UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

Commission File Number 001-16817

Registrants telephone Number, Including Area Code: 617-796-8387

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

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

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x

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 o

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

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

Large accelerated filer o                                            Accelerated filer x

Non-accelerated filer o                                              Smaller reporting company o

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

The aggregate market value of the voting shares of the registrant held by non-affiliates was $247.9 million based on the $7.98 closing price per common share on the American Stock Exchange on June 29, 2007. For purposes of this calculation, an aggregate of 642,582.6 shares of common stock are held by the directors and officers of the registrant and have been included in the number of shares of common stock held by affiliates, which includes 35,000 shares of common stock held by Senior Housing Properties Trust.

Number of the registrant’s shares of common stock outstanding as of March 4, 2008: 31,818,144.

In this Annual Report on Form 10-K, the terms the “Company,” “Five Star”, “FVE”, “we”, “us” or “our”, include Five Star Quality Care, Inc., and its consolidated subsidiaries, unless the context indicates otherwise.

DOCUMENTS INCORPORATED BY REFERENCE

Certain information required in Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K is incorporated by reference from our definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 15, 2008, or our definitive Proxy Statement.

WARNING CONCERNING FORWARD LOOKING STATEMENTS

THIS ANNUAL REPORT CONTAINS STATEMENTS WHICH CONSTITUTE FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 AND OTHER FEDERAL SECURITIES LAWS.  THESE FORWARD LOOKING STATEMENTS AND THEIR IMPLICATIONS ARE BASED UPON OUR PRESENT INTENT, BELIEFS OR EXPECTATIONS, BUT FORWARD LOOKING STATEMENTS ARE NOT GUARANTEED TO OCCUR AND MAY NOT OCCUR.  OUR ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CONTAINED IN OR IMPLIED BY OUR FORWARD LOOKING STATEMENTS AS A RESULT OF VARIOUS FACTORS.  FOR EXAMPLE:

·      WE EXPECT TO OPERATE OUR REHABILITATION HOSPITALS PROFITABLY.  HOWEVER, WE ARE CURRENTLY EXPERIENCING LOSSES FROM THESE OPERATIONS AND WE MAY BE UNABLE TO OPERATE THESE HOSPITALS PROFITABLY.  SIXTY PERCENT OF PATIENTS AT OUR HOSPITALS ARE REQUIRED TO MEET CERTAIN MEDICARE REQUIREMENTS.  WHILE WE BELIEVE THAT WE ARE IN COMPLIANCE WITH THESE MEDICARE REQUIREMENTS, AND ALTHOUGH WE EXPECT TO CONTINUE TO BE IN COMPLIANCE WITH THESE REQUIREMENTS, THE PERCENTAGE OF PATIENTS AT THESE HOSPITALS WHO MEET THESE MEDICARE REQUIREMENTS MAY NOT BE OR REMAIN AS HIGH AS WE CURRENTLY ANTICIPATE OR MAY DECLINE.  FAILURE TO REMAIN IN COMPLIANCE WILL RESULT IN OUR RECEIVING LOWER MEDICARE PAYMENTS THAN WE CURRENTLY RECEIVE AT THESE HOSPITALS AND MATERIALLY AND ADVERSELY AFFECT OUR FUTURE RESULTS OF THESE OPERATIONS.

·      ALTHOUGH WE EXPECT TO LEASE FROM SENIOR HOUSING PROPERTIES TRUST, OR SENIOR HOUSING, 16 ADDITIONAL SENIOR LIVING COMMUNITIES WHICH SENIOR HOUSING HAS AGREED TO PURCHASE FROM THIRD PARTIES, THE DILIGENCE REGARDING THESE TRANSACTIONS HAS NOT YET BEEN COMPLETED AND WE OR SENIOR HOUSING MAY DECIDE NOT TO PROCEED WITH THESE TRANSACTIONS. CERTAIN OF THESE PURCHASES ARE CONTINGENT UPON APPROVALS FROM THIRD PARTY MORTGAGE LENDERS AND GOVERNMENT REGULATORY AGENCIES, WHICH APPROVALS MAY NOT BE OBTAINED. AS A RESULT, ONE OR MORE OF THESE PROPOSED LEASES MAY NOT OCCUR.

OTHER RISKS THAT MAY ADVERSELY IMPACT OUR FORWARD LOOKING STATEMENTS AND THEIR IMPLICATIONS ARE DESCRIBED IN THIS ANNUAL REPORT UNDER “ITEM 1A. RISK FACTORS.”

YOU SHOULD NOT PLACE UNDUE RELIANCE UPON OUR FORWARD LOOKING STATEMENTS.

EXCEPT AS REQUIRED BY LAW, WE UNDERTAKE NO OBLIGATION TO UPDATE OR REVISE ANY FORWARD LOOKING STATEMENTS AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE.

FIVE STAR QUALITY CARE, INC.

2007 ANNUAL REPORT ON FORM 10-K

Table of Contents

* Incorporated by reference from our Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 15, 2008, to be filed pursuant to Regulation 14A.

PART I

Item 1.  Business

GENERAL

We operate senior living communities, including independent living and congregate care communities, assisted living communities and nursing homes.  As of December 31, 2007, we operated 161 senior living communities with 17,906 living units, including 112 primarily independent and assisted living communities with 13,502 living units and 49 nursing homes with 4,404 living units.  Of our 112 primarily independent and assisted living communities, we leased 95 communities with 12,237 living units from Senior Housing Properties Trust, or Senior Housing, our former parent, and we owned or leased from parties other than Senior Housing 17 communities with 1,265 living units.  We leased 47 of our 49 nursing homes from Senior Housing.  Our 161 communities include 5,520 independent living apartments, 6,330 assisted living suites and 6,056 skilled nursing units.  As of December 31, 2007, we also operated five institutional pharmacies, and two rehabilitation hospitals that we leased from Senior Housing.  Our two rehabilitation hospitals had 321 beds available for inpatient services, three satellite locations, and 20 affiliated outpatient clinics.   Our principal executive offices are located at 400 Centre Street, Newton, Massachusetts 02458, and our telephone number is (617) 796-8387.

OUR HISTORY

Spin off from Senior Housing

We were created by Senior Housing in April 2000 to operate 54 nursing homes and two assisted living communities repossessed or acquired from former Senior Housing tenants.  We were incorporated in Delaware in April 2000 and reincorporated in Maryland on September 17, 2001. On December 31, 2001, Senior Housing distributed substantially all of our outstanding shares to its shareholders and we became a separate publicly owned company listed on the American Stock Exchange, or AMEX.

Acquisitions

In 2002, we commenced operations at 51 senior living communities, including 31 communities then operated by Marriott Senior Living Services, Inc., or MSLS, a wholly owned subsidiary of Marriott International Inc. and subsequently operated by Sunrise Senior Living Services, Inc., or SLS, a wholly owned subsidiary of Sunrise Senior Living, Inc., or Sunrise.  In 2003, we commenced operations at three senior living communities.  In 2004, we commenced operations at 47 senior living communities.

In March 2005, we acquired a 62 unit assisted living community located in Georgia for approximately $6.9 million.  In June 2005, we acquired six assisted living communities for approximately $59.0 million.  In order to finance this acquisition, we sold four senior living communities to Senior Housing in June 2005 for $24.0 million and Senior Housing leased these communities to us for initial rent of $2.2 million per year.  In August 2005, we sold the six communities we acquired in June 2005 to Senior Housing for net proceeds of $56.7 million and Senior Housing leased these communities to us for initial rent of $5.2 million per year.

Between September and December 2006, we leased from Senior Housing 11 senior living communities with 1,284 units which Senior Housing acquired from third parties.  Six of these communities are assisted living communities (three of which offer some skilled nursing services), three are independent living communities and two are continuing care retirement communities which offer independent living, assisted living and skilled nursing services.  Our rent payable to Senior Housing for these 11 communities is $9.0 million per year, plus future increases calculated as a percentage of the revenue increases at these communities after 2007.  We added these communities to our existing lease with Senior Housing which has a term ending in 2020, with renewal options thereafter.  Residents pay substantially all of our charges at these communities from their private resources.

In April 2007, we acquired a 48 unit assisted living community located in Tennessee for $5.0 million  We financed the acquisition by assuming a $4.6 million non recourse United States Department of Housing, or HUD, insured mortgage and paying the balance of the purchase price with cash on hand.  The interest rate on the assumed

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HUD insured mortgage is 7.65%.  Residents pay substantially all of our charges at this community from their private resources.

In January and February 2008, we leased nine senior living communities with 1,032 units which Senior Housing acquired from third parties.  Eight of these communities are assisted living communities (one of which offers some skilled nursing services and one of which offers some independent living services) and one is a continuing care retirement community which offers independent living, assisted living and skilled nursing services.  Our rent payable to Senior Housing for these nine communities is $10.7 million per year, plus future increases calculated as a percentage of the revenue increases for all of these communities after 2009.  We added these communities to our existing lease with Senior Housing which has a term ending in 2020, with renewal options thereafter.  Residents pay a majority of our charges at these communities from their private resources.

We currently intend to lease from Senior Housing 15 additional senior living communities with a total of 772 units which Senior Housing has agreed to purchase from three unrelated parties.  All of these communities are assisted living communities.  We expect our rent to Senior Housing for these 15 communities to be $11.9 million per year, plus future increases calculated as a percentage of the revenue increases at these communities after 2009.  We intend to add these communities to our existing lease with Senior Housing which has a term ending in 2020, with renewal options thereafter.  Residents pay a majority of our charges at these communities from their private resources.  Senior Housing’s purchase and our lease of these properties are contingent upon further diligence, consent from mortgage lenders and other customary closing conditions.  We can provide no assurance that we will lease these properties.

Pharmacies

Between September 2003 and November 2006, we acquired six institutional pharmacies and one mail order pharmacy located in Wisconsin, Nebraska, California, South Carolina and Virginia.

