 is not expected to have a material impact on the Company's financial statements. In April 1998, the AICPA issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities". In general, SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. Initial application of SOP 98-5 should be reported as the cumulative effect of a change in accounting principle. The required adoption in 1998 of SOP 98-5 is not expected to have a material impact on the Company's financial statements. Interest Paid Interest paid by the Company, net of interest capitalized, was $9,311,000 and $5,691,000 for the six months ended June 30, 1998 and 1997, respectively. The Company had $294,000 and $201,000 of capitalized interest for the six months ended June 30, 1998 and 1997, respectively. 2. STOCKHOLDERS' EQUITY Equity Offering In February 1998, the Company completed an offering of 353,201 additional shares of Core Group Common Stock resulting in net proceeds of approximately $9.5 million. Equity Issuance In May 1998, the Company issued 62,160 additional shares of Core Group Common Stock in connection with the acquisition of a medical office/clinic facility, representing additional equity of approximately $1.7 million. Special Stock Dividend Subsequent to the end of the second quarter, on July 24, 1998, the Company distributed 833,067 new shares of Core Group Common Stock at a price of $25.9407 per share to holders of Psychiatric Group Depositary Shares as a special stock dividend. Holders of Psychiatric Group Depositary Shares received 0.4 shares of Core Group Common Stock for each Psychiatric Group Depositary Share held and were paid cash-in-lieu of fractional shares of Core Group Common Stock based on the price of $25.9407. Stock Incentive Plans During the six months ended June 30, 1998, options to purchase 160,424 shares of Core Group Common Stock at a weighted average exercise price of $28.00 per share were issued pursuant to the Company's stock incentive plans. During the six months ended June 30, 1998, options to purchase 130,000 shares of Core Group Common Stock were exercised at a weighted average exercise price of $20.41 per share resulting in additional equity of $2,653,000. Options to purchase 10,000 shares of Core Group Common Stock at a weighted average exercise price of $32.06 and options to purchase 10,000 shares of Psychiatric Group Depositary Shares at a weighted average exercise price of $20.96 per share expired during the six months ended June 30, 1998. 7 9 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 3. EARNINGS PER SHARE The following is a reconciliation of the income or (loss) and share amounts used in the basic and diluted per share computations of income before extraordinary item attributable to Core Group Common Stock and Psychiatric Group Depositary Shares:
Three Months Ended June 30, Six Months Ended June 30, ----------------------------------------------- ------------------------------------------------ 1998 1997 1998 1997 ----------------------- ---------------------- ----------------------- ----------------------- Income Income Income Income (In thousands) (Loss) Shares (Loss) Shares (Loss) Shares (Loss) Shares ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Attributable to Core Group Income before extraordinary item $ 12,709 -- $ 11,129 -- $ 25,293 -- $ 21,059 -- Less Series B preferred dividend requirement (2,150) -- -- -- (4,300) -- -- -- Outstanding common shares -- 24,054 -- 23,457 -- 23,886 -- 23,456 Deferred common shares -- 1 -- 2 -- 1 -- 3 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Basic EPS components 10,559 24,055 11,129 23,459 20,993 23,887 21,059 23,459 Effect of dilutive potential common shares - Stock options -- 116 -- 85 -- 130 -- 93 DER's -- 143 -- 99 -- 137 -- 94 Subordinated convertible bonds payable -- -- -- -- -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Diluted EPS components $ 10,559 24,314 $ 11,129 23,643 $ 20,993 24,154 $ 21,059 23,646 ========== ========== ========== ========== ========== ========== ========== ========== Attributable to Psychiatric Group Basic EPS components $ (1,484) 2,084 $ 1,203 2,084 $ (245) 2,084 $ (8,267) 2,084 Effect of dilutive potential common shares - Stock options -- -- -- -- -- -- -- -- DER's -- -- -- 14 -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Diluted EPS components $ (1,484) 2,084 $ 1,203 2,098 $ (245) 2,084 $ (8,267) 2,084 ========== ========== ========== ========== ========== ========== ========== ==========
4. COMMITMENTS As of June 30, 1998, the Company had funded $7.5 million of a $17 million commitment to develop two skilled nursing properties in Las Vegas, Nevada to be operated by an experienced operator of skilled nursing facilities. The Company has a $35 million forward funding commitment to develop up to five assisted living facilities to be managed by an experienced operator of assisted living facilities. As of June 30, 1998, the Company had funded $3.8 million under this commitment for the development of three facilities having total development costs of approximately $18.6 million. The Company has a similar commitment of $22.5 million to develop up to 11 Alzheimer's care facilities to be managed by an experienced operator of Alzheimer's care facilities. The Company also has agreed to provide an additional $9.4 million of real estate financing to an experienced operator of long-term acute care facilities for which there are currently no identified projects. 5. STATUS OF PSYCHIATRIC GROUP INVESTMENTS Subsequent to the end of the second quarter, on July 1, 1998, the Company received $35 million as payment in full of its Psychiatric Group's two New York Four Winds mortgage loans resulting in the accrual of a 8 10 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) $2.73 million impairment loss in the second quarter of 1998. On a consolidated basis, the Company used the proceeds from the mortgage loans payoff to pay down outstanding borrowings under its bank credit facility. On a Group basis, the proceeds from the payment of the Four Winds mortgage loans were first used by the Psychiatric Group to repay the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Company's Core Group by the Psychiatric Group and to maintain a cash reserve of approximately $2.3 million for the net current liabilities of the Psychiatric Group. Substantially all of the remaining proceeds were distributed to holders of Psychiatric Group Depositary Shares on July 24, 1998 as a special dividend paid in the form of 0.4 shares of Core Group Common Stock per Psychiatric Group Depositary Share. In order to effectuate the stock dividend, the Psychiatric Group purchased 833,067 shares of Core Group Common Stock from the Core Group at a price of $25.9407 per share, which represented the average trading price of the Core Group Common Stock for the last ten trading days prior to the July 17, 1998 record date for the special dividend, as provided in the certificate of designation for the Psychiatric Group Stock. The Four Winds loans represented the largest income-producing portion of the Psychiatric Group's portfolio. In the second quarter of 1998, the Four Winds loans contributed revenue of $1,776,000 to the Psychiatric Group. As a result of the payoff of these loans, second quarter 1998 results will be the last quarter to include results from the Four Winds loans and future quarters' results will be solely dependent on the remaining three assets in the portfolio. Furthermore, since the Psychiatric Group does not maintain a separate management structure, it has an ongoing obligation to pay for an allocated portion of the Company's general and administrative expenses, subject to a minimum of $250,000 annually, as well as for specific expenses directly related to the operations of the Psychiatric Group. Offsetting these expenses in future quarters will be a reduction of interest expense as a result of the repayment of the inter- Group loans to the Core Group. Interest expense on inter-Group loans to the Core Group was $347,000 for the second quarter of 1998. Due to these various factors, future quarterly cash flows and dividends will decrease very substantially. The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in significant impairment losses on psychiatric investments and the periodic restructuring of psychiatric operator payment obligations in previous years. The Company recorded an $11 million charge in the first quarter of 1997 for impairment of the carrying value of its two psychiatric investments in Florida. The Northpointe property, at which the operator ceased paying its obligations to the Company in February 1997 and ceased hospital operations in the second quarter of 1997, continues to remain idle. The Company incurred costs of approximately $75,000 during the second quarter of 1998 ($.04 per Psychiatric Group Depositary Share) and $225,000 for the first quarter of 1998 ($.11 per Psychiatric Group Depositary Share) to protect and maintain this property, including approximately $150,000 for unexpected expenditures. Although on an ongoing basis, the Company expects to incur costs of approximately $75,000 per quarter ($.04 per Psychiatric Group Depositary Share) to protect and maintain this property while various alternatives for the property are evaluated and pursued, the Company cannot be assured that other unexpected costs will not be incurred. Numerous discussions with health care operators and others regarding a potential sale or lease of the property continue. However, no agreement for sale or lease has been reached. If efforts to identify a health care operator for the property prove unsuccessful, the property will most likely have to be sold for its real estate value, however, the Company cannot be assured that the current carrying value of the property would be realized through a sale. Early in the fourth quarter of 1997, a restructuring of The Retreat's obligations to the Company was completed. The Retreat's restructured base rent is $35,000 per month ($105,000 per quarter or $.05 per Psychiatric Group Depositary Share) and additional rent will not accrue or be payable until August 1, 2000. The Company has received the base rent payments under the restructured terms through August 1998 but The Retreat is currently in default on other obligations owed to the Company. Although the restructured agreement with The Retreat was a positive step in stabilizing the cash flow and operations of this facility, as evidenced by the current default, the Company cannot be assured that The Retreat will be able to continue to meet its restructured obligations or continue operations. While 9 11 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) the Company has now reached an agreement in principle regarding the assumption of operations at The Retreat by a new operator, certain of the required key agreements remain under negotiation. The transfer of operations to the new operator will not occur unless those terms are satisfactorily resolved. If not resolved, the Company may decide to exercise any or all of its remedies. Even if there is a change in the operator of The Retreat, continued operations at The Retreat will remain uncertain until the new operator has demonstrated its ability to operate the facility successfully. In light of the volatile circumstances of the two Florida psychiatric properties, the Company cannot be assured that further impairment losses on these investments will not be required. Although the $2,500,000 balance outstanding under Rock Creek Center's (RCC) revolving credit agreement matured in June 1997 and the initial term of the RCC lease expired in December 1997, RCC has continued to make interest payments on the revolving credit agreement and the initial lease term has been extended to September 30, 1998, with a further extension pending as described below. RCC has met its rent and interest obligations to the Company through August 1998, however, the Company cannot be assured that RCC will not experience future operational and cash flow difficulties as it has in the past. At the end of June 1998, the operator of the Rock Creek Center (RCC) facility informed the Company that it had incurred a material, unanticipated liability to Medicare, which imperils the continuing operation of the facility. In response, the operator has commenced a significant revision and downsizing of its operations to focus on geriatric psychiatric care. In order to implement that change, the operator has given a WARN Act notice to its employees notifying them that the operations of the facility in its current mode will cease within 60 days of such notice and inviting them to reapply for positions in the proposed downsized operation. Under the currently applicable lease extension, the Company has the right, effective July 1, 1998, to negotiate with other potential health care operators regarding operating the facility and the Company has commenced marketing the property to potential new operators. An agreement in principle has been reached with the existing operator extending the current lease to March 31, 1999, and extending the maturity of the revolving credit agreement to March 31, 1999. Under the proposed arrangement, the operator will continue to pay interest on all outstanding obligations and will pay $5,000 per month against the principal balance of the revolving credit agreement. Although discussions with the current operator have not yet been successful in reaching a mutually acceptable long-term lease, purchase and sale agreement, and/or payment schedule for the payment of the balance of the revolving credit agreement, the operator of the facility has approached the Psychiatric Group with a proposal that may be practicable depending, in part, on the operator's ability to negotiate an acceptable compromise with Medicare regarding the unanticipated Medicare liability. Local and national operators have expressed interest in the facility; however, the Psychiatric Group cannot be assured that either a long-term lease extension or a new lease will be accomplished. If the current operator is unsuccessful in formulating a program which permits it to pay the newly-determined Medicare liability and to make suitable payments to the Psychiatric Group, and a facility lease with a new operator is not accomplished, a significant negative impact to the Psychiatric Group likely will result. Furthermore, if a new operator assumes operation of the RCC facility, the Company cannot be assured that the current operator will be able to pay the balance owed under the revolving credit agreement or that a new operator will be able to operate the facility successfully. The total revenue contribution to the Psychiatric Group from the RCC investment for the second quarter was $.17 per Psychiatric Group Depositary Share. Although management currently believes that the recorded amounts of its psychiatric investments are realizable, if the psychiatric operators are unable to adapt to the fundamental ongoing changes in the psychiatric industry successfully and consistently mitigate the negative impact of the ongoing changes on their financial performance, the Company may be required to restructure payment obligations further, identify alternative operators, pursue alternative uses for or dispositions of the properties and/or recognize additional impairment losses on its psychiatric investments. If the Company is required to take any of these actions, various costs are likely to be incurred by the Company in an effort to protect, maintain and pursue alternatives for its investments. The Company does not currently intend to make new investments in the psychiatric sector, and over time, may 10 12 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) sell, restructure or seek other means to reduce its investments in the psychiatric sector. In addition, the Company continues to encourage each of the psychiatric operators to pursue financing alternatives which might enable them to acquire the properties and/or repay their borrowings from the Company, as the case may be. Subject to the rights of the holders of the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, and any other preferred stock of the Company then outstanding, the Company expects to use the net proceeds of any future psychiatric property sales and/or psychiatric operator borrowing repayments to first repay then outstanding inter-Group loans and/or other liabilities owed by the Psychiatric Group and to distribute all remaining net proceeds, if any, in cash or Core Group Common Stock to holders of Psychiatric Group Depositary Shares. The Company cannot be assured that the efforts of psychiatric operators to obtain alternative financing will be successful or, if successful, that the amounts of such financing would be sufficient to enable the Company to realize the carrying amounts of its psychiatric investments. The dividend on the Company's Psychiatric Group Depositary Shares is determined each quarter based upon the operating results of the Company's Psychiatric Group. Historically, the level of dividends of the Psychiatric Group have varied quarter-to-quarter. Any significant advance of additional funds to psychiatric hospital operators, modification of terms covering the rental or interest obligations of its psychiatric properties or nonpayment or deferral of such obligations as they become due likely will have an adverse impact on the Company's Psychiatric Group results of operations and cash flows, as well as on the quarterly dividend payment on Psychiatric Group Depositary Shares. In addition to the foregoing, future operating results, cash flows and dividends of the Company's Psychiatric Group will be affected by changes in the level of additional rent, the amount of additional financial advisory fees and, to the extent necessary, various costs which might be incurred in an effort to protect, maintain and pursue alternatives for its psychiatric investments. With the repayment of the Four Winds loans, future quarterly cash flows and dividends will decrease very substantially from previous quarters. Also, small events with respect to the Psychiatric Group's three remaining facilities will likely have a more significant effect on the Psychiatric Group's cash flows and dividends, and therefore the price of the Psychiatric Group Depositary Shares. The liquidity of the Psychiatric Group Depositary Shares will also likely be adversely affected. The Company will continue to review quarterly the performance of each of the remaining assets of the Psychiatric Group. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may then elect to redeem the outstanding Psychiatric Group Depositary Shares. 11 13 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes. The Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares with respect to dividend payments and liquidation rights. Attribution of the components of the Company's capital structure to its Core Group and Psychiatric Group for financial accounting and reporting purposes does not affect the legal title to assets or responsibility for liabilities of the Company, and each holder of Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to the risks associated with an investment in the Company and all of its businesses, assets and liabilities. Following is a discussion of the consolidated financial condition and results of operations of the Company, which should be read in conjunction with the consolidated financial statements and accompanying notes. For discussions of the financial condition and results of operations of the Core Group and the Psychiatric Group, see the management's discussion and analysis of financial condition and results of operations of the Core Group and the Psychiatric Group included elsewhere herein. Factors Regarding Future Results and Forward-Looking Statements This report includes and incorporates by reference statements that are not purely historical and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All statements other than historical fact contained in this report, including without limitation statements regarding rent or interest to be received from the Company's operators and tenants, plans with respect to individual facilities, expectations with respect to the specific terms and renewals of leases of the Company's facilities, the Company's anticipated dividends and dividend payout ratios, the potential redemption of the Company's shares, the Company's liquidity position, projected expenses associated with operating or maintaining individual properties, the Company's ability to realize the recorded amounts of its investments and the potential effect of new or existing regulations on the operations conducted at the Company's facilities, are forward-looking statements. All forward-looking statements included or incorporated by reference in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update such forward-looking statements. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct or that the Company will take any actions that may presently be planned. Certain factors that could cause actual results to differ materially from those expected include, among others: the financial success of the operations conducted at the Company's facilities and the financial strength of the operators and tenants of such facilities, the continuing ability of operators and tenants to meet their obligations to the Company under existing or restructured agreements, changes in operators or ownership of operators, the viability of alternative uses for the Company's properties when necessary, changes in government policy relating to the health care industry including reductions in reimbursement levels under the Medicare and Medicaid programs, operators' and tenants' continued eligibility to participate in the Medicare or Medicaid programs, reductions in reimbursement by other third- party payors, the impact of managed care pricing pressures, the requirement to provide care on a fixed-price basis, lower occupancy levels at the Company's facilities, a downturn in market lease rates for medical office space, higher than expected costs 12 14 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS associated with the maintenance and operation of the Company's medical office/clinic facilities, higher than expected turnover at the Company's medical office/clinic facilities, a reduction in demand for the services provided at the Company's facilities, the strength and financial resources of the Company's competitors, the availability and cost of capital, the Company's ability to make additional real estate investments at attractive yields and changes in tax laws and regulations affecting real estate investment trusts. For a further discussion of certain of these factors, see "- Future Operating Results" herein. OPERATING RESULTS Second Quarter and Year to Date 1998 Compared With 1997 For the second quarter of 1998, the Company reported net income attributable to Core Group Common Stock and Psychiatric Group Depositary Shares of $9,075,000 compared with $12,332,000 for the second quarter of 1997. An impairment loss on psychiatric notes receivable of ($2,730,000) was recorded in the second quarter of 1998. For the six months ended June 30, 1998, the Company reported income before extraordinary item attributable to Core Group Common Stock and Psychiatric Group Depository Shares of $20,748,000 compared with $12,792,000 for the six months ended June 30, 1997, which included an impairment loss on psychiatric real estate and notes receivable of ($11,000,000). For the six months ended June 30, 1998, the Company reported net income attributable to Core Group Common Stock and Psychiatric Group Depositary Shares of $20,748,000 compared with $1,365,000 for the six months ended June 30, 1997. An extraordinary loss on debt prepayment of ($11,427,000) was reported during the six months ended June 30, 1998. See the Consolidated Condensed Statements of Operations for the comparative gross and per share amounts attributable to the Core Group Common Stock and the Psychiatric Group Depositary Shares. Rental income was $22,484,000 for the second quarter of 1998, an increase of $4,667,000 or 26% from $17,817,000 for the second quarter of 1997. Rental income was $43,842,000 for the six months ended June 30, 1998 an increase of $8,215,000 or 23% from $35,627,000 for the six months ended June 30, 1997. This increase was primarily attributable to rental income from new Core Group properties acquired subsequent to the first quarter of 1997. These property additions also resulted in an increase in depreciation and amortization of $1,270,000 or 33% to $5,159,000 for the second quarter of 1998 compared with $3,889,000 for the second quarter of 1997 and an increase in depreciation and amortization of $2,316,000 or 30% to $10,033,000 for the six months ended June 30, 1998 compared with $7,717,000 for the six months ended June 30, 1997. Mortgage interest income was $1,655,000 for the second quarter of 1998, an increase of $124,000 or 8% from $1,531,000 in 1997. Mortgage interest income was $3,308,000 for the six months ended June 30, 1998, an increase of $260,000 or 9% from $3,048,000 for the six months ended June 30, 1997. This increase was primarily attributable to the funding of a mortgage note receivable in the second quarter of 1997. Additional rental and interest income was $3,400,000 for the second quarter of 1998, an increase of $253,000 or 8% from $3,147,000 for the second quarter of 1997. Additional rental and interest income was $6,820,000 for the six months ended June 30, 1998, an increase of $697,000 or 11% from $6,123,000 for the six months ended June 30, 1997. The increase in additional rental and interest income for the second quarter of 1998 was attributable to increases in additional rent of $133,000 from acute care properties and $27,000 from long-term care properties and an increase of $103,000 in additional rent and interest from psychiatric properties, partially offset by a $10,000 decrease in additional rent from rehabilitation properties. The increase in additional rental and interest income for the six months ended June 30, 1998 was attributable to increases in additional rent of $473,000 from acute care properties and $52,000 from long-term care properties and an increase of $193,000 in additional rent and interest from psychiatric properties, partially offset by a $21,000 decrease in additional rent from rehabilitation properties. 13 15 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Other property income of $384,000 for the second quarter of 1998 and $719,000 for the six months ended June 30, 1998, primarily represents property operating expense reimbursements and parking revenue from medical office/clinic facility tenants. Other interest income decreased $22,000 or 9% to $220,000 for the second quarter of 1998 from $242,000 for the second quarter of 1997. Other interest income decreased $811,000 or 64% to $461,000 for the six months ended June 30, 1998 from $1,272,000 for the six months ended June 30, 1997. This decrease resulted primarily from lower investable cash balances and a lower average balance of direct financing leases during the second quarter and first six months of 1998 compared to the same periods in 1997. The decrease is partially offset by interest income from a subordinated note receivable due from the operator of an Alzheimer's care facility, which was funded during the second quarter of 1998. Investable cash balances were significantly higher during the first quarter of 1997 due to the temporary investment of a portion of the proceeds of a public debt offering in late January 1997 until used to prepay the Company's private placement debt in late February 1997 after the prepayment notice period had expired. Property operating expense was $1,352,000 for the second quarter of 1998, an increase of $1,275,000 from $77,000 for the second quarter of 1997. Property operating expense was $2,567,000 for the six months ended June 30, 1998, an increase of $2,479,000 from $88,000 for the six months ended June 30, 1997. For the second quarter of 1998, approximately $1,225,000 of the increase was attributable to operating expenses of Core Group medical office/clinic facilities acquired subsequent to the first quarter of 1997 and $50,000 of the increase was attributable to costs related to the protection and maintenance of a closed psychiatric property in Florida. Approximately $2,204,000 of the increase during the first six months of 1998 was attributable to operating expenses of Core Group medical office/clinic facilities acquired subsequent to the first quarter of 1997 and $275,000 of the increase was attributable to costs related to the protection and maintenance of a closed psychiatric property in Florida, including approximately $150,000 for unexpected expenditures. Interest expense was $5,308,000 for the second quarter of 1998, an increase of $830,000 or 19% from $4,478,000 for the second quarter of 1997. Interest expense was $10,250,000 for the six months ended June 30, 1998, a decrease of $335,000 or 3% from $10,585,000 for the six months ended June 30, 1997. The increase in interest expense for the second quarter of 1998 was primarily attributable to a higher average balance of bank credit facility borrowings and the assumption of two mortgage loans in connection with the acquisition of medical office/clinic facilities. This increase is partially offset by a higher level of capitalized interest in 1998 compared to 1997. The decrease in interest expense during the first six months of 1998 was primarily attributable to a lower weighted average effective interest rate on long-term debt during 1998, partially offset by a higher amount of long-term debt during 1998. In late January 1997, the Company sold $220 million of publicly-traded unsecured senior notes with a weighted average effective interest rate of approximately 7.56%. The Company used the proceeds of this offering to pay off the borrowings under its bank credit facility outstanding at the time and to prepay $152 million of 11.03% private placement debt in late February 1997 prior to its scheduled maturity, incurring an extraordinary charge in the first quarter of 1997 of $11,427,000. General and administrative expenses were $2,322,000 for the second quarter of 1998, an increase of $374,000 or 19% from $1,948,000 for the second quarter of 1997. General and administrative expenses were $4,428,000 for the six months ended June 30, 1998, an increase of $600,000 or 16% from $3,828,000 for the six months ended June 30, 1997. This variation was primarily attributable to hiring of additional personnel, higher compensation and benefits expense, an increase in travel expense and an increase in financial advisory services provided to the Psychiatric Group. 14 16 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Future Operating Results The operators and tenants of most of the Company's facilities derive a substantial percentage of their total revenues from federal and state health care programs such as Medicare and Medicaid and from other third-party payors such as private insurance companies, self-insured employers and health maintenance organizations. Such operators and tenants also are subject to extensive federal, state and local government regulation relating to their operations, and most of the Company's facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with mandated procedures, licensure requirements under state law and certification standards under the Medicare and Medicaid programs. A reduction in reimbursement levels under the Medicare or Medicaid programs, a reduction in reimbursement by other third-party payors or an operator's or tenant's failure to maintain its certification under Medicare or Medicaid programs could adversely affect revenues to the Company's facilities. The nature of health care delivery in the United States continues to undergo change and further review at both the national and state levels. Generally accepted goals of reform continue to include controlling costs and improving access to medical care. Various plans to decrease the growth in Medicare spending have been proposed and passed by both Houses of Congress. These plans generally include revisions to and limits on Medicare and federal programs providing Medicaid reimbursement to state health care programs and have had and potentially would have an adverse impact on the level of funds available in the future to health care facilities. The Balanced Budget Act of 1997 contains extensive changes to the Medicare and Medicaid programs intended to reduce the projected amount of increase in Medicare spending by an estimated $115 billion and Medicaid spending by an estimated $13 billion over five years. In addition, the Budget Act repealed certain limits on states' ability to reduce their Medicaid reimbursement levels. The Budget Act has the potential to reduce significantly federal spending on health care services provided at each of the Company's facilities and provided by the physician tenants of the Company's medical office/clinic facilities, and to affect revenues of the Company's operators and tenants adversely. In particular, the Budget Act's limitations on reimbursable costs and reductions in payment incentives and capital related payments, as well as the change toward a prospective payment system, may have a material adverse effect on operator revenues at the Company's rehabilitation, long-term acute care, and psychiatric hospitals. The Budget Act's freeze on acute care hospital reimbursement rates may also have an adverse effect on the operator revenues at the Company's acute care hospitals. In addition, the prospective payment system imposed by the Budget Act on the operators of the Company's skilled nursing facilities may have a material adverse effect on the operator revenues at such facilities if the operators are unable to effectively respond to the financial incentives provided by the prospective payment system. The Company cannot be assured that the changes effected by the Budget Act will not have a material adverse effect on the Company's financial condition or results of operation. The Company's Board and management are monitoring the effect of the Budget Act on the Company's facilities and potential changes to reimbursement programs closely. The Company believes that the changes effected by the Budget Act and changes proposed at the federal and state level may pose risks for certain institutions that are unwilling or unable to respond. At the same time, the Company believes that this changing health care environment will provide the Core Group with new opportunities for investment. The ongoing changes in the health care industry include trends toward shorter lengths of hospital stay, increased use of outpatient services, increased federal, state and third-party oversight of health care company operations and business practices, and increased demand for discounted or capitated health care services (delivery of services at a fixed price per capita basis to a defined group of covered parties). Furthermore, federal, state and third-party payors continue to propose and adopt various cost containment measures that restrict the scope of reimbursable health care services and limit increases in reimbursement rates for such services. Payors also are continuing to enforce compliance with program requirements aggressively and to pursue providers that they 15 17 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS believe have not complied with such requirements. Outpatient business is expected to increase as advances in medical technologies allow more procedures to be performed on an outpatient basis and as payors continue to direct more patients from inpatient care to outpatient care. In addition, the entrance of insurance companies into managed care programs is accelerating the introduction of managed care in new localities, and states and insurance companies continue to negotiate actively the amounts they will pay for services. Moreover, the percentage of health care services that are reimbursed under the Medicare and Medicaid programs continues to increase as the population ages. States are also expanding their Medicaid programs. Continued eligibility to participate in these programs is crucial to a provider's financial strength. As a result of the foregoing, revenues and margins may decrease at the Company's facilities. Notwithstanding the potential for increasing government regulation, the Company believes that health care will continue to be delivered on a local and regional basis and that well-managed, high-quality, cost-controlled facilities will continue to be an integral part of local and regional health care delivery systems. The Company also believes that certain acute care hospitals will need to reconfigure or expand existing facilities or to affiliate themselves with other providers so as to become part of comprehensive and cost-effective health care systems. Such systems likely will include lower cost treatment settings, such as ambulatory care clinics, outpatient surgery centers, long-term acute care hospitals, skilled nursing facilities, assisted living and Alzheimer's care facilities and medical office/clinic facilities. In general, the Core Group facilities are part of local or regional health care delivery systems or are in the process of becoming integrated into such systems. The Company's future operating results could be affected by the operating performance of the Company's lessees and borrowers. The rental and interest obligations of its facility operators are primarily supported by the facility- specific operating cash flow. Real estate investments in the Company's portfolio are generally further supported by one or more credit enhancements that take the form of cross-default provisions, letters of credit, corporate and personal guarantees, security interests in cash reserve funds, accounts receivable or other personal property and requirements to maintain specified financial ratios. During the second quarter of 1998, the Company renewed leases for four of its acute care hospitals, operated by Tenet Healthcare Corporation, under the same lease terms and provisions as previously in place. The four leases accounted for approximately 27% of the Company's total revenues in 1997. Aggregate revenues from a lease maturing in February 1999 accounted for 11% of the Company's total revenues in 1997. The property is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). The lease grants the operator options to extend the term of the lease for eight consecutive five-year renewal terms. Base and additional rent during the first three extended terms would be on the same terms and conditions as the current initial term. Minimum rent during the final five extended terms would be fair market rental but without separate additional rent. The lease also grants the operator the option to purchase the leased property at fair market value at the expiration of any term of the lease. If the lease is not renewed and the current operator does not exercise its option to purchase the property, the Company will be required to seek a new operator for the property. The future operating results of the Company will be affected by additional factors including the amount, timing and yield of additional real estate investments and the competition for such investments. Operating results also will be affected by the availability and terms of the Company's future equity and debt financing. The Company's financing strategy to facilitate future growth includes objectives to reduce its cost of capital over time and enhance its liquidity and financial flexibility. Fundamental changes in the psychiatric industry continue to impact negatively the facility-specific operating cash flow at the Company's psychiatric properties. Institutions responsible for the reimbursement of care provided to patients who use inpatient psychiatric treatment services have directed efforts toward decreasing 16 18 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS their payments for such services, thereby reducing hospital operating revenues. Some cost-cutting measures used by such institutions include decreasing the inpatient length of stay, intensively reviewing utilization, directing patients from inpatient care to outpatient care and negotiating reduced reimbursement rates for services. The wider use of psychotropic drugs also has resulted in significant declines in the average length of stay. In addition, aggressive program compliance enforcement and increased scrutiny of past and current billing practices has resulted in the filing of lawsuits against some providers and significant negative publicity which has further exacerbated the financial and operational difficulties of providers. Although the operators of the psychiatric hospitals are responding by increasing case management, developing lower cost outpatient and daypatient programs and reducing operating costs, their efforts are generally not consistently mitigating the negative impact of these fundamental psychiatric industry changes. As a result, certain of the psychiatric hospital operators have not consistently met their contractual payment obligations to the Company as scheduled and the Company cannot be assured that psychiatric hospital operators will be able to meet such payment obligations in the future. In general, the operators of the Psychiatric Group's properties have very limited access to financing for their operating and capital needs. To the extent the psychiatric hospitals have increased working capital needs in the future, the Company may be the only source of such financing. Subsequent to the end of the second quarter, on July 1, 1998, the Company received $35 million as payment in full of its Psychiatric Group's two New York Four Winds mortgage loans resulting in the accrual of a $2.73 million impairment loss in the second quarter of 1998. On a consolidated basis, the Company used the proceeds from the mortgage loans payoff to pay down