In December 2007, we decided to sell one institutional pharmacy located in California and our mail order pharmacy located in Nebraska.  The operating results of these two parts of our pharmacy business are now included in discontinued operations.

Rehabilitation Hospitals

In February 2006, we agreed to lease two rehabilitation hospitals from Senior Housing.  We commenced operations at these two hospitals on October 1, 2006.  Our lease with Senior Housing for these two hospitals expires on June 30, 2026, with one renewal option for an additional 20 years.  These hospitals provide extensive inpatient and outpatient health rehabilitation services including some services that we believe are similar to services we currently provide in some of our senior living communities.  Our rent payable to Senior Housing for these hospitals is $10.6 million per year.

Termination of SLS Management Agreements

During 2005 and 2006, we terminated management agreements for the 30 senior living communities that SLS managed for us and began to directly operate these communities for our own account.  In connection with these terminations, we paid SLS termination fees totaling $216.1 million.  We no longer pay management fees to SLS.

Discontinued Operations

During 2003, 2004 and 2005, we ceased operations at two skilled nursing facilities which we previously leased from Senior Housing and eight assisted living facilities, two of which we previously leased from Senior Housing.

During 2006, we ceased operations at two skilled nursing facilities located in Connecticut that we leased from Senior Housing.  Senior Housing sold these facilities in November 2006 for net proceeds of approximately $5.6 million, which caused a $559,000 reduction in the annual rent we pay to Senior Housing.

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During 2007, we agreed with Senior Housing that it should sell two assisted living communities in Pennsylvania, which we lease from Senior Housing.  We and Senior Housing are in the process of selling these assisted living communities and, upon their sale, our annual rent payable to Senior Housing will decrease by approximately 9.5% of the net proceeds of the sale to Senior Housing.

As discussed above, in December 2007, we decided to sell one institutional pharmacy located in California and our mail order pharmacy located in Nebraska.

Equity and Debt Financings

In 2005, we issued 7,750,000 common shares in an underwritten public offering raising net proceeds of $55.6 million.  In 2006, we issued 11,500,000 common shares in an underwritten public offering raising net proceeds of $114.1 million and we issued $126.5 million principal amount of Convertible Senior Notes due 2026, or the Notes.  The Notes bear interest at 3.75% per annum, payable semi-annually, and will mature on October 15, 2026.  We may prepay the Notes at anytime after October 20, 2011 and the Note holders may require that we purchase all or a portion of these Notes on each of October 15, 2013, 2016 and 2021.

OUR GROWTH STRATEGY

We believe that the aging of the U.S. population will increase demand for independent living properties, assisted living communities, nursing homes, pharmacies and rehabilitation services. Our principal growth strategy is to profit from this increasing demand by operating properties that provide high quality services to senior residents who pay with private resources and by growing our pharmacies and rehabilitation health services businesses.

We seek to improve the profitability of our existing operations by increasing revenues and improving margins. We attempt to increase revenues by increasing rates and utilization of our facilities and services. We attempt to improve margins by limiting increases in expenses and improving operating efficiencies.

In addition to managing our existing operations, we intend to continue to grow our business through acquisitions of independent and assisted living communities where residents’ private resources account for a large majority of revenues. Since we became a public company in late 2001, we have acquired and currently operate 111 primarily independent and assisted living communities that as of December 31, 2007 generated approximately 86% of their revenue from residents’ private resources, rather than from Medicare or Medicaid. We prefer to acquire communities which have achieved or are close to stabilized operations, although we occasionally purchase turn around facilities which we believe are located where we can make significant improvements in operations.  We also seek to make acquisitions where we can realize cost savings by combining acquired operations with our existing operations.

In October 2006, we began to operate two rehabilitation hospitals located in Braintree and Woburn, Massachusetts.  These hospitals offer extensive inpatient and outpatient services.  We may seek to acquire additional rehabilitation hospitals, as well as expand our rehabilitation business at our existing senior living communities.

Although expansion of our nursing home business is not our primary growth strategy, we have in the past considered acquiring additional nursing homes. Most nursing homes are financially dependent upon the Medicare and Medicaid programs. Accordingly, we believe the potential for profitable operations of nursing homes is limited by government rate settings. In these circumstances, we are only interested to expand our nursing home operations at prices which we believe take into account the risks inherent in government funding. In the past few years, we have been unable to buy nursing homes at prices we consider appropriate, but we may continue to investigate such opportunities in the future.

TYPES OF PROPERTIES

Our present business plan contemplates the ownership, leasing and management of independent living apartments or congregate care communities, assisted living communities, nursing homes and rehabilitation hospitals. Some of our properties combine more than one type of service in a single building or campus.  We operate most of our pharmacies and several of our outpatient rehabilitation clinics from leased commercial spaces.

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Independent Living Apartments or Congregate Care Communities.  Independent living apartments, or congregate care communities, provide high levels of privacy to residents and require residents to be capable of relatively high degrees of independence. An independent living apartment usually bundles several services as part of a regular monthly charge. For example, one or two meals per day in a central dining room, weekly maid service or services of a social director may be included in the base charge. Additional services are generally available from staff employees on a fee for service basis. In some independent living properties, separate parts of the community are dedicated to assisted living or nursing services.  As of December 31, 2007, our business included 5,520 independent living apartments in 39 communities.

Assisted Living Communities.  Assisted living communities are typically comprised of one bedroom units which include private bathrooms and efficiency kitchens. Services bundled within one charge usually include three meals per day in a central dining room, daily housekeeping, laundry, medical reminders and 24 hour availability of assistance with the activities of daily living such as dressing and bathing. Professional nursing and healthcare services are usually available at the community on call or at regularly scheduled times.  As of December 31, 2007, our business included 6,330 assisted living suites in 104 communities.

Nursing Homes.  Nursing homes generally provide extensive nursing and healthcare services similar to those available in hospitals, without the high costs associated with operating theaters, emergency rooms or intensive care units. A typical purpose built nursing home includes mostly one and two bedrooms with a separate bathroom in each room and shared dining facilities.  Nursing homes are staffed by licensed nursing professionals 24 hours per day.  As of December 31, 2007, our business included 6,056 skilled nursing beds in 75 communities.

Rehabilitation Hospitals.  Rehabilitation hospitals, also known as inpatient rehabilitation facilities, or IRFs, provide intensive physical therapy, occupational therapy and speech language pathology services beyond the capabilities customarily available in skilled nursing facilities.  Patients in IRFs generally receive a minimum of three hours of rehabilitation services daily.  IRFs also provide onsite pharmacy, radiology, laboratory, telemetry, hemodialysis and orthotics/prosthetics services.  Outpatient satellite clinics are often included as part of the services offered by IRFs.  Our two rehabilitation hospitals had 321 beds available for inpatient services as of December 31, 2007 and provided services at three satellite locations.  In addition, these two hospitals operate 20 affiliated outpatient clinics where patients discharged from the hospitals can continue their therapy programs and receive amputee, brain injury, cardio-pulmonary, orthopedic, spinal cord injury, stroke and neurorehabilitation rehabilitation services.

Pharmacies.  Our institutional pharmacies are located in five leased commercial spaces and one owned commercial space containing approximately 54,839 square feet plus parking areas for our delivery vehicles.

OPERATING STRUCTURE

We have four divisional offices which are located throughout the country.  Each divisional office is responsible for multiple regions and is headed by a divisional vice president with extensive experience in the senior living and health rehabilitation industries.  We have several regional offices within each division.  Each regional office is responsible for multiple communities and is headed by a regional director of operations with extensive experience in the senior living industry.  Each regional office is typically supported by a clinical or wellness director, a rehabilitation services director, a regional accounts manager, a human resources specialist and a sales and marketing specialist.  Regional staffs are responsible for all our senior living community operations within the region, including:

·      resident services;

·      Medicare and Medicaid billing;

·      marketing and sales;

·      hiring of community personnel;

·      compliance with applicable legal and regulatory requirements; and

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·      supporting our development and acquisition plans within their region.

Our home office staff performs the following tasks:

·                  general oversight of our regional staff, pharmacy and rehabilitation hospital operations;

·                  the establishment of company wide policies and procedures relating to resident care;

·                  human resources policies and procedures;

·                  information technology;

·                  private pay billing;

·                  licensing and certification maintenance;

·                  legal services;

·                  central purchasing;

·                  budgeting and supervision of maintenance and capital expenditures;

·                  implementation of our growth strategy; and

·                  accounting and finance functions, including operations budgeting, parts of accounts receivable and collections, accounts payable and parts of our payroll, financial reporting, and tax planning and compliance.

STAFFING

Independent and assisted living community staffing.  Each of the independent and assisted living communities we operate has an executive director responsible for the day to day operations of the community, including quality of care, resident services, sales and marketing, financial performance and staff supervision. The executive director is supported by department heads, who oversee the care and service of the residents, a wellness director, who is responsible for coordinating the services necessary to meet the health care needs of our residents and a marketing director, who is responsible for selling our services.  Other important staff includes the dining services coordinator, the activities coordinator and the property maintenance coordinator.

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

Rehabilitation hospital staffing.  Each IRF is operated under the leadership of a hospital based chief executive officer with the support of senior staff, including a medical director, chief financial officer, director of patient care services, director of rehabilitation and director of case management.  The hospitals are also staffed with board certified physicians who primarily specialize in internal medicine, neurology or physiatry, as well as other licensed professionals, including rehabilitation nurses, physical therapists, occupational therapists, speech and language pathologists, nutrition counselors, neuropsycologists and pharmacists.  Each outpatient clinic associated with our IRFs is managed by an outpatient director who is a registered occupational or physical therapist.

Pharmacy operations and staffing.  Our institutional pharmacy operation provides prescriptions, medical supplies, equipment and services to operators and residents of senior living communities.  We do not sell “over the

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counter” to the public.  Each of our pharmacies is managed by an executive director, who is responsible for the day to day operations of each pharmacy and our mail order business, including billings, sales and marketing, financial performance, compliance with regulatory codes regarding the dispensing of controlled substances and staff supervision.  Other pharmacy personnel include licensed dispensing pharmacists, a director of pharmacy consultation, a medical records director, a nurse consultant, pharmacy technicians and billing personnel.

EMPLOYEES

As of March 4, 2008, we had approximately 18,301 employees, including 12,550 full time equivalents. Approximately 89 employees, including approximately 74 full time equivalents, are represented under one collective bargaining agreement, which has a remaining term of approximately two years.  We have no employment agreements with our employees except for seven contracts entered into with former owner operators of certain pharmacies which we acquired. We believe our relations with our union and non-union employees are good.

GOVERNMENT REGULATION AND REIMBURSEMENT

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

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

Assisted Living Communities.  According to the National Center for Assisted Living and the National Academy for State Health Policy, or the National Academy, a majority of states provide or are approved to provide Medicaid payments for services to some residents in assisted living communities under waivers granted by the Federal Centers for Medicare and Medicaid Services, or CMS, or under Medicaid state plans.  Most other states are planning some Medicaid funding by preparing state plan amendments or requesting waivers. State Medicaid programs control costs for assisted living and other home and community-based services by various means such as restrictive financial and functional eligibility standards, enrollment limits and waiting lists. Because rates paid to assisted living community operators are generally lower than rates paid to nursing home operators, some states use Medicaid funding of assisted living as a means of lowering the cost of services for residents who may not need the higher intensity of health related services provided in nursing homes. States that administer Medicaid programs for services in assisted living communities are responsible for monitoring the services at, and physical conditions of, the participating communities. Different states apply different standards in these matters, but generally we believe these monitoring processes are similar to the concerned states’ inspection processes for nursing homes.

As a result of the large number of states using Medicaid to purchase services at assisted living communities and the growth of assisted living in recent years, a majority of states have adopted licensing standards applicable to assisted living communities. A majority of states have licensing statutes or standards specifically using the term “assisted living” and have requirements for communities servicing people with Alzheimer’s disease or dementia. The majority of states have revised their licensing regulations recently or are reviewing their policies or revising their regulations. State

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regulatory models vary; there is no national consensus on a definition of assisted living, and no uniform approach by the states to regulating assisted living communities. Most state licensing standards apply to assisted living communities whether or not they accept Medicaid funding. Also, according to the National Academy, a few states require certificates of need from state health planning authorities before new assisted living communities may be developed. Based on our analysis of current economic and regulatory trends, we believe that assisted living communities that become dependent upon Medicaid or other public payments for a majority of their revenues may decline in value because Medicaid rates may fail to keep up with increasing costs. We also believe that assisted living communities located in states that adopt certificate of need requirements or otherwise restrict the development of new assisted living communities may increase in value because these limitations upon development may help ensure higher occupancy and higher non-governmental rates.

The US Department of Health and Human Services, the Government Accountability Office, or GAO, and the Senate Special Committee on Aging have recently studied and reported on the development of assisted living and its role in the continuum of long term care and as an alternative to nursing homes.  In 2003, the GAO recommended that CMS strengthen its oversight of state quality assurance in Medicaid home and community-based services waiver programs.  Since then, CMS has commenced a series of actions to increase its oversight of state quality assurance programs for assisted living facilities and has provided guidance and technical assistance to the states to improve their ability to monitor and improve the quality of services paid for through Medicaid waiver programs.  Also in 2003, a working group of assisted living providers, consumers and regulatory organizations made recommendations to the Senate Special Committee on Aging on a range of subjects, including staffing, funding and regulation of assisted living.  We cannot predict whether these activities and reports will result in governmental policy changes or new legislation, or what impact any changes may have. Based upon our analysis of current economic and regulatory trends, we do not believe that the federal government is likely to have a material impact upon the current regulatory environment in which the assisted living industry operates unless it also undertakes expanded funding obligations.  Although CMS is implementing provisions of the Deficit Reduction Act of 2005, or the DRA, enacted in February 2006, that encourage state Medicaid programs to expand their use of home and community based services as alternatives to institutional services, we do not believe a materially increased financial commitment from the federal government to fund assisted living is presently likely. However, we do anticipate that assisted living communities will increasingly be licensed and regulated by the various states, and that, in the absence of federal standards, the states’ policies will continue to vary widely.

Nursing Homes-Reimbursement.  About 63% of all nursing home revenues in the U.S. in 2006 (the most recent date for which information is publicly available) came from publicly funded programs, including about 43% from Medicaid programs and 17% from the Medicare program. Nursing homes are among the most highly regulated businesses in the Country. The federal and state governments regularly monitor the quality of care provided at nursing homes. State health departments conduct surveys of resident care and inspect the physical condition of nursing home properties. These periodic inspections and occasional changes in life safety and physical plant requirements sometimes require nursing home operators to make significant capital improvements. These mandated capital improvements have in the past usually resulted in Medicare and Medicaid rate adjustments, albeit on the basis of amortization of expenditures over expected useful lives of the improvements. Under the Medicare prospective payment system, or the PPS, capital costs are part of the prospective rate and are not community specific.  The PPS and other recent legislative and regulatory actions with respect to state Medicaid rates are limiting the reimbursement levels for some nursing home services. At the same time, federal and state enforcement and oversight of nursing homes have been increasing, making licensing and certification of these communities more rigorous.

The PPS was intended to reduce the rate of growth in Medicare payments for skilled nursing communities.  Under the current Medicare payment system, skilled nursing facilities receive a fixed payment for each day of care provided to residents who are Medicare beneficiaries. Each resident is assigned to a care group depending on that resident’s medical characteristics and service needs.  These care groups are known as Resource Utilization Groups, or RUGs.  Per diem payment rates are established for each of these care groups.  Medicare payments cover substantially all services provided to Medicare residents in skilled nursing communities, including ancillary services such as rehabilitation therapies.  The PPS is intended to provide incentives to providers to furnish only necessary services and to deliver those services efficiently.  According to the GAO, between fiscal year 1998 and fiscal year 1999, the first full year of the changed Medicare payment system phase in, the average Medicare payment per day declined by about 9%.

From November 1999 to January 2006, Congress and CMS provided some periodic relief from the effect of the PPS, through temporary increases in skilled nursing facility payment rates and temporary moratoria on some therapy limitations for skilled

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nursing residents covered under Medicare Part B.  Effective January 1, 2006, CMS implemented changes to the payment categories it uses to set daily payment rates for Medicare beneficiaries in skilled nursing facilities. CMS introduced nine new payment categories for medically complex patients, increasing the number of categories from 44 to 53, and made revisions to its payment rates for current RUGS. Also effective January 1, 2006, these RUG changes caused the elimination of certain temporary additional payments for certain skilled nursing care and rehabilitation groups.  The financial impact of these changes to the Medicare rates on our operations was to effectively eliminate an October 2005 Medicare 3% rate increase; but then in October 2006 and again in October 2007, the Medicare rates were increased by 3%.

                Under the DRA, the federal government is slowing the growth of Medicare and Medicaid payments for nursing home services by several methods.  Medicare bad debt reimbursement has been reduced from 100% to 70% for uncollected cost sharing payments from Medicare beneficiaries who are not eligible for Medicaid.  Limits on Medicare payments were also implemented for outpatient therapies in 2006, with an exception process, under which beneficiaries could request an exemption from the cap and be granted the amount of services deemed medically necessary by Medicare.  Under the Tax Relief and Health Care Act of 2006, enacted in December 2006, the exemption process was extended an additional year through 2007.  Under the Medicare, Medicaid and SCHIP Extension Act of 2007, enacted in December 2007, the exemption process for therapy services has been extended an additional six months through June 30, 2008.  In addition, the DRA increased the “look-back” period for prohibited asset transfers that disqualify individuals from Medicaid nursing home benefits from three to five years.  The period of Medicaid ineligibility begins on the date of the prohibited transfer or the date an individual has entered the nursing home and would otherwise be eligible for Medicaid coverage, whichever occurs later, rather than on the date of the prohibited transfer, effectively extending the Medicaid penalty period and placing added burdens on nursing homes to collect charges directly from residents and their transferees.  The DRA includes a demonstration project that in 2007 awarded competitive grants to a majority of states to provide home and community based long term care services to qualified individuals relocated from nursing homes, providing an increased federal medical assistance percentage for 12 months for each qualifying beneficiary, during a grant period of at least two years.  The DRA also includes a post acute payment reform demonstration program that will compare and assess costs and outcomes of services at different long term care sites over three years.  Effective January 1, 2007, states may include home and community based services as optional services under their Medicaid state plans, rather than only pursuant to waivers or demonstration projects, and such states may cap enrollment, maintain waiting lists and offer the services in only some regions of a state, as they may with waivers.  These initiatives will likely decrease the demand for nursing home services and nursing home occupancy levels, which declined slightly from 2000 through 2006, may continue to decline.