outstanding borrowings under its bank credit facility. On a Group basis, the proceeds from the payment of the Four Winds mortgage loans were first used by the Psychiatric Group to repay the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Company's Core Group by the Psychiatric Group and to maintain a cash reserve of approximately $2.3 million for the net current liabilities of the Psychiatric Group. Substantially all of the remaining proceeds were distributed to holders of Psychiatric Group Depositary Shares on July 24, 1998 as a special dividend paid in the form of 0.4 shares of Core Group Common Stock per Psychiatric Group Depositary Share. In order to effectuate the stock dividend, the Psychiatric Group purchased 833,067 shares of Core Group Common Stock from the Core Group at a price of $25.9407 per share, which represented the average trading price of the Core Group Common Stock for the last ten trading days prior to the July 17, 1998 record date for the special dividend, as provided in the certificate of designation for the Psychiatric Group Stock. The Four Winds loans represented the largest income-producing portion of the Psychiatric Group's portfolio. In the second quarter of 1998, the Four Winds loans contributed revenue of $1,776,000 to the Psychiatric Group. As a result of the payoff of these loans, second quarter 1998 results will be the last quarter to include results from the Four Winds loans and future quarters' results will be solely dependent on the remaining three assets in the portfolio. Furthermore, since the Psychiatric Group does not maintain a separate management structure, it has an ongoing obligation to pay for an allocated portion of the Company's general and administrative expenses, subject to a minimum of $250,000 annually, as well as for specific expenses directly related to the operations of the Psychiatric Group. Offsetting these expenses in future quarters will be a reduction of interest expense as a result of the repayment of the inter- Group loans to the Core Group. Interest expense on inter-Group loans to the Core Group was $347,000 for the second quarter of 1998. Due to these various factors, future quarterly cash flows and dividends will decrease very substantially. The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in significant impairment losses on psychiatric investments and the periodic restructuring of psychiatric operator payment obligations in previous years. The Company recorded an $11 million charge in the first quarter of 1997 for impairment of the carrying value of its two psychiatric investments in Florida. The Northpointe property, at which the operator ceased paying its obligations to the Company in February 17 19 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1997 and ceased hospital operations in the second quarter of 1997, continues to remain idle. The Company incurred costs of approximately $75,000 during the second quarter of 1998 ($.04 per Psychiatric Group Depositary Share) and $225,000 for the first quarter of 1998 ($.11 per Psychiatric Group Depositary Share) to protect and maintain this property, including approximately $150,000 for unexpected expenditures. Although on an ongoing basis, the Company expects to incur costs of approximately $75,000 per quarter ($.04 per Psychiatric Group Depositary Share) to protect and maintain this property while various alternatives for the property are evaluated and pursued, the Company cannot be assured that other unexpected costs will not be incurred. Numerous discussions with health care operators and others regarding a potential sale or lease of the property continue. However, no agreement for sale or lease has been reached. If efforts to identify a health care operator for the property prove unsuccessful, the property will most likely have to be sold for its real estate value, however, the Company cannot be assured that the current carrying value of the property would be realized through a sale. Early in the fourth quarter of 1997, a restructuring of The Retreat's obligations to the Company was completed. The Retreat's restructured base rent is $35,000 per month ($105,000 per quarter or $.05 per Psychiatric Group Depositary Share) and additional rent will not accrue or be payable until August 1, 2000. The Company has received the base rent payments under the restructured terms through August 1998 but The Retreat is currently in default on other obligations owed to the Company. Although the restructured agreement with The Retreat was a positive step in stabilizing the cash flow and operations of this facility, as evidenced by the current default, the Company cannot be assured that The Retreat will be able to continue to meet its restructured obligations or continue operations. While the Company has now reached an agreement in principle regarding the assumption of operations at The Retreat by a new operator, certain of the required key agreements remain under negotiation. The transfer of operations to the new operator will not occur unless those terms are satisfactorily resolved. If not resolved, the Company may decide to exercise any or all of its remedies. Even if there is a change in the operator of The Retreat, continued operations at The Retreat will remain uncertain until the new operator has demonstrated its ability to operate the facility successfully. In light of the volatile circumstances of the two Florida psychiatric properties, the Company cannot be assured that further impairment losses on these investments will not be required. Although the $2,500,000 balance outstanding under Rock Creek Center's (RCC) revolving credit agreement matured in June 1997 and the initial term of the RCC lease expired in December 1997, RCC has continued to make interest payments on the revolving credit agreement and the initial lease term has been extended to September 30, 1998, with a further extension pending as described below. RCC has met its rent and interest obligations to the Company through August 1998, however, the Company cannot be assured that RCC will not experience future operational and cash flow difficulties as it has in the past. At the end of June 1998, the operator of the Rock Creek Center (RCC) facility informed the Company that it had incurred a material, unanticipated liability to Medicare, which imperils the continuing operation of the facility. In response, the operator has commenced a significant revision and downsizing of its operations to focus on geriatric psychiatric care. In order to implement that change, the operator has given a WARN Act notice to its employees notifying them that the operations of the facility in its current mode will cease within 60 days of such notice and inviting them to reapply for positions in the proposed downsized operation. Under the currently applicable lease extension, the Company has the right, effective July 1, 1998, to negotiate with other potential health care operators regarding operating the facility and the Company has commenced marketing the property to potential new operators. An agreement in principle has been reached with the existing operator extending the current lease to March 31, 1999, and extending the maturity of the revolving credit agreement to March 31, 1999. Under the proposed arrangement, the operator will continue to pay interest on all outstanding obligations and will pay $5,000 per month against the principal balance of the revolving credit agreement. Although discussions with the current operator have not yet been successful in reaching a mutually acceptable long-term lease, purchase and sale agreement, and/or payment schedule for the payment of the balance of the revolving credit agreement, the operator of the facility has approached the Psychiatric Group with a proposal that may be practicable depending, in part, on the operator's ability to negotiate an acceptable compromise with Medicare regarding the unanticipated Medicare liability. Local and national operators have expressed interest in the facility; however, the Psychiatric Group cannot be assured that 18 20 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS either a long-term lease extension or a new lease will be accomplished. If the current operator is unsuccessful in formulating a program which permits it to pay the newly-determined Medicare liability and to make suitable payments to the Psychiatric Group, and a facility lease with a new operator is not accomplished, a significant negative impact to the Psychiatric Group likely will result. Furthermore, if a new operator assumes operation of the RCC facility, the Company cannot be assured that the current operator will be able to pay the balance owed under the revolving credit agreement or that a new operator will be able to operate the facility successfully. The total revenue contribution to the Psychiatric Group from the RCC investment for the second quarter was $.17 per Psychiatric Group Depositary Share. Although management currently believes that the recorded amounts of its psychiatric investments are realizable, if the psychiatric operators are unable to adapt to the fundamental ongoing changes in the psychiatric industry successfully and consistently mitigate the negative impact of the ongoing changes on their financial performance, the Company may be required to restructure payment obligations further, identify alternative operators, pursue alternative uses for or dispositions of the properties and/or recognize additional impairment losses on its psychiatric investments. If the Company is required to take any of these actions, various costs are likely to be incurred by the Company in an effort to protect, maintain and pursue alternatives for its investments. The Company does not currently intend to make new investments in the psychiatric sector, and over time, may sell, restructure or seek other means to reduce its investments in the psychiatric sector. In addition, the Company continues to encourage each of the psychiatric operators to pursue financing alternatives which might enable them to acquire the properties and/or repay their borrowings from the Company, as the case may be. Subject to the rights of the holders of the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, and any other preferred stock of the Company then outstanding, the Company expects to use the net proceeds of any future psychiatric property sales and/or psychiatric operator borrowing repayments to first repay then outstanding inter-Group loans and/or other liabilities owed by the Psychiatric Group and to distribute all remaining net proceeds, if any, in cash or Core Group Common Stock to holders of Psychiatric Group Depositary Shares. The Company cannot be assured that the efforts of psychiatric operators to obtain alternative financing will be successful or, if successful, that the amounts of such financing would be sufficient to enable the Company to realize the carrying amounts of its psychiatric investments. The dividend on the Company's Psychiatric Group Depositary Shares is determined each quarter based upon the operating results of the Company's Psychiatric Group. Historically, the level of dividends of the Psychiatric Group have varied quarter-to-quarter. Any significant advance of additional funds to psychiatric hospital operators, modification of terms covering the rental or interest obligations of its psychiatric properties or nonpayment or deferral of such obligations as they become due likely will have an adverse impact on the Company's Psychiatric Group results of operations and cash flows, as well as on the quarterly dividend payment on Psychiatric Group Depositary Shares. In addition to the foregoing, future operating results, cash flows and dividends of the Company's Psychiatric Group will be affected by changes in the level of additional rent, the amount of additional financial advisory fees and, to the extent necessary, various costs which might be incurred in an effort to protect, maintain and pursue alternatives for its psychiatric investments. With the repayment of the Four Winds loans, future quarterly cash flows and dividends will decrease very substantially from previous quarters. Also, small events with respect to the Psychiatric Group's three remaining facilities will likely have a more significant effect on the Psychiatric Group's cash flows and dividends, and therefore the price of the Psychiatric Group Depositary Shares. The liquidity of the Psychiatric Group Depositary Shares will also likely be adversely affected. The Company will continue to review quarterly the performance of each of the remaining assets of the Psychiatric Group. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may then elect to redeem the outstanding Psychiatric Group Depositary Shares. 19 21 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Many existing information systems currently record years in a two-digit format and will be unable to properly interpret dates beyond the year 1999 which could lead to business disruptions (the Year 2000 Issue). The Company is currently upgrading its internal information systems in the normal course of business and does not expect the Year 2000 Issue to have a material impact on the Company's future operations or financial results. However, the Company's future operations could be disrupted and/or its financial results could be negatively impacted by the Year 2000 Issue if the Company's lessees and borrowers do not adequately address the Year 2000 Issue with respect to their information systems. As health care providers, the Company's lessees and borrowers generally rely extensively on information systems, including systems for capturing patient and cost information and for billing and collecting reimbursement for health care services provided. Furthermore, the Company's lessees and borrowers likewise are dependent on a variety of third parties who must also adequately address the Year 2000 Issue, including private and government payors. Although, the Company believes that its lessees and borrowers are generally addressing their Year 2000 Issues, it is not possible for the Company to determine or be assured that adequate remediation of the Year 2000 Issue will be accomplished by such lessees and borrowers. Furthermore, it is not possible for the Company to determine or be assured that the various payors and other third parties upon which the Company's lessees and borrowers are dependent for reimbursement and information will accomplish adequate remediation of their Year 2000 Issues. Accordingly, although the Company believes that the impact of the Year 2000 Issue, as it relates to its internal information systems, will not be material, the Company cannot be assured that the Year 2000 Issues of its lessees and borrowers, and the third parties upon which they are dependent, will not have a material impact on the Company's future operations and/or financial results. LIQUIDITY AND CAPITAL RESOURCES As of August 11, 1998, the Company had a remaining commitment of approximately $9.1 million to fund the development of two skilled nursing facilities. In addition, the Company had a $35 million forward funding commitment to develop up to five assisted living facilities to be managed by an experienced operator of assisted living facilities. As of August 11, 1998, $5.0 million has been funded under this commitment for the development of three facilities having total development costs of approximately $18.6 million. The Company has a similar commitment of $22.5 million to develop up to 11 Alzheimer's care facilities to be managed by an experienced operator of Alzheimer's care facilities. The Company also has agreed to provide an additional $9.4 million of real estate financing to an experienced operator of long-term acute care facilities for which there are currently no identified projects. The Company has continued to increase its liquidity and enhance its financial flexibility. In October 1997, the Company completed a $100 million preferred equity offering and used the net proceeds to pay off all outstanding borrowings under its bank credit facility at the time and used the remaining proceeds to fund Core Group investments. In December 1997, the Company closed on a new $250 million unsecured revolving bank credit facility which matures on December 31, 2000. In February 1998, the Company completed an offering of 353,201 additional shares of Core Group Common Stock resulting in net proceeds of approximately $9.5 million. In May 1998, the Company issued 62,160 additional shares of Core Group Common Stock in connection with the acquisition of a medical office/clinic facility, representing additional equity of approximately $1.7 million. In addition, options to purchase 130,000 shares of Core Group Common Stock were exercised during the first six months of 1998, resulting in additional equity of $2.7 million. In July 1998, the Company received $35 million as payment in full of its Psychiatric Group's two New York Four Winds mortgage loans and used the proceeds to pay down outstanding borrowings under its bank credit facility. As of August 11, 1998, the Company had $45.5 million of outstanding borrowings under its $250 million bank credit facility and had $2.2 million in cash and short-term investments. The Company's total indebtedness as of August 11, 1998 was $289.3 million. The Company expects to utilize its bank credit facility to fund its future Core Group acquisitions and its other commitments. The Company may incur additional indebtedness or refinance 20 22 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS existing indebtedness if the Company determines that opportunities to pursue such transactions would be attractive. The Company currently believes it has sufficient capital to meet its commitments and that its cash flow and liquidity will continue to be sufficient to fund current operations and to provide for the payment of dividends to stockholders in compliance with the applicable sections of the Internal Revenue Code governing real estate investment trusts. 21 23 AMERICAN HEALTH PROPERTIES, INC. CORE GROUP COMBINED CONDENSED BALANCE SHEETS (In thousands)
June 30, December 31, 1998 1997 ------------ ------------ ASSETS (Unaudited) Real estate investments Real property and mortgage notes, net $ 808,908 $ 696,154 Construction in progress 11,325 4,729 Accumulated depreciation (110,093) (100,493) ------------ ------------ 710,140 600,390 Other notes receivable and direct financing leases 3,764 3,053 Revolving loan to Psychiatric Group 2,028 3,379 Fixed rate loan to Psychiatric Group 9,175 9,175 Other assets 13,065 13,082 Cash and short-term investments 1,854 23,053 ------------ ------------ $ 740,026 $ 652,132 ============ ============ ATTRIBUTED LIABILITIES AND TOTAL ATTRIBUTED EQUITY Bank loans payable $ 75,000 $ -- Mortgage notes payable 21,068 17,922 Notes and bonds payable 226,049 225,891 Accounts payable and accrued liabilities 12,497 12,760 Dividends payable 13,853 13,555 Deferred income 4,069 3,736 ------------ ------------ 352,536 273,864 ------------ ------------ Commitments and contingencies Total Attributed Core Group Equity 387,490 378,268 ------------ ------------ $ 740,026 $ 652,132 ============ ============
The accompanying notes are an integral part of these financial statements. 22 24 AMERICAN HEALTH PROPERTIES, INC. CORE GROUP COMBINED CONDENSED STATEMENTS OF OPERATIONS (Unaudited) (In thousands except per share amounts)
Three Months Ended June 30, Six Months Ended June 30, ------------------------------ ------------------------------ 1998 1997 1998 1997 ------------ ------------ ------------ ------------ REVENUES Rental income $ 22,129 $ 17,475 $ 43,132 $ 34,704 Mortgage interest income 117 15 230 15 Additional rental income 3,130 2,980 6,256 5,752 Other property income 384 34 719 34 Other interest income 141 157 302 1,088 Interest income on loans to Psychiatric Group 347 394 712 784 ------------ ------------ ------------ ------------ 26,248 21,055 51,351 42,377 ------------ ------------ ------------ ------------ EXPENSES Depreciation and amortization 4,971 3,701 9,657 7,343 Property operating 1,277 52 2,267 63 Interest expense 5,308 4,478 10,250 10,585 General and administrative 1,936 1,648 3,790 3,233 ------------ ------------ ------------ ------------ 13,492 9,879 25,964 21,224 ------------ ------------ ------------ ------------ Minority interest 47 47 94 94 ------------ ------------ ------------ ------------ INCOME BEFORE EXTRAORDINARY ITEM 12,709 11,129 25,293 21,059 EXTRAORDINARY LOSS ON DEBT PREPAYMENT -- -- -- (11,427) ------------ ------------ ------------ ------------ NET INCOME $ 12,709 $ 11,129 $ 25,293 $ 9,632 ============ ============ ============ ============ SERIES B PREFERRED DIVIDEND REQUIREMENT $ (2,150) $ -- $ (4,300) $ -- ============ ============ ============ ============ ATTRIBUTABLE TO CORE GROUP COMMON STOCK - INCOME BEFORE EXTRAORDINARY ITEM $ 10,559 $ 11,129 $ 20,993 $ 21,059 ============ ============ ============ ============ NET INCOME $ 10,559 $ 11,129 $ 20,993 $ 9,632 ============ ============ ============ ============ Basic per share amounts - Income before extraordinary item $ 0.44 $ 0.47 $ 0.88 $ 0.90 Extraordinary loss on debt prepayment $ -- $ -- $ -- $ (0.49) Net income $ 0.44 $ 0.47 $ 0.88 $ 0.41 Weighted average common shares 24,055 23,459 23,887 23,459 Diluted per share amounts - Income before extraordinary item $ 0.43 $ 0.47 $ 0.87 $ 0.89 Extraordinary loss on debt prepayment $ -- $ -- $ -- $ (0.48) Net income $ 0.43 $ 0.47 $ 0.87 $ 0.41 Weighted average common shares and dilutive potential common shares 24,314 23,643 24,154 23,646 Dividends declared per common share $ 0.5450 $ 0.5250 $ 1.0900 $ 1.0500