                Nursing Homes-Survey and Enforcement. Twenty years ago, Congress enacted major reforms to federal and state regulatory systems for nursing homes that participate in the Medicare and Medicaid programs, under the Omnibus Reconciliation Act of 1987, or OBRA 87.  Since then, the GAO reports that, while much progress has been made, substantial problems remain in the effectiveness of federal and state regulatory activities. In July 1998, the GAO issued a report which found inadequate care in a significant portion of California nursing homes.  Since 1999, the U.S. Department of Health and Human Services, Office of Inspector General has issued several reports concerning quality of care in nursing homes, and the GAO has issued several reports, most recently in 2007, recommending that CMS and the states strengthen their compliance and enforcement practices, including federal oversight of state actions, to better ensure that nursing homes provide adequate care and states act more consistently.  The Senate Special Committee on Aging and other congressional committees have also held hearings on these issues, most recently in 2007. As a result, CMS has undertaken an initiative to increase the effectiveness of Medicare and Medicaid nursing home survey and enforcement activities.  CMS is taking steps to focus more survey and enforcement efforts on nursing homes with findings of substandard care or repeat violations of Medicare and Medicaid standards and to identify chain operated communities with patterns of noncompliance.  CMS is increasing its oversight of state survey agencies and requiring state agencies to use enforcement sanctions and remedies more promptly when substandard care or repeat violations are identified, to investigate complaints more promptly, and to survey communities more consistently. In addition, CMS adopted regulations expanding federal and state authority to impose civil monetary penalties in instances of noncompliance. A small number of nursing homes with a history of serious quality problems are designated by CMS as “special focus facilities,” or SFFs, inspected more frequently and subject to more stringent enforcement actions.  Homes in the SFF initiative for six months or longer are now listed on the Medicare website at Medicare.gov.  The GAO has recommended several steps to make enforcement by CMS and the states more timely and effective, especially for SFFs. Medicare survey results, including fire safety reports, and average nursing and nursing assistant staff hours per resident for each nursing home are posted on the Medicare website at www.medicare.gov. CMS issued a proposed rule

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in 2006 that would require older nursing homes to install sprinklers.  Nursing homes that do not have sprinklers or hard-wired smoke detectors are required to install battery powered smoke detectors in the interim.  Currently all of our nursing homes except one have sprinklers and we believe the one nursing home without sprinklers is in compliance with the current requirements because it has a combination of hard wired and battery operated smoke detectors.  When deficiencies under state licensing and Medicare and Medicaid standards are identified, sanctions and remedies such as denials of payment for new Medicare and Medicaid admissions, civil monetary penalties, state oversight and loss of Medicare and Medicaid participation or licensure may be imposed on nursing home operators. Our communities incur sanctions and penalties from time to time. If we are unable to cure deficiencies which have been identified or that are identified in the future, additional sanctions may be imposed, and if imposed, may adversely affect our ability to meet our financial obligations and negatively affect our financial condition and results of operations.

                In 2000 and 2002, the Department of Health and Human Services and CMS issued reports linking nursing staffing levels with quality of care. The Bush administration has indicated that it does not intend to impose minimum staffing levels or to increase Medicare or Medicaid rates to cover the costs of increased staffing at this time; however, CMS publishes the nurse and nursing assistant staffing level at each nursing home on the internet at www.medicare.gov to create market pressure to improve nursing home operations.

                Rehabilitation Hospital Regulations and Rate Setting. Our two rehabilitation hospitals are subject to federal, state and local regulations that affect their business activities and determine the rates they receive for services.  These hospitals are subject to periodic inspection by governmental and non-governmental agencies to ensure continued compliance with various licensure and accreditation standards.  In addition, these facilities are certified by CMS to participate in the Medicare program and receive a significant portion of their revenues from that program.

                On May 7, 2004, CMS issued a rule establishing revised Medicare standards that rehabilitation hospitals are required to meet in order to participate as IRFs in the Medicare program, known as the “75% Rule.” An IRF that failed to meet the requirements of the 75% Rule would be subject to reclassification as a different type of healthcare provider; and the effect of such reclassification would be to lower Medicare payment rates.  Under the Medicare, Medicaid and SCHIP Extension Act of 2007, adopted in December 2007, for cost reporting periods starting on or after July 1, 2007, the 75% requirement for IRFs was permanently rolled back to 60%, and selected secondary medical conditions are included to qualify patients under the 60% requirement.   The rule now generally provides that, to be considered an IRF and receive reimbursement for services under the IRF prospective payment system, at least 60% of a facility’s total inpatient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions.  Under the 75% Rule, to maintain their revenue levels many rehabilitation hospitals have needed to reduce the number of non-qualifying patients treated and replace them with qualifying patients, establish other sources of revenues or both.  Before the 2007 amendment, the 75% Rule was being phased in over a four year period that began on July 1, 2004.  For cost reporting periods starting on and after July 1, 2006, 60% of a facility’s inpatient population must have required intensive rehabilitation services for one of CMS’ designated medical conditions.  For cost reporting periods starting on and after July 1, 2007, the requirement was 65%, and for cost reporting periods starting on and after July 1, 2008, the requirement was 75%. As a result of the rollback amendment, the requirement is now 60% for these and future cost reporting periods.  Congress has directed the Secretary of Health and Human Services to report to it by June 2009 on Medicare beneficiaries’ access to medically necessary rehabilitation services, the potential effect of the 75% Rule and alternatives or refinements, and any variation in patient outcomes and costs across settings of care. We believe our hospitals have been and are operating in compliance with this rule and we are taking actions to assure continued compliance; however, we can provide no assurance that we will be able to continue to comply with this rule. Also pursuant to the Medicare, Medicaid and SCHIP Extension Act of 2007, the annual inflation increase factor for Medicare payment rates for IRFs is set at zero percent for each of federal fiscal years 2008 and 2009, except for payment units occurring before April 1, 2008.  Our current Medicare inflation increase factor for federal fiscal year 2008 was set at approximately four percent effective October 1, 2007, and we understand that this increase factor will be reduced to zero effective as of April 1, 2008.  Although we anticipate that the effect of the rate rollback may be counterbalanced and neutralized by the reduction of the prior law’s 65% and 75% minimum percentage requirements to 60% under current law, the zero per cent inflation increases to our fiscal 2008 and 2009 rates after April 1, 2008, will affect the profitability of our rehabilitation operations.

                Certificates of Need. Most states limit the number of nursing homes and hospitals by requiring developers to obtain certificates of need before new communities may be built and a few states also limit the number of assisted living facilities by requiring certificates of need.  Also, states such as California and Texas that have eliminated certificate of need laws often have retained other means of limiting new development, such as the use of moratoria, licensing laws or

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limitations upon participation in the state Medicaid program. We believe that these governmental limitations may make existing nursing homes and hospitals more valuable by limiting competition.

                Other Matters. Federal and state efforts to target fraud and abuse and violations of anti-kickback laws and physician referral laws by Medicare and Medicaid providers have also increased. In March 2000, the U.S. Department of Health and Human Services Office of Inspector General issued compliance guidelines for nursing communities to assist them in developing voluntary compliance programs to prevent fraud and abuse.  The Office of Inspector General issued compliance program guidance for hospitals in 1998 and supplemental guidance in 2005.  Rules governing the privacy, use and disclosure of individually identified health information took effect in 2003, with civil and criminal sanctions for noncompliance. Any adverse determination concerning any of our licenses or eligibility for Medicare or Medicaid reimbursement and the increasing costs of required compliance with applicable federal or state regulations could adversely affect our ability to meet our financial obligations and negatively affect our financial condition and results of operations.

                Under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or the MPDIMA, effective January 1, 2006, Medicare beneficiaries may receive prescription drug benefits by enrolling in private health plans or managed care organizations, or if they remain in traditional Medicare, by enrolling in stand alone prescription drug plans.  We believe this new law will increase the demand for pharmacy products and services by Medicare beneficiaries.  We also believe that this new Medicare drug benefit may reduce the profitability of providing pharmacy products and services, as the Government implements various cost control procedures.  We cannot predict the net impact of this program at this time.

                A number of legislative proposals that would affect major reforms of the healthcare system are being considered during the current Presidential campaign, have been introduced in the U.S. Congress and are being considered by some state governments, such as programs for national health insurance, the option of block grants for states rather than federal matching money for certain state Medicaid services, additional policies encouraging state Medicaid programs to use home and community based long term care services rather than nursing homes, laws authorizing or directing Medicare to negotiate rate reductions for prescription drugs, additional Medicare and Medicaid enforcement procedures and federal and state cost containment measures, such as freezing Medicare or Medicaid nursing home and rehabilitation hospital payment rates at their current levels and reducing or eliminating annual Medicare or Medicaid inflation allowances or gradually reducing rates for nursing homes and rehabilitation hospitals.  In connection with recent fiscal pressures on state governments and increasing costs of Medicaid funding, legislation and regulation to reduce Medicaid nursing home payment rates in some states are possible in the future. We cannot predict whether any of these legislative or regulatory proposals will be adopted or, if adopted, what effect, if any, these proposals would have on our business.

INSURANCE

                Litigation against senior living operators has been increasing during the past few years.  As a result, liability insurance costs over the past few years has been rising.  In recent years, our insurance costs for workers compensation and employee healthcare have also increased significantly.  To partially offset these insurance cost increases, we have taken a number of actions including the following:

·                  we have increased the deductible or retention amounts for which we are liable under our liability insurance;

·                  we have established an offshore captive insurance company which participates in our liability insurance program. Some of our premiums for liability insurance are paid to this company which may retain some of these amounts and the earnings on these amounts based upon our actual claims experiences;

·                  we have acquired another offshore insurance company and established a captive insurance program for our workers compensation insurance obligations in those states which permit such arrangements. This program may allow us to reduce our net workers compensation insurance costs by allowing us to retain the earnings on our reserves, provided our claims experience is as projected by various statutory and actuarial formulas;

·                  we have increased the amounts which some of our employees are required to pay for health insurance coverage and as co-payments for health services and pharmaceutical prescriptions and decreased the amount of certain healthcare benefits;

·                  we have become fully self insured for all health related claims of covered employees;

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·                  we have hired professional advisors to help us establish programs to reduce our insured workers compensation and professional and general liabilities, including a program to monitor and pro-actively settle liability claims and to reduce workplace injuries; and

·                  we have hired insurance and other professionals to help us establish appropriate reserves for our retained liabilities and captive insurance programs.

               We self insure up to certain limits for workers compensation and professional liability.  Claims in excess of these limits are insured with third party insurance providers up to contractual limits, over which we are self insured.  Our current insurance arrangements generally are renewable in June 2008. We do not know if our insurance charges and self insurance reserve requirements will increase, and we cannot now predict the amount of any such increase, or to what extent, if at all, we may be able to offset any increase through use of higher deductibles, retention amounts, self insurance or other means in the future.

COMPETITION

               The senior living services, pharmacy and the health rehabilitation businesses are highly competitive. We compete with service providers offering alternate types of services, such as home healthcare services, as well as other companies providing community based services and rehabilitation services.  We may expand our business with Senior Housing; however, Senior Housing is not obligated to provide us with opportunities to lease additional properties. We have large lease obligations and limited financeable assets. Many of our competitors have greater financial resources than we do.  Some of our competitors are operated by not for profit entities which have endowment income and do not have the same financial pressures that we experience.  For all of these reasons and others, we cannot provide any assurance that we will be able to compete successfully for business.

ENVIRONMENTAL MATTERS

                Under various federal, state and local laws, owners as well as tenants and operators of real estate may be required to investigate and clean up hazardous substances released or otherwise present at a property, and may be held liable to a governmental entity or to third parties for property damage or personal injuries and for investigation and clean up costs incurred in connection with any such hazardous substances.  Under our leases with Senior Housing, we have also agreed to indemnify Senior Housing for any such liabilities related to the properties we lease from Senior Housing. In addition, some environmental laws create a lien on a contaminated site in favor of the government for damages and costs it incurs in connection with the contamination, which lien may be senior in priority to our debt obligations or our leases. We have reviewed environmental surveys of all of our leased and owned communities. Based upon that review we do not believe that any of these properties are subject to any material environmental contamination. However, no assurances can be given that a prior owner, operator or occupant of our communities did not create a material environmental condition not known to us which might have been revealed by a more in depth study of the properties or that future uses or conditions (including, without limitation, changes in applicable environmental laws and regulations) will not result in the imposition of environmental liability upon us. The presence or discovery of any material environmental contaminants at our communities could have a material adverse impact on us.

INTERNET WEBSITES

               Our internet website address is www.fivestarqualitycare.com.  Copies of our governance guidelines, code of business conduct and ethics and the charters of our audit, quality of care, compensation and nominating and governance committees are posted on our website and may be obtained free of charge by writing to our Secretary, Five Star Quality Care, Inc., 400 Centre Street, Newton, MA 02458 or at our website.  We make available, free of charge, on our website, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as soon as reasonably practicable after these forms are filed with, or furnished to, the Securities and Exchange Commission.  Any shareholder or other interested party who desires to communicate with our independent directors, individually or as a group, may do so by filling out a report on our website. Our board also provides a process for our security holders to send communications to the entire board. Information about the process for sending communications to our board can be found on our website.  Our website address and website addresses of one or more unrelated third parties are included several times in this Annual Report

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on Form 10-K as textual references only and the information in the websites are not incorporated by reference into this Annual Report on Form 10-K.

Item 1A.  Risk Factors

Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of, or that we currently think are immaterial, may also impair our business operations or financial results. If any of the events or circumstances described in the following risks occurs, our business, financial condition or results of operations could suffer and the trading price of our debt or equity securities could decline.  Investors and prospective investors should consider the following risks and the information contained under the heading “Warning Concerning Forward Looking Statements” before deciding whether to invest in our securities.

RISKS RELATED TO OUR BUSINESS

A small percentage decline in our revenues or increase in our expenses could have a material negative impact upon our operating results.

               For the year ended December 31, 2007, our revenues were $972.9 million and our operating expenses were $949.3 million. A small percentage decline in our revenues or increase in our expenses could have a material negative impact upon our operating results.

We may not achieve the anticipated benefits from our lease of the two rehabilitation hospitals and they may be subject to Medicare reclassifications resulting in lower Medicare rates.

               We are currently experiencing losses from our operation of our two rehabilitation hospitals.  In addition, the two rehabilitation hospitals may be subject to retroactive rate adjustments.  We may be unable to operate these hospitals profitably and we may continue to experience losses from our operation of these hospitals.  If we are unable to operate these hospitals successfully, our reputation as a provider of health and rehabilitation services may be damaged. Even if we successfully operate these hospitals, these operations may have little or no benefit to our other operations.

               A significant amount of the revenues at our rehabilitation hospitals is paid by Medicare and we became more dependent upon the Medicare program when we began to operate these hospitals than we were before we assumed these operations.  For cost reporting periods starting on and after July 1, 2006, 60% of an IRF’s total inpatient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions.  While we believe we are in compliance with the 60% requirement, and we expect to remain in compliance with this rule, we may not be able to remain in compliance.  Such an event would result in these hospitals being subject to Medicare reclassification to a different type of provider and our receiving lower Medicare payment rates.  Reductions in our Medicare payments as a result of the reclassification of our rehabilitation hospitals would materially and adversely affect our financial conditions and results of operations.

Pursuant to the Medicare, Medicaid and SCHIP Extension Act of 2007, the annual inflation increase factor for Medicare payment rates for IRFs is set at zero percent for each of federal fiscal years 2008 and 2009, except for payment units occurring before April 1, 2008.  Our current Medicare payment rate increase for federal fiscal year 2008 was set at approximately 4% effective October 1, 2007, and we understand that this increase will be reduced to zero effective as of April 1, 2008.  Although we anticipate that the effect may be counterbalanced by the reduction of the prior law’s 65% and 75% minimum percentage requirements to 60% under current law, the zero percent inflation increases to our fiscal 2008 and 2009 rates after April 1, 2008, will affect the profitability of our rehabilitation operations.

The failure of Medicare and Medicaid rates to match our costs will reduce our income.

Some of our current operations, especially our nursing homes and rehabilitation hospitals, receive significant revenues from the Medicare and Medicaid programs.  During the year ended December 31, 2007, approximately 34% of our senior living revenues and 69% of our hospital revenues were received from these programs.  The federal government and some states are now experiencing or projecting increasing fiscal deficits. Historically, when

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governmental deficits have increased, cut backs in Medicare and Medicaid funding have often followed.  These cut backs sometimes include rate reductions, but more often result in a failure of Medicare and Medicaid rates to increase by sufficient amounts to offset increasing costs.  In 2006, there were cut backs to Medicare funding which affected profitability of our current and continuing nursing home operations.  Also, for payment units on and after April 1, 2008, Medicare market basket increases to IRF rates are set at zero percent for federal fiscal years 2008 and 2009, which will affect the profitability of our rehabilitation operations.  We cannot now predict whether future Medicare and Medicaid rates will be sufficient to cover our future cost increases.  Future Medicare and Medicaid rate declines or a failure of these rates to cover increasing costs could result in our experiencing lower earnings or losses.

Circumstances that adversely affect the ability of seniors to pay for our services could have a material adverse effect on us.

               Approximately 66% of our senior living revenues for the year ended December 31, 2007 were paid by residents from their private resources. We expect to continue to rely on the ability of our residents to pay for our services from their own financial resources. Inflation or other circumstances that adversely affect the ability of the elderly to pay for our services could have a material adverse effect on our business, financial condition and results of operations.

Seniors’ inability to sell real estate may delay their moving into senior living facilities.

Recent housing price declines and reduced home mortgage availability have negatively affected the U.S. housing market, with certain geographic areas experiencing more acute deterioration than others.  This softening U.S. housing market, higher oil prices, stock market volatility, and lower consumer confidence are adversely affecting the overall U.S. economy, with many economists predicting a near-term recession and some predicting a prolonged period with little or no economic growth. These current difficulties may have a negative effect on our revenues or lead to increased reliance on Medicare and Medicaid for our revenues.  Specifically, if seniors have a difficult time selling their homes, these difficulties could impact their ability to relocate into our senior living communities or finance their stays at our facilities with private resources.

The nature of our business exposes us to litigation risks. As a result, our insurance costs have increased and may continue to increase, and we self insure a large portion of our litigation risks.

                The nature of our business exposes us to litigation, and we are subject to lawsuits in the ordinary course of our business. In several well publicized instances, private litigation by residents of senior living communities for alleged abuses has resulted in large damage awards against other operating companies. Today, some lawyers and law firms specialize in bringing litigation against senior living companies. As a result of this litigation and potential litigation, our cost of liability insurance has increased during the past few years. Medical liability insurance reform has become a topic of political debate and some states have enacted legislation to limit future liability awards. However, if such reforms are not generally adopted, we expect our insurance costs may continue to increase. To reduce costs, we self insure a significant amount of our litigation liability risks. Although our reserves for liability self insurance have been determined with guidance from third party professionals, our reserves may prove inadequate. Increasing liability insurance costs and increasing self insurance reserves may materially negatively affect our results of operations or make those results less consistent.

Our business is subject to extensive regulation which increases our costs and may result in losses.

               Licensing and Medicare and Medicaid laws require operators of senior living communities and rehabilitation hospitals to comply with extensive standards governing operations. There are also various laws prohibiting fraud and abuse by senior living and rehabilitation hospital operators, including civil and criminal laws that prohibit false claims for Medicare and Medicaid coverage and that regulate patient referrals. In recent years, the federal and state governments have devoted increased resources to monitoring the quality of care at senior living communities and to anti-fraud investigations. When quality of care deficiencies are identified or improper billing is uncovered, various sanctions may be imposed, including denial of new admissions, exclusion from Medicare or Medicaid program participation, monetary penalties, governmental oversight or loss of licensure. Our communities incur sanctions and penalties from time to time. As a result of this extensive regulatory system and increasing enforcement initiatives, we have experienced increased costs for monitoring quality of care compliance and billing procedures, and we expect these costs may continue to increase. Also, if we become subject to additional regulatory sanctions at any of our existing facilities, or as a result of

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purchasing facilities with prior deficiencies which we are unable to correct or resolve, our business may be adversely affected and we might experience financial losses.

Our growth strategy may not succeed.