The accompanying notes are an integral part of these financial statements. 23 25 AMERICAN HEALTH PROPERTIES, INC. CORE GROUP COMBINED CONDENSED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands)
Six Months Ended June 30, ------------------------------ 1998 1997 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 25,293 $ 9,632 Extraordinary loss on debt prepayment -- 11,427 Depreciation, amortization and other non-cash items 10,891 8,591 Deferred income 489 (231) Change in other assets (389) (1,523) Change in accounts payable and accrued liabilities (417) 3,385 ------------ ------------ 35,867 31,281 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Acquisition and construction of real estate properties (114,105) (15,923) Mortgage note receivable fundings (179) (3,684) Other notes receivable (1,236) -- Direct financing leases 525 158 Paydowns on revolving loan to Psychiatric Group 1,351 43 Administrative capital expenditures (61) (11) ------------ ------------ (113,705) (19,417) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Borrowings (payments) on bank loans payable 75,000 (39,500) Proceeds from notes payable issuance -- 218,965 Prepayment of notes payable -- (163,176) Principal payments on mortgage notes payable (229) -- Financing costs paid (7) (2,152) Proceeds from sale of common stock 9,475 -- Proceeds from exercise of stock options 2,653 100 Dividends paid (30,253) (24,626) ------------ ------------ 56,639 (10,389) ------------ ------------ INCREASE (DECREASE) IN CASH AND SHORT-TERM INVESTMENTS (21,199) 1,475 CASH AND SHORT-TERM INVESTMENTS, BEGINNING OF PERIOD 23,053 1,480 ------------ ------------ CASH AND SHORT-TERM INVESTMENTS, END OF PERIOD $ 1,854 $ 2,955 ============ ============
The accompanying notes are an integral part of these financial statements. 24 26 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CORE GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 1. GENERAL American Health Properties, Inc., a Delaware corporation (the Company, which term refers to the Company and its subsidiaries unless the context otherwise requires), is a self-administered real estate investment trust (REIT) that commenced operations in 1987. The Company has investments in health care properties, including acute care, rehabilitation, long-term acute care and psychiatric hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities. The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes. The Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares with respect to dividend payments and liquidation rights. Basis of Presentation The combined condensed financial statements of the Core Group included herein have been prepared by the Company without audit and include all normal, recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results of operations pursuant to the rules and regulations of the Securities and Exchange Commission. These financial statements should be read in conjunction with those included in the Company's annual report on Form 10-K for the year ended December 31, 1997. The financial statements of the Core Group include the financial position, results of operations and cash flows of the Company's core investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities, an allocated portion of the Company's general and administrative expense, all corporate assets and liabilities and related transactions associated with the ongoing operations of the Company which are not separately identified with either operating Group, an attributed amount of inter-Group loans receivable from the Psychiatric Group and an attributed amount of the Company's stockholders' equity. The Core Group financial statements are prepared using the amounts included in the Company's consolidated financial statements. Although the financial statements of the Core Group and the Psychiatric Group separately report the assets, liabilities (including contingent liabilities), stockholders' equity and items of income, expense and cash flow of the Company attributed to each such Group, such attribution does not affect the legal title to assets or responsibility for liabilities of the Company or any of its subsidiaries. Furthermore, such attribution does not affect the rights of creditors of the Company or any subsidiary, including rights under financing covenants. Each holder of Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to risks associated with an investment in the Company and all of its businesses, assets and liabilities. Financial effects arising from one Group that affect the Company's consolidated results of operations, financial condition, cash flows or borrowing costs may also affect the results of operations, financial condition, cash flows or borrowing costs of the other Group. In addition, net losses of either Group, as well as dividends and distributions on, and repurchases or redemptions of, Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares will reduce the funds of the Company legally available for dividends on Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares. Accordingly, the Core 25 27 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CORE GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) Group's financial statements should be read in conjunction with the Company's consolidated financial statements and the financial statements of the Psychiatric Group. These financial statements include the accounts of the Core Group business. The Core Group and the Psychiatric Group financial statements, taken together, comprise all of the accounts included in the Company's consolidated financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. New Accounting Standards In the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Core Group's financial statements. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", establishes standards for reporting financial and descriptive information about reportable operating segments. In general, reportable operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The required adoption in 1998 of SFAS No. 131 is not expected to have a material impact on the Core Group's financial statements. In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employer's Disclosures about Pensions and Other Post Retirement Benefits". SFAS No. 132 revises employer's disclosures about pension and other post retirement benefits to the extent practicable, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures that are no longer useful. The required adoption in 1998 of SFAS No. 132 is not expected to have a material impact on the Core Group's financial statements. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. It also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The required adoption in 1999 of SFAS No. 133 is not expected to have a material impact on the Core Group's financial statements. In April 1998, the AICPA issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities". In general, SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. Initial application of SOP 98-5 should be reported as the cumulative effect of a change in accounting principle. The required adoption in 1998 of SOP 98-5 is not expected to have a material impact on the Core Group's financial statements. Interest Paid Interest paid by the Core Group, net of interest capitalized, was $9,311,000 and $5,691,000 for the six months ended June 30, 1998 and 1997, respectively. The Core Group had $294,000 and $201,000 of capitalized interest for the six months ended June 30, 1998 and 1997, respectively. 26 28 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CORE GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 2. ATTRIBUTED EQUITY Equity Offering In February 1998, the Company completed an offering of 353,201 additional shares of Core Group Common Stock resulting in net proceeds of approximately $9.5 million. Equity Issuance In May 1998, the Company issued 62,160 additional shares of Core Group Common Stock in connection with the acquisition of a medical office/clinic facility, representing additional equity of approximately $1.7 million. Sale of Stock to Psychiatric Group Subsequent to the end of the second quarter, on July 24, 1998, the Core Group sold 833,067 new shares of Core Group Common Stock to the Company's Psychiatric Group at a price of $25.9407 per share, which the Psychiatric Group concurrently distributed to holders of Psychiatric Group Depositary Shares as a special stock dividend. The proceeds of approximately $21.6 million were used by the Core Group to pay down outstanding borrowings under the Company's bank credit facility. Stock Incentive Plans During the six months ended June 30, 1998, options to purchase 160,424 shares of Core Group Common Stock at a weighted average exercise price of $28.00 per share were issued pursuant to the Company's stock incentive plans. During the six months ended June 30, 1998, options to purchase 130,000 shares of Core Group Common Stock were exercised at a weighted average exercise price of $20.41 per share resulting in additional equity of $2,653,000. Options to purchase 10,000 shares of Core Group Common Stock at a weighted average exercise price of $32.06 expired during the six months ended June 30, 1998. 3. EARNINGS PER SHARE The following is a reconciliation of the income and share amounts used in the basic and diluted per share computations of income before extraordinary item attributable to Core Group Common Stock:
Three Months Ended June 30, Six Months Ended June 30, ----------------------------------------------- ----------------------------------------------- 1998 1997 1998 1997 ----------------------- ---------------------- ----------------------- ---------------------- (In thousands) Income Shares Income Shares Income Shares Income Shares ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Income before extraordinary item $ 12,709 -- $ 11,129 -- $ 25,293 -- $ 21,059 -- Less Series B preferred dividend requirement (2,150) -- -- -- (4,300) -- -- -- Outstanding common shares -- 24,054 -- 23,457 -- 23,886 -- 23,456 Deferred common shares -- 1 -- 2 -- 1 -- 3 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Basic EPS components 10,559 24,055 11,129 23,459 20,993 23,887 21,059 23,459 Effect of dilutive potential common shares - Stock options -- 116 -- 85 -- 130 -- 93 DER's -- 143 -- 99 -- 137 -- 94 Subordinated convertible bonds payable -- -- -- -- -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Diluted EPS components $ 10,559 24,314 $ 11,129 23,643 $ 20,993 24,154 $ 21,059 23,646 ========== ========== ========== ========== ========== ========== ========== ==========
4. COMMITMENTS Inter-Group Loans Subsequent to the end of the second quarter, in July 1998, the Core Group received $11.2 million from the Psychiatric Group for the payoff of the entire outstanding balance of fixed and revolving inter-Group loans owed to the Core Group by the Psychiatric Group. The Core Group used the proceeds from the 27 29 AMERICAN HEALTH PROPERTIES, INC. NOTES TO CORE GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) payoff of the inter-Group loans to pay down outstanding borrowings under the Company's bank credit facility. The Company's Board has established certain management policies relating to the Core Group's inter-Group loans to the Psychiatric Group. Under the policies currently in effect, which may be modified or rescinded at any time in the sole discretion of the Company's Board, the aggregate revolving inter-Group loans owed by the Psychiatric Group to the Core Group are limited to a maximum of $7,870,000 at any one time outstanding, which limit is to be reduced dollar-for-dollar by any permanent repayment in the future of borrowings under a revolving credit agreement provided to a Psychiatric Group hospital operator; provided that the limit on the aggregate revolving inter-Group loans will not be reduced below $5,000,000. Except for such revolving inter-Group loans, no additional fixed rate or other inter-Group loans will be advanced by the Core Group to the Psychiatric Group. Real Estate Properties As of June 30, 1998, the Core Group had funded $7.5 million of a $17 million commitment to develop two skilled nursing properties in Las Vegas, Nevada to be operated by an experienced operator of skilled nursing facilities. The Core Group has a $35 million forward funding commitment to develop up to five assisted living facilities to be managed by an experienced operator of assisted living facilities. As of June 30, 1998, the Core Group had funded $3.8 million under this commitment for the development of three facilities having total development costs of approximately $18.6 million. The Core Group has a similar commitment of $22.5 million to develop up to 11 Alzheimer's care facilities to be managed by an experienced operator of Alzheimer's care facilities. The Core Group also has agreed to provide an additional $9.4 million of real estate financing to an experienced operator of long-term acute care facilities for which there are currently no identified projects. 28 30 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Following is a discussion of the combined financial condition and results of operations of the Core Group, which should be read in conjunction with (a) the combined financial statements and accompanying notes of the Core Group and (b) management's discussion and analysis of financial condition and results of operations and the financial statements and accompanying notes of the Company and the Psychiatric Group included elsewhere herein. Factors Regarding Future Results and Forward-Looking Statements This report includes and incorporates by reference statements that are not purely historical and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All statements other than historical fact contained in this report, including without limitation statements regarding rent or interest to be received from the Company's operators and tenants, plans with respect to individual facilities, expectations with respect to the specific terms and renewals of leases of the Company's facilities, the Company's anticipated dividends and dividend payout ratios, the potential redemption of the Company's shares, the Company's liquidity position, projected expenses associated with operating individual properties, the Company's ability to realize the recorded amounts of its investments and the potential effect of new or existing regulations on the operations conducted at the Company's facilities, are forward-looking statements. All forward-looking statements included or incorporated by reference in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update such forward-looking statements. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct or that the Company will take any actions that may presently be planned. Certain factors that could cause actual results to differ materially from those expected include, among others: the financial success of the operations conducted at the Company's facilities and the financial strength of the operators and tenants of such facilities, the continuing ability of operators and tenants to meet their obligations to the Company under existing or restructured agreements, changes in operators or ownership of operators, the viability of alternative uses for the Company's properties when necessary, changes in government policy relating to the health care industry including reductions in reimbursement levels under the Medicare and Medicaid programs, operators' and tenants' continued eligibility to participate in the Medicare or Medicaid programs, reductions in reimbursement by other third- party payors, the impact of managed care pricing pressures, the requirement to provide care on a fixed-price basis, lower occupancy levels at the Company's facilities, a downturn in market lease rates for medical office space, higher than expected costs associated with the maintenance and operation of the Company's medical office/clinic facilities, higher than expected turnover at the Company's medical office/clinic facilities, a reduction in demand for the services provided at the Company's facilities, the strength and financial resources of the Company's competitors, the availability and cost of capital, the Company's ability to make additional real estate investments at attractive yields, increases in general and administrative expenses attributable to the Core Group as Core Group revenues increase relative to those of the Psychiatric Group and changes in tax laws and regulations affecting real estate investment trusts. For a further discussion of certain of these factors, see "- Future Operating Results" herein. OPERATING RESULTS Second Quarter and Year to Date 1998 Compared With 1997 For the second quarter of 1998, the Core Group reported net income attributable to Core Group Common Stock of $10,559,000, or $.43 per share on a diluted basis, compared with $11,129,000, or $.47 per share on a diluted basis, for the second quarter of 1997. For the six months ended June 30, 1998, the Core Group reported 29 31 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS income before extraordinary item attributable to Core Group Common Stock of $20,993,000, or $.87 per share on a diluted basis, compared with $21,059,000 or $.89, per share on a diluted basis, for the six months ended June 30, 1997. For the six months ended June 30, 1998, the Core Group reported net income attributable to Core Group Common Stock of $20,993,000, or $.87 per share on a diluted basis, compared with $9,632,000, or $.41 per share on a diluted basis, for the six months ended June 30, 1997, which included an extraordinary loss on debt prepayment of ($11,427,000), or ($.48) per share on a diluted basis. Rental income was $22,129,000 for the second quarter of 1998, an increase of $4,654,000 or 27% from $17,475,000 for the second quarter of 1997. Rental income was $43,132,000 for the six months ended June 30, 1998, an increase of $8,428,000 or 24% for 1998 compared with $34,704,000 for the six months ended June 30, 1997. This increase was primarily attributable to rental income from new properties acquired subsequent to the first quarter of 1997. These property additions also resulted in an increase in depreciation and amortization of $1,270,000 or 34% to $4,971,000 for the second quarter of 1998 compared with $3,701,000 for the second quarter of 1997 and an increase in depreciation and amortization of $2,314,000 or 32% to $9,657,000 for the six months ended June 30, 1998 compared with $7,343,000 for the six months ended June 30, 1997. Mortgage interest income of $117,000 for the second quarter of 1998 and $230,000 for the six months ended June 30, 1998 was attributable to the funding of a mortgage note receivable in the second quarter of 1997. Additional rental and interest income was $3,130,000 for the second quarter of 1998, an increase of $150,000 or 5% from $2,980,000 for the second quarter of 1997. Additional rental and interest income was $6,256,000 for the six months ended June 30, 1998, an increase of $504,000 or 9% from $5,752,000 for the six months ended June 30, 1997. The increase in additional rental and interest income for the second quarter of 1998 was attributable to increases in additional rent of $133,000 from acute care properties and $27,000 from long-term care properties, partially offset by a $10,000 decrease in additional rent from rehabilitation properties. The increase in additional rental and interest income for the six months ended June 30, 1998 was attributable to increases in additional rent of $473,000 from acute care properties and $52,000 from long-term care properties, partially offset by a $21,000 decrease in additional rent from rehabilitation properties. Other property income of $384,000 for the second quarter of 1998 and $719,000 for the six months ended June 30, 1998, primarily represents property operating expense reimbursements and parking revenue from medical office/clinic facility tenants. Other interest income decreased $16,000 or 10% to $141,000 for the second quarter of 1998 from $157,000 for the second quarter of 1997. Other interest income decreased $786,000 or 72% to $302,000 for the six months ended June 30, 1998 from $1,088,000 for the six months ended June 30, 1997. This decrease resulted primarily from lower investable cash balances and a lower average balance of direct financing leases during