                Since our spin off from Senior Housing on December 31, 2001, we have grown rapidly through acquisitions.  Our business plan includes acquiring additional senior living communities and possibly additional pharmacies and rehabilitation hospitals.  Our growth strategy involves risks, including the following:

·                  we may be unable to locate senior living communities, pharmacies or rehabilitation hospitals that receive a large percentage of their revenues from private resources;

·                  we may be unable to locate senior living communities, pharmacies or rehabilitation hospitals available for purchase at acceptable prices;

·                  we may be unable to access capital to make acquisitions or operate acquired businesses;

·                  acquired operations may not perform in accord with our expectations;

·                  we may be required to make significant capital expenditures to improve acquired facilities, including capital expenditures that may not have been anticipated by us at the time of the acquisition;

·                  we may have difficulty retaining key employees and other personnel at acquired facilities;

·                  acquired operations may subject us to unanticipated contingent liabilities or regulatory problems;

·                  to the extent we incur acquisition debt or leases, our operating leverage may increase and, to the extent we issue additional equity to fund our acquisitions, our shareholders’ percentage of ownership will be diluted; and

·                  combining our present operations with newly acquired operations may disrupt operations or cost more than anticipated.

For these reasons and others:

·                  our business plan to grow may not succeed;

·                  the benefits which we hope to achieve by growing may not be achieved;

·                  we may suffer declines in profitability or suffer recurring losses; and

·                  our existing operations may suffer from a lack of management attention or financial resources if such attention and resources are devoted to a failed growth strategy.

                When we acquire new communities, we sometimes see a decline in community occupancy and it may take a period of time for us to stabilize acquired community operations.  Our efforts to restore occupancy or stabilize acquired communities’ operations may not be successful.  In addition, we cannot provide any assurance that we will not experience a decline in occupancy at the rehabilitation hospitals we recently began to operate.  Although we have expanded our pharmacy businesses, we have recently reclassified two parts of our pharmacy business as discontinued because we do not believe we can successfully operate those parts of this business.  Rehabilitation hospitals and pharmacies are businesses with which we have limited experience, and our initiatives in these areas may not be successful.

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Increases in our labor costs may have a material adverse effect on us.

                Wages and employee benefits represent approximately 43% of our 2007 total operating costs.  We compete with other operators of senior living communities and rehabilitation hospitals with respect to attracting and retaining qualified personnel responsible for the day to day operations of each of our communities. A shortage of nurses or other trained personnel may require us to increase the wages and benefits offered to our employees in order to attract and retain these personnel or to hire more expensive temporary personnel. Also, we have to compete for lesser skilled workers with numerous other employers.  Further, when we acquire new facilities, we may be required to pay increased compensation or offer other incentives to retain key personnel and other employees. Employment statistics recently published by the government indicate a tight job market, despite the prospects for a general economic slowing. Historically, such statistics have sometimes foretold increased wage pressures and we may experience such wage pressures.  For example, recent wage increases in Connecticut made our previous operations in that state unprofitable. Employee benefits costs, including employee health insurance and workers compensation insurance costs, have materially increased in recent years. To help control these costs, we partially self insure our workers compensation insurance and fully self insure our employee health insurance. Although our self insurance reserves have been determined with guidance from third party professionals, our reserves may be inadequate. Increasing employee health and workers compensation insurance costs and increasing self insurance reserves for labor related insurance may materially negatively affect our earnings. No assurance can be given that our labor costs will not increase or that any increase will be matched by corresponding increases in rates charged to residents. Any significant failure by us to control our labor costs or to pass on any increased labor costs to residents through rate increases could have a material adverse effect on our business, financial condition and results of operations.

Our business requires us to make significant capital expenditures to maintain and improve our facilities.

                Our communities sometimes require significant expenditures to address ongoing required maintenance and to make them attractive to residents.  Physical characteristics of senior living communities and rehabilitation hospitals are mandated by various governmental authorities; changes in these regulations may require us to make significant expenditures.  In addition, we often are required to make significant capital expenditures when we acquire new facilities.  Our available financial resources may be insufficient to fund these expenditures.  In addition to capital expenditures we are making at some of our senior living communities, we expect that we will need to make certain capital expenditures at the rehabilitation hospitals we recently began to operate, which could be significant.  Senior Housing has historically provided most of the capital we need to improve the properties we lease from them.  However, whenever Senior Housing provides such capital, our rent increases and we may be unable to pay the increased rent without experiencing losses.

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

                We compete with numerous other companies that provide senior living and rehabilitation hospital services, including home healthcare companies and other real estate based service providers. Historically, nursing homes and rehabilitation hospitals have been somewhat protected from competition by state laws requiring certificates of need to develop new communities; however, these barriers have been eliminated in many states. Also, there are fewer barriers to competition for home healthcare or for independent and assisted living services. Growth in the availability of nursing home alternatives, including assisted living communities, has had and may in the future have the effect of reducing the occupancy or profitability at nursing homes, including those we operate. Many of our existing competitors are larger and have greater financial resources than us. Some of our competitors are not for profit entities which have large endowments which allow them to operate without the financial pressures which we face.  We cannot provide any assurances that we will be able to attract a sufficient number of residents to our communities or that we will be able to attract employees and keep wages and other employee benefits, insurance costs and other operating expenses at levels which will allow us to compete successfully or to operate profitably.

We are subject to possible conflicts of interest; we have engaged in, and expect to continue to engage in, transactions with related parties.

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

·                  as of December 31, 2007, we leased from Senior Housing 142 of the 161 senior living communities that we operated and our two rehabilitation hospitals for total annual rent of approximately $118.3 million and $10.6 million, respectively;

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·                  Reit Management & Research LLC, or RMR, is the manager of Senior Housing, we purchase various management services from RMR and a subsidiary of RMR leases office space to us;

·                  our Chief Executive Officer, Evrett W. Benton, and our Chief Financial Officer, Bruce J. Mackey Jr., are also part-time employees of RMR, our managing directors, Barry M. Portnoy and Gerard M. Martin, are directors of RMR, Mr. Portnoy is a managing trustee of Senior Housing and Mr. Portnoy also is the majority beneficial owner and the chairman of RMR; and

·                  under our shared services agreement with RMR, in the event of a conflict between Senior Housing and us, RMR may act on behalf of Senior Housing rather than on our behalf.

                On December 31, 2001, Senior Housing distributed substantially all of its ownership of our shares to its shareholders. Simultaneously with the spin off, we entered into agreements with Senior Housing and RMR which, among other things, limit ownership of more than 9.8% of our voting shares, restrict our ability to take any action that could jeopardize the tax status of Senior Housing as a real estate investment trust and limit our ability to acquire real estate of types which are owned by Senior Housing or other real estate investment trusts managed by RMR. As a result of these agreements, our leases with Senior Housing and our shared services agreement with RMR, Senior Housing, RMR and their respective affiliates have significant roles in our business and we do not anticipate any changes to those roles in the future. We believe our affiliations with Senior Housing and RMR have been and will be beneficial to us.  Although we do not believe the potential conflicts have adversely affected, or will adversely affect, our business, not everyone may agree with our position.

The limitations on the ownership of our shares and other anti-takeover provisions in our governing documents and in our material agreements may prevent our shareholders from receiving a takeover premium for their shares.

                Our charter places restrictions on the ability of any person or group to acquire beneficial ownership of more than 9.8% (in number of shares or value, whichever is more restrictive) of any class of our equity securities. The terms of our leases with Senior Housing and our shared services agreement with RMR provide that our rights under these agreements may be cancelled by Senior Housing and RMR, respectively, upon the acquisition by any person or group of more than 9.8% of our voting stock, and upon other change in control events, as defined in those documents. If the breach of these ownership limitations causes a lease default, shareholders causing the default may become liable to us or to other shareholders for damages. Additionally, on March 10, 2004, we entered into a rights agreement whereby in the event a person or group of persons acquires or attempts to acquire 10% or more of our outstanding common shares, our shareholders, other than such person or group, will be entitled to purchase additional shares or other securities or property at a discount. These agreements and other provisions in our charter and bylaws may increase the difficulty of acquiring control of us by means of a tender offer, open market purchases, a proxy fight or otherwise, if the acquisition is not approved by our board of directors. Other provisions in our governing documents which may deter takeover proposals include the following:

·                  staggered terms for members of our board of directors;

·                  the power of our board of directors, without a shareholders’ vote, to authorize and issue additional shares and create classes of shares on terms that it determines;

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

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

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

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We may be unable to access the capital necessary to repay debts or to grow.

We are currently funding our operations and growth strategy through a combination of capital market offerings, cash generated from operations, cash on hand, expanded leases with Senior Housing and borrowings.  Our  business and growth strategies depend, in part, upon our ability to raise additional capital at reasonable cost to repay debts or fund new investments. This ability and cost, in turn, is subject to credit market volatility.   Recently there has been a tightening of liquidity in debt capital markets.  This tightening has had, and may have, at least two consequences to us:

·                  First, a part of our cash balances have been historically invested in auction rate securities, or ARS.  Historically we have had the option to liquidate these investments whenever the interest rate reset auctions close, usually every 35 days or less.  After successful auctions in January 2008, starting in February 2008 the scheduled interest rate reset auctions for these ARS have failed and through March 4, 2008 we have not had the option to liquidate our holdings for approximately $63.4 million of our ARS investments.  The securities we hold are highly rated and issued by entities which operate student loan programs pursuant to the Federal Family Education Loan Program.  As a result of these failed auctions, the interest we earn on these investments has increased. However, at this time we do not know when we may be able to sell these securities or the price at which they may be sold.  At this time, we continue to hold approximately an additional $11.5 million of similar ARS where reset auctions are scheduled to occur in the future, and we are unable to predict whether these auctions, or future auctions for the ARS where auctions have failed, will be successfully completed.

·                  Second, our outstanding debt securities are not rated by any generally recognized rating agencies.  If our debt obligations were rated we do not believe they would achieve investment grade ratings.  We believe that, during periods of tightened liquidity in debt capital markets, borrowings by unrated, or less than investment grade rated, companies like us may be difficult to obtain and increasingly expensive.  We do not expect the current market conditions to adversely affect our existing $40 million revolving credit facility which we renewed in June 2007.  However, if the current market conditions persist, we believe we may experience difficulty to renew this credit facility when it expires in 2009 and that our costs of any such renewal may be higher than the costs we incurred to put the current facility in effect and to borrow under it.  Also, so long as the current market conditions persist, we may be unable to increase our borrowings on terms which are similar to our historical terms or on any terms.

If we are unable to liquidate our holdings of ARS or to access additional borrowings on reasonable terms as a result of a long term continuation of the current debt capital market conditions or for other reasons, our business and financial results may be materially adversely affected.

RISKS RELATED TO OUR NOTES AND COMMON SHARES

The Notes we issued in October 2006, will be effectively subordinated to the debts of our subsidiaries and to our secured debt.

The Notes we issued in October 2006 are issued by our parent company and certain of our subsidiaries.  We are a holding company and conduct substantially all of our operations through subsidiaries. Consequently, our ability to pay debt service on the Notes will be dependent upon the cash flow of our subsidiaries and payments by those subsidiaries to us as dividends or otherwise. Our subsidiaries are separate legal entities and have their own liabilities. Payments due on our Notes are effectively subordinated to liabilities of our non-guarantor subsidiaries.  Certain of our subsidiaries guarantee our obligations under the Notes and those subsidiaries and additional subsidiaries guarantee our obligations under our revolving credit facility.  In addition, as of December 31, 2007, our non-guarantor subsidiaries had approximately $16.0 million of secured indebtedness outstanding, and may add additional secured indebtedness that would effectively rank senior to the outstanding Notes, and any new notes we may issue.  The Notes are unsecured and, as such, effectively subordinated to our secured debt.  In addition, non-guarantor subsidiaries have substantial additional obligations, including trade payables and lease obligations, to which the Notes are and will be effectively subordinated.

Our right to receive assets of any of our subsidiaries upon its liquidation or reorganization will be structurally subordinated to the claims of our subsidiaries’ creditors, except to the extent that we are recognized as a creditor of such subsidiary, in which case our claims would still be subordinated to any security interests in the assets of such subsidiaries

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and any indebtedness of our subsidiaries that is senior to that held by us. In the event of our insolvency, bankruptcy, liquidation, reorganization, dissolution or winding up, we and the subsidiaries that guarantee our outstanding Notes, or any new notes we may issue, may not have sufficient assets to pay amounts due on any or all such notes.

We may be required to prepay our debts at the option of Note holders or upon a change of control.

In certain change of control circumstances or if our common shares are no longer traded on a national securities exchange or on an established over the counter market in the United States, holders of our outstanding Notes may have the right to require us to purchase their Notes at their principal amount plus accrued interest.  Holders of these Notes also have the right to require us to purchase for cash all or a portion of their Notes on each of October 15, 2013, October 15, 2016 and October 15, 2021; however, we may not have sufficient financial resources at those times to pay the repurchase price and our then existing indebtedness could restrict or prohibit the repurchase.  Any notes we may issue in the future may have similar or even more onerous terms.

If we redeem the Notes before maturity, our Note holders may be unable to reinvest proceeds at the same or a higher rate.

We may redeem all or a portion of our outstanding Notes after a certain amount of time.  Generally, the redemption price will equal the principal amount being redeemed, plus any accrued and unpaid interest to, but excluding the redemption date.  If a redemption occurs, holders of these Notes may be unable to reinvest the money they receive in the redemption at a rate that is equal to or higher than the rate of return on the redeemed Notes.  Notes we may issue in the future may also permit redemption before maturity and create similar risks.

There may be no public market for our Notes.

Although our outstanding Notes are traded in the Private Offerings, Resale and Trading through Automated Linkages, or PORTAL, Market of the National Association of Securities Dealers, Inc., these Notes are not listed on any securities exchange.  We can provide no assurance that an active trading market for these Notes will exist in the future.  Also the limited liquidity of the trading market for our existing Notes, or any notes we may issue in the future, and the market price quoted for such notes may be adversely affected by changes in the overall market for fixed income securities, by changes in our financial performance or prospects, or by changes in the prospects for the senior living industry generally.

Increased leverage may harm our financial condition and results of operations.

Our total consolidated long term debt as of December 31, 2007 was approximately $142.3 million and represented approximately 62% of our total book capitalization as of that date.  In addition to our indebtedness, we have substantial lease and other obligations.  The indenture governing our outstanding Notes does not limit the amount of additional indebtedness, including senior or secured indebtedness, which we can create, incur, assume or guarantee, nor does the indenture limit the amount of indebtedness or other liabilities that our subsidiaries can create, incur, assume or guarantee.

Our level of indebtedness could have important consequences to our investors, because:

·                  it could affect our ability to satisfy our debt obligations;

·                  the portion of our cash flows from operations required to make interest and principal payments will not be available for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other purposes;

·                  it may impair our ability to obtain additional financing in the future;

·                  it may limit our flexibility in planning for, or reacting to, changes in our business and industry; and

·                  it may make us more vulnerable to downturns in our business, our industry or the economy in general than a company with less debt leverage.

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Conversion rights of our outstanding Notes may be detrimental to holders of our common shares.

Our outstanding Notes are convertible into our common shares in various circumstances.  The initial conversion rate (equivalent to an initial conversion price of $13.00 per common share) is subject to adjustment upon the occurrence of various events, including if we make dividends or distributions on our common shares.  If a holder elects to convert these Notes in connection with a “make whole fundamental change”, as defined in the indenture governing these Notes, that occurs on or prior to October 20, 2011, the conversion rate may be increased by a premium based on the market price of our common shares at the time.  Make whole fundamental changes include certain transactions constituting a change of control, our liquidation, dissolution or similar events.

The conversion of some or all of our outstanding Notes will dilute the ownership interests of our shareholders.  Any sales in the public market of the common shares issuable upon such conversion could adversely affect prevailing market prices of our common shares.  In addition, the existence of the outstanding convertible Notes may encourage short selling by market participants because the conversion of these Notes could depress the price of our common shares.  These conversion rights also may make more difficult or discourage a party from taking over our company and removing incumbent management and may discourage or impede transactions that might otherwise be in the interests of our common shareholders.  Any future issuance of convertible securities by us may create similar risks.

Future issuances of common shares and hedging activities may depress the trading price of our common shares.

We may issue equity securities in the future for a number of reasons, including to finance our operations and growth strategy, to adjust our ratio of debt to equity, to satisfy our obligations upon the exercise of outstanding warrants or options or for other reasons.  Any issuance of equity securities, including the issuance of shares upon conversion of our outstanding Notes as described above, could dilute the interests of our existing shareholders, and could substantially decrease the trading price of our common shares and of the Notes.  In addition, the price of our common shares could also be affected by possible sales of our common shares by investors who view our outstanding Notes as a more attractive means of equity participation in us and by hedging or arbitrage trading activity involving both our outstanding Notes and common shares.  This hedging or arbitrage could, in turn, lower the trading price of our outstanding Notes and of our common shares.

We do not intend to pay cash dividends on our common shares in the foreseeable future.

We have never declared or paid any cash dividends on our common shares, and we currently do not anticipate paying any cash dividends in the foreseeable future. Because we do not anticipate paying cash dividends, holders who convert our outstanding Notes into our common shares will not realize a return on their investment unless the trading price of our common shares appreciates.

The price of our common shares has fluctuated, and a number of factors may cause our common share price to decline.

The market price of our common shares has fluctuated and could fluctuate significantly in the future in response to various factors and events, including, but not limited to, the risks set out in this Annual Report, as well as:

·                  the liquidity of the market for our common shares;

·                  changes in our operating results;

·                  changes from analysts’ expectations; and

·                  general economic and industry trends and conditions.

In addition, the stock market in recent years has experienced broad price and volume fluctuations that often have been unrelated to the operating performance of particular companies.  These market fluctuations may also cause the market

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price of our common shares to decline.  Shareholders may be unable to resell our common shares at or above price at which they purchased our shares.

Item 1B.  Unresolved Staff Comments

                None

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Item 2.  Properties

OUR SENIOR LIVING COMMUNITIES

As of December 31, 2007, we operated 161 senior living communities which we have categorized into two groups as follows:

Independent and Assisted Living Communities

As of December 31, 2007, we operated 112 independent and assisted living communities.  We lease 95 of these communities from Senior Housing and four of these communities from Health Care Property Investors, or HCPI, and we own the remaining 13 communities.  These communities have 13,502 living units and are located in 24 states.  The following table provides additional information about these communities and their operations as of December 31, 2007:

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Skilled Nursing Communities

As of December 31, 2007, we operated 49 skilled nursing communities.  We lease 47 of these communities from Senior Housing and we own the other two communities.  These communities have 4,404 living units and are located in 11 states.  The following table provides additional information about these communities and their operations as of December 31, 2007:

OUR INPATIENT REHABILITATION HOSPITALS

As of December 31, 2007, we operated two inpatient rehabilitation hospitals that we lease from Senior Housing.  These hospitals are located in Massachusetts.  We commenced operations at these two hospitals on October 1, 2006.  These two hospitals have 321 beds available for inpatient services and provide services at three satellite locations.  In addition, these two hospitals operate 20 affiliated outpatient clinics.  The hospitals had revenues of $102.0 million in the year ended December 31, 2007 and occupancy was 63%.  During the year ended December 31, 2007 approximately 65% of the revenues at these hospitals came from the Medicare program, 4% came from the Medicaid program and the 31% balance came from health insurance companies or other sources.