the second quarter and first six months of 1998 compared to the same periods in 1997. The decrease is partially offset by interest income from a subordinated note receivable due from the operator of an Alzheimer's care facility, which was funded during the second quarter of 1998. Investable cash balances were significantly higher during the first quarter of 1997 due to the temporary investment of a portion of the proceeds of a public debt offering in late January 1997 until used to prepay the Company's private placement debt in late February 1997 after the prepayment notice period had expired. Interest income on inter-Group loans to the Psychiatric Group was $347,000 for the second quarter of 1998, a decrease of $47,000 or 12% from $394,000 for the second quarter of 1997. Interest income on inter-Group loans to the Psychiatric Group was $712,000 for the six months ended June 30, 1998, a decrease of $72,000 or 9% from $784,000 for the six months ended June 30, 1997. This decrease reflects a lower average balance 30 32 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS outstanding on loans to the Psychiatric Group as a result of repayments by the Psychiatric Group from its available undistributed cash flow. Property operating expense was $1,277,000 for the second quarter of 1998, an increase of $1,225,000 from $52,000 for the second quarter of 1997. Property operating expense was $2,267,000 for the six months ended June 30, 1998, an increase of $2,204,000 from $63,000 for the six months ended June 30, 1997. This increase was attributable to operating expenses associated with medical office/clinic facilities acquired subsequent to the first quarter 1997. Interest expense was $5,308,000 for the second quarter of 1998, an increase of $830,000 or 19% from $4,478,000 for the second quarter of 1997. Interest expense was $10,250,000 for the six months ended June 30, 1998, a decrease of $335,000 or 3% from $10,585,000 for the six months ended June 30, 1997. The increase in interest expense for the second quarter of 1998 was primarily attributable to a higher average balance of bank credit facility borrowings and the assumption of two mortgage loans in connection with the acquisition of medical office/clinic facilities. This increase is partially offset by a higher level of capitalized interest in 1998 compared to 1997. The decrease in interest expense during the first six months of 1998 was primarily attributable to a lower weighted average effective interest rate on long-term debt during 1998, partially offset by a higher amount of long-term debt during 1998. In late January 1997, the Company sold $220 million of publicly-traded unsecured senior notes with a weighted average effective interest rate of approximately 7.56%. The Company used the proceeds of this offering to pay off the borrowings under its bank credit facility outstanding at the time and to prepay $152 million of 11.03% private placement debt in late February 1997 prior to its scheduled maturity, incurring an extraordinary charge in the first quarter of 1997 of $11,427,000. General and administrative expenses were $1,936,000 for the second quarter of 1998, an increase of $288,000 or 17% from $1,648,000 for the second quarter of 1997. General and administrative expenses were $3,790,000 for the six months ended June 30, 1998, an increase of $557,000 or 17% from $3,233,000 for the six months ended June 30, 1997. This variation was attributable to an increase in the Company's consolidated general and administrative expenses which are allocated between the Core Group and Psychiatric Group primarily based on revenues, and an increase in Core Group revenues relative to the Company's consolidated revenues. The increase in the Company's consolidated general and administrative expenses affecting the Core Group was primarily attributable to hiring of additional personnel, higher compensation and benefits expense and an increase in travel expense. Future Operating Results The operators and tenants of most of the Company's facilities derive a substantial percentage of their total revenues from federal and state health care programs such as Medicare and Medicaid and from other third-party payors such as private insurance companies, self-insured employers and health maintenance organizations. Such operators and tenants also are subject to extensive federal, state and local government regulation relating to their operations, and most of the Company's facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with mandated procedures, licensure requirements under state law and certification standards under the Medicare and Medicaid programs. A reduction in reimbursement levels under the Medicare or Medicaid programs, a reduction in reimbursement by other third-party payors or an operator's or tenant's failure to maintain its certification under Medicare or Medicaid programs could adversely affect revenues to the Company's facilities. The nature of health care delivery in the United States continues to undergo change and further review at both the national and state levels. Generally accepted goals of reform continue to include controlling costs and improving access to medical care. Various plans to decrease the growth in Medicare spending have been proposed 31 33 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS and passed by both Houses of Congress. These plans generally include revisions to and limits on Medicare and federal programs providing Medicaid reimbursement to state health care programs and have had and potentially would have an adverse impact on the level of funds available in the future to health care facilities. The Balanced Budget Act of 1997 contains extensive changes to the Medicare and Medicaid programs intended to reduce the projected amount of increase in Medicare spending by an estimated $115 billion and Medicaid spending by an estimated $13 billion over five years. In addition, the Budget Act repealed certain limits on states' ability to reduce their Medicaid reimbursement levels. The Budget Act has the potential to reduce significantly federal spending on health care services provided at each of the Core Group's facilities and provided by the physician tenants of the Core Group's medical office/clinic facilities, and to affect revenues of the Core Group's operators and tenants adversely. In particular, the Budget Act's limitations on reimbursable costs and reductions in payment incentives and capital related payments, as well as the change toward a prospective payment system, may have a material adverse effect on operator revenues at the Core Group's rehabilitation and long-term acute care hospitals. The Budget Act's freeze on acute care hospital reimbursement rates may also have an adverse effect on the operator revenues at the Core Group's acute care hospitals. In addition, the prospective payment system imposed by the Budget Act on the operators of the Core Group's skilled nursing facilities may have a material adverse effect on the operator revenues at such facilities if the operators are unable to effectively respond to the financial incentives provided by the prospective payment system. The Company cannot be assured that the changes effected by the Budget Act will not have a material adverse effect on the Core Group's financial condition or results of operation. The Company's Board and management are monitoring the effect of the Budget Act on the Core Group's facilities and potential changes to reimbursement programs closely. The Company believes that the changes effected by the Budget Act and changes proposed at the federal and state level may pose risks for certain institutions that are unwilling or unable to respond. At the same time, the Company believes that this changing health care environment will provide the Core Group with new opportunities for investment. The ongoing changes in the health care industry include trends toward shorter lengths of hospital stay, increased use of outpatient services, increased federal, state and third-party oversight of health care company operations and business practices, and increased demand for discounted or capitated health care services (delivery of services at a fixed price per capita basis to a defined group of covered parties). Furthermore, federal, state and third-party payors continue to propose and adopt various cost containment measures that restrict the scope of reimbursable health care services and limit increases in reimbursement rates for such services. Payors also are continuing to enforce compliance with program requirements aggressively and to pursue providers that they believe have not complied with such requirements. Outpatient business is expected to increase as advances in medical technologies allow more procedures to be performed on an outpatient basis and as payors continue to direct more patients from inpatient care to outpatient care. In addition, the entrance of insurance companies into managed care programs is accelerating the introduction of managed care in new localities, and states and insurance companies continue to negotiate actively the amounts they will pay for services. Moreover, the percentage of health care services that are reimbursed under the Medicare and Medicaid programs continues to increase as the population ages. States are also expanding their Medicaid programs. Continued eligibility to participate in these programs is crucial to a provider's financial strength. As a result of the foregoing, revenues and margins may decrease at the Core Group's facilities. Notwithstanding the potential for increasing government regulation, the Company believes that health care will continue to be delivered on a local and regional basis and that well-managed, high-quality, cost-controlled facilities will continue to be an integral part of local and regional health care delivery systems. The Company also believes that certain acute care hospitals will need to reconfigure or expand existing facilities or to affiliate themselves with other providers so as to become part of comprehensive and cost-effective health care systems. Such systems likely will include lower cost treatment settings, such as ambulatory care clinics, 32 34 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS outpatient surgery centers, long-term acute care hospitals, skilled nursing facilities, assisted living and Alzheimer's care facilities and medical office/clinic facilities. In general, the Core Group facilities are part of local or regional health care delivery systems or are in the process of becoming integrated into such systems. The Core Group's future operating results could be affected by the operating performance of the Core Group's lessees and borrowers. The rental and interest obligations of its facility operators are primarily supported by the facility-specific operating cash flow. Real estate investments in the Core Group's portfolio are generally further supported by one or more credit enhancements that take the form of cross-default provisions, letters of credit, corporate and personal guarantees, security interests in cash reserve funds, accounts receivable or other personal property and requirements to maintain specified financial ratios. Financial effects arising from the Psychiatric Group that affect the Company's consolidated results of operations, financial condition or borrowing costs may also affect the results of operations, financial condition or borrowing costs of the Core Group. In July 1998, the Company's Psychiatric Group received $35 million as payment in full of mortgage loans owed to the Psychiatric Group by the operator of its two New York Four Winds psychiatric facilities. The proceeds from the payment of the Four Winds mortgage loans were first used to repay the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Core Group by the Psychiatric Group. The Core Group's interest income from these inter-Group loans was $347,000 for the second quarter of 1998 ($.014 per common share). In addition, as a result of the Four Winds mortgage loans payoff, the allocation of the Company's consolidated general and administrative expenses, which is primarily based on the relative revenues of the two Groups, will be increased to the Core Group by approximately $80,000 per quarter (less than $.005 per common share). Since the Company's consolidated general and administrative expenses are allocated between the Core Group and Psychiatric Group primarily based on revenues, the amount of such expenses allocated to the Core Group will further increase in the future if revenues of the Psychiatric Group decline for any reason, including the disposition or restructuring of the remaining Psychiatric Group assets or the nonpayment by Psychiatric Group operators of their rent and interest obligations to the Psychiatric Group. Accordingly, the Core Group's financial statements should be read in conjunction with the financial statements of the Psychiatric Group and the Company's consolidated financial statements. During the second quarter of 1998, the Company renewed leases for four of its acute care hospitals, operated by Tenet Healthcare Corporation, under the same lease terms and provisions as previously in place. The four leases accounted for approximately 29% of the Core Group's total revenues in 1997. Aggregate revenues from a lease maturing in February 1999 accounted for 12% of the Core Group's total revenues in 1997. The property is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). The lease grants the operator options to extend the term of the lease for eight consecutive five-year renewal terms. Base and additional rent during the first three extended terms would be on the same terms and conditions as the current initial term. Minimum rent during the final five extended terms would be fair market rental but without separate additional rent. The lease also grants the operator the option to purchase the leased property at fair market value at the expiration of any term of the lease. If the lease is not renewed and the current operator does not exercise its option to purchase the property, the Company will be required to seek a new operator for the property. The future operating results of the Core Group will be affected by additional factors including the amount, timing and yield of additional real estate investments and the competition for such investments. Operating results also will be affected by the availability and terms of the Company's future equity and debt financing. The Company's financing strategy to facilitate future growth includes objectives to reduce its cost of capital over time and enhance its liquidity and financial flexibility. 33 35 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Many existing information systems currently record years in a two-digit format and will be unable to properly interpret dates beyond the year 1999 which could lead to business disruptions (the Year 2000 Issue). The Company is currently upgrading its internal information systems in the normal course of business and does not expect the Year 2000 Issue to have a material impact on the future operations or financial results of the Company's Core Group. However, the future operations of the Company's Core Group could be disrupted and/or its financial results could be negatively impacted by the Year 2000 Issue if the Company's Core Group lessees and borrowers do not adequately address the Year 2000 Issue with respect to their information systems. As health care providers, the Company's Core Group lessees and borrowers generally rely extensively on information systems, including systems for capturing patient and cost information and for billing and collecting reimbursement for health care services provided. Furthermore, the Company's Core Group lessees and borrowers likewise are dependent on a variety of third parties who must also adequately address the Year 2000 Issue, including private and government payors. Although, the Company believes that the Core Group lessees and borrowers are generally addressing their Year 2000 Issues, it is not possible for the Company to determine or be assured that adequate remediation of the Year 2000 Issue will be accomplished by such lessees and borrowers. Furthermore, it is not possible for the Company to determine or be assured that the various payors and other third parties upon which the Company's Core Group lessees and borrowers are dependent for reimbursement and information will accomplish adequate remediation of their Year 2000 Issues. Accordingly, although the Company believes that the impact of the Year 2000 Issue, as it relates to its internal information systems, will not be material to the Company's Core Group, the Company cannot be assured that the Year 2000 Issues of its Core Group lessees and borrowers, and the third parties upon which they are dependent, will not have a material impact on the future operations and/or financial results of the Company's Core Group. LIQUIDITY AND CAPITAL RESOURCES As of August 11, 1998, the Core Group had no borrowings outstanding under its fixed rate or revolving inter- Group loans to the Psychiatric Group. Under management policies currently in effect, the Core Group may provide the Psychiatric Group with revolving inter-Group loans of up to $7,870,000. As of August 11, 1998, the Core Group had a remaining commitment of approximately $9.1 million to fund the development of two skilled nursing facilities. In addition, the Company had a $35 million forward funding commitment to develop up to five assisted living facilities to be managed by an experienced operator of assisted living facilities. As of August 11, 1998, $5.0 million has been funded under this commitment for the development of three facilities having total development costs of approximately $18.6 million. The Core Group has a similar commitment of $22.5 million to develop up to 11 Alzheimer's care facilities to be managed by an experienced operator of Alzheimer's care facilities. The Core Group also has agreed to provide an additional $9.4 million of real estate financing to an experienced operator of long-term acute care facilities for which there are currently no identified projects. The Company has continued to increase its liquidity and enhance its financial flexibility. In October 1997, the Company completed a $100 million preferred equity offering and used the net proceeds to pay off all outstanding borrowings under its bank credit facility at the time and used the remaining proceeds to fund Core Group investments. In December 1997, the Company closed on a new $250 million unsecured revolving bank credit facility which matures on December 31, 2000. Thus far in 1998, the Company's Core Group has raised additional equity of approximately $35.5 million. In February 1998, the Company completed an offering of 353,201 additional shares of Core Group Common Stock resulting in net proceeds of approximately $9.5 million. In May 1998, the Company issued 62,160 additional shares of Core Group Common Stock in connection with the acquisition of a medical office/clinic facility, representing additional equity of approximately $1.7 million. In July 1998, the Core 34 36 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Group sold 833,067 shares of Core Group Common Stock to the Company's Psychiatric Group resulting in proceeds to the Core Group of approximately $21.6 million. In addition, options to purchase 130,000 shares of Core Group Common Stock were exercised during the first six months of 1998, resulting in additional equity of $2.7 million. The Core Group also received $11.2 million in July 1998 from the Psychiatric Group for the payoff of the entire outstanding balance of fixed and revolving inter-Group loans owed to the Core Group by the Psychiatric Group. The Core Group used the proceeds from the payoff of the inter-Group loans and the sale of additional shares to pay down outstanding borrowings under the Company's bank credit facility. As of August 11, 1998, the Company had $45.5 million of outstanding borrowings under its $250 million bank credit facility and had $2.2 million in cash and short-term investments. The Company's total indebtedness as of August 11, 1998 was $289.3 million. The Company expects to utilize its bank credit facility to fund its future Core Group acquisitions and its other commitments. The Company may incur additional indebtedness or refinance existing indebtedness if the Company determines that opportunities to pursue such transactions would be attractive. The Company currently believes it has sufficient capital to meet its commitments and that its cash flow and liquidity will continue to be sufficient to fund current operations and to provide for the payment of dividends to stockholders in compliance with the applicable sections of the Internal Revenue Code governing real estate investment trusts. 35 37 AMERICAN HEALTH PROPERTIES, INC. PSYCHIATRIC GROUP COMBINED CONDENSED BALANCE SHEETS (In thousands)
June 30, December 31, 1998 1997 ------------ ------------ ASSETS (Unaudited) Real estate investments Real property and mortgage notes, net $ 46,907 $ 49,622 Accumulated depreciation (2,118) (1,742) ------------ ------------ 44,789 47,880 Other notes receivable 2,500 2,500 Other assets 613 614 ------------ ------------ $ 47,902 $ 50,994 ============ ============ ATTRIBUTED LIABILITIES AND TOTAL ATTRIBUTED EQUITY Revolving loan from Core Group $ 2,028 $ 3,379 Fixed rate loan from Core Group 9,175 9,175 Accounts payable and accrued liabilities 1,284 433 Dividends payable 1,333 1,292 Deferred income 250 22 ------------ ------------ 14,070 14,301 ------------ ------------ Commitments and contingencies Total Attributed Psychiatric Group Equity 33,832 36,693 ------------ ------------ $ 47,902 $ 50,994 ============ ============
The accompanying notes are an integral part of these financial statements. 36 38 AMERICAN HEALTH PROPERTIES, INC. PSYCHIATRIC GROUP COMBINED CONDENSED STATEMENTS OF OPERATIONS (Unaudited) (In thousands except per share amounts)
Three Months Ended June 30, Six Months Ended June 30, -------------------------- -------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- REVENUES Rental income $ 355 $ 342 $ 710 $ 923 Mortgage interest income 1,538 1,516 3,078 3,033 Additional rental and interest income 270 167 564 371 Other interest income 79 85 159 184 ---------- ---------- ---------- ---------- 2,242 2,110 4,511 4,511 ---------- ---------- ---------- ---------- EXPENSES Depreciation and amortization 188 188 376 374 Property operating 75 25 300 25 Interest expense on loans from Core Group 347 394 712 784 General and administrative 386 300 638 595 Impairment loss on real estate and notes receivable 2,730 -- 2,730 11,000 ---------- ---------- ---------- ---------- 3,726 907 4,756 12,778 ---------- ---------- ---------- ---------- NET INCOME (LOSS) $ (1,484) $ 1,203 $ (245) $ (8,267) ========== ========== ========== ========== Basic per share amounts - Net income (loss) $ (0.71) $ 0.58 $ (0.12) $ (3.97) Weighted average depositary shares 2,084 2,084 2,084 2,084 Diluted per share amounts - Net income (loss) $ (0.71) $ 0.57 $ (0.12) $ (3.97) Weighted average depositary shares and dilutive potential depositary shares 2,084 2,098 2,084 2,084 Dividends declared per depositary share $ 0.6400 $ 0.6300 $ 1.2800 $ 1.3800
The accompanying notes are an integral part of these financial statements. 37 39 AMERICAN HEALTH PROPERTIES, INC. PSYCHIATRIC GROUP COMBINED CONDENSED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands)
Six Months Ended June 30, -------------------------- 1998 1997 ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES Net (loss) $ (245) $ (8,267) Depreciation, amortization and other non-cash items 428 442 Deferred income (8) (18) Impairment loss on real estate and notes receivable 2,730 11,000 Change in other assets 1 108 Change in accounts payable and accrued liabilities 1,033 (141) ---------- ---------- 3,939 3,124 ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES Principal payments on mortgage notes receivable 39 35 Other notes receivable -- 114 ---------- ---------- 39 149 ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Payments on revolving loan from Core Group (1,351) (43) Dividends paid (2,627) (3,230) ---------- ---------- (3,978) (3,273) ---------- ---------- INCREASE (DECREASE) IN CASH AND SHORT-TERM INVESTMENTS -- -- CASH AND SHORT-TERM INVESTMENTS, BEGINNING OF PERIOD -- -- ---------- ---------- CASH AND SHORT-TERM INVESTMENTS, END OF PERIOD $ -- $ -- ========== ==========
The accompanying notes are an integral part of these financial statements. 38 40 AMERICAN HEALTH PROPERTIES, INC. NOTES TO PSYCHIATRIC GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 1. GENERAL American Health Properties, Inc., a Delaware corporation (the Company, which term refers to the Company and its subsidiaries unless the context otherwise requires), is a self-administered real estate investment trust (REIT) that commenced operations in 1987. The Company has investments in health care properties, including acute care, rehabilitation, long-term acute care and psychiatric hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities. The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes. The Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares with respect to dividend payments and liquidation rights. Basis of Presentation The combined condensed financial statements of the Psychiatric Group included herein have been prepared by the Company without audit and include all normal, recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results of operations pursuant to the rules and regulations of the Securities and Exchange Commission. These financial statements should be read in conjunction with those included in the Company's annual report on Form 10-K for the year ended December 31, 1997. The financial statements of the Psychiatric Group include the financial position, results of operations and cash flows of the Company's psychiatric hospital investments, an allocated portion of the Company's general and administrative expense, an attributed amount of inter-Group debt payable to the Core Group and an attributed amount of the Company's stockholders' equity. The Psychiatric Group financial statements are prepared using the amounts included in the Company's consolidated financial statements. Although the financial statements of the Psychiatric Group and the Core Group separately report the assets, liabilities (including contingent liabilities), stockholders' equity and items of income, expense and cash flow of the Company attributed to each such Group, such attribution does not affect the legal title to assets or responsibility for liabilities of the Company or any of its subsidiaries. Furthermore, such attribution does not affect the rights of creditors of the Company or any subsidiary, including rights under financing covenants. Each holder of Psychiatric Group Depositary Shares, Core Group Common Stock or Series B Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to risks associated with an investment in the Company and all of its businesses, assets and liabilities. Financial effects arising from one Group that affect the Company's consolidated results of operations, financial condition, cash flows or borrowing costs may also affect the results of operations, financial condition, cash flows or borrowing costs of the other Group. In addition, net losses of either Group, as well as dividends and distributions on, and repurchases or redemptions of, Psychiatric Group Depositary Shares, Core Group Common Stock or Series B Depositary Shares will reduce the funds of the Company legally available for dividends on Psychiatric Group Depositary Shares, Core Group Common Stock and Series B Depositary Shares. Accordingly, the Psychiatric Group's financial statements should be read in conjunction with the Company's consolidated financial statements and the financial statements of the Core Group. 39 41 AMERICAN HEALTH PROPERTIES, INC. NOTES TO PSYCHIATRIC GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) These financial statements include the accounts of the Psychiatric Group business. The Psychiatric Group and the Core Group financial statements, taken together, comprise all of the accounts included in the Company's consolidated financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. New Accounting Standards In the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Psychiatric Group's financial statements. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", establishes standards for reporting financial and descriptive information about reportable operating segments. In general, reportable operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The required adoption in 1998 of SFAS No. 131 is not expected to have a material impact on the Psychiatric Group's financial statements. In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employer's Disclosures about Pensions and Other Post Retirement Benefits". SFAS No. 132 revises employer's disclosures about pension and other post retirement benefits to the extent practicable, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures that are no longer useful. The required adoption in 1998 of SFAS No. 132 is not expected to have a material impact on the Psychiatric Group's financial statements. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. It also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The required adoption in 1999 of SFAS No. 133 is not expected to have a material impact on the Psychiatric Group's financial statements. In April 1998, the AICPA issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities". In general, SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. Initial application of SOP 98-5 should be reported as the cumulative effect of a change in accounting principle. The required adoption in 1998 of SOP 98-5 is not expected to have a material impact on the Psychiatric Group's financial statements. Interest Paid Interest paid by the Psychiatric Group on inter-Group loans from the Core Group was $712,000 and $784,000 for the six months ended June 30, 1998 and 1997, respectively. 40 42 AMERICAN HEALTH PROPERTIES, INC. NOTES TO PSYCHIATRIC GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 2. DEBT Inter-Group Loans Subsequent to the end of the second quarter, in July 1998, the Psychiatric Group paid off the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Core Group by the Psychiatric Group. The Company's Board has established certain policies relating to the Core Group's inter-Group loans to the Psychiatric Group. Under the policies currently in effect, which may be modified or rescinded at any time in the sole discretion of the Company's Board, the aggregate revolving inter-Group loans owed by the Psychiatric Group to the Core Group are limited to a maximum of $7,870,000 at any one time outstanding, which limit is to be reduced dollar-for- dollar by any permanent repayment in the future of borrowings under a revolving credit agreement provided to a Psychiatric Group hospital operator; provided that the limit on the aggregate revolving inter-Group loans will not be reduced below $5,000,000. Except for such revolving inter-Group loans, no additional fixed rate or other inter-Group loans will be advanced by the Core Group to the Psychiatric Group. 3. ATTRIBUTED EQUITY Special Stock Dividend Subsequent to the end of the second quarter, on July 24, 1998, the Psychiatric Group purchased 833,067 new shares of Core Group Common Stock from the Company's Core Group at a price of $25.9407 per share, which the Psychiatric Group concurrently distributed to holders of Psychiatric Group Depositary Shares as a special stock dividend. Holders of Psychiatric Group Depositary Shares received 0.4 shares of Core Group Common Stock for each Psychiatric Group Depositary Share held and were paid cash-in-lieu of fractional shares of Core Group Common Stock based on the price of $25.9407. Stock Incentive Plans Options to purchase 10,000 shares of Psychiatric Group Depositary Shares at a weighted average exercise price of $20.96 per share expired during the six months ended June 30, 1998. 4. EARNINGS PER SHARE The following is a reconciliation of the income or (loss) and share amounts used in the basic and diluted per share computations of income before extraordinary item attributable to Psychiatric Group Depositary Shares:
Three Months Ended June 30, Six Months Ended June 30, ----------------------------------------------- ------------------------------------------------ 1998 1997 1998 1997 ----------------------- ---------------------- ----------------------- ----------------------- Income Income Income Income (In thousands) (Loss) Shares (Loss) Shares (Loss) Shares (Loss) Shares ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Basic EPS components $ (1,484) 2,084 $ 1,203 2,084 $ (245) 2,084 $ (8,267) 2,084 Effect of dilutive potential depositary shares - Stock options -- -- -- -- -- -- -- -- DER's -- -- -- 14 -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Diluted EPS components $ (1,484) 2,084 $ 1,203 2,098 $ (245) 2,084 $ (8,267) 2,084 ========== ========== ========== ========== ========== ========== ========== ==========
5. STATUS OF PSYCHIATRIC GROUP INVESTMENTS Subsequent to the end of the second quarter, on July 1, 1998, the Psychiatric Group received $35 million as payment in full of its two New York Four Winds mortgage loans resulting in the accrual of a $2.73 million impairment loss in the second quarter of 1998. Proceeds from the payment of the Four Winds mortgage loans 41 43 AMERICAN HEALTH PROPERTIES, INC. NOTES TO PSYCHIATRIC GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) were first used to repay the entire balance of approximately $11.2 million of fixed and revolving inter-Group loans owed to the Company's Core Group by the Psychiatric Group and to maintain a cash reserve of approximately $2.3 million for the net current liabilities of the Psychiatric Group. Substantially all of the remaining proceeds were distributed to holders of Psychiatric Group Depositary Shares on July 24, 1998 as a special dividend paid in the form of 0.4 shares of Core Group Common Stock per Psychiatric Group Depositary Share. In order to effectuate the stock dividend, the Psychiatric Group purchased 833,067 shares of Core Group Common Stock from the Core Group at a price of $25.9407 per share, which represented the average trading price of the Core Group Common Stock for the last ten trading days prior to the July 17, 1998 record date for the special dividend, as provided in the certificate of designation for the Psychiatric Group Stock. The Four Winds loans represented the largest income-producing portion of the Psychiatric Group's portfolio. In the second quarter of 1998, the Four Winds loans contributed revenue of $1,776,000 to the Psychiatric Group. As a result of the payoff of these loans, second quarter 1998 results will be the last quarter to include results from the Four Winds loans and future quarters' results will be solely dependent on the remaining three assets in the portfolio. Furthermore, since the Psychiatric Group does not maintain a separate management structure, it has an ongoing obligation to pay for an allocated portion of the Company's general and administrative expenses, subject to a minimum of $250,000 annually, as well as for specific expenses directly related to the operations of the Psychiatric Group. Offsetting these expenses in future quarters will be a reduction of interest expense as a result of the repayment of the inter- Group loans to the Core Group. Interest expense on inter-Group loans to the Core Group was $347,000 for the second quarter of 1998. Due to these various factors, future quarterly cash flows and dividends will decrease very substantially. The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in significant impairment losses on the three remaining psychiatric investments and the periodic restructuring of psychiatric operator payment obligations in previous years. The Psychiatric Group recorded an $11 million charge in the first quarter of 1997 for impairment of the carrying value of its two psychiatric investments in Florida. The Northpointe property, at which the operator ceased paying its obligations to the Psychiatric Group in February 1997 and ceased hospital operations in the second quarter of 1997, continues to remain idle. The Psychiatric Group incurred costs of approximately $75,000 during the second quarter of 1998 ($.04 per depositary share) and $225,000 for the first quarter of 1998 ($.11 per depositary share) to protect and maintain this property, including approximately $150,000 for unexpected expenditures. Although on an ongoing basis, the Psychiatric Group expects to incur costs of approximately $75,000 per quarter ($.04 depositary share) to protect and maintain this property while various alternatives for the property are evaluated and pursued, the Psychiatric Group cannot be assured that other unexpected costs will not be incurred. Numerous discussions with health care operators and others regarding a potential sale or lease of the property continue. However, no agreement for sale or lease has been reached. If efforts to identify a health care operator for the property prove unsuccessful, the property will most likely have to be sold for its real estate value, however, the Psychiatric Group cannot be assured that the current carrying value of the property would be realized through a sale. Early in the fourth quarter of 1997, a restructuring of The Retreat's obligations to the Psychiatric Group was completed. The Retreat's restructured base rent is $35,000 per month ($105,000 per quarter or $.05 per depositary share) and additional rent will not accrue or be payable until August 1, 2000. The Psychiatric Group has received the base rent payments under the restructured terms through August 1998 but The Retreat is currently in default on other obligations owed to the Psychiatric Group. Although the restructured agreement with The Retreat was a positive step in stabilizing the cash flow and operations of this facility, as evidenced by the current default, the Psychiatric Group cannot be assured that The Retreat will be able to continue to meet its restructured obligations or continue operations. While the Psychiatric Group has now reached an agreement in principle regarding the assumption of operations at The Retreat by a new operator, certain of the required key agreements remain under negotiation. The transfer of operations to the new operator will not occur unless those terms are satisfactorily resolved. If not 42 44 AMERICAN HEALTH PROPERTIES, INC. NOTES TO PSYCHIATRIC GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) resolved, the Psychiatric Group may decide to exercise any or all of its remedies. Even if there is a change in the operator of The Retreat, continued operations at The Retreat will remain uncertain until the new operator has demonstrated its ability to operate the facility successfully. In light of the volatile circumstances of the two Florida psychiatric properties, the Psychiatric Group cannot be assured that further impairment losses on these investments will not be required. Although the $2,500,000 balance outstanding under Rock Creek Center's (RCC) revolving credit agreement matured in June 1997 and the initial term of the RCC lease expired in December 1997, RCC has continued to make interest payments on the revolving credit agreement and the initial lease term has been extended to September 30, 1998, with a further extension pending as described below. RCC has met its rent and interest obligations to the Psychiatric Group through August 1998, however, the Psychiatric Group cannot be assured that RCC will not experience future operational and cash flow difficulties as it has in the past. At the end of June 1998, the operator of the Rock Creek Center (RCC) facility informed the Psychiatric Group that it had incurred a material, unanticipated liability to Medicare, which imperils the continuing operation of the facility. In response, the operator has commenced a significant revision and downsizing of its operations to focus on geriatric psychiatric care. In order to implement that change, the operator has given a WARN Act notice to its employees notifying them that the operations of the facility in its current mode will cease within 60 days of such notice and inviting them to reapply for positions in the proposed downsized operation. Under the currently applicable lease extension, the Psychiatric Group has the right, effective July 1, 1998, to negotiate with other potential health care operators regarding operating the facility and the Psychiatric Group has commenced marketing the property to potential new operators. An agreement in principle has been reached with the existing operator extending the current lease to March 31, 1999, and extending the maturity of the revolving credit agreement to March 31, 1999. Under the proposed arrangement, the operator will continue to pay interest on all outstanding obligations and will pay $5,000 per month against the principal balance of the revolving credit agreement. Although discussions with the current operator have not yet been successful in reaching a mutually acceptable long-term lease, purchase and sale agreement, and/or payment schedule for the payment of the balance of the revolving credit agreement, the operator of the facility has approached the Psychiatric Group with a proposal that may be practicable depending, in part, on the operator's ability to negotiate an acceptable compromise with Medicare regarding the unanticipated Medicare liability. Local and national operators have expressed interest in the facility; however, the Psychiatric Group cannot be assured that either a long-term lease extension or a new lease will be accomplished. If the current operator is unsuccessful in formulating a program which permits it to pay the newly-determined Medicare