OUR SENIOR HOUSING LEASES

We have six leases with Senior Housing.  Four of these leases are for 112 skilled nursing facilities and independent and assisted living communities that we operate, one of these leases is for the 30 communities previously managed by SLS that we now operate and one lease is for the two rehabilitation hospitals that we operate.  The following is a summary of the material terms of our leases.  Because it is a summary, it does not contain all of the information that may be important to you.  If you would like more information, you should read the leases which are among the exhibits listed in Item 15 of this Annual Report on Form 10-K and incorporated herein by reference.

The following table is a summary of our leases:

(1)                                  Three of these four leases exist to accommodate mortgage financings in effect at the time Senior Housing acquired the leased properties; we have agreed to combine all four of these leases into one lease when these mortgages are paid.

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Percentage rent. All of our senior living community leases with Senior Housing require us to pay additional rent equal to 4% of the amount by which gross revenues of the communities we operate exceed gross revenues in a base year.  Different base years apply to these communities, which is generally set at the first full calendar year after each community is leased.

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

Rent during renewal term.  Rent during each renewal term is the same as the minimum rent and percentage rent payable during the initial term.

Licenses.  Our leases require us to obtain, maintain and comply with all applicable permits and licenses necessary to operate the leased properties.

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

Assignment and subletting.  Senior Housing’s consent is generally required for any direct or indirect assignment or sublease of any of the properties.  Also, in the event of any assignment or subletting, we remain liable under the applicable lease.

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

·                  “all-risk” property insurance, in an amount equal to 100% of the full replacement cost of the properties;

·                  business interruption insurance;

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

·                  flood insurance, if any property is located in whole or in part in a flood plain;

·                  workers compensation insurance, if required by law; and

·                  such additional insurance as may be generally maintained by companies providing senior living services, including professional and general liability insurance.

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

Damage, destruction, condemnation and environmental matters.  If any of the leased properties is damaged by fire or other casualty or taken for a public use, we are generally obligated to rebuild unless the community cannot be restored. If the property cannot be restored, Senior Housing will generally receive all insurance or taking proceeds and we are liable to Senior Housing for the amount of any deductible or deficiency between the replacement cost and the insurance proceeds, and our rent will be adjusted pro rata.  We are also required to remove and dispose of any hazardous substance at the leased properties in compliance with all applicable environmental laws and regulations.

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

·                  our failure to pay rent or any money due under the lease when it is due;

·                  our failure to maintain the insurance required under such lease;

·                  any person or group acquiring ownership of 9.8% or more of our outstanding voting stock or any change in our control or sale of a material portion of our assets without Senior Housing’s consent;

·                  the occurrence of certain events with respect to our insolvency or dissolution;

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

·                  our being declared ineligible to receive reimbursement under Medicare or Medicaid programs for any of the leased properties which participate in such programs or the revocation of any material license required for our operations; and

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

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

·                  accelerate the rents;

·                  terminate the leases in whole or in part;

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

·                  make any payment or perform any act required to be performed by us under the leases; and

·                  rent the property and recover from us the difference between the amount of rent which would have been due under the lease and the rent received from the re-letting.

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

Management.  We may not enter into any new management agreement affecting any leased property without the prior written consent of Senior Housing.

Lease subordination.  Our leases may be subordinated to any mortgages on properties leased from Senior Housing.

Financing limitations; security.  Without Senior Housing’s consent we may not incur debt secured by our investments in our tenant subsidiaries. Further, our tenant subsidiaries are prohibited from incurring liabilities other than operating liabilities incurred in the ordinary course of business, liabilities secured by our accounts receivable or purchase money debt. We have pledged 100% of the equity interests of certain of our tenant subsidiaries to Senior Housing and to certain of its lenders, and we may pledge interests in our leases only if the pledge is approved by Senior Housing.

Non economic circumstances.  If we determine that continued operations of one or more properties is not economical, we may negotiate with Senior Housing to close or sell that community, including Senior Housing’s ownership in the property. In the event of such a sale, Senior Housing receives the net proceeds and our rent for the remaining properties in the affected lease is reduced according to formulas.

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Item 3.    Legal Proceedings

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

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

None.

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PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common shares are traded on the AMEX (symbol: FVE). The following table sets forth for the periods indicated the high and low sale prices for our common shares as reported by the AMEX:

The closing price of our common shares on the AMEX on March 4, 2008, was $6.90 per share.

As of March 4, 2008, there were 3,000 shareholders of record, and we estimate that as of such date there were in excess of 35,300 beneficial owners of our common shares.

We have not paid any dividends in the past and do not expect to pay dividends in the future.

We issued unregistered shares during the fourth quarter as follows: on November 19, 2007, pursuant to our stock option and stock incentive plan, we issued 111,300 shares of common stock, par value $0.01 per share, valued at $8.90 per share (the closing price of our common shares on the AMEX on that day) to certain employees and others who provide services to us.  We issued these grants pursuant to an exemption from registration contained in section 4(2) of the Securities Act of 1933, as amended.

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Item 6.    Selected Financial Data

The following table sets forth selected financial data for the periods and dates indicated.  Our comparative results are impacted by community acquisitions and dispositions during the periods shown.  This data should be read in conjunction with, and is qualified in its entirety by reference to, management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K.

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

GENERAL INDUSTRY TRENDS

The senior living industry is experiencing growth as a result of demographic factors.  According to census data, the population in the United States over age 75 is growing much faster than the general population.  A large number of independent and assisted living communities were built in the 1990s.  This development activity caused an excess supply of new, high priced communities.  Longer than projected fill up periods resulted in low occupancy, price discounting and financial distress for many independent and assisted living operators.  Development activity was significantly reduced in the early part of this decade.  We believe that the nationwide supply and demand for these types of facilities is about balanced today.  We believe that the aging of the U.S. population and the almost complete reliance of independent and assisted living services upon revenues from residents’ private resources should mean that these types of facilities can be profitably operated.  However, it appears to us that some investors may be assuming that the improvements in financial results realized at these types of communities during the past few years may continue indefinitely.  The reported sales prices being paid today for some independent and assisted living communities seem to exceed replacement cost, including fill up losses.  We are concerned that new development activity may occur in the near future, and it is currently unclear whether this activity will result in excess or moderate new supply which can be absorbed without adversely affecting existing market conditions in this industry.

The increasing availability of assisted living facilities in the 1990s caused occupancy at many nursing homes to decline.  This fact, together with restrictions on development of new nursing homes by most states, has caused nursing care to be delivered in many older facilities.  We believe that many nursing homes currently in operation are becoming physically obsolete and that eventually political pressures from an aging population will cause governmental authorities to permit increased new construction.

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Rehabilitation hospitals provide intensive medical services, including physical therapy, occupational therapy and speech language services beyond the capability customarily available in skilled nursing facilities.  We believe that if we are successful in our operation of our rehabilitation hospitals, our reputation in the rehabilitation business (including providing outpatient rehabilitation services) will be enhanced.  A reputation for providing high quality rehabilitation services may help create opportunities to acquire additional IRFs or to provide increasing amounts of rehabilitation services at our senior living communities.

Institutional pharmacies provide large quantities of drugs at locations where patients with recurring pharmacy requirements are concentrated.  The business rationale for an institutional pharmacy is to deliver drugs and pharmacy services more efficiently and at lower costs than from expensive retail locations which cater to short term requirements.  The aging of the population and recent pharmacological innovations have created rapidly growing demand for pharmacy drugs and services.  We believe the MPDIMA will also increase the demand for pharmacy products and services by Medicare beneficiaries but may reduce profitability, as the government implements various cost control procedures. We cannot predict the net impact of the MPDIMA at this time.

We earn our senior living revenue primarily by providing housing and services to our senior living residents.  During 2007, approximately 34% of our senior living revenues came from the Medicare and Medicaid programs and 66% of our senior living revenues came from residents’ private resources.  We bill all private pay residents in advance for the housing and services to be provided in the following month.

Our material expenses were:

·                  Wages and benefits – includes wages for our employees working at our senior living communities and wage related expenses such as health insurance, workers compensation insurance and other benefits.

·                  Other operating expenses – includes utilities, housekeeping, dietary, maintenance, marketing, insurance and community level administrative costs at our senior living communities.

·                  Hospital expenses – includes wages and benefits for our hospital based staff and other operating expenses related to our hospital business.

·                  Pharmacy expenses – includes the cost of drugs dispensed to our patients as well as wages and benefits for our pharmacies staff and other operating expenses related to our pharmacy business.

·                  Rent expense – we lease 142 of our 161 senior living communities and two rehabilitation hospitals from Senior Housing and four senior living communities from HCPI.

·                  General and administrative expenses – principally wage related costs for headquarters and regional staff supporting our communities, hospitals and pharmacies.

·                  Depreciation and amortization expense – we incur depreciation expense on buildings and furniture and equipment that we own, and we incur amortization expense on certain identifiable intangible assets related to our pharmacy acquisitions.

·                  Interest and other expenses – primarily includes interest on outstanding debt and amortization of deferred financing costs.

Our reportable segments consist of our senior living community business and our rehabilitation hospital business that we began to operate in October 2006.   In the senior living community segment, we operate independent living and congregate care communities, assisted living communities and nursing homes.  Our rehabilitation hospital segment provides inpatient health rehabilitation services at our two hospital locations and three satellite locations and outpatient health rehabilitation services at 20 outpatient clinics.  We did not report our rehabilitation hospital business as a separate segment in 2006 since we only began to operate these hospitals in October 2006.  We do not consider our pharmacy operations to be a significant, separately reportable segment of our business but we report our pharmacy revenues and expense as separate items within our corporate and other activities.  All of our operations and assets are located in the United States.

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We use segment operating profit as an important measure to evaluate our performance and for business decision making purposes.  Segment operating profit excludes interest and other income, interest expense and certain corporate expenses.

Year ended December 31, 2007 versus year ended December 31, 2006

The following tables present an overview comparison of our operations for the years ended December 31, 2007 and 2006:

Senior living communities:

Comparable Communities (communities that we operated continuously since January 1, 2006):

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Rehabilitation hospitals:

Corporate and Other (1):