liability and to make suitable payments to the Psychiatric Group, and a facility lease with a new operator is not accomplished, a significant negative impact to the Psychiatric Group likely will result. Furthermore, if a new operator assumes operation of the RCC facility, the Psychiatric Group cannot be assured that the current operator will be able to pay the balance owed under the revolving credit agreement or that a new operator will be able to operate the facility successfully. The total revenue contribution to the Psychiatric Group from the RCC investment for the second quarter was $.17 per depositary share. Although management currently believes that the recorded amounts of its psychiatric investments are realizable, if the psychiatric operators are unable to adapt to the fundamental ongoing changes in the psychiatric industry successfully and consistently mitigate the negative impact of the ongoing changes on their financial performance, the Psychiatric Group may be required to restructure payment obligations further, identify alternative operators, pursue alternative uses for or dispositions of the properties and/or recognize additional impairment losses on its investments. If the Psychiatric Group is required to take any of these actions, various costs are likely to be incurred by the Psychiatric Group in an effort to protect, maintain and pursue alternatives for its investments. The Psychiatric Group does not currently intend to make new investments, and over time, may sell, restructure or seek other means to reduce its investments. In addition, the Psychiatric Group continues to encourage each of the psychiatric operators to pursue financing alternatives which might enable them to acquire the properties and/or 43 45 AMERICAN HEALTH PROPERTIES, INC. NOTES TO PSYCHIATRIC GROUP COMBINED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) repay their borrowings from the Psychiatric Group, as the case may be. Subject to the rights of the holders of the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, and any other preferred stock of the Company then outstanding, the Psychiatric Group expects to use the net proceeds of any future property sales and/or operator borrowing repayments to first repay then outstanding inter-Group loans and/or other liabilities owed by the Psychiatric Group and to distribute all remaining net proceeds, if any, in cash or Core Group Common Stock of the Company to holders of Psychiatric Group Depositary Shares. The Psychiatric Group cannot be assured that the efforts of psychiatric operators to obtain alternative financing will be successful or, if successful, that the amounts of such financing would be sufficient to enable the Psychiatric Group to realize the carrying amounts of its investments. The Company continues to retain an investment banking firm to provide financial advisory services to the Psychiatric Group. These services include supplemental monitoring of the performance of individual assets, assistance in potential sales or restructurings of particular investments and continuing assessments of available strategic alternatives for the portfolio. The cost of the financial advisory services are specifically charged to the operating results of the Psychiatric Group. The Psychiatric Group's dividend is determined quarterly based upon each quarter's operating results. Historically, the level of dividends of the Psychiatric Group have varied quarter-to-quarter. Any significant advance of additional funds to operators of the Psychiatric Group's properties, modification of terms covering the rental or interest obligations of its properties or nonpayment or deferral of such obligations as they become due likely will have an adverse impact on the Psychiatric Group results of operations and cash flows, as well as on the quarterly dividend payment on Psychiatric Group Depositary Shares. In addition to the foregoing, future operating results, cash flows and dividends of the Psychiatric Group will be affected by changes in the level of additional rent, the amount of additional financial advisory fees and, to the extent necessary, various costs which might be incurred in an effort to protect, maintain and pursue alternatives for its investments. With the repayment of the Four Winds loans, future quarterly cash flows and dividends will decrease very substantially from previous quarters. Also, small events with respect to the Psychiatric Group's three remaining facilities will likely have a more significant effect on the Psychiatric Group's cash flows and dividends, and therefore the price of the Psychiatric Group Depositary Shares. The liquidity of the Psychiatric Group Depositary Shares will also likely be adversely affected. The Company will continue to review quarterly the performance of each of the remaining assets of the Psychiatric Group. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may then elect to redeem the outstanding Psychiatric Group Depositary Shares. 44 46 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Following is a discussion of the combined financial condition and results of operations of the Psychiatric Group, which should be read in conjunction with (a) the combined financial statements and accompanying notes of the Psychiatric Group and (b) management's discussion and analysis of financial condition and results of operations and the financial statements and accompanying notes of the Company and the Core Group included elsewhere herein. Factors Regarding Future Results and Forward-Looking Statements This report includes and incorporates by reference statements that are not purely historical and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All statements other than historical fact contained in this report, including without limitation statements regarding rent or interest to be received from the Company's operators, plans with respect to individual facilities, expectations with respect to the specific terms and renewals of leases of the Company's facilities, the Company's anticipated dividend and dividend payout ratios, the potential redemption of the Company's Shares, the Company's liquidity position, projected expenses associated with maintaining individual properties, the Company's ability to realize the recorded amounts of its investments and the potential effect of new or existing regulations on the operations conducted at the Company's facilities, are forward-looking statements. All forward-looking statements included or incorporated by reference in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update such forward-looking statements. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct or that the Company will take any actions that may presently be planned. Certain factors that could cause actual results to differ materially from those expected include, among others: the financial success of the operations conducted at the Company's facilities and the financial strength of the operators of such facilities, the continuing ability of operators to meet their obligations to the Company under existing or restructured agreements, changes in operators or ownership of operators, the viability of alternative uses for the Company's properties when necessary, changes in government policy relating to the health care industry including reductions in reimbursement levels under the Medicare and Medicaid programs, operators' continued eligibility to participate in the Medicare or Medicaid programs, reductions in reimbursement by other third-party payors, the impact of managed care pricing pressures, the requirement to provide care on a fixed-price basis, lower occupancy levels at the Company's facilities, a reduction in demand for the services provided at the Company's facilities, the strength and financial resources of the Company's competitors, the availability and cost of capital, the Company's ability to make additional real estate investments at attractive yields and changes in tax laws and regulations affecting real estate investment trusts. For a further discussion of certain of these factors, see "- Future Operating Results" herein. OPERATING RESULTS Second Quarter and Year to Date 1998 Compared With 1997 For the second quarter of 1998, the Psychiatric Group reported a net loss of ($1,484,000), or ($.71) per Psychiatric Group Depositary Share on a diluted basis, compared with net income of $1,203,000, or $.57 per Psychiatric Group Depositary Share on a diluted basis, for the second quarter of 1997. For the six months ended June 30, 1998, the Psychiatric Group reported a net loss of ($245,000), or ($.12) per Psychiatric Group Depositary Share on a diluted basis, compared with a net loss of ($8,267,000), or ($3.97) per Psychiatric Group Depositary Share on a diluted basis. The net loss for the second quarter of 1998 and six months ended June 30, 1998 includes an impairment loss on notes receivable of ($2,730,000), or ($1.31) per Psychiatric Group Depositary Share on a 45 47 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS diluted basis. The net loss for the six months ended June 30, 1997 includes an impairment loss on real estate and notes receivable of ($11,000,000), or ($5.28) per Psychiatric Group Depositary Share on a diluted basis. Rental income was $710,000 for the six months ended June 30, 1998, a decrease of $213,000 or 23% from $923,000 for the six months ended June 30, 1997. The decrease in rental income for the six months ended June 30, 1998 was primarily due to the reduction of base rent from one of the Florida properties as a result of a lease restructuring early in the fourth quarter of 1997. Additionally, the first quarter of 1997 included base rent received for one month from the other Florida property before the operator stopped paying rent and subsequently ceased operations in the second quarter of 1997. Additional rental and interest income was $270,000 for the second quarter of 1998, an increase of $103,000 or 62% from $167,000 for the second quarter of 1997. Additional rental and interest income was $564,000 for the six months ended June 30, 1998, an increase of $193,000 or 52% from $371,000 for the six months ended June 30, 1997. This increase was primarily attributable to an increase in additional interest received from the Four Winds Hospital - Katonah facility. Property operating expense of $75,000 for the second quarter of 1998 and $300,000 for the six months ended June 30, 1998 represents costs related to the protection and maintenance of one of the properties in Florida, including approximately $150,000 for unexpected expenditures, incurred after the operator ceased operations in the second quarter of 1997. Interest expense on inter-Group loans from the Core Group was $347,000 for the second quarter of 1998, a decrease of $47,000 or 12% from $394,000 for the second quarter of 1997. Interest expense on inter-Group loans from the Core Group was $712,000 for the six months ended June 30, 1998 a decrease of $72,000 or 9% from $784,000 for the six months ended June 30, 1997. This decrease reflects a lower average balance outstanding on loans from the Core Group as a result of repayments by the Psychiatric Group from its available undistributed cash flow. General and administrative expenses were $386,000 for the second quarter of 1998, an increase of $86,000 or 29% from $300,000 for the second quarter of 1997. General and administrative expenses were $638,000 for the six months ended June 30, 1998, an increase of $43,000 or 7% from $595,000 for the six months ended June 30, 1997. The Company's consolidated general and administrative expenses are allocated between the Core Group and Psychiatric Group primarily based on revenues, however significant costs directly related to either Group are specifically charged to the applicable Group. Costs allocated to the Psychiatric Group based on revenues and direct costs charged to the Psychiatric Group both decreased for the second quarter and first half of 1998 compared to the comparable periods in 1997. The Psychiatric Group was specifically charged for $225,000 and $302,000 of costs in the second quarter and first six months of 1998, respectively, for financial advisory services provided primarily by an investment banking firm which included supplemental monitoring of the performance of the Psychiatric Group's properties and assistance in addressing operational and cash flow difficulties of certain operators of the properties. On a comparative basis, general and administrative expenses for the second quarter and first six months of 1997 included $132,000 and $248,000 of such financial advisory costs. Future Operating Results The operators and tenants of most of the Company's facilities derive a substantial percentage of their total revenues from federal and state health care programs such as Medicare and Medicaid and from other third-party payors such as private insurance companies, self-insured employers and health maintenance organizations. Such operators and tenants also are subject to extensive federal, state and local government regulation relating to their operations, and most of the Company's facilities are subject to periodic inspection by governmental and other 46 48 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS authorities to assure continued compliance with mandated procedures, licensure requirements under state law and certification standards under the Medicare and Medicaid programs. A reduction in reimbursement levels under the Medicare or Medicaid programs, a reduction in reimbursement by other third-party payors or an operator's or tenant's failure to maintain its certification under Medicare or Medicaid programs could adversely affect revenues to the Company's facilities. The nature of health care delivery in the United States continues to undergo change and further review at both the national and state levels. Generally accepted goals of reform continue to include controlling costs and improving access to medical care. Various plans to decrease the growth in Medicare spending have been proposed and passed by both Houses of Congress. These plans generally include revisions to and limits on Medicare and federal programs providing Medicaid reimbursement to state health care programs and have had and potentially would have an adverse impact on the level of funds available in the future to health care facilities. The Balanced Budget Act of 1997 contains extensive changes to the Medicare and Medicaid programs intended to reduce the projected amount of increase in Medicare spending by an estimated $115 billion and Medicaid spending by an estimated $13 billion over five years. In addition, the Budget Act repealed certain limits on states' ability to reduce their Medicaid reimbursement levels. The Budget Act has the potential to reduce significantly federal spending on health care services provided at each of the Psychiatric Group's facilities, and to affect revenues of the Psychiatric Group's operators adversely. In particular, the Budget Act's limitations on reimbursable costs and reductions in payment incentives and capital related payments, as well as the change toward a prospective payment system, may have a material adverse effect on operator revenues at the Psychiatric Group's hospitals. The Company cannot be assured that the changes effected by the Budget Act will not have a material adverse effect on the Psychiatric Group's financial condition or results of operation. The Company's Board and management are monitoring the effect of the Budget Act on the Psychiatric Group's facilities and potential changes to reimbursement programs closely. The Company believes that the changes effected by the Budget Act and changes proposed at the federal and state level may pose risks for certain institutions that are unwilling or unable to respond. The ongoing changes in the health care industry include trends toward shorter lengths of hospital stay, increased use of outpatient services, increased federal, state and third-party oversight of health care company operations and business practices, and increased demand for discounted or capitated health care services (delivery of services at a fixed price per capita basis to a defined group of covered parties). Furthermore, federal, state and third-party payors continue to propose and adopt various cost containment measures that restrict the scope of reimbursable health care services and limit increases in reimbursement rates for such services. Payors also are continuing to enforce compliance with program requirements aggressively and to pursue providers that they believe have not complied with such requirements. Outpatient business is expected to increase as advances in treatment techniques and pharmacology allow more care to be provided on an outpatient basis and as payors continue to direct more patients from inpatient care to outpatient care. In addition, the entrance of insurance companies into managed care programs is accelerating the introduction of managed care in new localities, and states and insurance companies continue to negotiate actively the amounts they will pay for services. Moreover, the percentage of health care services that are reimbursed under the Medicare and Medicaid programs continues to increase as the population ages. States are also expanding their Medicaid programs. Continued eligibility to participate in these programs is crucial to a provider's financial strength. As a result of the foregoing, revenues and margins may decrease at the Psychiatric Group's facilities. Fundamental changes in the psychiatric industry continue to impact negatively the facility-specific operating cash flow at the Psychiatric Group's properties. Institutions responsible for the reimbursement of care provided to patients who use inpatient psychiatric treatment services have directed efforts toward decreasing their payments for such services, thereby reducing hospital operating revenues. Some cost-cutting measures used by 47 49 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS such institutions include decreasing the inpatient length of stay, intensively reviewing utilization, directing patients from inpatient care to outpatient care and negotiating reduced reimbursement rates for services. The wider use of psychotropic drugs also has resulted in significant declines in the average length of stay. In addition, aggressive program compliance enforcement and increased scrutiny of past and current billing practices has resulted in the filing of lawsuits against some providers and significant negative publicity which has further exacerbated the financial and operational difficulties of providers. Although the operators of the psychiatric hospitals are responding by increasing case management, developing lower cost outpatient and daypatient programs and reducing operating costs, their efforts are generally not consistently mitigating the negative impact of these fundamental psychiatric industry changes. As a result, certain of the Psychiatric Group hospital operators have not consistently met their contractual payment obligations to the Psychiatric Group as scheduled and the Psychiatric Group cannot be assured that hospital operators will be able to meet such payment obligations in the future. In general, the operators of the Psychiatric Group's properties have very limited access to financing for their operating and capital needs. The Psychiatric Group provided such financing under a revolving credit agreement to the operator of one of its psychiatric properties. As of June 30, 1998, outstanding borrowings under such agreement totaled $2,500,000, which amount remains outstanding even though the financing matured June 30, 1997. In the past, the Psychiatric Group has provided similar financing to other operators of its properties which have been unable to pay off their outstanding borrowings. The Psychiatric Group cannot be assured that the operator currently borrowing under a revolving credit agreement will be able to secure replacement financing from third-party lenders or to pay off its outstanding borrowings. To the extent the operators of the Psychiatric Group's properties have increased working capital needs in the future, the Psychiatric Group may be the only source of such financing. In the event the Company's Board of Directors determines that it is appropriate to provide additional working capital financing to a psychiatric hospital operator, it may cause the Core Group to make revolving inter-Group loans to the Psychiatric Group to fund such financing (to the extent consistent with its then-existing policies), although the Company's Board of Directors is under no obligation to do so. Subsequent to the end of the second quarter, on July 1, 1998, the Psychiatric Group received $35 million as payment in full of its two New York Four Winds mortgage loans resulting in the accrual of a $2.73 million impairment loss in the second quarter of 1998. Proceeds from the payment of the Four Winds mortgage loans were first used to repay the entire balance of approximately $11.2 million of fixed and revolving inter-Group loans owed to the Company's Core Group by the Psychiatric Group and to maintain a cash reserve of approximately $2.3 million for the net current liabilities of the Psychiatric Group. Substantially all of the remaining proceeds were distributed to holders of Psychiatric Group Depositary Shares on July 24, 1998 as a special dividend paid in the form of 0.4 shares of Core Group Common Stock per Psychiatric Group Depositary Share. In order to effectuate the stock dividend, the Psychiatric Group purchased 833,067 shares of Core Group Common Stock from the Core Group at a price of $25.9407 per share, which represented the average trading price of the Core Group Common Stock for the last ten trading days prior to the July 17, 1998 record date for the special dividend, as provided in the certificate of designation for the Psychiatric Group Stock. The Four Winds loans represented the largest income-producing portion of the Psychiatric Group's portfolio. In the second quarter of 1998, the Four Winds loans contributed revenue of $1,776,000 to the Psychiatric Group. As a result of the payoff of these loans, second quarter 1998 results will be the last quarter to include results from the Four Winds loans and future quarters' results will be solely dependent on the remaining three assets in the portfolio. Furthermore, since the Psychiatric Group does not maintain a separate management structure, it has an ongoing obligation to pay for an allocated portion of the Company's general and administrative expenses, subject to a minimum of $250,000 annually, as well as for specific expenses directly related to the operations of the Psychiatric Group. Offsetting these expenses in future quarters will be a reduction of interest expense as a result of the repayment of the inter- Group loans to the Core Group. Interest 48 50 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS expense on inter-Group loans to the Core Group was $347,000 for the second quarter of 1998. Due to these various factors, future quarterly cash flows and dividends will decrease very substantially. The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in significant impairment losses on the three remaining psychiatric investments and the periodic restructuring of psychiatric operator payment obligations in previous years. The Psychiatric Group recorded an $11 million charge in the first quarter of 1997 for impairment of the carrying value of its two psychiatric investments in Florida. The Northpointe property, at which the operator ceased paying its obligations to the Psychiatric Group in February 1997 and ceased hospital operations in the second quarter of 1997, continues to remain idle. The Psychiatric Group incurred costs of approximately $75,000 during the second quarter of 1998 ($.04 per depositary share) and $225,000 for the first quarter of 1998 ($.11 per depositary share) to protect and maintain this property, including approximately $150,000 for unexpected expenditures. Although on an ongoing basis, the Psychiatric Group expects to incur costs of approximately $75,000 per quarter ($.04 depositary share) to protect and maintain this property while various alternatives for the property are evaluated and pursued, the Psychiatric Group cannot be assured that other unexpected costs will not be incurred. Numerous discussions with health care operators and others regarding a potential sale or lease of the property continue. However, no agreement for sale or lease has been reached. If efforts to identify a health care operator for the property prove unsuccessful, the property will most likely have to be sold for its real estate value, however, the Psychiatric Group cannot be assured that the current carrying value of the property would be realized through a sale. Early in the fourth quarter of 1997, a restructuring of The Retreat's obligations to the Psychiatric Group was completed. The Retreat's restructured base rent is $35,000 per month ($105,000 per quarter or $.05 per depositary share) and additional rent will not accrue or be payable until August 1, 2000. The Psychiatric Group has received the base rent payments under the restructured terms through August 1998 but The Retreat is currently in default on other obligations owed to the Psychiatric Group. Although the restructured agreement with The Retreat was a positive step in stabilizing the cash flow and operations of this facility, as evidenced by the current default, the Psychiatric Group cannot be assured that The Retreat will be able to continue to meet its restructured obligations or continue operations. While the Psychiatric Group has now reached an agreement in principle regarding the assumption of operations at The Retreat by a new operator, certain of the required key agreements remain under negotiation. The transfer of operations to the new operator will not occur unless those terms are satisfactorily resolved. If not resolved, the Psychiatric Group may decide to exercise any or all of its remedies. Even if there is a change in the operator of The Retreat, continued operations at The Retreat will remain uncertain until the new operator has demonstrated its ability to operate the facility successfully. In light of the volatile circumstances of the two Florida psychiatric properties, the Psychiatric Group cannot be assured that further impairment losses on these investments will not be required. Although the $2,500,000 balance outstanding under Rock Creek Center's (RCC) revolving credit agreement matured in June 1997 and the initial term of the RCC lease expired in December 1997, RCC has continued to make interest payments on the revolving credit agreement and the initial lease term has been extended to September 30, 1998, with a further extension pending as described below. RCC has met its rent and interest obligations to the Psychiatric Group through August 1998, however, the Psychiatric Group cannot be assured that RCC will not experience future operational and cash flow difficulties as it has in the past. At the end of June 1998, the operator of the Rock Creek Center (RCC) facility informed the Psychiatric Group that it had incurred a material, unanticipated liability to Medicare, which imperils the continuing operation of the facility. In response, the operator has commenced a significant revision and downsizing of its operations to focus on geriatric psychiatric care. In order to implement that change, the operator has given a WARN Act notice to its employees notifying them that the operations of the facility in its current mode will cease within 60 days of such notice and inviting them to reapply for positions in the proposed downsized operation. Under the currently applicable lease extension, the Psychiatric Group has the right, effective July 1, 1998, to negotiate with other potential health care operators regarding operating the facility and the Psychiatric Group has commenced marketing the property to potential new 49 51 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS operators. An agreement in principle has been reached with the existing operator extending the current lease to March 31, 1999, and extending the maturity of the revolving credit agreement to March 31, 1999. Under the proposed arrangement, the operator will continue to pay interest on all outstanding obligations and will pay $5,000 per month against the principal balance of the revolving credit agreement. Although discussions with the current operator have not yet been successful in reaching a mutually acceptable long-term lease, purchase and sale agreement, and/or payment schedule for the payment of the balance of the revolving credit agreement, the operator of the facility has approached the Psychiatric Group with a proposal that may be practicable depending, in part, on the operator's ability to negotiate an acceptable compromise with Medicare regarding the unanticipated Medicare liability. Local and national operators have expressed interest in the facility; however, the Psychiatric Group cannot be assured that either a long-term lease extension or a new lease will be accomplished. If the current operator is unsuccessful in formulating a program which permits it to pay the newly-determined Medicare liability and to make suitable payments to the Psychiatric Group, and a facility lease with a new operator is not accomplished, a significant negative impact to the Psychiatric Group likely will result. Furthermore, if a new operator assumes operation of the RCC facility, the Psychiatric Group cannot be assured that the current operator will be able to pay the balance owed under the revolving credit agreement or that a new operator will be able to operate the facility successfully. The total revenue contribution to the Psychiatric Group from the RCC investment for the second quarter was $.17 per depositary share. Although management currently believes that the recorded amounts of its psychiatric investments are realizable, if the psychiatric operators are unable to adapt to the fundamental ongoing changes in the psychiatric industry successfully and consistently mitigate the negative impact of the ongoing changes on their financial performance, the Psychiatric Group may be required to restructure payment obligations further, identify alternative operators, pursue alternative uses for or dispositions of the properties and/or recognize additional impairment losses on its investments. If the Psychiatric Group is required to take any of these actions, various costs are likely to be incurred by the Psychiatric Group in an effort to protect, maintain and pursue alternatives for its investments. The Psychiatric Group does not currently intend to make new investments, and over time, may sell, restructure or seek other means to reduce its investments. In addition, the Psychiatric Group continues to encourage each of the psychiatric operators to pursue financing alternatives which might enable them to acquire the properties and/or repay their borrowings from the Psychiatric Group, as the case may be. Subject to the rights of the holders of the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, and any other preferred stock of the Company then outstanding, the Psychiatric Group expects to use the net proceeds of any future property sales and/or operator borrowing repayments to first repay then outstanding inter-Group loans and/or other liabilities owed by the Psychiatric Group and to distribute all remaining net proceeds, if any, in cash or Core Group Common Stock of the Company to holders of Psychiatric Group Depositary Shares. The Psychiatric Group cannot be assured that the efforts of psychiatric operators to obtain alternative financing will be successful or, if successful, that the amounts of such financing would be sufficient to enable the Psychiatric Group to realize the carrying amounts of its investments. The Company continues to retain an investment banking firm to provide financial advisory services to the Psychiatric Group. These services include supplemental monitoring of the performance of individual assets, assistance in potential sales or restructurings of particular investments and continuing assessments of available strategic alternatives for the portfolio. The cost of the financial advisory services are specifically charged to the operating results of the Psychiatric Group. The Psychiatric Group's dividend is determined quarterly based upon each quarter's operating results. Historically, the level of dividends of the Psychiatric Group have varied quarter-to-quarter. Any significant advance of additional funds to operators of the Psychiatric Group's properties, modification of terms covering the rental or interest obligations of its properties or nonpayment or deferral of such obligations as they become due likely will have an adverse impact on the Psychiatric Group results of operations and cash flows, as well as on the quarterly dividend payment on Psychiatric Group Depositary Shares. In addition to the foregoing, future operating results, cash flows and dividends of the Psychiatric Group will be affected by changes in the level of additional 50 52 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS rent, the amount of additional financial advisory fees and, to the extent necessary, various costs which might be incurred in an effort to protect, maintain and pursue alternatives for its investments. With the repayment of the Four Winds loans, future quarterly cash flows and dividends will decrease very substantially from previous quarters. Also, small events with respect to the Psychiatric Group's three remaining facilities will likely have a more significant effect on the Psychiatric Group's cash flows and dividends, and therefore the price of the Psychiatric Group Depositary Shares. The liquidity of the Psychiatric Group Depositary Shares will also likely be adversely affected. The Company will continue to review quarterly the performance of each of the remaining assets of the Psychiatric Group. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may then elect to redeem the outstanding Psychiatric Group Depositary Shares. Many existing information systems currently record years in a two-digit format and will be unable to properly interpret dates beyond the year 1999 which could lead to business disruptions (the Year 2000 Issue). The Company is currently upgrading its internal information systems in the normal course of business and does not expect the Year 2000 Issue to have a material impact on the future operations or financial results of the Company's Psychiatric Group. However, the future operations of the Company's Psychiatric Group could be disrupted and/or its financial results could be negatively impacted by the Year 2000 Issue if the Company's Psychiatric Group lessees and borrowers do not adequately address the Year 2000 Issue with respect to their information systems. As health care providers, the Company's Psychiatric Group lessees and borrowers generally rely extensively on information systems, including systems for capturing patient and cost information and for billing and collecting reimbursement for health care services provided. Furthermore, the Company's Psychiatric Group lessees and borrowers likewise are dependent on a variety of third parties who must also adequately address the Year 2000 Issue, including private and government payors. Although, the Company believes that the Psychiatric Group lessees and borrowers are generally addressing their Year 2000 Issues, it is not possible for the Company to determine or be assured that adequate remediation of the Year 2000 Issue will be accomplished by such lessees and borrowers. Furthermore, it is not possible for the Company to determine or be assured that the various payors and other third parties upon which the Company's Psychiatric Group lessees and borrowers are dependent for reimbursement and information will accomplish adequate remediation of their Year 2000 Issues. Accordingly, although the Company believes that the impact of the Year 2000 Issue, as it relates to its internal information systems, will not be material to the Company's Psychiatric Group, the Company cannot be assured that the Year 2000 Issues of its Psychiatric Group lessees and borrowers, and the third parties upon which they are dependent, will not have a material impact on the future operations and/or financial results of the Company's Psychiatric Group. LIQUIDITY AND CAPITAL RESOURCES At August 11, 1998, the Psychiatric Group had no borrowings outstanding under its fixed rate or revolving inter-Group loans from the Core Group. The Company's Board of Directors has established certain management policies relating to the Psychiatric Group's inter-Group loans from the Core Group. Under the policies currently in effect, which may be modified or rescinded at any time in the sole discretion of the Company's Board of Directors, the aggregate revolving inter-Group loans owed by the Psychiatric Group to the Core Group are limited to a maximum of $7,870,000 at any one time outstanding, which limit is to be reduced dollar-for-dollar by any permanent repayment in the future of borrowings under a revolving credit agreement provided to a Psychiatric Group hospital operator; provided that the limit on the aggregate revolving inter-Group loans will not be reduced below $5,000,000. Except for such revolving inter-Group loans, no additional fixed rate or other inter-Group loans will be advanced to the Psychiatric Group by the Core Group. The Psychiatric Group has no third-party sources of additional financing and, as a result, is dependent on the Core Group for all such financing. Although the Core 51 53 AMERICAN HEALTH PROPERTIES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS Group may make this financing available, there is no obligation of the Company's Board of Directors to cause the Core Group to provide funds to the Psychiatric Group if the Board of Directors determines that it is in the Company's best interest not to do so. To the extent needed funds are not advanced by the Core Group, the Psychiatric Group would experience immediate, significant negative effects. The Psychiatric Group does not expect to make any additional acquisitions or capital investments. Future dividend payments will be determined quarterly and will be primarily dependent upon the financial performance of the Psychiatric Group. Subject to the rights of the holders of the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, and any other preferred stock of the Company then outstanding, the Psychiatric Group expects to distribute a substantial portion of its funds from operations and net proceeds from asset dispositions, after payments of inter-Group loan obligations, to holders of Psychiatric Group Depositary Shares. In general, the Psychiatric Group will not retain any significant amount of its cash flow, and as discussed above, its sources of financing and liquidity will be limited. 52 54 PART II. OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) The Annual Meeting of Shareholders of American Health Properties, Inc. was held on May 22, 1998 ("Annual Meeting"). (b) Not applicable. (c) (i) At the Annual Meeting, Peter K. Kompaniez and Joseph P. Sullivan, were elected as Class II directors to serve for a three-year term until the 2001 Annual Meeting of Shareholders. Voting results for these directors are summarized as follows: Peter K. Kompaniez Votes For--22,894,824; Votes Withheld--145,158 Joseph P. Sullivan Votes For--22,903,801; Votes Withheld--136,181 Class III directors whose term of office continues until the 1999 Annual Meeting of Shareholders include Sheldon S. King, John P. Mamana, M.D. and Louis T. Rosso. Class I directors whose term of office continues until the 2000 Annual Meeting of Shareholders include James L. Fishel and James D. Harper, Jr.. (ii) At the Annual Meeting, shareholders approved the appointment of the accounting firm of Arthur Andersen LLP as the auditors and as independent public accountants for the Company for the fiscal year ending December 31, 1998. Votes For--22,870,024; Votes Against--57,920; Votes Abstained--112,038. (d) Not Applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 27 Financial Data Schedule (b) Reports on Form 8-K On April 20, 1998, the Company filed a Current Report on Form 8-K for the purpose of reporting selected financial information (statements of operations, funds from operations, net income (loss) per share on both a basic and diluted basis, funds from operations per share on both a basic and diluted basis, dividends per share, preferred dividends, weighted average shares, weighted average shares and dilutive potential shares, total assets, total debt and total shareholders' equity) with respect to the consolidated Company, Core Group and Psychiatric Group for the three months ended March 31, 1998 and 1997. 53 55 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: August 11, 1998 AMERICAN HEALTH PROPERTIES, INC. By: JOSEPH P. SULLIVAN By: MICHAEL J. MCGEE ---------------------------------- ----------------------------------- Joseph P. Sullivan Michael J. McGee Chairman of the Board, President & Senior Vice President & Chief Executive Officer Chief Financial Officer (Principal Executive Officer) (Principal Financial and Accounting Officer) 54 56 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION - ----------- ----------- 27 FINANCIAL DATA SCHEDULE
EX-27 2 FINANCIAL DATA SCHEDULE
5 1,000 6-MOS DEC-31-1998 JUN-30-1998 1,854 0 0 0 0 0 0 (112,211) 776,725 0 247,117 0 100,002 241 321,079 776,725 0 55,150 0 12,600 2,730 0 10,250 25,048 0 25,048 0 0 0 25,048 0 0 Basic earnings per share attributable to- Core Group Common Stock Net income $0.88 Psychiatric Group Depositary Shares Net income (loss) $(0.12) Diluted earnings per share attributable to- Core Group Common Stock Net income $0.87 Psychiatric Group Depositary Shares Net income (loss) $(0.12)
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